New Risk Parameters needed
Have the old ones outlived their usefulness?
Hedge Funds look set for their third month of losses. They are meant to deliver positive returns, and avoid losses. Have too many investors piled in, using the wrong assumptions about risks in the sector?
March was bad, and so was April. May looks to be the third month in a row where the average hedge fund has shown a negative return. Professionals within the industry are full of reassurance: all investments go through bad patches, we are told, and returns this month will not be as bad as some fear. But some investors have not been comforted. Many funds are getting hit with redemptions, and de-gearing seems to be sweeping through the sector. Meantime, we see many illiquid instruments trading lower in value, with sellers more eager than buyers. Early this year when the global economy seemed headed towards recession, investors flooded into Hedge Funds, seeking the promise of positive returns. But the returns have been disappointing. Is it time now to think more clearly about risk?
A question that needs to be asked is, do investors in Hedge Funds measure risks appropriately? And if so, why was this weak performance not anticipated? Those new to the industry, as I was a few years ago, may be surprised that the sector relies so heavily upon risk measures calculated purely from historical data. Typically, a risk analysis will involve looking backwards at historical returns. The historical data series is examined with a mathematical formula which generates a measure of the volatility of those returns. Many analysts consider this as the "risk" that they are accepting in order to gain the returns inherent in the fund's approach to trading. Risk is compared with reward through a measure called a "Sharp Ratio" which is simply a ratio between reward and risk (i.e. the "excess" return beyond the risk free rate) divided by the volatility. A high Sharp Ratio suggests that an investor is getting a high return with limited risk. And many "low volatility" funds are sold on the basis that although returns are lower than can be achieved elsewhere, those returns are likely to be more stable. In effect, by accepting a lower return, the investor is buying an insurance policy against losses. But is this "insurance" real or perceived? Does the investor really get secure protection from future losses?
What we do see is that statistical Sharp ratios are often employed as a sales tool. Hedge Funds are complicated beasts, and investors in the sector normally will not know the details of a fund's positions, so they look for comfort where they can find it, in the historical data. Often ignored or undervalued in the analysis are more qualitative or intuitive approaches to risk analysis, most probably because these assess ments are difficult to make objectively in relation to complex and often non-transparent investing strategies used by hedge funds.
Unfortunately, there are a number of drawbacks inherent in this mathematical approach to risk measurement. The first and foremost is the warning contained in the prospectus of many funds: "Historical returns are not necessarily indicative of future returns." The reality is that, while many funds may have generated stable returns in the past, rates of return can change, sometimes dramatically. Market conditions may have shift, or traders may lose their focus. Success spoils many good managers, as they begin to be more interested in enjoying the fruiits of their labor, rather than working as hard as did in the early days of a fund's life. So returns may shift abruptly into a less favorable direction.
Other surprises that I found when I first looked at this sector, is how infrequently analysts in the sector talk about cycles. Cycles are apparent in many markets. And those underlying economic cycles can have a dramatic impact upon fund returns. But in a sector where funds can go short as well as long, it can be difficult to tie fund performance to simple cyclical measures, because hedge funds usually have the flexibility to ride out a cycle by reversing the direction of their exposures as the cycle changes. Nevertheless, one cycle which remains important is that which comes from changes in crowd behaviour. Asset sectors go in and out of favor. An obvious, but under-appreciated way of generating outsized returns is to invest in sectors that are out of favor, and then ride upwards the increase in valuations which may come as these areas are discovered by the crowd.
A good example of this phenomenon is the extraordinary performance of RAB Capital's Special Situations fund, which returned an amazing 2000%+ over about two years. RAB performance is somewhat more transparent than many funds because the manager is a publicly quoted company, listed in London. The team is highly professional, and expert at what it does, but the up and downward journey in the returns of RAB's premier fund tells an interesting story.
The fund's main area of investment has been junior mining shares, which started severely out of favor, and "off the radar screens" of most hedge funds and large institutional investors. RAB invested where others feared to tread. A fall in the dollar, and resulting rise in gold and commodity prices have brought these smaller companies very much into favor. In the past two years, the sector was "discovered" and the crowd rushed in and bid up valuations. The RAB fund benefited enormously, because the small size of these companies meant that valuations rose quickly as the liquidity flowed in.
