One of the most overused words in hedge fund sales is “sophisticated.”  If we had a nickel for every time a hedge fund marketing sheet proclaimed that a fund was for “sophisticated investors,” we’d be running a hedge fund for, well, sophisticated investors.

But what exactly does it mean to be sophisticated?  This is a question addressed by Jan de Dreu of RBS and Jacob Bikker of De Nederlandsche Bank in a study of Dutch pension plans.  The duo bases its analysis on the fair assumption that “sophisticated” means “not succumbing to behavioural finance biases.”   While many studies have examined behavioural biases in individual in private investors, they write, “much less is known about professional parties.”

They focus their attention on three cues of (the lack of) sophistication:

• “Gross Investment Rounding” (i.e. choosing asset allocation percentages that end in 5% or 10%)
• “Lack of Diversification” (basically, the lack of idiosyncratic risk such as that found in alternative investments)
• “Home Bias” (the tendency to invest close to home, where opportunities are more familiar)

They also examine overall risk as a sign of sophistication, but purposely avoid overall returns since they are beyond the direct control of investment professionals.

Totally “Gross”

Institutional investors such as pension funds tend to use traditional “60/40″ or “70/30″ splits between equities and fixed income.  While the average numbers across all investors tend to shift slightly each year (see related post), many institutions stick stubbornly to simple proportions like these – ones that end in a zero or a five.

But modern portfolio theory dictates that optimal allocations to various asset classes can and should be dynamic and are rarely nice even numbers like these.  (Although, like a broken clock, we suppose that a “60/40″ allocation is correct on the odd occasion).

Consultants and hedge fund sales people know all too well the inertia they face when they argue that optimizers recommend that alternative asset allocations should comprise 40, 50 or even 100% of a client’s portfolio.  Instead of adopting the “optimal” solution, investment committees will often default to something more plausible – say, 10%.  In a sense, they are effectively adding a “career-risk” variable to the optimization.  (After all, idiosyncratic risk has a much greater influence over career than systematic risk).

When they examined nearly 750 Dutch pension funds, they found that the vast majority had policy allocations to equities that ended in multiples of five.  In fact, there even seemed to be a tendency for policy allocations to end in “0″, instead of “5″.

Rather than optimally dividing the remainder of the portfolio between bonds and other assets (alternatives, cash etc.), even the bond allocation percentages seemed pretty engineered…

You don’t need to be a finance Ph.D. to see that such allocations look pretty fishy – suggesting that they were created by humans, rather than portfolio optimizers.

But de Dreu and Bikker also point out something else in these charts: that there is very little agreement on the appropriate allocation to equities and bonds.  “60/40″ is by no means the standard allocation.

When they dove into these results further, they found that large (“sophisticated”) funds tended not to use multiples of 5% as much as their smaller counterparts. (chart below created using data in the paper)

One might expect that larger investors might have a lower propensity to use “gross rounding”.  But we were struck by the gradual increase in the gross rounding over time of the largest institutions.  Are they becoming less sophisticated?  And did the small and medium-sized institutions become more sophisticated between 2004 and 2006?

Who knows.  But here’s a theory:  After taking a bath in the equity market, small and medium-sized plans called in the consultants to conduct ALM studies…

Alternative Reality

Okay, so it’s a bit self-referential for us to argue that the use of alternative investments signals “sophistication” and then say that alternative investments tend to attract “sophisticated investors”.  But in any event, de Dreu and Bikker confirm the intuition that large investors tend to hold more alternative investments than small ones.  (chart below created with data from paper).

As you might also guess, funds that did not use gross rounding for policy allocations were twice as likely to use alternative investments.  (We wondered if this is because of greater sophistication or simply because the introduction of a third asset class – alternative investments – simply forces investment committees to tweak their existing gross roundings.)

Home Sweet Home

Finally, de Dreu and Bikker examine whether small or unsophisticated funds tend to invest a higher proportion of their portfolios in Europe.

As you might guess due to their relative lack of investment manpower, smaller funds do indeed invest more in Europe.  But the duo also finds that nearly half of funds that use gross rounding (allocations ending in multiples of 5%), invest in the EMU.  This compares to only about a third of funds that do not use gross rounding – suggesting that “sophisticated” pension funds tend to invest more outside of Europe that their less sophisticated brethren.

The paper includes several other notable observations about the behaviour of different types of and sizes of pension funds.  Assuming the Dutch aren’t all that different from the rest of us, these results should help explain a lot of the frustration faced by consultants and hedge fund sales people as they try to make the case for alternative investments.

By: Alexander Ineichen.

Once upon a time, not so long ago, there was a bear named Winnie-the-Bear who lived in the Trillion Acre Wood. On some level, he was a silly old bear. Nevertheless, he was wondering what the fuss about hedge funds was all about. He invited his two best friends, George Jones, the famous hedge fund manager, and Ben Put, the famous academic and central banker since the 1980s, to the Trillion Acre Wood for a third chat on hedge funds (Act 1, Act 2).

Winnie-the-Bear: Thanks again for joining me. Hedge funds were unduly demonized. I think I got that. But what really is a hedge fund?

Ben Put: Hedge funds are mysterious investment pools for well-heeled investors, who seek very high returns by taking very great risks. Hedge funds are run by sinister men who go around kicking dogs, taking candy from babies, and making massively leveraged bets in the equity markets.

More…

This month, we bring you Act II of Alexander Ineichen’s “Ineichen Dialogues” (Act I here)  In it, his three characters Winnie-the -Bear, George Jones and Ben Put discuss recent developments in the financial world with the kind of clarity your children will surely appreciate (pdf version).

By: Alexander Ineichen, CFA, CAIA

Once upon a time, not so long ago, there was a bear named Winnie-the-Bear who lived in the Trillion Acre Wood. On some level, he was a silly old bear. Nevertheless, he was wondering what the fuss about hedge funds was all about. He invited his two best friends, George Jones, the famous hedge fund manager, and Ben Put, the famous academic and central banker since the 1980s, to the Trillion Acre Wood for a further chat on hedge funds.

Winnie-the-Bear: Thanks for joining me again. With all the fuss about hedge funds they clearly are going to face tough regulatory headwinds going forward, no? I find the topic of hedge fund regulation difficult to grasp, actually quite weird, to be honest. I wonder; if ‘pro’ is the opposite of ‘con’ what is the opposite of ‘progress’?

George Jones: Yes, hedge fund regulation is weird. Regulators regulate banks. Banks screw up. There’s a run on the banks. Banks cut credit lines to hedge funds. Hedge funds pull the cash from the banks. System breaks. Politicians save the banks and then go on and blame hedge funds. If it weren’t so sad it would be comical.

Winnie-the-Bear: It seems to me that politics is the art of looking for trouble, finding it everywhere, diagnosing it incorrectly and applying the wrong remedies. I find hedge fund regulation in Europe is particularly weird. You know, putting hedge fund regulation on top of the agenda at a G8 summit in 2007 and then?after the banking system collapsed in 2008?carrying on emphasizing hedge fund regulation in 2009, seems odd.

Ben Put: It is odd. You would have thought that the political energy was better spent elsewhere, wouldn’t you? The reason is that financial regulation in Europe is conducted by a species from a different planet.

Winnie-the-Bear: Extraterrestrials? What, Martians, Klingons, Vogoons, the Borg?

Ben Put: No; the LaRasmussteinmontians.

Winnie-the-Bear: Why do the LaRasmussteinmontians feel the urge to regulate hedge funds?

Ben Put: Extraterrestrials go through mid-life too.

George Jones: Ben is pulling your leg Winnie. He’s a funny guy. Ben uses extraterrestrials as a placeholder for Continental European politicians.

Winnie-the-Bear: Why?

George Jones: Mainly because their lines of reasoning are – to him – so far off from common as well as economic sense that it is sometimes difficult to acknowledge that they inhibit the same planet as we do.

Winnie-the-Bear: I see. Politics is supposed to be the second oldest profession. I have come to realize that it bears a very close resemblance to the first.

George Jones: Napoleon was probably on to something when he said: In politics, stupidity is not a handicap. However, as fun as it is to lament about politicians, they might actually not be as daft as the intelligentsia regularly likes to portray them. Ideologically, Continental European politicians just have read different books than their Anglo-Saxon peers.

Ben Put: Don’t tell me you’re an Austrian?

Winnie-the-Bear: Vienna is said to be quite nice this time of the year.

George Jones: Ben is referring to the Austrian school of economics that argues for greater economic freedom, small government and the abolition of central banks. It was tried in the 1930s and failed miserably, wiping out nearly one third of the Western world’s GDP with a quarter of the labor force thrown onto the streets. Authorities and central banks are currently doing everything to prevent a repeat. They have succeeded; so far.

Winnie-the-Bear: Do Austrians blame central banks for the crisis?

George Jones: Yes, they do. They argue it is central bankers’ cheap money policies and emergency credit enhancing that fuelled the credit bubble. I’m glad that someone blames central bankers for the financial crisis; most other people blame hedge funds.

Winnie-the-Bear: Austrian economics sounds like 19th century laissez-faire to me.

George Jones: It is. However, the Austrians have some arguments speaking for them. One is that they hold that the complexity of human behavior makes mathematical modeling of the evolving market impossible. Second, they argue it is credit that matters, not money, when explaining business cycles. In other words, they can better explain bubbles and bursts. This is something the rational-man and efficient market theory disciples struggle with to this day, including our central banker friend. Thirdly, Austrians believe that the ever-evolving economic world is too complex, dynamic, and multi-faceted to be hampered with by political animals and bureaucrats. They also stress that economic failure is quite natural and healthy.

Winnie-the-Bear: Failure is painful. How can that be a good thing?

George Jones: All living species experience pain. It is the pain that tells you: stop doing what you’re doing and don’t do it again! It’s a primordial but very effective part of learning and elementary to progress.

Winnie-the-Bear: I think I can relate to this. Good judgment comes from experience, and often experience comes from bad judgment.

George Jones: Yes, I like to call it learning by doing. Economic failure allows weak hands to hand over their capital?or what is left of it?to strong hands.

Ben Put: The market fundamentalists say that the only thing we did right was allowing Lehman to fail. I hope you don’t agree; do you?

George Jones: I wouldn’t go as far as that. I do admit though that the market fundamentalist Austrians at least have a point. Failures should be allowed to collapse and be replaced by creative new forces rather than being propped up as zombies. Financial institutions have been failing for centuries and the world has survived.

Winnie-the-Bear: Is that true?

George Jones: Yes. On average we can track a financial crisis every 10 to 15 years back to the Middle Ages. The market fundamentalists argue that had the central bank allowed the failure of LTCM to run its course in 1998, Lehman, Bear Stearns, et al would still be here. Everyone would have lost so much capital that the madness of serial bubbles – dotcoms, housing, consumption etc. – would never have occurred. Consider the alternative had they propped up the bankrupt Lehman. There would be even more of the same insanity in our central banks and governments than we have now. The idea that a problem of too much debt and too much consumption can be solved by more gigantic debt and consumption is—again according to this line of thinking—ludicrous.

Winnie-the-Bear: Am not sure I get that.

George Jones: Ever been to the Yellowstone Park, Winnie?

Winnie-the-Bear: Sure. Love it.

George Jones: As you remember, the big fire from 1988 destroyed 1.5 million acres. Lightning sparks several hundred fires within the park every year. Most burn less than an acre, or maybe a few acres before dying out. As of 1988, even the largest fire ever recorded had burned only twenty-five thousand acres. So when a lightning bolt sparked a small fire near Yellowstone’s southern boundary in June of 1988, no one was unduly alarmed.

Winnie-the-Bear: Big events having small beginnings… We talked about this the last time.

George Jones: Exactly. What makes this case special is that the authorities from 1890 onward had a zero tolerance policy, even for forest fires sparked by natural causes. They intervened. One of the unintended effects of this intervention was that the forests began aging. Old trees were not replaced by younger trees. The natural evolution of the forest changed. The trouble is that fires are an indispensable component of the natural dynamics that keep forests in a more or less stable state.

Winnie-the-Bear: It doesn’t take too much imagination to apply this Yellowstone effect to the financial system, does it?

