Friday, 26 August 2011

Chart of the Day - Extremely High Correlation of Stocks - Implications for Hedge Funds

I'm doing some work on risk measurement/management at a hedge fund management company. The investment strategy of the hedge fund is long/short equity. Most of the work revolves around measurements at the portfolio level, and the aim of measuring and controlling risk is to produce steady returns for investors. This is only possible on a sustainable basis with a diversified portfolio, unless the hit-rate is unusually high. Whilst  I have met managers with very concentrated portfolios based on very stringent selection criteria, and who have very high career hit-rates (as high as over 90% in one case), most mangers (probably more than the 80:20 rule would suggest) run portfolios diversified by stock, sector and to some extent theme.

Effective risk management is partly about being aware what has a high probability of working and when. One of the lessons of the Credit Crunch for many in hedge fund land is that there are market circumstances in which the previously assumed risk controls will not work. That is, the manager has a series of limits and stops and processes which in combination will produce the desired outcomes for most market conditions. The rub, as revealed in 2008-9, is in the conditional "most". Managers have to be aware of in what market circumstances their approach to markets will not work.

For most equity long/short managers most of the time the key decision variables at the portfolio level are about managing the net exposures to market, and specifically about managing the net beta-adjusted exposure to the market. There is a sub-set of equity managers for whom this is not true - those which have a limit on their net exposure to markets, and are structurally close to net neutral, say a band of 0-20% net long. Often the latter funds are quantitatively-driven equity long/short funds, but some discretionary managers choose to be close to net neutral. For these net-constrained funds returns have to come from stock selection to a much greater extent than funds with wider investment powers. The corollary is often a larger gross exposure to markets - consistent with the formulation of information ratios of managers. Typically, funds with a small net exposure limit target lower absolute returns, and implicitly rank risk-adjusted returns as a higher goal than absolute returns. 

The majority of managers in equity long/short try to use the additional degrees of freedom they have in balance sheet disposition to produce higher absolute returns (than a net-neutral manager) though nearly always with higher volatility of returns. The tactical shape of the fund should be a function of two things: the market regime and the opportunity set for the particular investment style of the manager. There is a considerable range of understanding amongst managers of the necessity of taking these two dimensions into account in setting the net exposure of equity hedge funds. The best managers are good at both, but the majority of equity hedge fund managers are not. Yes, the majority.

The successful shaping of the hedge fund balance sheet requires two attributes in the manager: an ability to read the market regime in multi-dimensions, and a high degree of self knowledge about the applicability (and effectiveness) of their investment processes. Around the time of the Tech Bubble the first required ability was demonstrated a lot by equity hedge fund managers. The monetary stimulus provided by Greenspan on fears of the Millennium bug was read by managers as a bull market condition green light, and most managers were very net long in 1999, and investors were gorged on the excellent returns produced. The reverse happened from March 2000 onwards. By the 3Q 2000 many equity hedge funds were net short on a tactical basis, i.e . the managers jobbed from the short side.  From 2003 to mid 2008 a net long bias and a buy-the-dips mentality were positive attributes for managers. Over the same period many new hedge fund managers joined the industry, and several big names closed down, citing the lack of shorting opportunities as a reason.

So coming into the Credit Crunch phase of 2008 only a minority of equity hedge fund managers expressed an ability to read the market regime by going net neutral or net short. A majority of managers had never been net short to that point, and many did not have that available as a choice because of their offering memoranda, or because the operational limits they gave themselves precluded it.  

Current market conditions have echoes of 2008-9: large daily declines in equity prices, volatility and rising fear gauges in the price of gold and the cost of interbank borrowing. These are difficult conditions in which to manage an equity hedge fund. Quite how difficult is in part reflected in today's chart of the day. Every manager can tell you about the level of market volatility reflected in the Vix Index. This captures the current level of volatility in the market on a traded basis. The actual volatility experienced in the market is lower than the traded level, though intra-day measured volatility can be higher than that indicated by the Vix.

All equity hedge fund managers are aware of how volatility shifts impact their style because they can see it in the daily P&L changes per position, and the same at the portfolio level, and they are aware of the Vix. Those managers who take risk measurement more seriously will be aware of the Value-at-Risk of their portfolios. The same portfolio will have a different measured risk dependent on market conditions - when markets are more volatile measured risk goes up for the same portfolio. What is less well explored is the other element that feeds into the risk measure VaR, that of correlation.

The inter-relatedness of positions has an impact on measured risk. The more related the positions the less diversification there is in a portfolio. Consequently managers structurally build diversification into their portfolios by having limits on sectors/industries/macro-related themes as well as limits to specific stock risk by constraining holding size. But correlation is not stable. Cross-sectional correlation varies through time. In up-trending markets (scenario 1) volatility drops and stocks tend to become less correlated. For sideways moving markets (scenario 2) two stocks in the same sector could quite feasibly act differently - one going up and the other staying the same price, or even falling. Scenario 1 is better for producing returns from net market exposure, and scenario 2 is a richer market opportunity for returns purely from idiosyncratic stock risk (selection).

