Daily Dose of Optimism

Some More Wisdom on "Hedge Funds" that Don't Hedge

Jeff Matthew's piece on Friday, Since When Did "Hedge Funds" Stop Hedging?, reminded me of this piece below by Carlo Cannell, from 1999. Cannell's article is more data-driven, whereas Matthews extrapolated wildly from a conversation he heard at Starbucks (as we bloggers are wont to do). My money says that Matthews is right about as early as Cannell was - which means we've got a great year ahead of us in 2007. Enjoy! - Ed

Bogus hedge funds -- those with no short positions -- will not survive the next market downturn
By J. Carlo Cannell (Red Herring - February 1999)

Phoenician sailors earned a thick slice of the profits from a successful voyage. Today a different risk-taker -- the modern-day hedge fund manager, or "hedgie" -- earns a similar benefit on land.

According to Hedge Fund Research, there are now more than 3,200 hedgies, two-thirds of whom operate in the United States. Estimates of their total capital under management vary from $150 billion to $250 billion.

Hedge funds have multiplied because in a bull market there are few better businesses. Assuming a standard 20 percent profit allocation, for example, a hedge fund general partner who started 1997 with $100 million and matched the S&P 500 would have received a paycheck of more than $6 million the next New Year's Eve -- healthy compensation for matching an index.

The rot in this picture is that most of these hedge funds have little or no short exposure. According to Edward Bowman of Hawthorne, the asset management division of PNC Bank, less than 10 percent of what are today called hedge funds have had any real hedge for the past several years.

This fall provided some vindication for the classic hedge. By early October the Russell 2000 was down more than 20 percent for the year; classic hedge funds were up more than 20 percent, but hedge funds as a whole were down more than 40 percent. During the last "trough" for hedge funds, in the early 1970s, there were fewer than 300 funds managing only a few billion dollars. Going forward, will we see an attrition to this level? Yes.

HEDGE HOGS

When things are good for hedgies, they're really good. Hedgies are the ultimate purchase managers, meeting, playing, and dining with scores of interesting entrepreneurs. Travel and computers are often their biggest expense items.

The hedgie mortality rate, however, is high. A shocking survey published in 1998 by Montgomery Asset Management indicates that the average U.S. investor expects the market to return 34 percent annually over the next ten years. The historical reality is somewhere closer to a 7 percent annual return. Fueled by these inflated expectations, some of the long-only managers masquerading as genuine hedgies will fall into a chasm of margin calls and redemptions like oblivious motorists plummeting off a cliff.

THE LONG AND SHORT OF IT

The Harvard-educated sociologist Alfred Winslow Jones is the father of the true hedge fund. In 1949 he structured a portfolio consisting of common stocks that held both long and short positions at all times -- even in a rising market. Mr. Jones's theory was that one can analyze a particular business even though the stock markets can't be reliably forecast. Buying good, well-respected but neglected companies long while shorting wildly overvalued companies should yield above-average results, he reasoned. By 1966 his fund had nearly doubled the results of the Dreyfus Fund, one of the better-reporting funds of the day. "Hedging," Mr. Jones often said, "is a speculative tool used to conservative ends."

KEEPING THE FAITH

A couple of years ago, as I broiled under the sizzle of short squeezes, a colleague told me that "a hedge fund doesn't have to hedge." What does it mean, then, to manage a hedge fund? Why do I deserve these high fees without undertaking the difficult process of researching short candidates -- a specialized and painstaking task that is usually more than twice as time-consuming as researching long candidates?

It hasn't been easy to be faithful. The longest-running bull market in history has toughened and twisted those true hedge fund managers who have survived it. I know one traditional hedgie who regularly vomited from anxiety during trading. Another has become so skeptical of financial statements that he retains private detectives to verify all information.

Windsurfers on the San Francisco Bay are an apt metaphor for today's proliferating hedgies. Both love to perform acrobatic feats in steady, high summer winds. Those winds, like the last 25 years in the equity market, can seem remarkably predictable. But eventually fluke winds do arrive, and the equipment's lack of keel and buoyancy makes the cold water and strong tides treacherous. The windsurfer's sailboard, like the fake hedge fund, is not an all-season craft.

Thoughts like these make cranks like me feel a little better.

