Open Letter to Sergey and Larry

Dear Sergey and Larry,

Unless you've been under a rock, (that's where I've been for a couple of months,) every finance pundit in the world has proclaimed your stock split is abusive.  They won't say that, but that's what they mean.  You think you're an innovator at abusive corporate governance.  You're not.

As my sister says, here's the thing: You went about this all wrong.  What you have is a serious case of hedge fund envy!  Public companies have governance.  Hedge funds don't.  Hedge fund managers take 20% of "partner" asset growth every year, and partners have no votes on the assets themselves.  You poor suckers with public companies have to listen to your "board" and sometimes do what is right for the shareholders.

I have a business proposition for you: Announce that you have reconsidered the stock split.  That the market has spoken, whatever you want.  You'll look somewhere between "moderately shareholder friendly" and "heroic in a new age of market transparency".

At the same time, you launch a hedge fund.  Call it a family office, with a little "outside money" to provide incentives to the senior team.  (If you need help with any of the various technical terms here, please call me,) even though the two of you retain 97.4% of the equity in the new management company.

Target a $5 billion raise from outside investors.  Quietly take the assets up to $10 billion shortly after launch when investors are excited. Now, buy $10 billion of Google stock.  Obviously, these should be voting shares that you don't already control.  Presto!  You now increase your control block using other people's money, but the joy here is that if Google succeeds, you take their money, not just their vote!

If you need my consulting services on this project, Google me...


Best regards,

Marc

Insider Trading: What Are The Odds?

The latest hoopla over potential insider trading at SAC doesn't look good...for the prosecutors.  Anyone can tell you SAC trades a lot.  If you trade a lot (I mean a whole lot!) you will have insider-trading-like success if someone picks through your every trade--after the fact!

Here's a thought experiment.  Start with 10,000 stocks.  On any given day, for any given stock, the price either move up or down by 1% (49.9% probability each), or move up or down by 25% (with 0.1% probability each.)

Suppose every single day you pick 100 stocks to buy, that you will subsequently sell the next day.  You'd expect every day that 0.1 trades would look like insider buys because you'd buy right before they jumped by 25%, and you'd sell the day they jumped.  Similarly, You'd expect the same number of insider sells. 

In ten years, regulators flagged 18 trades by SAC.  In my simple example, you'd have 18 in less than a year.

Wait, you say, SAC's flagged trades happened many days in a row.  Okay, fine.  Don't buy and sell immediately.  Randomize each day, so that there is a chance you randomly accumulate a position over three days, followed by selling for three days to unload the position.   This is like the probability of flipping a coin (HHH) followed by (TTT) (or visa versa) at the same time the underlying stock falls in the 0.1% chance of a 20% move up (or down) on day three.

Rare indeed.  I bet 18 times in 10 years is not so far off, statistically speaking.  (But I'm not smart enough to do that math.)

Scary Times, Indeed!

In this Wall Street Journal column, which includes the now-ever-present depressing (and depressed) mug of John Paulson, the author notes that this is a scary time of year for hedge funds.  Many face their notice periods for year end redemptions by their investors.

This is truly scary.  Imagine you work at a desk, in an office.  And, you get paid for this.  If you perform successfully, you might even get a bonus.  One day your boss fires you.  That's tragic.  Suppose you say to your boss, "No problem.  I'm out of here.  However, as you might recall, you have to keep paying me until I say my work is done, and I clean out my office.  Oh, and I no longer have anywhere to move the stuff that's in my office, so I'll just sit here with my tchotchkes.  Call me in two years.  Don't sue me, please, because I can pay my lawyers with your corporate card."

This is essentially the scary situation faced by hedge fund managers.  If investors "ask" for their money back at the same time as others, no one gets their money back.  The hedge fund managers suspend redemptions, and keep charging fees as long as they feel appropriate.

The only Halloween surprise in sight is just how poorly investors will be treated (and tricked) by those entrusted with their assets.

Simple Theories of Hedge Fund Risk Taking

I've been on a several day rant about hedge fund age and size, all beginning with some miserable research by Pertrac.  (See here, here and here.)  In the last installment, I said I'd give a simple answer to the question: Why might risk taking by hedge fund managers fall, as the funds grow, or the fund ages?

