Sunday, November 4, 2012

How Hard Is It to Make Money?

Find below links to a few very interesting pieces.
They basically touch topics such as:

1) value-destruction in the money management industry,
2) our belief that we are better than what reality actually states (that, on average, we kinda suck),
3) people rely much more on trust than they rely on logical reasoning and facts.

Here is a link to a December 2011 letter by Absolute Return Partners' Niels Jensen on wealth destruction in our industry:
Niels Jensen - Absolute Return Partners - The Facts They Don't Want You To Know (Dec2011)

Here is a link to a FT Alphaville article about Niels' piece: 05 Dec 2012 - FT Alphaville - Spot The Dog let off the Leash

Daniel Kahneman - Mad Money on trust / logical reasoning x action

A Foolish Interview with Michael Mauboussin (chief investment strategist at Legg Mason Capital Management and adjunct professor of finance at the Columbia Business School) touching a mix of these topics.

Here is a screenshot of "Hedge Fund Market Wizards" (Jack Schwager). Chapter 10, interview with Martin Taylor, EM money manager.

So what am I doing in this cloudy Sunday afternoon? It certainly IS cloudy or I wouldn't be writing a blog entry on such a dangerous topic considering the beach is a few blocks away.

Why dangerous?
Because I am putting my neck on the line. A lot of money managers still think too highly of themselves, their methods and their image even if not having superb risk-adjusted returns. In my defense I am only stating facts. Not comparing myself to any manager or stating that I am any successful. I am just letting the lady reader know that I am aware of how hard it is to make money at all times and that the road to good risk-adjusted returns is deeply challenging.

I'd ask the reader to first check out all the pieces mentioned above before continuing reading. They state the facts and findings and I just want to add a little personal touch, in a blunt kind of way. And that is the dangerous point.

Again, bear with me if I sound confusing as I usually am. These topics touch sensible and interconnected matters.

Managing money is difficult. Beating benchmarks is difficult. Remaining alive for many years is difficult.

From Niels' piece:

"Using data from 1980 to 2008, the authors calculated the compound annual return for the average hedge fund to be 13.8%, easily outperforming more traditional asset classes over the period in question. This number makes hedge fund managers look like superstars when compared to traditional fund managers and is used by the hedge fund industry as one of the key reasons why everyone should invest in hedge funds.
Now to the naked reality. The best performance in the hedge fund industry came in the early years when assets under management were much smaller. The authors adjusted for this by calculating dollar-weighted returns instead; i.e. more recent returns when assets under management have been much bigger carry a higher weight than more distant returns when assets under management were negligible. The dollar-weighted number is thus a much better proxy for actual profits earned by investors in hedge funds. For the whole period 1980-2008 that number is 6.1% as opposed to the 13.8% headline number. Hardly blowing your socks off!"

I am writing about this because I strongly believe that the investment industry in Brazil is at a cross-roads.

Two major trends seem to have lost a lot of its power: the fall in nominal and real interest rates and the cheapness in relative (versus other countries) equity valuation. These 2 strong trends that had been ongoing since the late 90s/early 2000s after Lula was elected president and the volatility of inflation and its level has decreased were the fuel for another super trend which was the rise of the local currency, the BRL, versus the dollar

The multi-strategy and long-biased equity industry have had these 3 tail winds in the past 10 years and now I see them coming to a pause, especially considering the amount of securities available versus the amount of liquid funds searching for yield and the much lower nominal yields.

Brazilians aren't used to such low nominal interest rates and there will be a flood of capital into a rather young investment management industry. Managers have little experience in allocating capital into different markets. For example, during the period of 2010-2011 the multi-strategy (Multimercado) industry didn't show great performance. Coincidence or not the Ibovespa peaked in 3Q10, there was a change in leadership on the brazilian Central Bank, more government interventions in the FX market and there was a change in legislation that enabled funds to allocate some of their capital into off-shore vehicles which are used to place bets in foreign markets, such as in equity index, commodities, interest rate and currency futures. When did the local industry got back on its feet and performed very well? It might be a coincidence, but right when a new interest rate easing cycle begun in August 2011. In 2012 many funds have shown superb performances which, last I checked, had a 95%+ correlation with January 2014 DI (interest rate) futures. Should we dismiss these results because most of the funds seem to have been riding the bet on declining yields? Absolutely not. Absolutely no. A lot of merit goes into that. But I think this is certainly something that the local investor should keep an eye out for.

A few money managers in the country that had most of their performance derived from very concentrated bets had raised a LOT of capital recently and I think it will be very tough to deliver performance in the future unless they find different drivers than the ones from 2002 until recently.