J. Carlo Cannell is the president of Cannell Capital Management, an alternative asset adviser.

Google Video: Warren Buffett at the University of Florida

I came across this great video of Warren Buffett speaking to MBA students at the University of Florida. The entire video is about 1 hour and 30 minutes long, but I highly recommend it, particularly if you have never actually seen or heard Buffett speak. Having read many of his letters in the past, I was interested to see Buffett animate the same material in person.

Many of the questions address the 1998 implosion of Long Term Capital Management and the crash in emerging Asian markets, so I assume that the video was filmed around then. I don't know that Buffett is as spry today as he was in this video, but I was nonetheless impressed by his enthusiasm and energy. Now, it could be my imagination, but I also sensed a great deal of nervousness. For a $40 billion man, he is remarkably human and self-effacing; there are those who have achieved far less, but are far more comfortable with blustery self-promotion (yes, I'm thinking Trump.)

So, let me focus on what I found to be an overlooked but inspirational excerpt (begins at 55:20 of the video):

Q: What's the benefit of being an out-of-towner, as opposed to being on Wall Street?

A: I worked on Wall Street for a couple of years...and I've got my best friends actually, on both coasts, and I get ideas when I go there...but the best way to think about investments is to be in a room with no one else and just think. And if that doesn't work, nothing else will. 

I have been sensing for quite some time now that the prerequisite for me taking my investing game to the next level is basically spelled out above. In that spirit, I find this an inspiring reminder to remain focused on my objectives. - Ed

Ken Fisher's Latest Column

Ken Fisher's latest column is up at Forbes.com. If you hurry, you can read it for free (registration required) at Forbes.com before they add it to the $5 archive. In this month's edition, Ken calls Congress for the Republicans, and has some interesting stock picks, two of which I have selected below. - Ed

Link: Fear Will Fade - Forbes.com.

Readers didn't much believe me last month when I said the Republicans wouldn't lose Congress in November. If I'm right and these skeptics are wrong, fears of a big political fallout will fade--which is bullish--and you should buy now before the fear fades. No surprise that readers have this view, since the media are close to unanimous in decreeing that the probability of a Democratic victory is high.

[...]

Germany's  SGL Carbon (6, SGG)  has fallen 33% since May and has yet to recover as it supplies primarily the hard-hit steel and semiconductor industries with carbon and graphite products, which include electrodes, laboratory components and furnace linings. If the economy doesn't roll over, SGL Carbon is too strong not to bounce back. It sells at 80% of sales and 15 times 2007 earnings. 

The Chinese stock market fell in 2003, 2004 and 2005.  China Netcom Group (36, CN) didn't suffer that fate and in fact was in public hands only for the third of those years. Still, in that backdrop you can buy it at only one times revenue, seven times trailing earnings and three times cash flow (in the sense of net income plus depreciation).

With $10 billion in revenue and 120 million voice customers and 13 million broadband customers in ten northern provinces, it is one of China's biggest telecom firms and will move up smartly when the Chinese market recovers.

Jim Rogers Moving to China

For those of you who attempt to divine trends by watching what better informed and more successful people than you are doing (as opposed to merely saying), I have an interesting data point for you, and yes, this item is from today (Tuesday), so I should get a little credit for giving you something on time, as opposed to months after the fact:

II.com: Rogers Going Where The Action May Be

Apparently Jim Rogers, who back in 1970s co-founded hedge fund Quantum with George Soros, is leaping into Asia, just as he said he would in March. Rogers, who is also an author of several books, including Investment Biker, reportedly is putting his New York townhouse up for sale and moving to Asia. He bought his not-so-humble six-story digs for $107,000 29-years ago and is asking $15 million. The house has a greenhouse, gym, wine cellar and a view of the Hudson River to die for.

Rogers, according to Bloomberg News, is giving it all up to relocate to the Far East because he expects a boom soon in Chinese stocks. Rogers reportedly is not sure yet where he and his family will settle, but he told Bloomberg News he’s looking for a “Chinese-speaking city” since his child is bilingual in Mandarin and English.

Not mentioned in the Bloomberg article was Rogers' likely desire to avoid rabid Rogers International Raw Materials Fund investors, but that would be some irresponsible speculation!

So there you have it: Rogers says now is the time to start looking at Chinese stocks. Interesting. When I know more about this, I will make sure to position my portfolio accordingly and then write about it for you to copy. (Just kidding).

Rogers' last major accomplishment was the performance of his commodity index, as well as the timeliness of his call (basically, at a 25 year absolute bottom in commodities). The index he designed and launched in 1998 is up 263% since inception (follow link for details).

