Friday, 17 June 2011

Battle of the Quants London 2011

This year I have experienced two rounds of the Battle of the Quants. The first was the edition of the radio show "The Naked Short Club" broadcast on Monday of this week.

                           Host Dr.Stu bursts into the studio with his posse, and sets about arranging the guests

The show featured a line up of speakers that were going to feature at the conference later in the week:

Dr. Marco Fasoli- Managing Partner, Titian Global;  
Robert Passarella- MD, Dow Jones;  
Con Keating*- European Federation of Financial Analysts;
Simon Kerr- Enhance Consulting/Hedge Fund Journal;  
Bartt Kellermann- Organiser, Battle of the Quants

There was some great too-ing and fro-ing between guests as topics were debated - both sides seemingly with conviction. It was the best edition of the show I have been on myself.

                                                                  Bartt Kellerman, Rob Passarella, and guest announcer 
                                                                                        and "Dazed & Confused" Editor Rod Stanley squeeze into the studio.

                                                                              Rod Stanley reads his script, while  Dr. Marco Fasoli 
                                                                                         and Con Keating prepare to respond to a tough question.

If you would like to listen to this show you can hear it via this download link.

My second round of  Battle of the Quants was the full conference held on Thursday the 16th June, at which the Keynote Speaker was Dr.Paul Wilmott, Ph.D, publisher of the eponymous quant magazine and website. His professional background includes trading volatility at a hedge fund, so he has seen and applied quantitative methods as used in finance in practice as well as in theory. He addressed his audience of quants and investors in quant funds on some of the problems of doing this. He cited calibration and market completeness as particular problems.

An example of calibration is the the estimation of volatility for the pricing of derivatives. Models have to be fit for purpose and reflect the world as is. According to Paul Wilmott re-calibration of a model by changing parameters is a form of model risk. He was aghast to inform his audience that regulators of financial activity like to see re-calibration of banks' models used to price products and estimate risk, sometimes to the point of enforcing re-calibration.

Dr.Wilmott sees the concept of market completeness as somewhat dangerous. Markets are incomplete in reality - even fast moving markets with very large volumes have gaps in price, as fx markets show over and over, and the flash crash in the S&P showed last year. The quant maven asked rhetorically "Why then is the idea of market completeness popular?" It is because it enables market participants to use ideas of risk neutrality and a certain type of mathematics. The danger is in the fact that risk neutrality in a state of market completeness is a special circumstance, and not  the governing mode of markets.

The Keynote Speaker had a theory about quantitative techniques as used in finance - that most people who use them don't much go beyond the tools of second year undergraduate mathematics. In particular, Paul Wilmott claimed that knowledge of fluid dynamics and the maths of mechanics would replicate how most people in the market address some very complex real world topics in finance. He gave an example of coming across a group in a financial institution attempting to model hurricane activity who assumed a log-normal distribution.

My own take on this is that the application of quantitative techniques to markets is no different than, say, a fundamentally driven approach: there are a range of abilities and resources being applied within the broad category.  So for those that analyse industries and companies there will be some who rely only on street research; there will be those who carry out there own research, and those that employ expert networks. The depth of knowledge and understanding of a company or industry will vary a lot, and (relative) bet size should vary with the size of the edge (and risk/reward).

A good example of how different market participants cope with the shortcomings of modelling is in the pricing of traded options. All market participants (apart from the retail punters) are aware that the distribution of market returns is not log-normal. If you like, if you have a Bloomberg screen you will know that there is a smile in option pricing in OTM puts. If you are running money at a long only institution  and use options you will be aware that   those OTM puts are not necessarily expensive, but reflect a higher probability of a large fall in the underlying asset than is reflected in a log-normal distribution of returns. For the long only investor, who would hedge or take risk using options over a period of weeks-to-months, the assumption of the distribution of returns is flawed but sufficient for the purpose. For a market maker, who is modelling a three dimensional volatility surface and managing risk through constructing a risk book with a positive gamma, and has a time frame of intra-day and over-night risk, the assumption of log-normal returns is not adequate. No market maker uses pricing software that assumes that naive distribution of returns. So the different utility functions of the types of market participants will feed into the willingness to operate with a pricing model that is known to have shortcomings.