For now, let's forget about survivorship bias.  I'll give two answers for the price of one.

Scenario One:

In the first post, I said it may be the case that someone starts a hedge fund because they have a good investment idea.  If the manager has success, he (yes, typically "he",) is now reasonable wealthy.  Taking 2% management fees and 20% performance fees on even a small portfolio with good returns makes a manager wealthy. 

If you are that manager, you now (a) no longer have a great idea (since yours worked!) and you have much more of your own money.  What do you do?  You diversify!  Only a fool invests in a single strategy that just had outstanding returns!

You look to other attractive strategies, probably several of them.  They may be almost as good as your first but probably not.  At least they likely they have reasonably low correlation amongst them.  That's good.  But, that means your risk drops.

Additionally, they will also be similar to what your competitors are doing.  That's not so good.  You now run a generic multi-strategy hedge fund like everyone else from your HBS class.  (Worse yet, you now manage a big staff, for which you have no skills.  Good luck trying to be Daniel Och.)

In any case, your new "used to be hot" single strategy fund is now a lower risk, multi-strategy, fund.

Scenario Two:

And Now Back To Our Regularly Sponsored Bad Research Discussion

I'm back to picking through the wreckage of this research by Pertrac on the relationship between performance of hedge funds and their size or age.

In my first post, I explain that two very simple theories may explain a link between smaller, younger funds and better performance.  However, just as importantly, an incredibly common data problem (survivorship bias, where we only have data on better funds) could also explain the result.

In my second post, after having actually looked at some of the paper, I expressed shock and horror that the Pertrac authors actually imposed extra survivorship bias in their data.  I must admit, I really haven't read the paper that carefully.  I just cannot bring myself to care, since it is fundamentally so flawed.

However, I did leave readers hanging...sort of...saying I'd address the four potentially interesting comments in the paper.  The fact is, I was very generous.  Two of them a redundant.  So, what are the two comments that might matter?

Survivorship Bias, Hedge Funds and Bad Research

On Friday I challenged myself to read this "research" by Pertrac that claims to identify the impact of fund size and age on hedge fund performance.  In that post, I gave two very simple explanations for why small and young hedge funds might perform better.

Explanation one: People start hedge funds with a really good idea.  When that above average idea has played out, they become average.

Explanation two: Small funds, executing the same strategy as large funds, can operate in relatively less liquid parts of a market, therefore appearing to perform better when they're really collecting a liquidity premium.

More importantly, however, survivorship bias will explain that result too.  And even more results.

I wrote the post without reading the paper.  Now I've read the paper.  It's worse than I expected!

The authors actually imposed more bias on the data in an attempt to clean it!  Page 10 says they removed 311 funds that did not report December 2010 results.  Who fails to report numbers?  I doubt top performers fail to report voluntarily.  In the section "III. A Final Check on The Dead" I figured I was dead meat...they somehow corrected for survivorship. How wrong I was!  This section details how they carefully removed all the data about funds they believed had died.

So, now we know that the study carefully analyzes a large database of funds that has just as "carefully" removed from study the funds that have died either during the year in question or during prior years.  I would have no problem with this removal of data if we had any reason to believe the deaths are random!  However, hedge fund death is nearly entirely performance driven (if not actual, than at least fraudulent performance driven...as in the whole portfolio was invested in a fraud.)

Next post I will discuss the only four potentially interesting statements in the Pertrac study.  Here's a hint: They all involve statements about volatility.

Why Do You Start A Hedge Fund?

I cannot believe I missed the release of this paper by Pertrac, discussing performance differences across different age and size hedge funds.  We're going to try a fun, iterative and interactive approach to this paper.

I've downloaded it, but I have not read it.  In fact, I've only read the tagline from Albourne Village that says "Pertrac Finds Younger of Smaller Hedge Funds Outperform".

(Some readers may know my dissertation covered this topic for mutual funds.  The hedge fund conclusions fall in the category of "Duh!")

This should be entertaining.  It's too bad Yom Kippur starts so soon, or I could go all day with this one.  There will be more.

So, why do you start a hedge fund?  Other than the obvious: You want to make a lot of money.

