Monday, July 25, 2011

Unreasonable Claim of the Week

There's a standard strategy in emerging markets hedge fund investing that too many investors seem to be willing to tolerate: Go long emerging markets equities, which are viewed as "long term attractive" at the same time as they tend to be very "risky", and "hedge" with developed markets positions with better liquidity.

Think that sounds silly?  Think that sounds like your front airbags deploying when you're hit from the side?

In a story from Pension and Investments on emerging markets investment strategy we hear from the experts:
PIMCO limits losses in its [emerging markets] strategy at 30% — or 1.5 standard deviations from the long-run average volatility in emerging markets equity of 20% — but doesn't give up any returns to do so, Ms. Gordon  [executive vice president and lead portfolio manager in emerging markets equity at PIMCO in London] said. “You're not giving up upside; you're capping downside,” she said.
That's because PIMCO looks for the cheaper ways to hedge against major losses. One example is the Australian dollar: AUD options won't hedge against minor performance bumps in the road, “but it is an asset that correlates with a rise in risk aversion in a global meltdown,” Ms. Gordon said.

Translation?  PIMCO doesn't actually limit losses at 30%, and PIMCO does limit upside.  Instead of buying high expected return emerging markets equities, they buy hopefully correlated, liquid, cheap and low expected return stuff that they think might have high returns if emerging markets crash. 

For you home chefs, here's a recipe for your own emerging markets hedge fund:
Start with $100,000:
  • Buy $50,000 of EEM, the iShares Emerging Markets Index ETF.
  • Pick three emerging markets countries or regions you think are cool places you'd like to visit that have single country ETFs.  Looking for inspiration?  Here's a list.  Invest $10,000 in each three.
  • Buy $2,000 worth of three month, 30% out of the money puts on the S&P500.  (That means you own the right to sell the S&P500 at a price 30% below where it is the day you buy, for about three months.)
  • Every month, buy more of the options the same way, and rebalance your long positions to 50% EEM, 10% each of your three hot picks.
If you are successful, please send 2% management fees, and 20% performance fees.