Nonlinear Dynamics in Portfolio Management
There have been a lot of articles recently about the poor performance of hedge fund of funds, and hedge funds generally. I’ve written before on this topic, so if you have a subscription to RealMoney, and want to peruse my earlier pieces on market structure, here they are (with their odd titles, I wanted something more consistent):
- Managing Liability Affects Stocks, Pt. 1
- Separating Weak Holders From the Strong
- Get to Know the Holders’ Hands, Part 1
- Get to Know the Holders’ Hands, Part 2
Many investment managers seem to not think globally about their businesses. It becomes: “Follow my process. Buy and sell securities that my process reveals. Succeed. Rake in more money to invest, if my marketing guy is competent.”
Market environments like this reveal the weaknesses inherent in balance sheets of all sorts. Every investment enterprise, every company, and even you have a balance sheet. During times of stress, those balance sheets get tested. Many of them are found wanting, if one can read the writing on the wall. 
An investment manager thinking globally, using logic from a source like Co-opetition, or Michael Porter’s Five Forces considers not only his actions, and the actions of securities that he has bought or sold short, but considers in broad the actions of other managers, and companies that he does not own. He also considers the affairs of his investors, and the stresses they are under. What if they are under stress, and need to redeem funds at an inopportune time? What if they pour in money in a frenzy during good times?
It is important, then, to think about how a manager should structure the cash flows of his fund. How liquid/fungible are the assets? As with a money market or stable value fund, how much can the book value (what investors can withdraw) differ from the market value (best estimate of what the securities are worth)?
With some open-end real estate funds, they limit redemptions to the amount of cash that can be realized at each withdrawal date, and investors stand in line for the portion of their money that they will receive. Or, consider hedge funds with illiquid positions. Many funds, including the famed Citadel, are restricting withdrawals in order to avoid fire sales (or forced buy-ins) of assets.
But there is more to the Co-opetition framework here. Shouldn’t managers try to estimate if there are too many other managers following their strategies? With all of the adulation over managing the endowments at Harvard and Yale, isn’t it possible that too many endowment managers got Swensen-envy, and decided to allocate to “alternative assets” at the worst possible time? That ’s a reason to be cautious on illiquid alternative asset classes. You can’t undo the decision without significant costs. Also, there is greater freedom to mess up, as happened with Calpers on real estate.
Another way to think about it, is that when too many managers pursue the same strategy, in absolute terms, it does not matter if you are the best manager of the strategy. If too much money is being thrown at the strategy, it will underperform, and the best manager will be carried down with the worst. The relative performance will be better, but there will still be a likely loss of assets in the “bust phase” of that market.
But in the present environment, we have had the challenge of many managers seeking returns off of every market anomaly that we collectively can imagine. When a market anomaly gets saturated with enough assets, returns become market-like. Risk becomes market-like as well, because the investors are subject to needs/fears for cash flow. In the recent past most anomalies have been saturated.
That is one great reason why so many seemingly unrelated asset classes have become so correlated. The investor base as a whole diversified, and all of the asset classes are subject to their greed and fear.
Now, there will always be new entrants with novel and profitable theories, but their success will attract imitators, and their returns will decline. Aleph will give way to Beth, oops, Alpha will decline, and the new methods will correlate with the market as a whole (Beta).
As for hedge fund-of-funds, they suffer from the conceit I described yesterday. They look at past uncorrelatedness, and presume that past is prologue. Thus someone with a positive alpha, and uncorrelated returns can get a big allocation, like Mr. Madoff.
As investors, we need to think about the markets as a whole. We can’t afford the luxury of ignoring the broader picture, as some stock pickers might. Instead, we need to consider the macro and the micro factors, and when we can find them with any accuracy, the technical factors.
This is not easy to do, and I often fail. But I would rather be approximately right than precisely wrong. May it be so for you as well.
December 18th, 200812:05 am at
Might even go so far as to say that strategies such as “quantitative style tilt” portfolios don’t have alphas. These characteristics were well-known in 1973 when Barr Rosenberg did the first careful analysis of their returns, and labeled them, “risk factors.” Since then some have taken to calling them, “betas.”
Treating “Value” (typically, Book/Price); momentum; response to earnings announcements; and smaller size as alphas works great for marketing, however.