Obvious Answer #2: You work at a hedge fund, and you have a really good idea, so you want to take a lot of risk with it, but your boss won't allow you to take enough risk.  This idea will take a while to play out.  (See last paragraph!)

You start a new hedge fund with a well developed, carefully researched plan.  You manage to raise a bit of money. Your idea works, over whatever (not too long, or you are out of business) time frame.  But, now you need a new strategy.  You had a trade, not a strategy.

Most people who think they have a strategy actually have a trade.  Now you need a new one.  You're larger, and you don't have the great, risky idea with which you started.  You now officially have weaker performance when you're bigger and older.

Obvious Answer #3: You work at a ledge fund with a strategy any moron could implement, but your boss is a greedy bastard, doesn't pay you and managed too much money, so you decide to do it right, start a new fund managing his strategy.  (Sandy Grossman once had a nerve to announce publicly that if you work at a hedge fund that manages $500 million, and hits capacity limits for the strategy, simply leaving the firm and starting a $100 million fund does not actually raise the capacity of the strategy!!)

Guess what?  You can outperform him for a while because you're not a moron!  But, the only reason you outperform is because you can do the same trades (think merger arb as a great example) with more of your portfolio in the sweet illiquid trades with no capacity.  You figure this isn't much more risky, because you're small and nimble.  You can get out of illiquid positions, the bastard can't. (See last paragraph!) This works for a while, until you also have too many dollars under management.  You are now your old boss.  Your head portfolio manager now quits.

Last Paragraph: Survivorship Bias.  Where is the guy who had John Paulson's view on housing three years earlier?  He was right...but early.  He's pumping gas in New Jersey.  Go find him...really!  Hedge funds self report to databases.  They aren't regulated.  Even weak performing ones just stop telling their story.  Everyone looks the other way. "Sure, there's survivorship bias, but the results are interesting."  That's wrong.  For my dissertation, I constructed a survivorship bias free database of mutual funds where reporting is legally required.  Survivorship bias matters.  Answers #2 and #3 give you a perfectly good hypothesis why small, young funds might outperform.  Survivorship bias gives you a perfectly good hypothesis why you'll observe that small young funds outperform.  You cannot separate the two without the data.

(So, I'll read the paper while I repent, and I'll report.  Since Kol Nidre allows me to repent for acts I will commit in the future, I'm repenting right now if for some reason the data is not biased!)

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.

Diamonds are a Hedge Fund Managers Best Friend?

In this Bloomberg story, the manager of an Oklahoma City based hedge fund claims he's a buyer of diamonds as an inflation hedge.  According to the story, individuals are selling diamonds at 50 to 60 cents on the dollar.  Sounds like a bargain.

First question: Why aren't they returning the diamonds to the store from which they bought them?  As I wrote some time ago, many jewelry stores give ridiculous buy back guarantees that they cannot possibly cover.  At least you ought to try!  If they don't take 'em back, sue 'em for their "unregulated insurance contracts"!

Second question: Doesn't this guy know that he can save half on diamonds any day of the week from these guys, high in the Empire State Building, or has he never listened to Bloomberg radio?  "Dial-a-Diamond and Save Half!"

In all seriousness, diamonds worked really well as an inflation hedge historically.  Where's my data?  I don't need any.  Historically, DeBeers held a monopoly on diamonds.  When you have a monopoly, you can maintain your real return substantially above the rate of inflation.

However, several years ago, DeBeers released (or lost?) their complete strangle-hold on the diamond market.  Roughly speaking, Russia and Canada had enough diamonds so that DeBeers could no longer effectively maintain their monopoly.  That's why DeBeers can (sort of) do business in the United States now, an its executives no longer risk arrest. 

(You'll note that's a link to a glorified jewelry store, which is a JV of DeBeers Group SA and LVMH.  Also, prior to settling anti-trust charges with the United States, DeBeers executives faced arrest here.  Shortly before the settlement, a senior executive flying to Canada was diverted to the U.S. due to bad weather.  The Feds pulled him off the plane.)

While historical prices look like diamonds hedged inflation, I doubt they did it effectively in practice.  Why?  That would mean DeBeers allowed someone to join their monopoly.  A monopolist doesn't do that!

Controlling supply means controlling production, but also resale.  So, DeBeers killed the secondary market for diamonds as well.  First, they did it psychologically. Diamonds are Forever after all!  You're emotionally attached to a rock.  You can't sell the family jewels. 