George Jones: No it doesn’t. By suppressing the natural dynamics of the forest, the authorities had driven the forests into an unstable state with a high density of burnable material everywhere. So the conclusion is that the forest is best left alone as it can take care of itself by regularly replacing the old and weak with the new and strong. The Austrians argue that the same is true for our economic systems. The intervention can be well intended. However, the long-term consequences could be much worse than non-intervention.

Winnie-the-Bear: A common mistake that people make when trying to design something completely foolproof is to underestimate the ingenuity of complete fools. Got that. What’s your view on central bank intervention in the 2008 financial crisis?

George Jones: Given the hand dealt to the central bankers I think they did well. They met head-on with the worst economic crisis since the Great Depression and did what central banks are supposed to do in that situation: they flooded the market with liquidity. Yes, there may be unknown long-term implications from these interventions, and yes in a perfectly free market and libertarian world it might have been better for the market to clear in the short-term. However, you need to survive the short-term to experience the long-term. The central banks made certain that the short term needs of the banking system were met, putting short-term necessities ahead of long-term niceties.

Ben Put: Thank you. What did you mean by the LaRasmussteinmontians having read different books?

George Jones: They’ve got something they call Ordnungspolitik.

Winnie-the-Bear: Uuh, sounds very strict. Sounds like more stick and less carrot.

Ben Put: Sounds more like a whip to me, rather than a stick, but never mind.

Winnie-the-Bear: Thank’s for the mental image, Ben.

George Jones: You can call it what you want, but yes, Continental Europeans are more interventionalist than Anglo-Saxons when dealing with economic affairs. Ordnungspolitik is influenced by the German school of economics.

Winnie-the-Bear: Another school? Please, can’t you people just merge the different schools and be done with it?

George Jones: The German historical school of economics held that history was the key source of knowledge about human actions and economic matters. The school rejected the universal validity of economic theorems. They saw economics as resulting from careful empirical and historical analysis instead of from logic and mathematics. The School also preferred the real world in terms of history, politics, and socio-economics, rather than abstract mathematical modeling in a model world.

Winnie-the-Bear: Boring!

George Jones: Most members of the school were concerned with social reform and improved conditions for the common man. They viewed government intervention in the economy as a positive and necessary force. The German school lead to the Freiburg School which builds on the political philosophy of Ordoliberalism.

Winnie-the-Bear: Thought there might be another school. This is really getting boring.

George Jones: I know. But bear with me. These ideas are experiencing quite a renaissance post the financial crisis. Ordoliberals are for competition and against extensive welfare as much as the next chap. However, it is the responsibility for human rights, moral conduct, and social norms and values that they suggest are better not left to the market place. One of its proponents, Wilhelm Röpke, sought to allow the maximum economic freedom and self-determination for each citizen. However, he also saw that the boundaries of this autonomy must exclude actions that weaken the social order and undermine the civic foundations of the market system.

Winnie-the-Bear: Why am I not familiar with these ideas?

George Jones: These ideas were written up in German mainly in the first half of the 20th Century and, as you can imagine, speaking German in the first half of the 20th Century didn’t exactly allow you to climb too high up the global popularity totem pole, did it? By the time these ideas had gotten translated into English, mainstream economics spent most of the time debating whether Keynesianism or Monetarism was the better idea.

Ben Put: This is only partially true George. We could argue …

Winnie-the-Bear: Boring! What’s the bottom line George?

George Jones: In a football tournament where different international teams compete you need an agreed set of rules, an event organizer as well as referees who understand the game and have both a yellow and a red card in their pocket. Then let the game commence with the football players playing the game, not the event organizers and referees.

Winnie-the-Bear: Got that. I heard that the inherent vice of capitalism is the unequal sharing of blessings; the inherent virtue of socialism is the equal sharing of miseries. Is that true?

Ben Put: Winston was spot on, Winnie! Capitalism has created the highest standard of living ever known on earth. The evidence is incontrovertible. Capitalism is based on entrepreneurialism, full stop. Entrepreneurialism works best when the sticky fingers are held off.

George Jones: Look who’s talking. Still carrying around an Ayn Rand photo in your wallet, Mr. Putoption?

Ben Put: There is a saying that socialists do not have children because if they did, they wouldn’t be socialists.

George Jones: There is no such saying. You just made this up.

Ben Put: Yes I did actually. However, someone could have said it before. It means that problems are not solved but band-aided and transferred in to the future for our children to solve. They know quite well that children cannot vote.

George Jones: Look who’s talking. Capitalism on the upside and socialism on the downside is indeed an interesting experiment. I’m not sure what will be the bigger surprise for our kids in adulthood when they learn that they share a common ancestor with monkeys or when they realize that they owe their parents and the world a lot of money. They might even suspect there is causality between the two.

Winnie-the-Bear: Reaping short-term profits while creating a long-term mess… Where did I hear that before?

George Jones: The funny thing is, Ben, socialists nowadays know too that free enterprise and competition are the only sustainable welfare-enhancers. Isn’t it interesting to observe how the capitalist nations are drifting to the left while the former socialists and communists are moving to the right as we speak? There is the possibility that the European ordoliberals actually do understand that hedge funds are an attractive business for an economy. After all, it creates ridiculously remunerated jobs which most people today agree is a good thing. They also realize the supportive role providers of risk capital and liquidity can play to the wheel-bearings of capital markets. In addition, if business moves from oversized banks to hedge funds, that’s another positive from a systemic risk point of view.

Winnie-the-Bear: Why’s that?

George Jones: The ‘too big to fail’ issue has not yet been solved. The hedge fund industry is very heterogeneous whereas banking is very homogeneous.  Business moving from big banks to the much smaller hedge funds and other much smaller financial firms creates a better balance which reduces the risk to the overall system. In addition, the not-too-big-to-fail institutions are not amused. Most of the not-too-big-to-fail fraternity operated diligently, survived the storm without governmental help and now face unfair competition from zombies on governmental life support.

Ben Put: I’ve never thought about it like that.

George Jones: I know. There are additional considerations. Continental Europeans aspire to get ‘their’ financial hub back. Today, the financial hub in Europe is London. However, at one stage Paris was the center for finance and trade and before that it was Amsterdam and before that it was Venice and so on. The way it works, Winnie, is that money and business goes where it wants to go. It goes where it is welcome, where it is not stigmatized or unduly taxed. It likes the presence of a rule of law and dislikes legal uncertainty and laws coming into force with retrospective effect. Winnie, when you build a dam across a streamlet, what happens after a while?

Winnie-the-Bear: The water flows beside the dam.

George Jones: Exactly. The same happens with capital. There is a natural flow. You can only control these flows intermittently. Capital – like water – seeks the way of least resistance. If London screws up, business will go to Switzerland. If the Swiss screw up, business will go to Singapore or wherever else it wants to go. The LaRasmussteinmontians know that too.

Ben Put: Doesn’t look like it. When they introduced the Euro some ten years ago, they also thought that Continental Europe could take market share away from London. It didn’t happen. London didn’t wobble. London even gained business due to business-unfriendly interventionalist behavior in the US. There is a saying that London is a great place to do business because of its regulation, and New York is a great place to do business despite its regulation.

Winnie-the-Bear: You made that up again?

George Jones: No, there actually was a saying along those lines a couple of years ago.  The saying feels dated though.

Winnie-the-Bear: So you think that the Europeans might be in the process of having another go at London?

George Jones: Yes. It could be that they envisage that the new normal is a tightly regulated market place.

Ben Put: The Italian PM will be wearing a chastity belt before that happens. One, Europeans cannot agree where the New London is supposed to be; Paris or Frankfurt. Brussels anyone? Second, it wasn’t a lack of regulation that helped cause this mess. It was a combination of anti-market regulation and the lack of supervision that caused this mess. Third, the suggested regulation comes in form of a hidden trade barrier. Local suppliers are favored while keeping foreign suppliers out. If hedge funds were cheese then the Continental European political will wants EU cheese-eaters to only consume EU cheese from EU cheese-makers using EU milk from EU cows fed in the EU munching EU grass.

Winnie-the-Bear: It’s impossible to rule a country that makes 250 kinds of cheese.

Ben Put: Yes. I must admit though, my analogy has its limitations. Europe has cheese. However, given that the Eurozone has no hedge fund industry to speak of, Continental Europe could continue to have exactly that: no hedge fund industry to speak of.

Winnie-the-Bear: Very funny, although it’s easy being a humorist when you’ve got the whole government working for you.

George Jones: I wouldn’t be so sure Ben. If there ever was a time for a more regulated market place, it is now. Governments around the world are – rightly or wrongly – taking power back from free markets, particularly financial markets, under the pretext that they have failed. Many investors are tired of a misbehaving financial sector and utterly disgusted by the Wall Street-Washington link. Trust needs to be rebuilt. The fear-and-greed gauge jumped to fear in 2008 and only gradually will move back the other way.

Winnie-the-Bear: But you think greed is good shall return? As in the past may not repeat itself, but it sure does rhyme?

George Jones: Yes, of course. Faster than anyone could have imagined only eight months ago it seems. Makes you wonder…

Winnie-the-Bear: Ben, you mentioned trade barriers. Wasn’t there a G20 meeting in London recently where all the leaders sang along to free trade?

Ben Put: Yes. That was rhetorical mastery, generally referred to as lip service. By not allowing the market to clear, many governments are effectively putting up trade barriers. Banks for example in Spain, Canada, Brazil and Australia did relatively well. Had the market cleared, banks from those countries could have been the strong hands that take the remaining capital off the weak hands. However, by saving the weak local banks, governments in those countries not only have created zombies but also kept foreigners out. Same for cars. So everyone who is intervening in the market place is indirectly putting up barriers for foreign capital.

Winnie-the-Bear: You’re not claiming that these countries had better regulation, are you?

Ben Put: They may or may not have had better regulation. What is undisputable from today’s perspective is that they had better implementation. They withheld the pressure from big business.

George Jones: In essence, Winnie, your Ronald Reagan quote on the second oldest profession from before was spot on.

***

Winnie-the-Bear: Thank you. Let’s move on. Let me ask you something I always wanted to know: are hedge fund managers really that smart?

George Jones: Depends on how you look at it. Who do you think is smarter, Albert Einstein or David Beckham?

Winnie-the-Bear: You can’t look good in knickers and be smart, so I’d say Albert Einstein. Wasn’t he the guy who invented the theory of reflexivity?

George Jones: It’s the theory of relativity, but never mind. The question is actually not as stupid as it initially sounds. We typically associate intelligence with IQ. We became accustomed to measuring the power of the human brain with the IQ test. However, when David scores through a free kick from miles away it is actually his brain that visualizes the situation, analyses the distances and movements of all elements, and orders the foot to hit the ball a certain way to give it the right curvature it typically has. Analysis, decision making, and execution are all done within the split of a second in David’s brain. We just do not measure that kind of brain activity with the IQ test. It is debatable whether it is easier to turn a good football player into a good physicist or a good physicist into a good football player.

Winnie-the-Bear: I know that the difference between genius and stupidity is that genius has limits but I’m not sure I know where you’re going with this.

George Jones: Don’t you think it’s fascinating how many intelligent and seemingly well educated people fail in life?

Winnie-the-Bear: Sort of. The trouble with the rat race is that even if you win, you’re still a rat.

George Jones: The reason is that intelligence, as in IQ test, only matters up to a certain point. From there other factors determine success. IQ is overrated.

Winnie-the-Bear: Why are you telling me this?

George Jones: You wanted to know whether hedge fund managers were smart. We need to be clear what exactly we mean with smart.

Ben Put: Hedge funds are a compensation scheme masquerading as an asset class. They’re not smart, they’re shrewd.

Winnie-the-Bear: That’s not nice Ben. Recently I saw an Ichneumon wasp lay her eggs in a live caterpillar after paralyzing it to provide fresh meat for the growing wasp larva feeding inside. The larva ate the internal organs in a judicious order, taking out the fat bodies and digestive organs first, leaving the vital heart and nervous system till last to keep the caterpillar alive as long as possible. Ben, you might not know this, but it’s a jungle out there. It ain’t all pretty. The weak are indeed sometimes eaten alive. Under competition you need to be shrewd like a fox just to survive. Although, that said, I’d say the shrewdness of the fox is often overrated because it is also credited with the stupidity of the chicken. Whether this analogy is applicable to investment management is, I guess, in the eye of the beholder.