(Note: I am talking about his INDEX and not his FUND, so if you have issues with the fund, which I understand, we can talk later...)

Also, if you consider yourself a serious investor, but have not read Hot Commodities, or don't already know the price of a bushel of corn, then buy it and read it today. You can thank me later. - Ed

Three Takes on Becoming a Great Investor

#1: Michael Mauboussin (Legg Mason)

Fortune: What's the key to successful investing?

Mauboussin: The first thing is to focus your investment process - a good process leads to a good outcome. The second thing is that you want to have some sort of edge - you want to have the odds in your favor [... which typically occurs] when expectations built into the stock are too negative or too positive.

#2: Glenn Greenberg (Chieftan Capital):

Three activities were viewed as irrelevant to investment results and were largely distractions:

1. Speaking with clients - written communications would only be twice per year;
2. Entertaining investment ideas from Wall Street analysts; and
3. Marketing their fund.

All clients would be invested in the same portfolio, and all their personal money would be invested alongside their clients.

Lastly, if they lacked the confidence to put 5% of the fund in a company, they would not buy any. [...]

Greenberg's investing style and approach to his career are patience-intensive. He waits for 2-3 investment opportunities per year, and spent many years learning about investing from others before starting his own firm.

Greenberg communicated his message clearly: "Don't be impatient. Try and find some place to learn where you are not on the tip of the spear. It will help you gain confidence and prevents you from blowing up. [...] If you want to be popular, look for a different line of work."

#3: Warren Buffett

"It is important to know and stick to your circles of competence and pass on things that don't fit squarely in your areas of expertise. My desk has three boxes, IN, OUT, and TOO HARD. We put a lot of stuff in the TOO HARD basket.

You have to segregate businesses you can understand and reasonably predict from those you don't understand and can't reasonably predict. An example is chewing gum versus software.

You also have to recognize what you can and can not know. Put everything you can't understand or that is difficult to predict in one pile. That is the "too hard" pile.

Once you know the other pile, then it is important to read a lot, read about the industries, get background information, etc. on the companies in those piles. Read a lot of 10Ks and Qs, etc. Read about the competitors. [...]

You can increase your sources of investment ideas by widening your circle of competence. I've widened my circle over the years. I only needed to understand insurance in 1951. There were enough opportunities in that sector alone."

Ed's takeaways:

• If you aren't sure what to do with your investments right now, focus on refining your process;
• Approach the market with your own set of criteria, and don't let yourself be distracted by noise;
• At an early stage in your investment career, focus on learning and developing best practices - no point in taking on more risk than you are ready for;
• Accept that you can't know everything, and focus first on companies you understand. You can broaden the range of businesses you understand over time.

Japanese Interest Rates and US Equity Market Volatility

For those of you wondering why US and global markets experienced such rapid declines over the past month or two, let me draw your attention to some information you may have missed. Basically, the Bank of Japan indicated back in March that it planned to end its zero-interest rate policy.

How do low bond yields overseas affect international markets? Via the mechanism of the "carry trade":

“Carry trading” is not something the average reader is likely to run across in his spare time. What it amounted to was borrowing yen at low interest rates, converting them to dollars and re-investing the money at a higher rate of return. Simple enough in theory, but you need large amounts of money to do it. And it involves a fair amount of risk; while yen lending rates may be low, a rise in the value of the yen could wipe you out. [...] As the real cost of money rises in Japan [via higher interest rates], the yen carry trade stops working. It needs to be “unwound.”

To get a sense of how this works, see current Japanese government bond yields, and compare with US and Brazil. Imagine earning that spread with huge leverage. Here's the explanation of how Japanese liquidity impacted US market volatility (from May 30th):

“The Bank of Japan is signaling an end to its zero-interest-rate policy. Speculators who have been borrowing Japanese Yen are simply racing to the exits,” said Dan Amoss, a commodities expert and contributing editor to The Daily Reckoning.

Amoss believes that traders are dumping assets in hopes to eliminate credit balances in Japan before rising Yen value and spiking interest rates spoil profitable investments. “Speculators are relieving the pressure on their short Yen positions through the liquidation of whatever assets they had been buying.”

A serious depression scare in 1999 caused the Bank of Japan to cut interest rates to zero. Savvy U.S. speculators and hedge funds took out enormous loans from Japanese banks and invested in a variety of international bonds and commodities.