If nothing else, grandma says they always go up in value faster than inflation.  Just get it appraised, the jeweler will confirm it.  Just don't try to actually sell it!  The jeweler won't transact at the appraised price!  And good luck selling it yourself even with Ebay and GIA certification. 

Worse, as a jeweler buying from an individual, you risked retaliation from DeBeers, who might cut off your reliable supply of stones. Now you're out of business.  So, that purchase of grandma's ring had better be at a very low price.

Mr. Shafer, of Covenant Financial, will retort that he buys large, rare diamonds that are less susceptible to manipulation.  First, he has no idea how rare they are.  Only DeBeers knows how rare they are.  Second, he faces insane transaction costs.  Yes, his problems are not as extreme a those hedging disasters with gold, but let's see him auction his diamonds at Christie's.

One more thought for Covenant Financial investors: You better make sure Mr. Shafer's wife doesn't custody the fund assets.  Insuring diamonds is incredibly expensive, and will eat those returns very quickly.

 

Nickel Mania

In 1980, when I was eleven, the U.S. Mint announced pennies would no longer contain 100% copper, starting in 1982.  I started hoarding pennies.  I saw certain wealth in my future. Being the sentimental sort, the first roll I sealed into a plastic tube, inscribed with "Donot Open Until 2000".  That roll appears in the image above.  My wife says this proves I was a lunatic at a very early age.

Before I went to college in 1987, I schlepped approximately $800 worth of pennies to my local bank.  That's a lot of copper.  And, a surprised bank teller.  I gave up on my copper trade: I had hoarded copper through some ridiculously high interest rates, most certainly losing money.

Yesterday, I had lunch with a friend thrilled with the nickel trade.  In case you are unaware, the metal value of a nickel is now about seven cents.  He explained that an unnamed hedge fund manager is out marketing with a picture of a vault full of nickels.  This is his actual strategy.

Aside from the legality of melting down US currency, let's think about expense.  If my brother the chemistry PhD student kept reasonable hours, I'd have the exact answer already as to how much energy is required to melt a nickel coin, separate the copper and nickel, etc.  (I know, specific heat, melting point, yada yada yada...I'll miss some detail in scaling it up and wasting energy in the process...I'll follow up with relevant details later.)

Clearly, you're better off reconstructing my 1980 penny hoard.  Those pennies are worth almost three cents today.  Pure copper will be easier to work with than the copper-nickel alloy of nickels, so I'm guessing the melt down expense may actually cover for the substantially higher storage cost of nickels versus pennies.

You want a better trade?  All donations to the strategy will be accepted via Paypal.  [This is not an offering to sell securities!  You will lose money, but I'm happy to accept your contributions!]

I have completely secure storage (in a safe deposit box) and clean title (I purchased direct from the issuer!) to U.S. government backed inflation indexed securities in small denominations.  Not only are they indexed to inflation, they carry an accrued premium above inflation based on the implied inefficiencies of one of the worst functioning government programs.  Equally importantly, storage costs are a mere fraction of coinage storage.  In the space required for a roll of nickels, I can hold almost $200 face value of these securities.

Want more information?  Here you go...Forever Stamps good for 1oz of first class postage, well, forever.  The best part of the current "Forever" stamps, truly appropriate for gambling on inflation?  The image is not Lady Liberty, but the Las Vegas replica!  (Note: not worth 1 of your 20 if you're counting.)

Amicus Curiae in the Madoff Case

In a previous post, I discussed the problem surrounding hedge fund due diligence, and the complete lack of incentives to identify hedge fund frauds once an invest has chosen to invest.  The basic argument says that hedge fund investors have strong negative incentives to actually determine if the fund in which they invest engages in fraud because if they figure it out, they cannot take their money and run, hoping to reach the exit first.  The laws governing partnerships bring them back.  Several high profile frauds have made this outcome clear.

One of the many cases surrounding Madoff's fraud considers whether investors who did not actually lose money, all in, should receive their fair share of recoveries based on their final account balances.  For example, someone who gave Madoff $1 million, and every month took out the gains, over a period of many years, made a lot of money.  At the end, however, they lost $1 million. (Here's the full story.)