George Jones: Shrewd has a somewhat negative connotation when you use it Ben. In investment management we often use terms such as savvy or street-smart to describe an attribute other than IQ or book-smartness.

Winnie-the-Bear: Now I remember. There are no secrets to investing that only some select priesthood knows. Successful investing requires a quality of temperament, not a high IQ. You need an IQ of 125, tops—anything more than that is wasted. But you do need a certain temperament, and must be able to think for yourself. Then constantly look for opportunities. You can learn every day. You can’t act every day, but you can learn every day.

George Jones: Absolutely. Commitment and high creativity are important contributing factors – next to opportunity and hard work – to success and are often unrelated to IQ or the number of books in your library. Let me test your imagination. Both of you write down what comes to your mind with using a blanket. You’ve got 30 seconds.

30 seconds later…

George Jones: Ben, what have you written?

Ben Put: Keeping warm, smothering fire, tying to trees as a hammock, improvised stretcher.

George Jones: Winnie, what have you written?

Winnie-the-Bear: To use on a bed. As a tent. To make smoke signals with. As a sail for a boat, cart or sled. As a substitute for a towel. As a target for shooting practice for short-sighted people. As a thing to catch people jumping out of burning buildings. As a cover for illicit sex in the woods…

George Jones: … Thank you, I think that’s enough. Ben, you probably have the highest IQ from all of us and potentially have the most extensive library at home, but you do not have what it takes to succeed as an investor. Winnie has. He has imagination. He’s got many ideas for using a blanket; he’s intellectually versatile. Winnie’s mind can leap from violent imagery to sex to people jumping out of buildings without missing a beat; your mind can’t.

Winnie-the-Bear: Imagination is more important than knowledge. Knowledge is limited.

George Jones: Exactly. Or as Will Rogers put it: There is nothing so stupid as the educated man if you get him off the thing he was educated in. Successful investors are savvy which is not measured by conventional means. Imagination and creativity are key determinants for success, not a high IQ; although it helps.

Winnie-the-Bear: You can’t do well in investments unless you think independently. And the truth is, you’re neither right nor wrong because people agree with you. You’re right because your facts and your reasoning are right. In the end that’s all that counts.

George Jones: Yes, as Ludwig Von Mises put it: Reason is the main resource of man in his struggle for survival.

Winnie-the-Bear: I think I understand. It is not enough to have a good mind. The main thing is to use it well. But smart people can overestimate their smartness, can’t they?

George Jones: Yes they can, it’s human nature. Overconfidence has to do with the belief that we are the smartest species on the planet. We’re not.

Ben Put: What?

George Jones: The dolphins are. As Douglas Adams put it: Man had always assumed that he was more intelligent than dolphins because he had achieved so much… the wheel, New York, wars, and so on, whilst all the dolphins had ever done was muck about in the water having a good time. But conversely the dolphins believed themselves to be more intelligent than man for precisely the same reasons.

Winnie-the-Bear: I think I know where you’re going with this. Rephrased you’re saying: Scholars in finance and consultants had always assumed that they were smarter than absolute return investors because they had achieved so much… benchmarks, tracking errors, performance attribution analysis, and so on, whilst all the absolute return investors had ever done was muck about making money and having a good time. But conversely the absolute return investors believed themselves to be smarter than scholars in finance and consultants for precisely the same reasons.

George Jones: Exactly. That pretty much sums it up.

Winnie-the-Bear: It is not clear that intelligence has any long-term survival value. You need to think on your own and be savvy too. I think I’ve got that. So it’s the most savvy who survive the storms, right?

George Jones: Let me ask you, was Ayrton Senna the best or worst racing driver of all times?

Winnie-the-Bear: The best, of course. He was a true champion. Why should he be considered as the worst?

George Jones: Because he drove into a concrete wall at 135 mph and died. Most other racing drivers don’t do that and go on and enjoy the groupies happily ever after.

Winnie-the-Bear: Am not sure I know where you’re going with this.

George Jones: Two points. First, we can argue he was the best because he achieved so much. But we can also argue he was the worst because he didn’t survive whereas most other racing drivers of his time did. As so often, it’s a matter of perspective. Second, we could argue that the reason he was the best was not because he was the most talented but because he took the most risk. All the years he might have been picking up Nickels in front of a steamroller. The more competitive and testosterone-prone an endeavor, the closer you need to go to the limit to win. As Mario Andretti put it: If everything is under control, you’re driving too slow.

Winnie-the-Bear: I think I understand. There’re old pilots and there’re bold pilots; but there’re no old bold pilots.

George Jones: Exactly. It doesn’t take too much imagination to apply this to the investment world, does it?

Winnie-the-Bear: No, it doesn’t. Let’s move on. I heard that some hedge funds are fraudulent. Is that true?

***

George Jones: Absolutely. When a tanned gentlemen drives his 1980s Corvette in front of a Florida retirement home, enters, tells the inhabitants that he runs a hedge fund, and then walks out with 100 million, then, yes, people typically go on an refer to this as a hedge fund fraud.

Ben Put: Isn’t hedge fund fraud more serious than that?

George Jones: Yes it is. However, if we were able to accurately aggregate all financial fraud conducted over the past 10, 20, 30, or 40 years and then measure the proportion of hedge funds, I’m quite certain we would find that the ‘market share’ of hedge funds is either smaller or much smaller than the market share of hedge funds on the overall financial industry would suggest. I wonder whether the Bonnie and Clyde of financial accounting – Fannie and Freddie – could confirm this.

Winnie-the-Bear: Why is hedge fund fraud small by comparison? After all, hedge funds are not as tightly regulated as other financial entities.

George Jones: That’s the point, they are not as tightly regulated. Regulation protects the investor – whatever that means – but not his money. History has shown that again and again and again. Regulation gives a false sense of security. When a business person walks into a hedge fund, he knows that he is on his own. He needs to be careful. He knows – as you put it Winnie – it’s a jungle out there. However, when a business person walks into, say, a big bank, up until quite recently, due diligence didn’t cross the business persons’ mind. This is wrong. A heavily regulated environment implies that someone else is responsible; it’s a disincentive to be diligent. Ever heard of the swimming pool effect Winnie?

Winnie-the-Bear: No, economics freaks me out.

George Jones: Many children drown in swimming pools every year. When a kid plays at the pool and there is one grownup watching, nothing happens normally. The reason is that the grownup knows that it is he or she who is responsible. However, there are various occasions where a kid had drowned while a number of grownups were at the pool. The reason for this is that when many grownups are around the pool, no one feels responsible. They all think someone else is taking care of the risks, that is, watching the kids. Regulation has the same effect. It encourages complacency. It encourages behavior where you believe someone else is responsible for the dangers, rather than yourself. Responsibility is the key issue. Hedge fund investors know that they’re alone. It keeps their senses alert. That’s a good thing.

Winnie-the-Bear: Am not sure I’m convinced; will need to think about this a bit. I still like your caveat emptor attitude but the world is clearly moving the other way. Wasn’t there a huge hedge fund fraud in 2008?

George Jones: There was a fraud by a guy called Arnie Awfullymad. He was caught and sentenced to 500 years in prison.

Winnie-the-Bear: Isn’t that rather harsh?

George Jones: Yes. Had he shot his investors instead of defrauding them, he would be a free man within ten years. The Awfullymad case is often portrayed as a hedge fund fraud but it wasn’t. The organization that was controlled by Arnie Awfullymad had the status of a broker/dealer, not a hedge fund. His company was regulated. The general and limited partners of hedge funds were the victims, not the fraudsters. Not only was the broker/dealer regulated, the regulatory authorities were warned over many years that there was something fishy.

Winnie-the-Bear: Sounds awfully mad to me. Where the regulators sleeping at the wheel?

George Jones: One could make an argument along those lines, yes. Elliot Spitzer recently put it as follows: Regulators get to the point of their incompetence and create the crisis because they fail to regulate, and then use the crisis as the argument for more power, and so now you have the Council of Regulators made up by the very same people who created the crisis in the first place.

Winnie-the-Bear: The regulators are all very nice people though.

George Jones: Yes, they are. That’s probably why it is typically them who run for public office. The bottom line is, Winnie, that the Awfullymad case was the greatest Ponzi scheme in the history of mankind and you do not detect these things with understaffed and underfunded bureaucratic entities that operate in a poorly organized regulatory framework. Regulation is a good thing in theory though.

Winnie-the-Bear: What’s a Ponzi scheme?

George Jones: The term is used for a scam that pays early investors returns from the investments of later investors. The scheme falls apart when more investors want their money than there are investors paying in.

Winnie-the-Bear: Where did he get the idea for such a scheme?

George Jones: Social security; functions on the same basis.

***

Winnie-the-Bear: So, George, how do we improve the system? It’s a complex problem.  This probably requires a complex solution, doesn’t it?

George Jones: Not necessarily. Do you know Alexander?

Winnie-the-Bear: Which one? The Swiss analyst or the Mesopotamian conqueror?

George Jones: I think it was the latter who, according to legend, solved a seemingly intractable problem in a rather unorthodox fashion while wintering in Gordium. A similar unorthodox act is required today.

Winnie-the-Bear: Must have been the latter. The former is a dreamer, a thinker, a speculative philosopher… or, as his wife would have it, an idiot.

Ben Put: So, George; how can we fix the system?

George Jones: The solution can be put in one word.

Winnie-the-Bear: In character, in manners, in style, in all things, the supreme excellence is simplicity. One word, I like that. What’s the word? Gimme the word.

George Jones: It starts with an “l”.

Winnie-the-Bear: Locusts, lunacy, liquidity, lost in space? Gimme the word.

George Jones: Leverage.

Winnie-the-Bear: The obvious is always least understood. Please elaborate.

George Jones: Money matters, but credit counts. Households, companies, governments cannot spend forever without balancing the budget once in a while. The ways we came to believe that a leverage of 20:1 or more is ok under certain circumstances is wrong…

Winnie-the-Bear: Because circumstances always change, right?

George Jones: Right. The theories and assumptions which allowed us to be comfortable with banks leverage at 20, 30, 40, 50, 60 or 70 are wrong. The theories and assumptions of households levering up 10:1 or higher are wrong. The theories and assumptions behind the current corporate governance practices which allows the agents to lever up and the principals having no clue are wrong. The theories and assumptions on which regulatory capital requirements are determined are wrong. Fix this, and we’re done.

Although, that said, the market is already taking care of this. The tectonic plates are moving. Throughout history, the center of the world has shifted to where the capital is, where the assets are. You don’t see any period in history where things are shifting to where the debt is. Those living off their social capital of their past need rebuild trust fast or die. It doesn’t happen often that a treasurer from a big debtor nation is laughed out of the room by students of a big creditor nation, but it does happen.

Winnie-the-Bear: So the debtors’ currency is going to continue to devalue.

George Jones: Of course. The belief in currency devaluation is based on the idea that a slow devaluation shall give way to increased employment opportunities.

However, I don’t think there ever has been a case in history where a country could devalue itself to prosperity.

Winnie-the-Bear: Hmm, why am I thinking of a tasty BBQ at a gaucho ranch in Patagonia?

… Well, never mind. With ‘we’re done’ you meant we’re done until the next financial crisis?

George Jones: Yes, of course. I wish all long-only investors good luck.

Winnie-the-Bear: Thought you might say that. The only thing we learn from history is that we learn nothing from history. What do you mean with the tectonic plates are moving?

George Jones: We have a tendency to focus on short-term volatility and thereby missing the bigger picture, that is, long-term change; trends that unfold slowly. In 1910, the market capitalization of Swiss stocks for example was smaller than that of UK stocks by the factor of 22.5 and smaller than Austria-Hungary by the factor of 3.8. By the end of 2008, Swiss market capitalization was still smaller than that of UK stocks. However, the factor was only 2.1, while Swiss market capitalization was 9.3 times the market cap of Austria and Hungary combined; both in currency neutralterms. Lacking the ambition to build an empire might be dull and might or might not rob its citizens of a sound sense of humor. However, failed empires are quite a prosperity killer.

Winnie-the-Bear: Dull is good. Wonder which empire is next in line to fail.

George Jones: Will Durant said that every form of government tends to perish by excess of its basic principle. Clement Attlee remarked that democracy means government by discussion, but it is only effective if you can stop people talking. Adding these two ideas might give you a hint Winnie.

Winnie-the-Bear: Got the hint. Civilizations die from suicide, not by murder.