But cyclical thrusts do not go on forever in a straight line. The dollar's slide stopped at the end of 2004, and since then the dollar has bounced, rising about 7.5% from its year-end low. Initially gold and gold stocks held, but in the past two months with the latest rally in the dollar and the de-gearing in the hedge fund sector, gold shares have slid in value as money flowed out of these shares. Like other investors in the mining sector, the RAB fund's performance has been hit, and they have suffered a drawdown. The result is ironic. Those who avoided the fund 2-3 years ago because the small cap mining sector was too tiny to be of interest missed out on the outsized returns. Eventually many were convinced by the strong performance and jumped in after the mining sector's market capitalisation grew and it became fashionable. Those who invested recently may be regreting their late arrival as the fund finally got hit with losses from a downcycle. RAB invests in small and mid-cap companies. Some of these shares are relatively illiquid, so it is not able to shift easily its overall position from long to short*. RAB has seen these shifts in investor preference before, and they prefer to ride out the correction, because they are convinced the the longer cycle is still up. (Indeed, they talk of a possible super up-cycle in commodities, lasting more than a decade.) Last year, the fund suffered a dip of 20% in its performance, but then went on to achieve a subsequent +100% return. Hurray for the big cycle, which has been so profitable to ride. These long waves of shifting investor interest are not caught by the statistical measures of risk and return. They are more qualitative and intuitive in nature. But they are of vast importance in determining a Hedge Fund's risk and returns.
A promising thing is that some new measures of risk are being introduced. Some managers and anlysts are beginning to "mine" the historical data on returns in new ways. Rather than simply looking at returns on a linear basis, to calculate volatilities and returns, they are beginning to look at how the data slices laterally. They are examining how returns shift over time, to see if there are cyclical patterns within the returns, and also if the movements correlate with external drivers like business cycles, and flows in and out of the investing strategy.
There is an old saying, if you go to a poker game, and you cannot spot the mug, he is you. A secret that few hedge funds fail to talk about is how one man's mistake is another man's alpha, and they need to have someone to make trading mistakes in order to allow others to make "excess returns". So if you want to find where the future big returns are going to come from, you might start looking where the big losses were just made. In the current investment world, Hedge funds have become so big (with their capital and their leverage) that they now dominate many investment areas. Once upon a time, when they were small and quick, and could benefit from the mistakes of others. Now they are so big, that in many areas they ARE the game, and will find it hard to make the big returns that they earned in the past, and have been promising for the future. In this new world, old ways of looking at risk are inadequate. Conditions have changed, and there may not be the same magnitude of traditional errors to generate the traditional alphas. And in the popular areas, there is alot of competition to find what alpha exists.
This may be overly dramatic, but when I think of the current situation, I picture a cartoon in my mind. It is as if hedge fund managers are all running around with hoovers, vacuuming up small bits of dust on the surface of a bubble (this being their alpha), but they are blind to the immense size of the bubble swelling beneath their feet. If this bubble goes pop, alot of the assets in which they invest may get dramatically repriced, meaning the low volatility environment of 2004 and early 2005 may be followed by a rapid shift to much higher volatility.
A scenario that I can readily imagine may be underway already. The stage is set for the drama. I see short term rates rising to a level where the hitherto acceptable rates for hedge funds of 5-8% would become unacceptable, and continuing redemptions would be triggered. Three month treasury rates are near 2.9%, up from 2.2% at the beginning of the year. So those funds yielding "acceptatble 5% returns" are now gaining an advantage of only 2.1% to a zero risk investment in a 3 months treasury bill. How much risk does that justify? Does it makes sense to borrow at Libor near 3% to get such low returns?
Meantime, the Carry Trade ratio (TNX-ten year yield divided by IRX-3 month rates) is already down to near 1.40 from over 5.00, so the maturity mismatch adds a spread of just over 1.00% on top of the near 3.00% borrowing cost, where before it added near 4.00%. The current 1.20% and 1.40 ratio is a meagre return for the risk. At the same time, countries like Korea are starting to say that they are unhappy holding such high percentages of their reserves in Dollars.
Might we see a time when many of those who hold bonds, stocks, and hedge funds, all decide to de-gear at the same time? This would create the perfect storm. Dollar bonds would get sold, pushing up long term rates. Foreign currency assets would get dragged into the crisis too, as those who have bought say Sterling bonds, and financed them with cheap dollar debt, decide to flatten some risk. And meantime, the de-gearing could be kept going by hedge fund investors de-leveraging their fund investments. In such a storm environment, hitherto low risk assets may see a jump in their volatility, as they get sold in unison. I think this crisis, if it comes, could usher in a much lower dollar, and higher longer term rates, to compensate those who do continue to dollar bonds and other dollar assets.
There are various events outside the markets, like terrorist attacks, which may trigger this. But they need not happen. A pain threshold may be reached, and if enough feel it at the same time, then simulatneous selling may be triggered. Historical volatilities, particularly those seen in the last two years or so may be useless in assessing this scenario.
Remember, if you are going to panic in a scenario like this, the time to panic (and take action) is early, while there are still decent profits to protect.
*Note: These comments are not intended as a sell recommendation against RAB or its funds. Indeed, it's Special Situations Fund may do very well if the worst case "Storm" scenario arises, since in all likelihood gold prices would rise and that may push the mining shares in RAB's portfolio up to higher levels. And as mentioned, that fund in 2004 followed a dip of 20% with a gain of over 100% in the subsequent 12 months.
