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December 20, 2012 6:06 pm
In recent decades, Harold Ehrlich has enthused about America’s hedge fund world. No wonder: not only is he an adviser to JPMorgan’s fund of hedge funds, but he used to run Bernstein-Macauley, the asset management group.
But these days Mr Ehrlich is disenchanted. So much so that he has circulated a memo to clients admitting that, “sad to say, the vast majority of all hedge funds worldwide have well underperformed virtually every major stock or bond index for some four years”.
“What explains such a fall from grace of even many long-time masters of the financial universe?” he asks. “Have such highly skilled super savvy ‘best of the best’ gone from being ‘smart’ to ‘dumb’? What went wrong?”
What, indeed? Mr Ehrlich is not the only person to be asking this question; other financiers are quietly muttering it too. But what makes his outcry particularly interesting is that Mr Ehrlich believes he has an answer: an addiction to momentum trading.
Back in the old days, he says, most hedge funds eschewed the idea of using strategies based on market timing, or even macroeconomics.
“Previously, most managers paid scant attention to business cycles, overall GDP trends or the potential effects of political forces ... they focused mainly on management prowess, product superiority, marketing clout,” his memo explains.
“But after the disaster of 2008”, momentum trading and “amateur economics” came to rule. “Managers paid increasing attention to the ‘big picture’. Risk on, risk off – adjusting exposure – [has] become an almost daily practice.” In other words, portfolio churning based on market timing has replaced any focus on fundamentals.
Many hedge fund managers might retort they have had little choice: in a climate of low volatility and interest rates, they have to hunt returns wherever they can, and politics is buffeting the markets now in unpredictable ways. But if that argument is correct, that in itself may point to a bigger problem that goes beyond the hedge funds.
Take a look, for example, at some ideas recently floated by Paul Woolley and Dimitri Vayanos, two London-based finance professors, in a paper* presented to a conference in New York. They believe the current obsession with momentum trading is just one sign of a wider structural flaw – and intellectual conceit – that is marring the financial world.
In particular, western investors, like regulators, have hitherto operated with the idea that markets are driven by free market forces; the dominant rhetoric was that investors allocate their money according to rational decisions about risk and reward.
But that is a sham. “Like regulators, funds have been following procedures based on the discredited theory of perfect markets,” the two professors write. But most households only “invest” by giving their money to institutions, rather than allocating it themselves; and they choose those investment groups not on any rational assessment of current or future trends (since they lack real data), but on crude measures of past performance.
As a result, institutional managers face pressure to herd into strategies that attempt to copy the previous “winners”, because that is how they can win clients. Hence the tendency of markets to produce asset bubbles; and the pressure to chase momentum.
So is there any solution? Mr Ehrlich thinks the problem could be solved if only disgruntled investors in hedge funds would pick up the phone and demand that hedge funds go back to investing basics. “Call your [hedge fund] managers and remind them that net cash returns, not just alpha, are required for you and your institution to stay the course,” he counsels his clients.
Profs Woolley and Vayanos are even more specific. They want investors to take 10 steps, including adopting a long-term investment approach based on dividend flows; insisting that annual turnover of portfolios is capped at 30 per cent; replacing benchmarks based on market capitalisation with more stable measures; and paying performance fees only on the basis of long-term results.
They also urge policy makers to support long-term investing in their tax codes and regulatory regimes, and to demand that public funds blaze a trail in setting a new investment style.
As advice goes, it sounds sensible, if not long overdue. But don’t bet on rapid change. After all, what makes Mr Ehrlich’s note so striking is precisely that it is relatively rare; most financial advisers (and investors) still prefer to grumble quietly, rather than speak out.
Until they make their voices heard, pressure for change will remain muted.
* Taming the Finance Monster; Central Banking Journal, December 2012. Paul Woolley and Dimitri Vayanos
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