Ben Put: George, you’re not suggesting banks should be split up, are you?

George Jones: Whatever it takes. It doesn’t matter that much how leverage is brought down. Many people find it rather odd that what used to be a bank a couple of decades ago, today is essentially a bank plus a hedge fund. A bank is supposed to raise money and lend it to sectors that need it. If you were to separate the bank bit from the hedge fund bit you would – in one go – make the system safer as well as more transparent. It’s the Gordian Knot…

Looks as if Messrs Glass and Steagall were on to something after all.

Winnie-the-Bear: Hold on. If a bank is a bank plus a hedge fund then subsidizing banks essentially means taking tax payers money and handing it over to hedge funds.

George Jones: Essentially, yes. The funny thing is that people think hedge funds charge high fees. However, hedge funds take 20% of the gross profits, do not take a performance cut when there is no performance, are not subsidized by the tax payer and do not participate on loss-recovery-profits. Too-big-to-fail banks on the other hand take roughly 60% of gross profits for their employees, pay bonuses irrespective whether there is a profit for shareholders or not, are subsidized by the tax payer and currently are only making a lot of money because the authorities manufactured, and are artificially maintaining, a positively sloped yield curve which incentivizes risk taking behavior and results in liquidity-driven asset inflation.

Ben Put: I’ve never thought about it like that.

George Jones: I know.

Winnie-the-Bear: But the banks are doing God’s work, George, are they not?

George Jones: That remark turned out to be a joke Winnie. Otherwise the sky would quite literally be the limit, wouldn’t it?

Winnie-the-Bear: A joke. Yes; am sure it was.

Ben Put: You’re too negative on banks George. After all it was no one other than René Descartes who said hundreds of years ago: I think, therefore I am entitled to a bonus.

George Jones: With the benefit of hindsight I believe it should be reasonably obvious to everyone that the bank-plus-hedge-fund combo isn’t necessarily the pinnacle of socio-economic wisdom. Ever been in Reykjavik Ben?

Ben Put: I think your line of thinking is too simplistic.

George Jones: This is a conversation between three fictional characters one of which is a talking bear. What did you expect?

Winnie-the-Bear: What about higher capital requirements for larger institutions and shouldn’t these large institutions be regulated internationally?

George Jones: Asymmetric capital requirements is certainly an idea worth thinking about as it addresses the negative externalities that are now obvious. International regulation is also a good idea in theory. Local regulation looks already challenging enough to me though…

Winnie-the-Bear: What about liquidity? Seems important too.

George Jones: Liquidity is a derivative of leverage. If your house is paid off, Winnie, you don’t care that much if prices wobble a little, do you? And if you call your financial advisor to inquire how much your assets are worth and he doesn’t pick up the phone because he’s currently standing on a chair throwing a lasso over the ceiling’s crossbar, you don’t care. You can wait.

Winnie-the-Bear: Hold on. What this means is that if banks and households were overleveraged – as they both had much more leverage than hedge funds – it was actually hedge funds that were the most sensible when dealing with leverage…

George Jones: Yes, funny isn’t it? Quite the opposite from public perception. Even at the peak in 2007, the entire hedge fund industry had less money under management than some of the banks that spiraled out of control. All the hedge fund losses in 2008 were smaller than all the other losses by a factor of between 100 and 150.

Winnie-the-Bear: Hedge funds as a beacon of humility? Well, well, I will need some time to digest that one…Whatever the case might be it certainly makes you wonder what all the fuss about hedge funds is all about. So why did hedge funds get smacked too?

George Jones: Bad luck. Unfortunate circumstances really. Their relationship with banks is symbiotic. It’s the industry’s Achilles’ heel. When banks went down it was difficult to entangle fast enough. The nightmare of any risk manager is not when markets fall but when markets fail.

Winnie-the-Bear: So one direct consequence of this crisis is that hedge funds will try to improve their financing and funding.

George Jones: Yes; it is in their best interest. It’s being done as we speak. However, hedge funds will remain part of the system. If the system fails the BritneyEffect applies.

Winnie-the-Bear: What’s the Britney Effect?

George Jones: It’s financial jargon for an effect that states if you think things cannot get any worse they actually can.

George and Ben had to run. Winnie thanked his friends for their patience and left some open questions for another day.

***

This article is a work of fiction and, except in the case of historical fact, any resemblance to actual persons, living or dead, is purely coincidental. Copyright © Alexander Ineichen 2009

Regular readers will recognize the name Alexander Ineichen from his book Asymmetric Returns (see related post) and from his several popular monographs on the “Search for Alpha”.  CAIA charter holders may also recognize his name from the bottom of their charter – he is a board member of the CAIA Association.

If you’ve read any of Ineichen’s work, you’ll know that he makes extensive use of literary, historical and cultural analogies.  He has just released the following short story about “Green Pigs” (an homage to “Black Swans”).

Try reading this one to your kids as a bedtime story tonight (download PDF version).  They’ll quickly know more about hedge funds and the credit crisis than the average investor.

A Green Pig Down Wall Street – Act I

By: Alexander Ineichen, CFA, CAIA

Once upon a time, not so long ago, there was a bear named Winnie-the-Bear who lived in the Trillion Acre Wood. On some level, he was a silly old bear. Nevertheless, he was wondering what the fuss about hedge funds was all about. He invited his two best friends, George Jones, the famous hedge fund manager, and Ben Put, the famous academic central banker, to the Trillion Acre Wood for a chat on hedge funds.

Winnie-the-Bear: Thank you for joining me for a new adventure. The financial crisis was a major disaster. Didn’t anyone see it coming?

George Jones: Very few did. The financial meltdown was a so-called Green Pig event.  These things are impossible or at least very difficult to predict.

Winnie-the-Bear: What’s a Green Pig event?

George Jones: It’s financial jargon for an event that is highly improbable to occur but has a major impact on everyone if it actually does occur. It’s from a famous book called The Green Pig – The improbable impact of the randomly fooled.

Winnie-the-Bear: Why call it green pig?

George Jones: All pigs are pink. But you can never be sure if all pigs are pink. If you thought all pigs are pink, the discovery of a green pig surely comes as quite a surprise, doesn’t it?

Ben Put: George is referring to the problem of induction which is the philosophical question of whether inductive reasoning leads to truth. As David Hume put it: No amount of observations of pink pigs can allow the inference that all pigs are pink, but the observation of a single green pig is sufficient to refute that conclusion.

George Jones: I’m sure that was helpful. I’ll give you an example Winnie: Approximately 65 million years ago an asteroid hit Earth and wiped out the dinosaurs. That asteroid was a Green Pig event. It doesn’t happen often and the impact was severe as it resulted in mass extinction. The dinosaurs were the masters of the universe of their time and didn’t see it coming.

Winnie-the-Bear: Dinosaurs, masters of the universe, Green Pig event, mass extinction, limited foresight… Sounds like investment banking.

George Jones: The parallel is striking, is it not? The analogy has its limitations though. The banks were saved, the dinosaurs not.

Winnie-the-Bear: Someone was talking to me about chaos theory in relation to the financial crises. They were referring to some sort of butterfly effect where the flatulence of a butterfly in Brazil can set off a Tornado in Texas. I’m not sure I got that right.

Ben Put: The butterfly effect refers to the notion of sensitive dependence on initial conditions, suggesting that small variations of the initial condition of a dynamic system may produce large variations in the long-term behavior of the system.

Winnie-the-Bear: George?

George Jones: What Ben is trying to say is that big events can have small beginnings.  These small beginnings can be as trivial as a butterfly’s food intolerance.  One small trivial event can cause another event to occur that would otherwise not have happened. This second event then causes a third event that would otherwise not have occurred, which then causes a forth, and so on. The initial event is too trivial to be predicted in advance.

Winnie-the-Bear: I understand. The big event in the end is caused by some sort of ripple effect.

George Jones: Exactly. The butterfly’s wind obviously is not the direct cause of something as powerful as a Tornado. It is the indirect cause of the Tornado. Think of the domino effect. The first domino stone to fall is and is not causing the last one to fall. The first stone does not touch the last stone directly but triggers a series of events “the ripple effect” that eventually causes the second last stone to bring down the last stone.

Ben Put: The system of dominoes is deterministic, not chaotic. The outcome is a combination of the first triggering action – a crepitating butterfly in your terminology Winnie -  and the configuration of the system.

Winnie-the-Bear: This is getting too complicated. Why don’t we just call the financial crisis an accident and be done with it? Accidents happen.

Ben Put: Accidents do not just happen. In complex systems, large accidents, though rare, are both inevitable and normal. These accidents are a characteristic of the system itself.

Winnie-the-Bear: George?

George Jones: What Ben is trying to say is that the coffeemaker or entertainment system of a commercial aircraft is not supposed to bring down the plane, but both have done so in the past. An airliner is a perfect example of what Ben calls a complex system: a large mass containing explosive fuel, flying at high speeds and operating along a fine boundary between stability and instability. Small forces can upset the system, causing a chain of events that results in the destructive release of the large amount of energy stored in the system. Interestingly, sometimes efforts to make those systems safer can make the systems more complex and therefore more prone to accidents. It does not take too much imagination to adapt this analogy to the world of finance, does it?

Winnie-the-Bear: No it doesn’t.

George Jones: Lord Bauer brought it to the point: A safe investment is an investment whose dangers are not at that moment apparent.

Winnie-the-Bear: Didn’t know Jack Bauer got knighted; thought he was a fictional character. But then, why am I not surprised?

George Jones: It’s Peter Thomas Bauer as in economic adviser to Margaret Thatcher.  It’s a good quote. Just because you believe all pigs are pink doesn’t really mean that you won’t?one day?discover that they are not.

Winnie-the-Bear: Got that. Not to be absolutely certain is, I think, one of the essential things in rationality. I think we can even go further by arguing that the only constant is change, continuing change, inevitable change, that is the dominant factor in society today.

George Jones: Absolutely. We can take it even further; in the end all things fail: strategies, empires, species, monetary systems, solar systems, life, the universe, etc. A long period of no accidents can lead to a false sense of safety, complacency and an underestimation of risk. Things just always can go wrong. I’d say Murphy’s Law applies: If people are allowed to screw up, they eventually will.

Ben Put: This is referred to in Minsky’s Financial Instability Hypothesis: Financial systems swing between robustness and fragility and these swings are an integral part of the process. Minsky claimed that in prosperous times, when corporate cash flow rises beyond what is needed to pay off debt, a speculative euphoria develops, and soon thereafter debts exceed what borrowers can pay off from their incoming revenues, which in turn produces a financial crisis. As a result of such speculative borrowing bubbles, banks and lenders tighten credit availability, even to companies that can afford loans, and the economy subsequently contracts.

Winnie-the-Bear: George?

George Jones: What Ben is trying to say is what all mariners have known for generations: a calm sea is nothing else than a storm in the making. Be careful out there. Even Minsky’s ponzi finance works as long as asset prices are rising. But once the bubble is pricked, the system destabilizes like a storm at sea releasing its pent-up energy all at once just to calm down thereafter for the energy of the next storm to build up slowly.

Winnie-the-Bear: So you’re saying that the seeds for the next meltdown are planted as we speak?

George Jones: Of course. Given that the implicit governmental guarantee for systemically important institutions is now an explicit one, the whole show really starts here.

Winnie-the-Bear: Oh my! Sounds like we’re in for a rocky ride. Are you in the deflation or inflation camp?

George Jones: I’m in the Minsky camp. Minsky postulated that a world with a large financial sector and an excessive emphasis on the production of investment goods creates instability both in terms of output and prices.  We should not see inflation and deflation as opposite scenarios. We could be in for a period of extreme price instability, in both directions, as the authorities slowly lose control of the situation; or don’t.

Winnie-the-Bear: We’d better be prepared for the ongoing volatility then. In your view, was 2008 an accident or a systems’ failure?

George Jones: Both. Let me explain. If you slip on a banana skin and hurt yourself, it’s an accident, agree?

Winnie-the-Bear: Agree. I think I know where you’re going with this. Had I foreseen the accident, it would not have occurred, right? Personally, I think everybody who predicts the future with a straight face should be required to change out of the business suit, wrap himself in a gypsy shawl, wear one of those pointed wizard’s hats with a picture of a crescent moon on it, and make conjuring sounds over a crystal ball. That way, everybody would know exactly what’s going on and how much credibility to give it.