However when markets fall for a period volatility rises and correlation increases. The correlation coefficients of stocks' betas go up - the market component of stock price changes goes up, and the sector effect increases and the idiosyncratic component of stock price changes declines. The chart of the day below illustrates that we are at an extreme for measured correlation amongst S&P500 constituents.

In such a market environment portfolio returns become a product of the net market exposure, driven by the weighted average of the portfolio betas. The extreme case illustrates the point - bank shares and commodity stocks have had the highest betas in the market for some years now. The return to the net exposure to these two sectors plausibly could have been the largest component of the return of individual equity hedge funds over the last three years. For net neutral equity hedge funds the net exposure decision on these two sectors over the last three years could have even been the decision that determined return outcomes.

For market conditions with high correlation between stocks it is just about impossible to drive returns from stock selection (idiosyncratic risk) alone. This has recently been explicitly recognised by one management team -  Ralph Jainz and Jonathan Sharpe of Ratio Asset Management wrote to their investors on closing their European equity hedge fund this month that "this year stock selection has not proved profitable." History suggests that it is difficult for diversified net neutral funds to make money when there is high correlation between stocks, and only managers who are adept at shaping the balance sheet of their hedge funds will actually make money, as opposed to defending their capital.  

Given that nowadays few managers can demonstrate an ability to read the market regime in multi-dimensions, and have a high degree of self knowledge about the applicability of their investment processes, I expect negative returns from the strategy for the current market. What is particularly disappointing is that the number of managers who can show they truly learned lessons from 2008-9, and can make money now, are so few. Maybe investors have to exhort their managers to take some off some of the net exposure restrictions - or do investors doubt that their managers have sufficient skills to handle wider investment powers?


Wednesday, 10 August 2011

What are Hedge Fund Managers made of?

What are HEDGE FUND MANAGERS made of?

     40% Work Rate
     15% Ambition
     15% Talent
     12% Hubris
     10% Entrepreneurialism
       8% Reactiveness


     35% Process
     20% Marketing
     20% Database and library
     15% Understanding
       5% Structure
       3% Risk measurement
       2% Promises

Add your own version and responses using the comments function below.

Thursday, 4 August 2011

The Hedge Fund Job Interview

I know the readership of this website includes partners in hedge fund management companies, but it has also attracted some people who are both relatively new to hedge funds and some looking to get into the hedge fund industry. So this article should work for both constituencies.

I came across some interview questions used by Lex Van Dam, who may be widely known for the tv programme "Million Dollar Trader", but who now runs his own small hedge fund company called Hampstead Capital. He was formerly a trader at Goldman Sachs and GLG Partners. Lex has been described as tough or brusque. When I have dealt with him he has been direct and commercial but polite. The directness of the questions are what an interviewee at a hedge fund may face because the people who run them often are strict over use of their time, as is Lex himself. The questions are biased towards hiring a trader for a hedge fund.  

a) To assess energy, drive, initiative
1.Why are you here?
2. How did you prepare for this interview?
3. What was on the front page of the FT today?
b) To assess personal growth and performance over time
4. Tell me about your job?
5. What could make you fail here?
c) To assess past accomplishments
6. What was the biggest success you had over the last 12 months?
7. What is the most pressure you have ever been under?
d) To assess problem solving skills
8 Is your intelligence above average? What percentage of people have above average intelligence?
9. Does the quality of your decision making improve under pressure?
10. How many buses are there in London?
11. What is 32*32? How confident are you about that answer?
12. How many degrees between the hands on the clock at 3.15?

e) To assess overall talent, technical competency and potential
13. What makes you a good trader?
14. What is the most money you have ever lost?
f) To assess management and organizational ability
15. If I gave you £100,000 what would you do with it?
16. What is the most difficult decision you ever had to make?

g) To assess team leadership and the ability to motivate others
17. Do you react better to compliments or criticism?
18. How do you deal with authority when you perceive them to be wrong?

h) To assess character - values, commitment, goals
19. What would you wear to the office?
20. How are you with money? Are you a big spender? Are you in debt?
21. Would you screw someone over to get ahead?

i) To assess personality and cultural fit
22. How do you measure success in your life?
23. Why should we hire you and not someone else?
24. If things go wrong do you tend to blame other people or take responsibility yourself?
25. How do you think the interview went? If you were me would you hire you?

Please feel free to add some questions of your own using the comments button below. The questions given here were disseminated on E-Financial News.

Monday, 1 August 2011

Hedge Fund Returns for 2011

A poll was conducted on this website recently asking this question:

"In 2010 the year was rescued in performance terms by the huge injection of QE2. So the outcome was a reasonable year. Is there a Second Act to rescue this year? What do you think hedge fund returns will be for the whole of 2011?"

Most respondents were still looking for positive returns from hedge funds in 2011 - only one-in-six who took part in the poll were looking for flat or negative returns for the year. 

Nearly three quarters of the votes were cast for either +2% or +5% returns, and only 8% of participants were looking for 7% or better returns for 2011 from hedge funds.  If the outcome was in the range suggested investors in hedge funds would probably be satisfied, with a couple of conditions. To give credibility to 5% returns from hedge funds, equity markets would have to be flat (or down on the year), and inflation would have to moderate between now and year end. How plausible are those conditions?