Interesting. A recent headline from Bloomberg (June 15) indicate that the Bank of Japan is backing away from any moves in the near term due to its impact on the Japanese equity markets:

The Bank of Japan kept its key interest rate near zero percent two days after the Nikkei 225 Stock Average sank to the lowest in almost seven months.         

The decision by Governor Toshihiko Fukui and his eight board colleagues, who have signaled since March they're preparing to increase rates, was unanimous, the bank said in Tokyo today.

Markets make big moves on the marginal liquidty created by hot money. For more global impact of this news, see my earlier post on the Saudi Arabian Stock Market Crash. - Ed

Is this at all a fair analogy?

Only time will tell, but it could be. The idea of a giant computer system sucking all the "alpha" out of the market sure ain't a pretty idea for flesh-based fund managers, but it's a possibility.

Renaissance Technologies was started by Jim Simons in 1982. Its $5 billion Medallion Fund has averaged 35% annual returns, after fees, since 1989, and is considered in the industry to be the most successful hedge fund, yielding returns ten percentage points higher than legendary investors Bruce Kovner, George Soros, or Paul Tudor Jones.  Extremely secretive, the company operates out of a mini-campus on Long Island, New York. Administrative functions are handled out of offices in Manhattan.

For over two decades, Renaissance has been at the forefront of research in mathematics and economic analysis. Renaissance employs more than 60 top scientific specialists, including mathematicians, physicists, astrophysicists and statisticians, who review market data to find statistical relationships that predict the price movements of commodities, currencies and stocks.

Renaissance uses computer-based models to predict price changes in easily-traded financial instruments. These models are based on analyzing as much data as can be gathered, then looking for non-random movements to make predictions. Renaissance represents a validation of the quantitative trading model and trades with such high-frequency that it accounts for 10% of all the trades occurring on NASDAQ some days.

For more information about Jim Simons, see here. - Ed

Tadawul (Saudi Arabia) Stock Market Crashes; Saudi King Abdullah Plans "Risk-Free Fund"

The Saudi Arabian stock market has been through a spectacular boom-bust cycle driven by a speculative frenzy over the boom in oil prices along with government sanctioned mass participation in the market:

In the past three years, up to nine million Saudis, or half the population, have started playing the market in the conservative desert state, whose strict brand of Islam outlaws standard forms of gambling.

They were encouraged by a government which hoped the bourse would enable citizens to share in the economic boom that has come with a rise in world oil prices not seen since the 1970s. It hoped that would help to iron out some of the country's huge disparities of wealth.

This rosy scenario of shared wealth ended badly after the Saudi Arabian Capital Markets Authority ("CMA") engaged in a ham-handed attempt to regulate speculative excesses:

The March 14 plunge was a severe reaction by speculators when the CMA decided to impose a daily price movement band of 10 percent.

The April 11 crash was a response to the CMA suspending two dealers on suspicions of market manipulation.

The lack of corporate transparency, small-time and first-time investors’ ignorance of the fundamentals of investments, and the long-term phenomenon of unmonitored margin lending by banks were some of the other factors that aggravated the plunge.

The resulting 50% crash produced a pretty ugly looking chart for the Tadawul Market Index:

Market strategists have also theorized that the Saudi crash put pressure on the US markets:

A lot of the selling in the U.S. stock market over the past two weeks was sparked by hedge funds invested in Saudi Arabia, said Jeffrey Saut, market strategist for Raymond James & Associates in St. Petersburg. He said the funds needed to raise cash, but their Saudi positions were illiquid, so they sold U.S. stocks instead.

Saudi investors are understandably upset:

Saudis hit by a recent stock market crash are resorting to car stickers to vent their anger at the wealthy speculators who have been blamed for the decline. The English-language stickers reading "Big Thieves!" show a stock market ticker and the names of some popular listed firms. [...]

The stock market crash, which affected more than 3.5  million middle income investors, has delayed the marriages of many people this summer, Asharq Al-Awsat newspaper reported. Every summer, tens of thousand of Saudis get married but this year, the number is expected to drop by more than 50 percent.

Saudi King Abdullah has a surefire plan:

BBC: Saudi King Plans "Risk-Free Fund" - Saudi Arabia's King Abdullah plans to set up a risk-free investment fund in a bid to attract small investors to the country's flagging stock market.

Saudi citizens will be able to invest up to 500,000 riyals ($133,000; £70,600), in the bourse - buying and selling on the market for two years. The individuals can keep any gains but the state will absorb losses.

