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The Hedge Fund: Consistency and Prevailing Return Indices

The Hedge Fund Allocator’s Boxing Match Dilemma     

 

In this corner, we have the undisputed champion of Outlier Risk ” Low Vol” Fund and how the implicit risk is often not implicit in the track record

vs.

And In this corner, we have the undisputed champion of High Vol Funds where the implicit risk is often more apparent in the track record.

 

Investors in hedge funds in contrast to mutual funds, tend to place more emphasis on track records at least on a shorter-term basis. Hedge fund investors tend to examine monthly returns and drawdowns and mutual fund investors tend to examine quarterly or annual returns and or adopt the throw away the key mentality.

 

However, investors learned or should have learned in 2008 that relying and particularly over-relying on the extrapolation of risks with certain strategies – particularly “ low vol” / “ low risk” strategies - from monthly returns can be costly. A number of strategies produce smooth attractive returns with little or modest volatility until they don’t. Option selling strategies, for example, may produce years of consistent positive returns with no losing months. Even a simplistic unsophisticated approach can be beguiling. If for example, a trader sells many way out of the options on the S&P, invariably, the options will expire worthless and the option seller’s track record will appear seductively “low risk” with consistent returns, no losses, and low vol.  To the uninitiated and uneducated investor, this will appear as a low-risk track with excellent reliable returns.

 

The problem with this hypothetical record is that on average at least once a year from 2000 to present, there has been 20 times the S&P has risen in one day 51 to 116 points. If a trader is a massive seller of call options the day before, it is likely the trader will suffer massive losses or at least significant volatility and interim drawdowns in trying to trade out of the losses.

 

This is not a knock at against option traders or any low vol strategy. Nor is it fair to assume that all “ low vol” traders are subject to extraordinary “outlier” risk. Rather it is counsel to understand what one is investing in and to avoid over-dependence on an individual or correlated low vol strategies – particularly if you do not completely understand how the fund is trading.

 

There is a dynamic tension in the spectrum of risk.  For the purpose the discussion, the generalization is that “low vol” strategies appear to be less risk in the short term but are subject to large “outlier” due to sudden unanticipated outlier episodic events, even anticipated outlier episodic events that are poorly managed and or outright trading errors in which for example the manager does not lift the legs of a hedge concurrently at exactly the most inauspicious time.

 

I like many other investors including many of whom I count much more intelligent than myself have learned these lessons in the school of high knocks, both on an undergraduate and graduate basis. Anyone remembers, “little” known firms such as Bear Stearns and Lehman Brothers. The problem is that people forget. Past performance is not necessarily indicative of future results, is the required disclosure. The problem is that investors tend to forget the past and wipe the slate clean. I suggest the following disclosure should be added:  Hope springs eternal.

 

The problem is that the status quo including when things are going well can be almost hypnotically seductive. Right now, in the economy, things appear to be going well. Wall Street is cheering the loosening of regulations. Was the reaction to the 2008 crisis too severe and were amendments to regulations post-2008 too severe? Or are we juicing up the economy with economic steroids with historical amnesia taking over? My concern is more of the latter. Are our economic muscles bulging now but quietly eroding our economic testicles which will be apparent only too soon enough?

 

Everyone is happy now, but you cannot fool mother nature. Life humbles and the markets speed it up.

 

And are we inflicting damage on the environment that will not be costly not only on the most important personal level but which is inextricably entwined and ultimately impactful on an economic level? What are the economic costs of more cancer and illness induced or exacerbated by environmental damages to the air, land, drinking water, and oceans?  Does anyone believe that the environment is sufficiently clean? I am concerned that we are being seduced by the pied piper of consistent economic returns, but which are fraught with “What me Worry-Alfred E Neuman” outlier risk returns that will rear its ugly head again. Some have foretold the drastic economic downturns 2001-2003 and 2008 but in general the common denominator, that all was good until it wasn’t. Sound familiar?

 

Am I foretelling gloom and doom? No. Am I attacking low vol funds? Absolutely not.

The two points that I am trying to bring home is the need for balance and everything is cyclical. Caveat Emptor.

 

No intent is made to:

  1. Provide investment advice, 

  2. Recommend a specific fund or type of funds.

The purpose of this article is to explain:

  1. The purpose of the indices

  2. The reasoning behind the indices

  3. The characteristics of each index