Don't let due diligence slip Bayou

For those who don't recall, Bayou Management's fraud used to be considered an "incredibly big" rip-off in the hedge fund world.  How far we've come in a few short years!

Few people outside a narrow range of experts are up to date on the litigation resulting from Bayou's liquidation.  However, this complex process has serious implications for those who suffered when someone else made off with their money, as well as anyone who invests in hedge funds today.

Here's the basic idea: Hedge funds are "partnerships" in a legal sense.  I'm no lawyer, so don't think I truly know what this means.  As a practical matter, however, this means investors are in it together, as partners. 

New Jersey's pension crisis...Congress's fault? First take.

This is so cliche that the state of NJ has a pension problem. It's like saying Illinois has a governor problem. Here's the latest word.

Why is it Congress's fault? Well, not entirely of course, but here's a convoluted start. UBIT. Unrelated Business Income Tax. What, you say? UBIT is a federal tax that prevents retirement plans (pension plans, your 401(k), etc.) from using leverage. In a nutshell, if these typically not taxed investment entities use leverage (that is, borrow money to fund their investing) they suddenly become taxable. Because, apparently, financing investments is an unrelated business to investing, which is the business of a pension plan.

What does this mean? In order to juice returns via leverage, rather than borrow money themselves, pension plans make investments in partnerships that may use leverage. These leverage using partnerships are normally called "hedge funds." The hedge funds hide the leverage within the partnership so everyone can comfortably say "this pension plan uses no leverage."

How does this work in practice? Suppose you are a completely competent pension plan manager who does not invest in hedge funds. You invest in a diversified, globally balanced portfolio of lots of different assets. You manage to earn, over time, for your pension plan 6%-9% annually with not very much volatility. Remember, you are highly diversified across asset classes and geographies.

Guess what: You don't exist! If you did exist, you'd do the following: You'd take your same investment strategy, leverage it up 2x-3x, making it riskier, but still attractive, you'd call yourself a hedge fund, and you'd own a 20% performance fee on what you used to do for $250k/yr.

Let's look at the math: Say the strategy has a 7% expected return, with 4% volatility. That's not bad. Suppose you borrow at 3%. Thus, you leverage the portfolio 3x, you now have a 7% + 2 x (7%-3%) = 15% expected return strategy. Yes, you have 3x the risk too. But, you've just hit the hedge fund sweet spot. Anyone who has ever met with a hedge fund manager knows they have to claim 15% gross returns to get in the door. It's in the hedge fund marketing manual. You now have a hedge fund with "higher expected returns than the equity market, and lower risk."

How's that you say? Well, the 20% performance fee means your performance, net of 2% management fee and 20% performance fee is still 10.4% [=(15% - 2%)x 0.80]. This easily beats the target your old pension plan guys need to meet their goals, so they are in! And, it gets better. That 20% performance fee, (or, as I like to say 20% at the money call your investors give you) actually reduces the volatility of the outcomes, which makes your 3x leveraged strategy not really look quite that volatile. (The performance fees "dampen" the upside volatility you see.)

Now, suppose instead you could use leverage without having to hide it in a hedge fund. Well, if that not particularly credit worthy hedge fund can borrow at 3%, say whatever you like about NJ, but it is more credit worthy than that fund. So, let's say it borrows at 2.5%. Oh, and it doesn't have to pay hedge fund fees anymore to get it's leverage. Let's go crazy and say the management fees are cut in half (only) and the performance fees are cut in half (only!) That makes for seriously well paid, highly qualified pension staff, trust me! (Remember, good investment people all HATE their clients, no matter what they say. They like investing, they don't like talking to clients. So, one big client beats many small ones...especially when the one big one is captive!)

Do the math again: 7% + 2 x (7% - 2.5%) = 16% gross return, and a (16% - 1%) x 0.9 = 13.5% net return. So, same strategy, same risk, generous fees to boot, picks up 3.1% incremental return. Assuming no UBIT.

Oh, and as a side effect, hedge fund fees come down, as HFs lose their lock on providing leverage to pension plans and the landscape becomes more competitive.

In another post, we'll go into why this same analysis should apply to pension plan's evaluation of their decisions to invest in hedge funds.