George Jones: Yes; as Bill Gates made clear in 1981: 640K ought to be enough for anybody. An accident is unpredictable by definition. In a complex system things are just a little bit more complicated…

Winnie-the-Bear: That’s probably why it’s called a complex system…

George Jones: Right. Research of accidents in complex man-made systems has shown that they are triggered not by one trivial banana skin but by about five to seven banana skins in a certain sequence. So there is a chaotic as well as a deterministic element. This is true with airliners, nuclear power plants, as well as with financial systems. In a letter to the Queen the Bank of England called the near collapse of the  financial system a failure of the collective imagination of many bright people.

Winnie-the-Bear: Many bright people; yes, of course. Never in the history of mankind have so many owed so much to so few. So what were these five to seven banana skins?

George Jones: The first banana skin was the US president endorsing housing to people who couldn’t afford housing.

Winnie-the-Bear: Was that before or after he endorsed Enron?

George Jones: Second, cheap money caused risk premiums to fall and leverage to rise in various markets. Central bankers are very nice people. Every time there is a fire somewhere in the financial system they come along and extinguish it. Third, banks found a way to sell sub-prime hamburgers for prime beef.

Winnie-the-Bear: So let’s blame the bankers then? After all there is a saying that states: Fool me once, shame on you. Fool me twice, shame on Wall Street.

George Jones: Why blame the sellers and not the buyers? It was the buyers who confused the hamburgers and thought they had fillet. Shouldn’t foolishness be punished? Shouldn’t markets serve as the ultimate teacher?  Isn’t learning by doing the best education? As Warren Buffet put it: A pin lies in wait for every bubble. And when the two eventually meet, a new wave of investors learns some very old lessons: First, many in Wall Street – a community in which quality control is not prized – will sell investors anything they will buy. Second, speculation is most dangerous when it looks easiest.

Ben Put: You are taking this too lightly.

George Jones: No, I’m not. Every buyer thinks he’s getting a good deal at the time of purchase, otherwise he wouldn’t buy. No one was ever forced to buy subprime hamburgers. If you drink ten espressos per day over ten years and expect to look like George Clooney, it’s not the coffee manufacturers’ fault if you find yourself walking home alone when the bar closes.

Winnie-the-Bear: I understand. You live and learn. At any rate, you live.

George Jones: Banks – by the way Winnie – were and are the most heavily regulated industry on the planet. You might as well blame bank regulation. A couple of years ago there was the joke that the traders occupied the large trading floor and the compliance officers occupy the small corner office and that soon the two would switch offices. It stopped being a joke.

Winnie-the-Bear: George, I sense that you have a tendency to blame the people who are responsible. I think I like that. Makes sense, doesn’t it?

George Jones: Yes; and thanks. In the case of banks, you could also blame the shareholders. It is them who provide the capital and select their agents.  German banker Carl Fürstenberg was probably on to something some hundred years ago when he said: Share holders are impertinent and stupid – stupid because they trust other people with their money without having sufficient control; impertinent because they want dividends, that is, they also want to be rewarded for their stupidity.

Winnie-the-Bear: Very funny. Life is a tragedy for those who feel, but a comedy to those who think. I too believe you cannot deal with the most serious things in the world unless you understand the most amusing. Let’s move on. So far we’ve got three banana skins.

George Jones: The fourth banana skin were the rating agencies.

Winnie-the-Bear: The jokes keep coming. They too are regulated, right?

George Jones: Yes, of course. They gave the false filet a stamp of approval. The president endorsing retail folks to lever up and rating agencies having a weird business model by itself and in isolation are rather trivial and don’t result in disaster. It is the combination…

Winnie-the-Bear: I think I’ve got that now. Butterfly rips the canvas and history takes its course. Please move on.

George Jones: Banana skin number five was the belief that house prices in the US cannot fall.

Winnie-the-Bear: Am not all too surprised. There can be few fields of human endeavor in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present. Beliefs can be quite powerful, can’t they?

George Jones: Yes. Different people have different beliefs. Some people believe man walked with dinosaurs, some don’t; some people believe markets are efficient, some don’t; some people believe they’re Elvis, some don’t; some people believe the Italian PM is groping nubile young wenches, some … well, never mind.  Banana skin number six is an increase in complexity. The people who had the responsibility didn’t understand what was going on. We forgot Peter Lynch’s wisdom: Never invest in an idea you can’t illustrate with a crayon.

Winnie-the-Bear: The farther one goes; the less one knows.

George Jones: I always knew there is a philosopher in you. This brings me to a related point. Prior to the idea of diversification taking over investment mantra on Wall Street in the 1960s, the wisdom of the time was actually portfolio concentration rather than diversification. The belief was to hold assets in which you had conviction or some special insight, some sort of edge.

Ben Put: You’re not suggesting we’re going back to managing money like in the 1950s, are you?

Winnie-the-Bear: I think I know where George is going with this: You will go most safely by the middle way.

George Jones: Exactly. Combine the two ideas. An investor who invests in hedge funds needs to diversify; even Ardi knew that. However, the hedge fund itself is normally very focused on one particular area of the market place and operates in a lean and entrepreneurial fashion rather than in a bureaucratic and committee-based fashion. Next to being good at marketing, many hedge funds have a high degree of specialization or, ideally, some sort of competitive advantage?their edge?in the market place. So a hedge fund portfolio incorporates both ideas. You have conservative risk mitigation on one end but you still have the entrepreneurial drive and focus that generates the returns on the other end.

Winnie-the-Bear: Well, I will need to think about this a bit. The sixth banana skin was complexity. I’ve got a T-shirt that says Simplicity is the ultimate sophistication. I thought that was obvious to everyone.

Ben Put: This goes by the name of critical state universality. Critical state universality dictates that the vast majority of details normally integral to our ideas about a system’s activity become irrelevant once the critical state is achieved. That is to say we can legitimately ignore many of the things that are ordinarily considered important and still understand the situation well enough to exert some control. In fact, we have to do this or else risk being confused and misled by excess information.

Winnie-the-Bear: George?

George Jones: What Ben is trying to say is that if someone weighed somewhere between 300-350 pounds, you wouldn’t need precision – you would know they were fat.

Winnie-the-Bear: Got that. Banana skin number seven?

George Jones: A run on the shadow banking system.

Winnie-the-Bear: What’s a shadow banking system? Sounds shady. Sounds like someone hiding something.

Ben Put: The shadow banking system consists of non-bank financial institutions that play a critical role in lending companies the money necessary to operate. Shadow banking institutions are typically intermediaries between investors and borrowers. By definition, shadow institutions do not accept deposits like a depository bank and therefore are not subject to the same regulations.

Winnie-the-Bear: George?

George Jones: The basic idea is to move risky assets that would require large amounts of regulatory capital off balance sheet so the risky assets that would require large amounts of regulatory capital do not require large amounts of regulatory capital.

Winnie-the-Bear: Sounds wrong. Is this being fixed?

George Jones: Not really. You do not accumulate political capital by fixing things. You accumulate political capital by talking about bonuses.

Winnie-the-Bear: Or by demonizing hedge funds. Any fool can criticize, condemn and complain – and most fools do. I think I understand. Any more banana skins? We’ve got seven.

George Jones: I think we’re done. Although of course we could go on. Some blame the dramatic transformation of markets due to deregulation as a major cause for the mess. The belief in the efficiency of markets was – as it turned out – too strong. Some argue that it was investment banks changing from personal liable entities to corporations with limited liability and hence an incentive to increase leverage. Some blame the oligopolistic nature of banking as part of the problem. Some thought it was rather weird that the ladies and gentlemen in Basel allowed banks to come up with their own risk models when determining risk for setting aside regulatory capital as well as ignoring the systemic risk from concentration of securities more or less in its entirety. The issue of contagion and herding due to the Basel accords will require some rethinking to say the least. Some argue it was the lack of congressional oversight due to the influence of campaign contributions in the US. Some blame derivatives like credit default swaps for the crisis. There certainly seems to have been some sort of regulatory gap.

Winnie-the-Bear: I heard derivatives are weapons of mass deception … Like hell, they are easy to enter and almost impossible to exit.

Ben Put: Derivatives are just tools. The tools do no harm by themselves. Take a chainsaw as an example. A chainsaw is a tool that allows you to cut trees much more efficiently than the next best alternative. However, if someone slices up his mother-in-law using a chainsaw, it is hardly the fault of the chainsaw, is it?

Winnie-the-Bear: Obviously not. I know where you’re going with this. It’s the use of the tool, not the tool itself that can cause harm. So it’s the son-in-laws’ fault?

George Jones: Well, some would argue it’s the mother-in-laws’ fault…

Ben Put: Whatever the case might be, the responsibility doesn’t rest with the chainsaw. If someone is determined to blow up a bank out of Singapore, he will do it with or without derivatives. Derivatives just allow you to blow up a bank out of Singapore more efficiently.

Winnie-the-Bear: Isn’t it the size of these markets which is the major concern?

George Jones: You’re trivializing the risks of derivatives to the system Ben. You address the complexity and the hidden leverage but not the huge off balance sheet characteristics that are the major risk to the overall system.  Market participants may ignore these systemic risks, believing they can always sell their positions, but regulators cannot ignore them because if too many participants are on the same side, positions cannot be liquidated without causing a discontinuity or a collapse. You wouldn’t want fans of the death metal band Obituary – all of whom are chainsaw experts, I’m sure – turning up for a concert all equipped with chainsaws, would you?

Ben Put: Fair enough. It is the misuse that is harmful to the single entity but it is the size and off-balance sheet risk which is the big issue for the system as a whole.

Winnie-the-Bear: Didn’t hedge funds contribute to the mess of 2008? I was told that hedge funds operate with tons of leverage including derivatives. Is that true?

George Jones: Yes, they do. Prior to the crisis, average leverage was, say, three times equity.

Winnie-the-Bear: Holy Moly. Three times? That’s horrendous.

George Jones: Pretty cheeky, isn’t it? Although in their defense, two thirds typically had leverage of two to one or less. That’s prior to the mess of 2008.

Winnie-the-Bear: How can they sleep at night? I find even two times a lot. Long-only managers use none. I sense that I am missing something. Why is leverage important?

George Jones: Leverage relative to equity is a measure for how bad things will get if you screw up. If you buy a house for say one million and your equity is 200,000 then you, as a private person, are more highly leveraged then about 90-95% of all hedge funds.

Winnie-the-Bear: What?

George Jones: Yes, many people don’t realize this. If your house loses 20% of its value or more, you have a problem. Banks use leverage of 20, 30, 40, or 50 times their equity….

Winnie-the-Bear: What?

George Jones: One German bank actually has a balance sheet leverage that is 70 times their equity as we speak.

Winnie-the-Bear: And I thought hedge funds were risky. Do people know this? I mean, do people know that banks are highly leveraged and hedge funds look vestal by comparison?

George Jones: No. Well, now they do. Derek Bok once said…

Winnie-the-Bear: Derek Bok?as in the lady coming out of the water in 10…

George Jones: No, Derek Bok, as in the former president of Harvard University, but thanks for the mental image… Where was I? Yes, he said, self-servingly and tongue firmly in cheek I’m sure: If you think education is expensive, try ignorance.

Winnie-the-Bear: Making a fuss about hedge fund leverage while accepting much higher leverage with banks seems a little odd from today’s perspective, I must say. Given what you’re saying, I’d rephrase your quote to: If you think hedge funds are risky, try banks.

George Jones: Well-deployed financial leverage can greatly enhance performance.  Nearly every corporation and every homeowner uses it in forms of loans, mortgages and so on. However, excessive leverage can be ruinous. What now seems apparent is that it is banks and home owners that misjudged the dangers of using leverage: not hedge funds. It is not leverage by itself that is dangerous; it is excess leverage that is dangerous to the entity using the leverage as well as the overall system. Bottom line is that drinking a glass of claret in the evening is good for you while downing a double magnum is not.

Winnie-the-Bear: What about fund of hedge funds? I hear they don’t use leverage. Aren’t they pretty dull?

***

George Jones: Yes, pretty dull. However, that’s a good thing. As I’m sure Gordon Gekko will state in his new film: Dull is good. There is potentially a link between tediousness and prosperity that is often overlooked. Survival is a prerequisite for long-term prosperity and it’s typically the dull who survive. Take the Swiss as an example.