*Con Keating told a good story off-air about getting through US Immigration quite a few years ago. Although UK passport holders benefited from a visa waiver scheme when travelling to the US, Brits still had to fill in the customs form. Keating completed his and waited-in-line to be seen by the customs/immigration officer. Many will know that the US immigration procedures for an alien can be tough - they don't hesitate in sending visitors back on the next flight. 

Finally Con Keating got over the yellow line and handed over his papers; the officer raised an eyebrow on reviewing them: "Mr. Keating you know we take immigration matters very seriously here. You don't appear to be doing the same: it says here under 'currency and valuable material' being brought into the United States that you are bringing in $223million. Is that correct?"

Keating confirmed that it was, and the officer went to have a consultation with his superior, eventually deciding that it was okay for the would-be visitor to enter the United States. Keating was much relieved as although he was there for a series of important business meetings he also had the job of delivering $223m of bearer bonds on behalf of his employers! 

Wednesday, 8 June 2011

Out of the Box - Graphic of the Day – Why Hedge Funds Will Continue to Grow

One of the advantages of looking at the activities of institutional investors is that their behaviour follows decision-making which stands for years at a time. The Investment Committee of a pension plan changes the strategic asset allocation say every 5 or more years. There may be a decision made to have 25% of plan assets in domestic equities with a tactical band of 20-30%, which allows for variation on an annual basis away from the central tendency of 25%. But for most of the time over six or seven years the plan assets will be around 25% in domestic equities from that point onwards, after a period of implementation.

The implementation of the change in asset mix will often take place over a year or more as mandates are changed, contractual notice is given to the money managers with the mandates, and the underlying assets are bought and sold. Allocations to domestic equity have tended to shrink over recent years, so the process might involve a plan sponsor giving six month notice to a Trust Bank that their mandate will halve in size, and then, in six months time the bank will liquidate a portion of their large cap mutual fund and transfer the cash to the pension plan's administrators.

The reverse process is expected to happen for hedge fund allocations over the next few years if the survey of investment consultants by Casey Quirk and eVestment Alliance is to be believed. The survey*, conducted in Dec 2010 and January 2011, asked investment consultants to forecast investment preferences and buying behaviour among North American institutional investors during 2011. One of the key trends that Casey Quirk identified was "The increasing role of heretofore "alternative" investments—hedge funds, private equity and real estate—which are emerging as the centerpiece of active asset management moving forward."

This trend in the use of alternatives reflect the new frameworks with which institutional investors and their consultants are building portfolios, with exposure defined less by product packaging or home bias, and more by the specific contributions investments make toward overall objectives. The framework is part of the new emerging paradigm for asset allocation amongst investing institutions in North America, shown in the Graphic of the Day below, and which will reinforce hedge fund growth.

Graphic of the Day  - Hedge Funds Break out of The Box

The Emerging Institutional Investment Framework

Source: Casey Quirk (Note Not to Scale)

The key point in this is that the way institutional investors see how they can use hedge funds is changing. It was hedge funds as part of an alternatives category - in a segmented ghetto by risk/return. This is changing towards hedge funds as sources of alpha within broader asset categories.  Hedge funds are breaking out of the box!

Putting this framework, and the consequent asset shifts, into practise over coming years will not benefit all asset management businesses. Amongst the attributes of the winning asset management firms, according to Casey Quirk and eVestment Alliance, will be
  • Managers offering non-correlated investments.
  • Firms offering both "traditional" and "alternative" investments will stand the best chance of providing institutional clients with a total portfolio solution.
  • Product development and innovation will remain critical competitive differentiators.
The survey collators go on to turn their gathered insights into a product opportunity map – showing where demand for product will be strongest.

