You remember the stockbroker of old: all hail fellow well met and golf jokes, often someone’s nephew, and who appeared at every cocktail party. Then he would phone you with an idea taken from his firm’s list of long positions, which you would be too flustered to turn down. After all, hadn’t he written a letter to get your lazy son into a good school?
This was all made possible by high commission rates. Now that electronic trading has brought those transaction costs down to the microscopic level, how are people like that paid for?
They have become fund of funds managers. Investors can sign up for a stock trading account online, so the barriers to the investing public disintermediating the stockbroker have gone away. But there is still some difficulty involved in investing in, and tracking the performance of, hedge funds. So we have fund of funds managers. Most of the time little skill is required, just enough to justify management and incentive fees sufficient to pay for the golf and parties.
The value of the fund of funds managers has not necessarily been increasing over time. For example, in May the HedgeFund.net multi-strategy fund of funds index was down by 170 basis points.
According to people in the industry, the index will proved to have fallen another 50bp to 100bp more last month. In the year to date, fund of fund performance will be plus 4 or 5 per cent.
The bad markets in May were a useful warning that volatility is on a rising path, we are probably at the beginning of a bear market for risk in the form of equities and corporate credit. A lot of apparently diversified markets turned out once again to be bets on the same thing: how much liquidity was available for risk.
Which is why it is worth examining how fund of funds managers who do outperform consistently are able to pull off the trick.
One such fund is Alpha Beta Capital Management in New York. The fund is relatively small at $120m; the plan is to grow to no more than $1bn. The fund did not have its origins in a stockbroker’s client list; it was founded in 2004, with much of the starting capital coming from Fred Adler, a tough minded, long time technology venture capitalist. Of the managing members, Phillip Chapman came out of the venture capital business and Barak Laks is a mathematician specialising in mathematical finance.
They don’t tell golf jokes.
Alpha Beta has earned 16.3 per cent in the year to date, which is pretty good for a diversified strategy, as distinct from a single lucky pick. The fund has 25 managers, divided into five “buckets” or categories of strategies. The focus is on picking newer managers in inefficient markets who do not have very much in the way of assets under management.
Alpha Beta also is willing to accept some illiquidity both in the funds in which it invests, which typically have longer lock-ups than many fund of fund managers prefer, and in the securities within the funds, which are in markets that take longer to get into and longer to get out of.
“It is not coincidental that hedge funds have underperformed the markets since 2000,” says Philip Chapman. “Most of the money in the industry has come in since then.” The correlation between hedge funds and equity markets has risen significantly and management fees and incentive fees mean you need outperformance just to break even.
Would you invest in mortgages now? No, of course not. You can read in weekly news magazines how bad housing is. Alpha Beta, however, picked a manager who positions himself relative to a model of mortgage prepayment rates. He made good money in May. “Housing and housing finance is not correlated with the equity markets,” as Mr Chapman points out. That is true in both directions. “Manufactured housing [trailer homes] had its worst year in 1999, which was the best year for the stock market,” says Mr Laks.
For all the hedge fund managers’ image as independent thinkers, that is not borne out by analysis. As Mr Laks says: “Take global macro managers, which is one of our categories. The vast majority of them are trend followers. You can replicate their strategy by using very simple trading rules, primarily the crossover of the seven and 28-day moving averages. You can do that with Visual Basic and Excel. It is not clear how that adds value.”
Another Alpha Beta manager trades the basis, or relative return, of US Treasuries and municipal bonds, which was the subject of a previous column. Munis are supposed to be the boring, tax advantaged workhorses of personal portfolios. “Our muni manager made 2 per cent in May, and has made 20 per cent year to date. On top of that, he is less leveraged than his peers.”
In addition to picking managers who are smaller, and uncorrelated with the market, Mr Chapman and Mr Laks spend 1 per cent of the fund’s assets every year on option premiums to hedge against “tail risk”, or the possibility of extremely bad markets in which all assets are correlated on a downward path. Mr Barak says: “We buy puts on
S&P 500 futures, and puts and calls on the US 10-year bond future, and we are working on a couple of more sophisticated things using the Vix, or volatility index.”
Like other insurance policies, this hedge loses money most of the time. “We made money in only one month since we started in 2004, which was May of this year. But we want to make sure we have something extra, in case correlation rises.”
Also, they are willing to divest themselves of managers whose balance sheets grow bigger than their strategies can handle. “We don’t make any rules,” says Mr Laks, “but we try to be very disciplined about timing exits. We try to take advantage of inefficiencies, and you cannot do that with an infinite amount of capital.” Also, inefficiencies do not last forever, as convertible bond arbitrage fund investors have found out.
There is an awful lot of overhead in the financial industry – it is just called
by different names over time. Funds of funds seem to be attracting more of that these days, and you want to avoid the world’s untalented nephews.