Winnie-the-Bear: You mean the yodeling, lederhosen-wearing, holey-cheese eating inhabitants of the Alps?

Ben Put: I think I know where you’re going with this. As Orson Welles’s Harry Lime famously noted in the 1949 film The Third Man, Italy under Borgias had 30 years of warfare, terror, murder and bloodshed, but produced Michelangelo, Leonardo da Vinci and the Renaissance. Switzerland, in contrast, had 500 years of brotherly love, democracy and peace. And what did that produce? The cuckoo clock.

George Jones: They are perceived as rather dull, I know. It’s because the Swiss stayed out of the big wars, had no battlefield victories and glorious generals to speak of, never had colonies, had no social upheavals. They never had a left-of-center governmental majority screwing up their economy in their entire history and they don’t even strike. They have produced hardly any people of world fame; no poets, no composers, no philosophers, no writers or painters of international acclaim; except perhaps a pedagogue, a psychiatrist, and a tennis player.

Winnie-the-Bear: Don’t forget the lady coming out of the water in Dr. No…

George Jones: Yes, of course. Thanks for the mental image… Where was I? Yes, the Swiss. While they might or might not be perceived as dull, Switzerland is arguably one of the, if not the most prosperous country on the planet, especially if you add quality-of-life factors on top of GDP per capita.

Winnie-the-Bear: Not sure I know where you’re going with this.

George Jones: The point is that large losses kill the rate at which capital compounds. Hence, boring is good; or as Oscar Wilde put it: It is better to have a permanent income than to be fascinating.

Winnie-the-Bear: I think I can relate to that. I’m more concerned about the return of my money than with the return on my money.

George Jones: Exactly. As one famous hedge fund manager put it: If investing is entertaining, if you’re having fun, you’re probably not making any money. Good investing is boring. Compounding capital tediously – as in dull – with no major interruptions results in long-term prosperity.

Winnie-the-Bear: I know. Compound interest is the eighth natural wonder of the world and the most powerful thing I have ever encountered.

George Jones: That’s essentially what fund of hedge funds try to do.

Winnie-the-Bear: What? Being dull?

George Jones: No, compound capital continuously without major interruptions. It was the investment biker who hit the proverbial nail on its proverbial head: The trick in investing is not to lose money. That’s the most important thing. If you compound your money at 9 percent a year, you’re better off than investors whose results jump up and down, who have some great years and horrible losses in others. The losses will kill you. They ruin your compounding rate, and compounding is the magic of investing.

Ben Put: Didn’t work in 2008, did it?

George Jones: No, it didn’t. However, had you invested 100 with the average fund of hedge fund at the beginning of the decade you would stand at 143 by August 2009 net of all fees. Had you invested 100 in US stocks your wealth would be at 70.

Winnie-the-Bear: Hold on. That’s a big difference. A gentleman from Wharton keeps telling me that stocks go up in the long-term.

George Jones: Fascinating, isn’t it? The problem is you might not live long enough to experience the long-term. The Nikkei would need to compound at more than ten percent per year for the next fifty years to pick up a four percent equity risk premium for the seventy year period to 2059.

Winnie-the-Bear: Got that. Forever is composed of nows. Surviving the short-term is a prerequisite for experiencing the long-term.

George Jones: By the way, for believing that stocks always go up in the long-term you need to ignore history more or less in its entirety. Societies, currencies, and equity markets have collapsed in the past and will continue to do so. Ever been to Germany, Japan, China, Russia, Portugal, Egypt, Argentina, or Zimbabwe? There might be hundreds of reasons why a long-only strategy works in the long-term. I just can’t think of one reasonable one.

Winnie-the-Bear: I think I now understand where you’re going with this. It ain’t what you don’t know that gets you in trouble. It’s what you know for sure that just ain’t so.

George Jones: Couldn’t have articulated it better myself. And this is why dull is good and the Swiss are prosperous. The stock market is exciting. It is very exciting to lose half of your investments not once within a decade but twice. Very exciting. Quite thrilling, really.

Winnie-the-Bear: The difficulty lies, not in the new ideas, but in escaping the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds.

George Jones: These are wise words, Winnie. Who said that?

Winnie-the-Bear: I just did. Stay focused please. So dull is good. Given what you just said I’m tempted to argue that the first rule of investment is don’t lose. And the second rule of investment is not to forget the first rule. What about the industry as a whole? Is it going to survive? It’s hardly dull.

***

George Jones: The hedge fund industry has survived many storms and is currently recovering from the 2008 tsunami to be prepared for the next one. It is not entirely random as to who survives in stressful situations or hostile environments and who does not. In mountaineering, it is not the best climbers who survive an accident but those who are best prepared and have no mismatch between perceived risk and true risk. Chance, as nearly everywhere else in the universe and human affairs, also plays a role.  Louis Pasteur’s statement, chance favors only the prepared mind, seems to hold true when survival in extreme sports is concerned. Or, as Benjamin Franklin put it: By failing to prepare, you are preparing to fail.

Winnie-the-Bear: I understand. The key is not to predict the future, but to be prepared for it.

George Jones: Absolutely. It also holds true for hedge funds. Active risk managers can get into dire straits. They can also either fail or endure, but those who have an edge in aligning true risk with perceived risk may improve their chances of survival.

Winnie-the-Bear: You’re saying doing well under stress is key?

George Jones: Yes. Stress is inevitable with any competitive environment…

Ben Put: Stress releases cortisol into the blood. It invades the hippocampus and interferes with its work. Stress causes most people to focus narrowly on the thing that they consider most important, and it may be the wrong thing. Under stress, emotion takes over from the thinking part of the brain, the neocortex, to affect an instinctive set of responses necessary for survival. This has been referred to as the hostile takeover of consciousness by emotion.

Winnie-the-Bear: George?

George Jones: What Ben is trying to say is that under stress what matters is not the number of books you have in your library but who you are. As Aldous Huxley put it: Experience is not what happens to a man; it is what a man does with what happens to him. Emotions rule. Emotions are genetic survival mechanisms, but they do not always work for the benefit of the individual. They work across a large number of trials to keep the species alive. The individual may live or die, but over a few million years, more mammals lived than died by letting emotion take over, and so emotion was selected as a stress response for survival.

Winnie-the-Bear: So you’re saying that education is an admirable thing, but it is well to remember from time to time that nothing that is worth knowing can be taught.

George Jones: From time to time, yes. As one famous hedge fund manager put it: Nothing is constant. Nothing is the way it’s always been. So what I find is that people who are really good at this (managing risk), have great intuition. They have great instinct. Their gut actually tells them something. The mathematics are important because they demonstrate you understand the problem, but ultimately the decision about whether or not to take a given risk, I think is really a human judgment call in every sense of the word.

Winnie-the-Bear: How should I behave in a stressful situation? Any tips?

George Jones: Crack a joke.

Winnie-the-Bear: What?

George Jones: Humor allows you to cope with fear. It is not a lack of fear that separates elite performers from the rest of us. They are afraid too, but they are not consumed by it. They manage fear…

Winnie-the-Bear: … as in to conquer fear is the beginning of wisdom.

George Jones: Yes. They use it to focus on taking correct action. Moods are contagious, and the emotional states involved with smiling, humor, and laughter are among the most contagious of all. Whether hedge fund investors share a laugh when their portfolio is under water, I do not know. According to this research, they should.

Winnie-the-Bear: If humor is the best approach when dealing with fear and stress, what is the worst?

George Jones: Hubris.

Winnie-the-Bear: I think I know that. The greatest deception men suffer is from their own opinions.

George Jones: Absolutely. That’s why conviction mentioned earlier is a double-edged sword. Here’s a true story. It’s about a US Army Ranger, arguably someone well trained for survival in hostile environments, who took a guided commercial rafting trip, fell off the boat and drowned in shallow water. The Ranger refused being rescued. He floated calmly downstream.  He felt he was in no real danger because of all the training he had had under much worse conditions. Then he arrived at a place where a big rock blocked the middle of the current. He was sucked under, pinned, and drowned. The official report said, the guest clearly did not take the situation seriously.

Winnie-the-Bear: How sad is that. Nothing in all the world is more dangerous than sincere ignorance and conscientious stupidity.

George Jones: The take-away of this story is twofold. First, elite training can cause overconfidence or an underestimation of risk. In the case of the ArmyRanger, this was clearly the case. Other examples include mountain climbers who climbed in the Himalayas yet died at their local beginners’ mountain that they thought they knew well. Second, experience is a good thing. However, most professionals with experience know that they have experience. This inflates confidence. This self-confidence is probably beneficial when the experience applies to the current environment.

However, experience can turn into ignorance when circumstances change and the experience does not apply anymore. Changing environments can cause a mismatch between true risk and perceived risk and impact one’s abilities to deal with it.

Winnie-the-Bear: I think I understand. You advocate being open-minded and intellectually flexible. Single-mindedness is all very well in cows or baboons; in an animal claiming to belong to the same species as Shakespeare it is simply disgraceful. A crisis is by definition a different environment. Different skills apply. I think the whole problem with the world is that fools and fanatics are always so certain of themselves, but wiser people so full of doubts.

George Jones: Exactly; or as Galbraith put it: One of the greatest pieces of economic wisdom is to know what you do not know. However, survivors are not always loved. Take cockroaches for example…

Winnie-the-Bear: I thought the going term for hedge funds was locusts.

Ben Put: I’d say cockroaches would be more appropriate: they’re a nuisance and there’s never just one of them…

Winnie-the-Bear: That’s not very nice of you to say. But then, words ought to be a little wild, for they are the assault of thoughts on the unthinking.

George Jones: Everyone dislikes cockroaches. This means that there is probably something quite remarkable to say about them. And there is. The cockroach is the oldest insect on our planet. It has been around for at least 325 million years. It can eat almost anything, can live 45 days without food, has a great defense system and an effective reproductive system.

Winnie-the-Bear: I think I know where you’re going with this: Hedge funds have been around for decades, can nourish on nearly any inefficiency, can live off the management fee for a while, and can move rapidly to a defensive stance through hedging and cutting losses short. As to their reproductive system, I assume …

George Jones: …it’s beyond the scope of this series, yes.

***

Winnie-the-Bear: So hedge funds are unpopular. I guess it is dangerous to be right in matters on which the established authorities are wrong. Do high fees contribute to hedge funds’ unpopularity?

George Jones: Could be. Douglas Adams comes to mind: Many men of course became extremely rich, but this was perfectly natural and nothing to be ashamed of because no one was really poor, at least no one worth speaking of.

Winnie-the-Bear: Doesn’t make them more popular, does it?

George Jones: No, it doesn’t.

Winnie-the-Bear: How can they get away with such high fees?

George Jones: The reason fees in traditional asset management are lower is because you, as an investor, do not really need external help to compound capital negatively, do you? Long-only managers in equities lost roughly 50% of their assets not once but twice this decade. Managing money relative to a benchmark is not the same as managing money where safety of principal is part of the value proposition. That’s why some people refer to the traditional asset management industry as fun management instead of fund management: It must be fun to manage other people’s money and not being held accountable for losing it.

Winnie-the-Bear: Finance is the art of passing currency from hand to hand until it finally disappears. Makes you wonder, doesn’t it? But in 2009 the stock market is up 22% while hedge funds are only up 20%. They’ve underperformed.

George Jones: Who cares? In 2008 the stock market fell by 45%. This means investors starting at 100 went to 55 and the 22% in 2009 only brought them back to 67. Hedge fund investors on the other hand lost 20% in 2008; they therefore went from 100 to 80 and the 20% in 2009 brought them back to 96. Going from 100 to 67 with other people’s money isn’t that difficult and therefore doesn’t carry a high price tag.

Winnie-the-Bear: Hold on. Hedge fund investors only went from 100 to 80 and back to 96 if they didn’t redeem at 80.

George Jones: Yes, of course. The math works differently if you buy high and sell low.

George and Ben had to run. Winnie thanked his friends for their patience and left some open questions for another day.

This article is a work of fiction and, except in the case of historical fact, any resemblance to actual persons, living or dead, is purely coincidental. Copyright © Alexander Ineichen 2009

BOSTON – One of the themes discussed by alternative investment industry bigwigs at this week’s Global Absolute Return Congress in Boston was the future of the funds of funds sector.  One of the sessions on the agenda was called “Funds of funds are dead.  Long live funds of funds.”

