Second leg of the Boston hedge fund triathlon

18 October 2007

After a couple of power bars and a shot of orange Gatorade, conference-goers wearily made their way back into the Boston-area plenary hall that yesterday was the scene of a grueling 10 hour hedge fund marathon.  On the agenda today: 130/30, risk, fund of hedge funds and commodities.

CAIA Association Executive Director Craig Asche fired the starter’s pistol at 7:32am by announcing the results from day one and introducing one of the titans of fixed income investing and 130/30 advocate, Morgan Stanley’s Marty Leibowitz.

One of league’s all-time leading point-getters

If Harry Markowitz is the Mick Jagger of finance, then Martin Leibowitz is the Wayne Gretzky - holder of many of hockey’s individual records.  Like Gretzky, Leibowitz is the holder of several league records including the most number of articles published in the Journal of Portfolio Management and the Financial Analysts Journal.  He has also won consecutive Graham & Dodd Awards for financial writing and was the first inductee into the Fixed Income Analysts’ Society Hall of Fame.  In his new book, “Capital Ideas Evolving”, Peter Bernstein dedicates an entire chapter to Leibowitz (see related posting) and Leibowitz, like Bernstein, has been the recipient of the CFA’s “Award for Professional Excellence”.

Leibowitz is the celebrated fixed income pioneer who spent the first 25 years of his career at Salomon Brothers, the next 10 years as the CIO of $300 billion pension giant TIAA-CREF and then joined Morgan Stanley in 2005.  Today, he delivered a flurry of complex charts and tables that have become the hallmark of his 40 year career.  But his message was clear: too much of the typical portfolio’s volatility comes from the market and not enough from manager skill (a.k.a. alpha, ”active risk”). (Amen)

Ergo, said Leibowitz, “130/30 is a particularly interesting way of seeking active risk”.  He had written extensively about 1X0/X0 in the past year and chose to expand on his most recent paper on the effect of short extension on the information ratio of a fund.  The bottom line was that there are diminishing returns to adding leverage to a 1X0/X0 fund (i.e. increasing “X”).  In other words, the first shorts (and the first additional longs) should provide the biggest bang for the buck. 

But while this bang for the buck gradually decreases as X rises, one should not stop adding leverage until the fund’s volatility bumps up against its maximum allowable limit.  High information ratios right out of the gate, warned Leibowitz, do not always mean high alphas if you’re not using all the risk-budget you’re allowed.  He added that most pension funds have a significant amount of “unused risk” headroom to exploit.

He also covered the sticky issue of whether a 1X0/X0 strategy actually remains “Beta 1″ when you add the shorts and new longs.  Leibowitz said that the 30/30 overlay portion of a 130/30 fund often has a variable beta - especially if the manager is a value investor who generally shuns such measures in favour of bottom-up stock-picking.  He did not see this as a huge issue as long as beta was always close to 1.

Risk and Band-aids, Cancers, Forest Fires, and Rear-view Mirrors

The pairing of Stanford’s Myron Scholes and Wharton’s Sandy Grossman on the same panel is always the source of great entertainment at this event. 

Scholes (whose hometown of Timmins, Ontario is misspelled on page 73 of Benoit Mandelbrot’s new book and also a little over 7 minutes into this American Finance Association video interview) refused to be forced into a corner by his friend and fellow academic.  Scholes was the mild-mannered counterbalance to Grossman’s colourful - yet likely accurate - dire economic predictions.  At times, the sparring resembled an animated after-dinner conversation between two friends over a glass of Port. 

Mark Anson, a member of the Editorial Board of the Journal of Alternative Investments and former CIO at the $8,000 gajillion California Public Employees Retirement System (CalPERS), waded in to the fray along with moderator Leslie Rahl, risk guru and Fannie Mae Board Member (a good career combination, we’d say).

Grossman argued that August’s liquidity shock was “just a stubbed toe, not a cancer” and that the Fed’s response amounted to a Band-aid.  He compared it to a run on a bank and said that as long as “assets remain higher than liabilities”, these situations could always repair themselves.

However, he warned the audience that if they wanted to see a real “disaster” in the next few years (defined as “something the Fed cannot fix” and where “assets fall below liabilities”) they need look no further than a potential major fall in the US dollar.  He said that the Fed would then be placed between a rock and a hard place, resulting in deflation, depreciation, higher rates and a general flight from US assets.  Said Grossman:

“The Fed didn’t create this problem and the Fed can’t undo it.  So you can’t count on the ‘Fed Put’ anymore….You ain’t seen nothing yet.”

It’s no wonder, as economist Grossman admitted, that people have begun referring to him using his profession’s traditional moniker - as the “dismal scientist”.

Scholes - apparently unfazed by the rampant misspelling of his hometown’s name - was more sanguine.  Unlike Grossman, he felt that liquidity shocks could indeed qualify as “disasters” in his mind.  So disasters are really nothing new.  He went on to draw the day’s biggest laughs when he admitted that the 1998 liquidity shock (a “stubbed toe” to Grossman) had actually been a “disaster” for him personally. 

When asked by Rahl whether the Fed’s “Band-aid” would be enough, Mark Anson recounted how Band-aids generally remain on his kids for only about 24 hours.  During that time, he simply hopes that the wound can heal itself enough to make the dressing unnecessary.  The big question, he said, is whether financial markets can heal themselves quickly enough or whether they will need to have the dressing changed several times.

A full-scale “metaphor-off” then broke out with Scholes drawing an analogy between Fed bail-outs of the economy and the forest fire risk in America’s Yellowstone National Park.  By putting out smaller fires over the years and thus preserving the underbrush, he said, the conditions in Yellowstone were now perfect for larger and more disasterous fires.  He pointed to Japan in 1990 as an example of one such mega “forest fire” that resulted from preventing small burns.   
  
Anson may have summed up the panel’s sense that we may be in uncharted territory when, in response to a question about ratings agencies, he made the general observation that “There is only so long you can drive looking out your rear-view mirror before you get hit head-on by a truck.”

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