Now comes the tough part which is really differentiating yourself from the crowd. The stage when you will have to look for opportunities in different niches. The stage when leverage on working-strategies of the past (leveraged beta) might not work. Just like it happened with the bull market in bonds and equities from 1982 in the US. In Brazil we had a commodities boom that worked in the past 10 years and macro stabilization (monetary and fiscal policy normalization, political goodwill increased considerably).

So.... how will the brazilian industry perform from here relative to the CDI (local benchmark, not an absolute return industry which is much fairer with the clients than the US absolute return industry) with a high concentration of assets under a few large managers (for the size of the local pool of securities) that grew very fast in the very recent past and with, I might be wrong on this, these 3 majors trends pausing?

Out of curiosity I would really like to see the performance breakdown of the top multi-strategy funds in the past 5 years. I think this should be the main question asset-allocators need addressed when deciding where to invest from now on.

...... to the next topic:

So, the whole idea for this entry originated today in a tweet from a colleague I met... through Twitter. I was looking for people who used DeMark technical indicators and some of my followers on twitter suggested his feed.
We exchanged a few messages about markets and when I went to NYC in September for a global macro conference we met for a chat over a few beers. Today he's online mentioning he trades off of technical indicators and that his employer wouldn't acknowledge that, meaning he pays for his chart-tools off of his own pocket, while using it to trade the company's money.

Where do I want to get? His tweet was just a cue into the pieces I mentioned above.

Money managers derive their returns from different investing or trading approaches. Some are well regarded. Others aren't.

Be them simple or not. You will get Fund Presentations with detailed descriptions of what their investment process consists of:
- what their macro backdrop is and how they got there
- how ideas are sourced and screened
- how market-timing is triggered- what their risk-management policy is
- how hedging is picked, if at all, etc

If equity long-biased Manager A picks the 5 bullet-points above and slap them on a nicely-done Powerpoint presentation I dare to say he has a better chance of raising funds or maintaining his client base after a few quarters or years of underperformance. Now if I tell you Manager A is married, has 2 kids, a PhD in physics from an Ivy League school and a beautifully architected office in a top-class neighborhood you should agree with me that the odds of fund raising or maintaining his client base after sub-par performance are even higher.

Martin Taylor points out the fact that Mark Mobius, a highly regarded "investment guru" in Emerging Markets for Franklin Templeton has underperformed the MSCI EM index for years but still manages billions of dollars in such strategy. How come? I'll leave it for Martin to opine: "The world of investment advisers is heavily influenced by media image so they suck their clients into this stuff.".

If I tell you that my Twitter friend trades off of DeMark technical indicators, spending 95% of his time analyzing charts, support lines and Sequential Countdown signals (then spends the remaining 5% of his time reading about actual fundamentals just for fun) I have a strong conviction that you would prefer Manager A. At least before letting you know what my friend's performance is relative to Mr. A's.

Does this make any sense? Empirical evidence from Kahneman and Niels' report cited above shows that this behavior is a reality.


People care a lot more than they should about how their money managers look on paper (what they say their investment process is, what their resumes are, how wealthy they already are) than they care about their managers' returns against simple benchmarks.

People usually trust managers who appear to be very sophisticated. Managers who appear knowledgeable about macro economic matters, policy and companies' fundamentals will often have an advantage over a blunt guy who says he uses charts and strong risk management or 'law of large numbers" (ie: selling option premium systematically over time in a variety of a-priori uncorrelated markets which is simply the same as buying a diversified book of bonds. Same final pay-out structure: paid par, positive carry, risk of default) to derive his returns from.

We're here to make money. And, above all, we're here not to lose money.

Sorry for such a messy post. Got tired of writing midway (it's been 3 hours on it), but wanted to put something out despite its form.

*Disclaimer: charts and data are presented as I receive/see them. Sources are usually not checked for validation and my own calculations are of 'back of the envelope'-type. I am aware that some math that I do myself might be wrong and/or misleading to some extent. In financial markets the rate of change of economic data is often more important than the actual level and the perception of 'what is priced in' is more important than 'what is actually going to happen'. This is actually the way people pick entry and exit points. So... yes, sometimes you might say 'This guy is an idiot, this is way wrong!' with a high conviction, being right. Not to worry. Markets are made of expectations and the clash of conviction between its participants. Portfolio managers know that being an idiot is sometimes profitable and being smart is often a bad choice. It is all reality, sometimes good, sometimes bad. By the way: corrections to my analysis and intelligent debate is welcome. Email: theintriguedtrader AT gmail dot com