King Abdullah did not give a starting date for the scheme - which could attract up to 3 million investors. However he said he was "determined" to implement it.

"The fund will be for people of limited income, employees and others...this group matter most to me," he said. "If they win then this is their luck, with God's will, and if they lose, then their capital is preserved with us," the monarch said.

Ah, it's nice to know oil dollars go to such productive uses. The BBC was kind enough to also note that the mass disruption of a market crash could increase the possibility of repercussions both within and beyond Saudi borders:

"Poverty and unemployment affect terrorism and instability and the king knows the result of this decision, which has important political significance"

I find this all very interesting, and it's suprising how little coverage this got in the US press - so much for those "efficient markets for information" that the internet is supposed to create.  - Ed

Ticker Garden: Watch Your Portfolio Grow

In the first-ever DDO beta-test of financial technology, I was recently asked by Hao-Hsiu Chiu, a  doctoral student at the Harvard Graduate School of Design, to take a look at the Ticker Garden, a stock market visualization tool. From the Digitectonics website:

Ticker Garden is a new kind of stock ticker with simplicity, usefulness, style and fun! It is an innovative data visualization application that monitors your stock portfolio. Different flowers represent the real-time performance of selected stocks via the color, height, & radian of animated blossoming flowers. A flower grows from the bottom (ground) & stops at the height reflecting its share price. The higher the stock price, the higher the 'flower stem'. As soon as it reaches the top, it begins to blossom fan-wise to the degree that reflects the percentage of price change. The color (green or red) & direction (upward or downward) of a blossom indicates a particular stock's status of ascent or descent in price compared to its previous trading day. A flying bee will show up around a flower if there is recent news of that particular stock.

 

I took a look at the tool and offered some feedback. Things I like about it:

• Simple and customizable market visualization
• Lite-install (simple executable file)
• Mountain range is great for major indices

Download it here. Feel free to give it a shot, and let Hao-Hsiu know what you think. - Ed

Charlie Munger on IQ in Money Management

I recently read notes of Charlie Munger's comments at the Wesco Financial ("WSC") annual meeting, and I thought they were pretty interesting, perhaps even more so than those from this year's Berkshire annual meeting.

Munger's Wesco comments have two primary advantages over Berkshire's: while much of the subject matter and commentary overlap, Munger at Wesco is both more pointed and more to the point. Perhaps Munger is the bitter half of the Berkshire duo because his net worth (while massive) is still only 1/20th of Warren's.

The excerpt below is from a discussion of how many smart Americans now want to work in money management, as opposed to other sectors of the economy. Munger believes this migration of brainpower is due to misplaced incentives that have led us into a "national scandal."

Of course, I'll grant that Munger may be angry that the competition amongst talented money mangers has heated up dramatically, even that someone may be able to outperform Berkshire Hathaway with computers. (Imagine Kasparov vs. Deep Blue)

But I also sense that when all the smart kids want to be money shufflers, and the only people willing to work with "old economy" companies are those who think they can buy them on credit, with a plan to re-sell the company in a public auction as little as six months later...well...something just might be out of whack. - Ed

Charlie Munger: "One unfortunate aspect of my practice is that I talk to a great many money managers who want to do better - do their function in life way better than other people do. I have very mixed feelings on this subject because I regard the amount of brainpower going into money management as a national scandal.

We have armies of people with advanced degrees in physics and math in various hedge funds and private-equity funds trying to outsmart the market. A lot of you older people in the room can remember when none of these people existed. There used to be very few people in the business, who were not very intelligent. This was a great help to me.

Now we have armies of very talented people working with great diligence to be the best they can be. I think this is good for the people in it because if you know enough about money management to be good at it, you will know a lot about life. That part is good.

But it's been carried to an extreme. I see prospectuses for businesses with 40-50 people with PhDs, and they have back tested systems and formulas and they want to raise $100 billion. [Reference to Jim Simons of Renaissance Technologies.] And they will take a very substantial override for providing this wonderful system. The guy who runs it has a wonderful investment record and his system is a lot of high mathematics and algorithms with data from the past." [...]

"At Samsung, their engineers meet at 11pm. Our meetings of engineers (meaning our smartest citizens) are also at 11pm, but they're working on pricing derivatifves. I think it's crazy to have incentives that drive your most intelligent people into a very sophisticated gaming system."