That turned out to be quite a prescient title.  HFR released its Q3 run-down of asset flows into and out of the hedge fund industry.  The firm found that…

“Investors continued to withdraw assets from funds of hedge funds during 3Q, but at a reduced rate. Fund of fund redemptions totaled only $3.2 billion in 3Q, compared to a cumulative withdrawal of more than $180 billion in the previous four quarters. In contrast to single-manager strategies, over 73 percent of all fund of funds experienced net outflows for the quarter.”

This seems to suggest that, in this post Madoff environment, funds of funds are only just dying more slowly than before – but that they are dying nonetheless.  In fact, Dow Jones ran a story on Wednesday titled “Investors favour direct route to hedge funds’ doors” in which it referenced investors’ “growing predilection for placing their cash directly with managers.”

But wait!  Research firm Brightonhouse Associates found that Q3 marked a turning point and suggests that funds of funds may live a long and happy life after all.  That company’s Q3 analysis finds that,

“2009 has proved to be the year of the bounce-back for the fund of funds industry. In the third quarter, both managers and investors expressed high levels of optimism and confidence in funds of funds. This was reflected in the HFRI Fund of Funds Composite Index, which showed fund of fund performance increased 1.13 percent in the month of August, and 8.03 percent year to date. Additionally, during the quarter, BHA analysts spoke with more than 140 investors that voiced an interest in hearing from funds of funds for research and due diligence purposes. This number represents nearly a 20 percent increase over the first quarter when many investors were much more skeptical of funds of funds across the board.”

So there you go.  Funds of funds are dead.  Long live funds of funds!

Time to move out?

While we’re on the topic of Boston…

Although we aren’t allowed to report on the specific proceedings of the Global ARC, there were several sessions involving other news makers in attendance.  For example, The New York Times ran this front page article on Paul Volker the day he addressed the gathering here in Beantown.

The Times reports that Volker…

“…wants the nation’s banks to be prohibited from owning and trading risky securities, the very practice that got the biggest ones into deep trouble in 2008. And the administration is saying no, it will not separate commercial banking from investment operations.”

In general, the audience here seemed somewhat sanguine about the possibility of some kind of Glass-Steagel II – choosing instead to focus on the immediate investment opportunities before them.  In fact, the audience made up of hedge fund managers, institutional investors and “quants” from both groups actually applauded when Volker called on universities to produce more civil engineers and less financial engineers.

A remarkable show of unity between investors and managers?  Perhaps.  But what surprised us a little more was the apparent common ground shared by the hedge fund community and left-of-center thought leaders such as Joe Stiglitz, Paul Volker, and Niall Ferguson – none of whom minced words when it came to their opinions on the causes of (and solutions to) the financial crisis.  One hedge fund manager summed it up Volker’s commentary as “holding up a mirror to the industry.”

Koo and the Gang

Richard Koo, author and Chief Economist of the Nomura Research Institute in Japan has the ears of various leaders around the world.  He has become the spokesman for a school of thought that believes deficit spending is critical in a “balance sheet recession” like the one we’re in right now.  Drawing on the Japanese experience during the “lost decade”, he argued that inflation should not be a concern since government debt is just filling the gap left behind by suddenly-thrifty US consumers.  He warned the audience not to assume that the US is continuing it’s spendthrift ways.  In fact, he noted, the US savings rate is now higher than Japan’s.

Regular readers will remember his remarks at Global ARC in San Francisco in the spring when he said that debt must migrate from private balance sheets to public ones since only governments have the ability to avoid the paradox of thrift.

Teach a Man to Fish…

One of the most popular sessions here was probably one that compared biological processes to financial ones.  One of the speakers, Andrew Haldane, Executive Director of Financial Stability delivered a fascinating speech earlier this year on the topic of systemic risk.  Some have called it one of the best speeches ever written on the topic.  In the text of that speech, Haldane draws on natural science and diseases for lessons on how to contain financial contagion.

Two of the other panelists, Lord Robert May of Oxford and George Sugihara of the University of California, co-wrote this article in Nature called “Complex systems: Ecology for bankers” (with Simon Levine of Princeton).  In it, they discussed the credit crisis in the following terms:

“An analogous situation exists within fisheries management. For the past half-century, investments in fisheries science have focused on management on a species-by-species basis (analogous to single-firm risk analysis). Especially with collapses of some major fisheries, however, this approach is giving way to the view that such models may be fundamentally incomplete, and that the wider ecosystem and environmental context (by analogy, the full banking and market system) are required for informed decision-making. It is an example of a trend in many areas of applied science acknowledging the need for a larger-system perspective.”

BOSTON – We’re in Boston this week co-chairing another edition of the strictly no-media Global Absolute Return Congress.  Each year this event seems to be growing in importance to the pension, endowment and hedge fund communities.  This year’s sold-out event program features Paul Volker, Myron Scholes, Joseph Stiglitz, Henry Kissinger, Pervez Musharraf (yes, that Pervez Musharraf), Niall Ferguson and other leading thinkers from the convergence of the financial and geopolitical spheres.  It’s no surprise this event is becoming known as “The Davos of hedge fund conferences.”

Six months ago, the bi-annual San Francisco edition of this event focused on the green shoots popping up in the economy in general and in the hedge fund industry in particular.  Now participants seem to be looking beyond these shoots and are now focusing more attention on the condition of the scorched financial ecosystem from which these shoots are sprouting.

In many ways, this ecosystem analogy took on a very literal form.  The kick-off session on Monday morning featured a zoologist, a marine biologist, a central banker and a risk manager from a sovereign wealth fund.   If you think the current travails of the financial system are unique, check out the state of fisheries management in the 1970’s, the spread of diseases such as HIV in the 1980’s, or the sudden desertification of the Sahara Desert over 5,000 years ago.

The theme of network dynamics weaved its way through most of today’s panels and presentations, culminating in wide-ranging conversation with Nobel Laureate Joseph Stiglitz.

Although the event is sold out, the Boston Chapter of the The CAIA Association is a partner in the event and is hosting a reception for conference attendees and for Boston-area CAIA Association members on Tuesday evening.  So if you’re a CAIA charter holder or candidate, you’re invited to the Hyatt Regency at 5:45pm Tuesday to share your thoughts on green shoots and the financial ecosystem.

By: Andrew Saunders, AllAboutAlpha.com Editorial Board.

This summer, Man Investments, one of the world’s largest alpha hunters announced a strategic reorganization of its hedge fund investment business. Long associated with systematic trading – AHL was launched way back in 1987 – Man has built a significant fund of funds (FoF) business, with the acquisition of Glenwood investments in 2000 and RMF Investment in 2002 making it one of the largest global investors in hedge funds through FoFs, seed investment and managed accounts.

Earlier this year, Man announced the consolidation of these well-known FOF franchises into one business, Man Investments. Spearheading the transition is John Rowsell, Managing Director who has leadership responsibilities over all business functions. We sought out John to see what drove the reorganization, his views on how a hedge fund investment business should be structured in this new era as well as gather his views on the managed account phenomenon where Man has been an early leader.

John has experience as both an allocator and manager. In the past, he served as CEO of Glenwood, Chief Investment Officer of Man Glenwood, Chairman of the Investment and Management Committees and also managed an internal hedge fund at McKinsey & Company.

Q1: Man Investments recently announced a strategic reorganization. Explain the strategic rationale for consolidating your investment businesses?

Man announced the creation of an integrated fund of fund business in March. The key strategic drivers behind this move are twofold: restructuring to ensure we maintain an obsessive focus on delivering long-term performance to investors; and ensuring that the business evolves to meet changing investor requirements.

Over the years we grew separate fund-of-fund businesses with unique competitive advantages: RMF’s systematic investment process; Glenwood’s bottom-up manager selection philosophy, and Man’s seeding and managed accounts. Structurally it was time to consolidate these processes and support them with Man’s capital, operational and technological infrastructure.

Over the past 12 months it has become clear that our investors are demanding enhanced transparency, institutional quality governance, flexible investment solutions and strong controls over invested assets. Creating an integrated business allows us to apply the full institutional scale and rigor of our global investment management franchise to solving our clients’ problems..

Q2: Under the new structure, you will have management responsibility over the integrated businesses including all business, operational and risk functions. What do you see as your biggest challenges and opportunities?

The lessons of 2008 have accelerated investor interest in managed account investments. The transparency, better liquidity management and control of assets that come from managed accounts have attracted a lot of attention. Some strategies are not appropriate for managed account investments in our view and transparency is only helpful if you have the systems, knowledge and expertise in place. Man has been investing through managed accounts for more than 12 years and is currently working to increase its assets invested through managed accounts (currently about $6 billion) in partnership with underlying managers. Keeping on the leading edge of risk management is essential here. This requires a huge investment of capital and expertise. There are tremendous benefits in having scale to help clients understand the risks and solve complicated investment problems.

Q3: How would you rate the investment opportunities over the next 6-12 months?

There has been a lot written lately about the potential shape of any economic recovery. While market conditions have visibly improved since Q1, we still feel that the risks of a severe dislocation, illiquidity and market failure remain. We have also seen over the course of the year that asset classes have become highly correlated, largely due to the ‘risk on/ risk off’ pattern that has occurred due to shifts in investor sentiment. As a result, we believe there is a high level of uncertainty surrounding the medium-term directional outlook and are therefore cautious about our levels of directional exposure at present. For this reason we are currently favoring liquid and fast-moving managers for the exposures we do take on.

We do however believe that this period of uncertainty and transition has provided strong risk/ return opportunities in other areas. One area is the existence of relative mis-pricing of related assets in global markets, which we believe can be exploited at an intra-capital structure, inter-company, inter-sector and inter-regional level. Practically this translates at present into: Equities, with a relatively low overall net exposure with a bias towards quality and dispersion; Credit, with a significant net long exposure within the limits of underlying liquidity; and Macro, with significant exposures to global macro and CTAs

Q4: Man Investments is a recognized leader in managed accounts, which have attracted considerable attention and popularity over the last 12 months. What key issues should managers and investors be aware of when establishing these structures?

Before considering a managed account solution, investors need to clearly understand their objectives and requirements. Risk management, portfolio construction, strategy exposure and operational control are all important dynamics. Understanding the infrastructure and expertise required to structure, manage and monitor the investment are also essential.

There are three main types of managed accounts solutions in the marketplace against which investors should evaluate their needs:  Direct access managed account platforms providing enhanced risk and operational monitoring but in a co-mingled structure giving little or no investor control; Customized, investor-driven managed accounts which provide large institutional investors with full control and segregated assets but which require significant expertise to manage; and Portfolio management driven managed accounts (as typified by the FoF model which allocates across many funds) where the investor sets up a “platform” of managed accounts and co-mingle their portfolios within the platform.

These accounts provide enhanced risk monitoring and full operational control but also require the expertise, resources and experience to set up, monitor and maintain a platform across a diversified set of strategies, styles and managers.

Whereas hedge fund investors need to be clear on the place for managed accounts in their portfolio, managers also need to understand the needs of their investors, evaluate the impact of each solution to their business and implement a solution which is scalable and meets the long term needs of their business. It’s important to keep in mind that running multiple managed account investments can be burdensome for hedge fund managers. Investors with a long track record of investing through managed account investments have a strong competitive advantage in this regard.

Q5: What is your view on the dynamic regulatory environments in the UK, Europe and the US. How are you staying on top of the developments?

From an investment standpoint one of the biggest surprises of the past year was the extent and willingness of Government to intervene in the economy. From global restrictions on short selling to government backstops, bank guarantees, private sector equity injections and the de-facto takeover of the GSEs – Fannie Mae and Freddie Mac – the scale of government intervention was unprecedented. From an investor’s standpoint, this intervention has been one of the most significant factors impacting investment returns and market/ price volatility.

Whilst it was notable that many of the regulatory reviews regarding the financial crisis have agreed that hedge funds were not the authors of the crisis, we are nonetheless in a world where regulation of all financial market participants is being looked at afresh. New initiatives run from the G20 Global Plan for Recovery and Reform, through the US Treasury Framework on Financial Regulatory Reform and review of markets, to the European Union’s draft Directive on Alternative Investment Fund Managers and the UK Turner Review. These proposals cover a wide range of market participants and activities, from executive remuneration to the capitalization of banks to the regulation of investment managers. We believe that the influx of new regulation will be capable of being addressed best by “institutional quality” managers, those with existing experience of operating in regulated environments around the globe, and with the resources to assess and address the changes as they are proposed and implemented.