2011 Product Opportunity Map

Source: Casey Quirk, eVestment Alliance

It is important to understand that the product opportunity map compares expected search activity for the upcoming year relative to forecast from the previous year. What is clear is that consultants continue to believe that longer-term trends in search activity favour hedge funds, funds of hedge funds, and non-U.S. equities. However, there is a perceived shift in the demand for funds of hedge funds:

"Consultants focused on larger investors, as well as those focused on non-profit funds, expect more searches for direct investments in hedge funds than they did in 2010. This reflects three realities.
  • First, most North American institutional investors selected a core fund of hedge funds in recent years, and few are yet convinced they need a change.
  • Second, and more importantly, larger investors now seek more specialized FOHF strategies in place of, or in addition to, a diversified FOHF mandate. This challenges many FOHF vendors who do not offer a focused product.
  • Finally, larger institutional investors—particularly well-funded non-profit funds—still seek to avoid higher fees and pooled vehicles offered by FOHFs.
FOHFs remain core investment vehicles among smaller pension plans who lack resources to select or access direct hedge fund investments. Additionally, investors increasingly are using outsourcing firms to provide exposure to a portfolio of hedge funds."

The trends identified by the survey authors will likely persist for some years, as allocations in pension plans change slowly, and allocations to hedge funds are going up – doubling in some forecasts. So hedge fund capital flows should be positive at the industry level on a multi-year outlook. There is still a role for funds of hedge funds serving American institutions, and indeed there should be growth in assets this year and next for funds of hedge funds as a whole. But to benefit from those allocations funds of hedge fund businesses are going to have to be in the top quintile of performance ranking over 5 years, and in 2008 specifically, or have a very good specialised product (by geography or investment strategy) to offer.

*This year, 55 investment consultants, representing an aggregate $10.4 trillion of assets under advisement participated in the survey.

Thursday, 2 June 2011

Seth Klarman of the Baupost Group - his top investment books

When I put my top investment books on this webpage (see lh margin) the choices inevitably reflected the style of investment I use myself. The books which enhanced that style rise to the top of the list, as well as those that are well written or well structured.

Similarly, looking at Seth Klarman's recommended reading list (given at the CFA conference last year), the choices reflect his value based style of investment:

Benjamin Graham's "The Intelligent Investor"

Joel Greenblatt's "You Can Be A Stock Market Genius"

Martin Whitman's "The Aggressive Conservative Investor"

Michael Lewis' "Moneyball: The Art of Winning an Unfair Game"

Andrew Ross Sorkin’s "Too Big to Fail"

Klarman also recommends the work of a couple of authors:  Jim Grant and Roger Lowenstein.

You will know Jim Grant from Grant’s Interest Rate Observer. So you probably know how well he writes. His book titles are: "Bernard M. Baruch: "The Adventures of a Wall Street Legend" (Simon & Schuster, 1983), "Money of the Mind" (Farrar, Straus & Giroux, 1992), "Minding Mr. Market" (Farrar, Straus & Giroux, 1993), "The Trouble with Prosperity" (Times Books, 1996) and "Mr. Market Miscalculates" (Axios Press, 2008).  

Roger Lowenstein I know best from his book on LTCM. These are some of his titles: "Buffett: The Making of an American Capitalist" (Random House,1995),  "When Genius Failed: The Rise and Fall of Long-Term Capital Management" (Random House 2000), "Origins of the Crash: The Great Bubble and Its Undoing" (Penguin Press, 2004), "The End of Wall Street" (Penguin Press, 2010).

Wednesday, 1 June 2011

Hedge Fund Radio on the 6th June

Make sure you listen out for the Monday, June 6th edition of the Sony Awards-nominated N@ked Short Club on Resonance FM [104.4FM within London/online worldwide on the internet here]: 1 hour of loose talk about hedge funds and the state of the world, plus sweet prose and heady music...No promotional agenda, no commercial intent...just Ponzi Bier and Pure Alpha both on tap.

Host, Dr. Stu will help callers to the Emergency Hedge Fund Helpline (1-800-DISTRESSED) to re-evaluate their Inner Mark to Market, with expert guests: David Miller, CIO- Cheviot; Mike Gasior- CEO, AFS (astrally projected from the US); Philippa Malmgren, President- Principalis; Simon Kerr- Enhance Consulting/Hedge Fund Journal; Stephen Pope, Managing Partner- Spotlight; plus City headhunteress/ writer, Sarah Dudney & the Galleon-smooth Anna Delaney.

The show is broadcast between 9-10pm/ 21.00-22.00 hrs., London time.

And you can listen to a podcast of the show at (for a period):