In addition to being regulated by the UK FSA, Man is regulated in 16 different regions by 21 separate regulatory bodies. This insight and experience is an asset to the investment process and our advice to clients.

Q6: Is the market becoming better informed on the risk/return profile of hedge fund investment strategies?

Apart from managed futures strategies, there is little doubt that hedge funds delivered disappointing returns in 2008. That hedge funds outperformed equities by a wide margin and were a victim rather than a cause of the credit crisis offers little solace. Perhaps even more so than performance, liquidity – or a lack of it – has taken center stage. Some managers took unpopular measures such as gating, side-pocketing or suspending redemptions altogether. In many cases this was justified by market developments and was in the best interests of investors. Nonetheless these events cast a spotlight on some factors that we believe investors really need to pay attention to. These include the capital position, governance arrangements and infrastructure/ expertise of your provider, the level of transparency and liquidity within your portfolio and the degree of asset control you maintain.

To us investing and education go hand-in hand – it is very much a partnership-based approach. While we provide our clients with the benefits of our investment strategy and views, hedge fund and market commentaries and outlooks, we prefer to think about ‘education’ as more of a two-way street. Our approach is to work with clients to develop customized portfolios at the individual manager and strategy levels – through this process we learn a tremendous amount about our clients’ needs and experiences – which in turn impacts our own views and processes. Tailoring portfolios to meet specific risk/ return targets, or to act as completion portfolios to existing hedge fund exposures and accommodate specific investment policies or themes is thought provoking work; and scale helps. Part of the process involves producing optimizations, liquidity and risk analysis, and leveraging deep managed account expertise and legal and financial engineering capabilities.

Q7: What are you hearing from you clients? How are you adding or deploying new talent and resources to service your clients?

At its most basic level, building a fund of hedge funds business is about finding great hedge fund managers and building robust portfolios. Although it might sound simple – this does not mean that it easy to execute well. It takes a huge amount of resources and capital and a lot of talent to run a top tier asset management shop. We are fortunately to have the balance sheet strength of the Man Group behind us which provides us with stable funding for recruitment and retention, innovation and infrastructure. Deploying this strength for the benefit of our clients is more important than ever now. Many of our clients have been feeling the pinch of running their endowments, foundations and plans with fewer resources and smaller budgets. This puts greater responsibilities on the shoulders of remaining staff.

With investors needing to closely examine their overall portfolio liquidity, risk exposures and operational arrangements, this puts tremendous pressure on investment staff to cover all of the bases. This is where deep partners can really provide added value to investors.

Central to the reorganization, we have consciously beefed up our risk management [45 professionals] and quantitative analysis teams [19 professionals] and deepened the bench in hedge fund research [28 professionals] and portfolio management [20 professionals] to ensure that we can fully support our clients in these areas. Our investment staff are based in NY, Chicago, London, Switzerland and Singapore which is critical to our manager sourcing, due diligence and client service functions. We put a large emphasis on attracting and retaining staff with diverse backgrounds in trading, banking, structuring, research and portfolio construction, operations and IR. On the managed account side, we also have a 30 + strong team of professionals dedicated to structuring, monitoring and managing managed accounts.

Today, we bring you the final installment of our “Summer of 1,000 Posts” (more…)

This week we’ll be looking at alternative investments in the mainstream by pulling from our archives of posts on media coverage of hedge funds and hedge fund investing for retail investors.  Enjoy.

Report shows that some wounds recently suffered by wealth managers may have been self-inflicted
A recent report by Capgemini and Merrill Lynch show that wealth managers may have stopped listening to clients at exactly the wrong moment.

Research shows private bankers still favour hedge funds. Managers not convinced though
Two different surveys paint a picture of concerned hedge fund managers – even though private bankers see continuing value in their craft.

Hedge funds & mutual funds: “resistance” and “turf wars” or just eloping in Vegas More…

Today, we bring you another installment of our “Summer of 1,000 posts” (more…)

This week’s sampling from our archives covers the topic of Institutional Investing…

Shipping as an alternative investment
Thought shipping was just a global growth play?  Apparently, it depends on how you measure it.

BCG Forecast: Institutions to seek “innovative products” such as HF and PE
A new report by the Boston Consulting Group explains why institutional investors have stuck with hedge funds and why alternative investments in general will play a key role going forward.

Report shows that some wounds recently suffered by wealth managers may have been self-inflicted
A recent report by CapGemini and Merrill Lynch show that wealth managers may have stopped listening to clients at exactly the wrong moment.

Alternative Viewpoints: When it comes to transparency, institutional investors are being treated as “second class citizens”
Guest contributor Steve Deutsch of Morningstar says that despite all the talk of “transparency”, the micro-economics of the institutional investment industry often prevent the message from getting through. More…

Today, we bring you another installment of our “Summer of 1,000 Posts” (more…)

This week’s sampling from our archives covers the topic of Hedge Fund Regulation…

Hedge Fund Standards Board issues rules on how to exit crowded theatres when someone yells “Fire!”
Here’s a set of safety instructions every movie usher needs to have.

“Libertarian Paternalism”: A happy medium on HF regulation?
Regulation may not be all that bad for the hedge fund industry if the proposals of this author are adopted by the SEC.

HF trade groups, regulators call truce: peace breaking out on several fronts
The first week of summer has apparently brought a serious thaw in relations between the hedge fund industry and international regulators.

Quick…What’s the similarity between California and Connecticut?
California and Connecticut are separated only by Colorado on an alphabetical list of US states.  But when it comes to hedge fund regulation they may be attached at the hip.

The United People’s Front for the Preservation of Rationalization Association Network Alliance
Tough times bring boom times for a plethora of new hedge fund industry trade groups. More…

Today, we bring you another installment of our “Summer of 1,000 posts” (more…)

This week we’ll be looking back through our archives to cull posts on the topic of CAPM/Alpha Theory…

How Hollywood, lotteries and mutual funds show that all risk is relative
Since the birth of the CAPM, empirical evidence has been uncooperative – showing that high risk investments produce lower returns, not higher ones.  Now one author looks beyond equity markets and finds even more evidence against the vaunted CAPM.

Real Estate Alpha
A lot of research has been conducted on real estate mutual funds.  But precious little has ever been conducted on the alpha produced by institutional funds that invest in commercial real estate – until now…

Crowds may not be so “wise” after all
A new book, an industry survey, and media reports have propelled the age-old topic of market efficiency into the spotlight this month.

Study hints that alpha may be finite (at least in the short term)
Is it a coincidence that hedge fund returns are exploding right after the biggest culling in the industry’s history? More…

Today, we bring you another installment of our “Summer of 1,000 posts” (more…)

This week’s sampling from our archives covers the topic of Investment Management Fees…

What really drives the closed-end HF discount?
Do premia and discounts on closed end hedge funds actually reflect anything about the funds themselves or do they just a response to exogenous factors?

Study looks at differences between institutional and retail mutual funds
Retail mutual funds have been researched in every conceivable way.  But we were surprised to learn that institutional mutual funds haven’t undergone the same level of scrutiny.  Until this year.

Closed-end HF Pricing: Rational Irrationality
If hedge funds are supposed to be so unique, then why do most closed-end HFs sell at a discount or premium to NAV at the same time?

Net effect of HF redemption/re-allocation cycle: billions in additional fees
Like water in a bathtub, assets seem to slosh in and out of the hedge fund industry frequently.  Unfortunately for investors, this can scrub under-performers clean of their requirement to provide a performance fee holiday. More…

Today, we bring you another installment of our “Summer of 1,000 posts” (more…)

This week’s sampling from our archives covers Portable Alpha and Alpha/Beta Separation.

Private equity survey may not be all doom & gloom
Despite recent research that suggests otherwise, we may be due for an unexpected boom in private equity beginning sooner than many expect.

“Beta blockers” aim to reduce the blood pressure of those facing hedge fund gates
Stressed about having your money locked up in a hedge fund?  Just pop a few of these…

Portable Alpha to be “reborn” according to author of new paper on the topic
Portable alpha may have died last year.  But according to at least one expert, it’s about to be reborn.

Did Pennsylvania take a wrong turn with portable alpha?
After the announcement by Pennsylvania’s state employees pension plan that it lost money on its portable alpha strategy, some are saying this is proof that portable alpha is “exotic and risky” and that its promoters are “thieves”.  We examine the validity of these claims. More…

Today, we bring you another installment of our “Summer of 1,000 posts” (more…)

This week’s sampling from our archives covers the topic of Performance, Analytics & Metrics…

Debate over value of Sharpe Ratio in HF analysis continues in new academic study
A 2007 academic study rained on the alternative hedge fund metrics parade and claimed that the good old fashioned Sharpe ratio was all you needed.  But another study released this spring suggests that alternative metrics such as the Sortino ratio, Omega ratio and Rachev ratio have a purpose after all.

Investing in some stocks should have qualified as an “extreme sport” says leading quant
Last week, a prominent academic showed how the S&P 500 had become an “extreme” sport before it tanked last year.  This week, that same researcher turns his focus on an individual stock that we know all too well.

Lintner Redux: Omega Ratios and Managed Futures
If only storied academic John Lintner had the Omega Ratio…

2008: The year of the small fund anomaly
Being small and young has always been a virtue in Hedgistan.  But one of these poles reversed in 2008.  Now being big and young seems to produce results.  Too bad it’s virtually impossible to achieve these ends simultaneously any more. More…

Today, we bring you the first in a series of exclusive interviews with key players in the world of alpha-centric investing.  Approximately once a month, we’ll pick someone from the pages of AllAboutAlpha.com or from the alternative investment industry in general and pose 7 topical and straightforward questions.

By Andrew Saunders, CAIA (AllAboutAlpha.com Editorial Board)

Roger Ibbotson, Ph.D., is the Chairman and Chief Investment Officer of Zebra Capital, a role he has held since the firm was founded in 2001.  However, many of you will know Roger as the founder and former Chairman of Ibbotson Associates, which he founded in 1977. (He sold his interest in Ibbotson Associates to Morningstar in 2006 and is no longer an executive with the company.)

Roger is also a professor in the Practice of Finance at the Yale School of Management.  His book with Rex A. Sinquefield, Stocks, Bonds, Bills and Inflation serves as the standard reference for information on investment market returns.  He also co-authored two books with Gary Brinson, Global Investing and Investment Markets, and in 2001 completed an investments textbook with Jack Clark Francis, Investments: A Global Approach.  Roger also recently published the Equity Risk Premium with William Goetzmann and Lifetime Financial Advice with Chen, Milevsky, and Zhu.

As regular readers are aware, Ibbotson conducts research on a broad range of financial topics, including investment returns, mutual funds, hedge funds, international markets, portfolio management and valuation. He is a regular contributor and editorial board member to various trade and academic journals and has received several awards, including the Review of Financial Studies Award (Best Paper in 1992) and the Graham and Dodd Scrolls (6 times).   His publications are regularly listed in the Top Ten Social Science Research Network Download lists.

He has also served as a consultant to many companies in the financial and investment industry and has managed bond portfolios, traded equity securities, and managed asset allocation accounts.

Q1: Roger, as we approach the second year anniversary of the great quant meltdown of August 2007, how would you characterize investor familiarity, knowledge of and openness to quant strategies?

During the summer of 2007 the risk (volatility) of hedge funds doubled.  It was also a time when many strategies were highly levered and underperforming.  Since most hedged funds targeted volatility, many had to unlever at the same time. Many of the quant funds had similar holdings, which caused the meltdown as they rushed to the same exits.  During the summer of 2008, something similar happened, but this time the cause was the short selling restrictions that the government implemented in an attempt to prop up the most vulnerable companies.  Once again the quant strategies suffered.

In both cases, the quant funds that were able to stick with their strategies were able to quickly recover.  But those who targeted volatility got whiplashed.  Those who kept their leverage intact did reasonably well.  Unfortunately, many investors lumped quant funds into one big category, and have become wary of the whole group.

Q2: Are there questions that investors should ask about quant strategies but do not? More…