Hedge Fund Industry Assets Recover to Last Summer’s High

Highlights from HFR Global Hedge Fund Industry Report 1Q 2012

• Total capital invested in the global hedge fund industry increased to $2.13 trillion, surpassing the previous record of $2.04 trillion set at mid-year 2011.

• Investor preferences for fixed income-based Relative Value and less correlated Macro strategies, which have been favoured for over two years, accelerated in 1Q12, with these two strategies receiving an overwhelming majority of the new investor capital for the quarter. Investors allocated $12.4 billion in net new capital to Relative Value and $7.8 billion to Macro, while redeeming $2.9 billion from Equity Hedge and $940 million from Event Driven strategies.

• Investor preference for the industry’s most established managers continued to be pronounced in 1Q12, with $18.3 billion in new capital allocated to firms with greater than $5 billion in AUM, while firms managing less than $5 billion experienced a combined net outflow of nearly $2 billion for the quarter. 

• Investors continued to reduce exposure to hedge funds via Funds of Hedge Funds, with FOFs experiencing a net outflow of $5 billion in 1Q, representing the 4th consecutive quarter in which FOFs experienced a net outflow. While only 13 percent of FOFs experienced net asset inflows during the quarter, as a result of performance gains, assets invested in FOFs increased by $14 billion to end 1Q12 at $644 billion.

UK Focused Hedge Funds to Benefit from More QE and More Devaluation

This short opinion piece from SVM's Colin McLean was so brief and on-the-money I thought I should share it. The third paragraph in particular is worth absorbing.

"The summer stockmarket sell-off caught most investors by surprise.  Expectations changed sharply as a good company reporting season in July gave way to a vacuum in US and EU political leadership in August. There are now mixed signals on the global economy, pointing to new risks.  But the crisis is throwing up new opportunities as well as dangers.

While some data is contradictory, evidence is mounting that global growth will disappoint.  Expectations are changing most rapidly in Europe, but in all regions scope for further effective stimulation is limited. Governments cannot re-run the unprecedented stimulation of 2009.

However, the UK can still do more than most to tackle the slowdown.  It has currency flexibility and an independent monetary policy, allowing it to move more rapidly than the US or Europe. Before the year end, another round of quantitative easing seems likely in the UK, and a further devaluation of the Pound by around 10% is possible.  This will immediately benefit Britain’s exporters and other global businesses listed in London. Stimulation would be a catalyst for money on the sidelines to buy shares. Hedge funds generally have had poor returns this year and will be eager for a rally. Portfolios need to be positioned ahead of this."


Net market exposures are currently low, and cash levels very high amongst hedge funds. There is a potential for a partial re-run of the equity rally provoked by the last round of Q.E., though markets never repeat exactly.

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?



   

Syz’s Altin Zigs When Others Zag

ALTIN AG (LSE:AIA) (SWX:ALTN), the Swiss alternative investment company listed on the London and Swiss stock exchanges, discloses quarterly its entire hedge fund portfolio holdings as part of its policy of full transparency to investors initiated in 2009. Looking at the strategy allocation shifts of the fund of funds managed by Banque Syz makes an interesting contrast with the expressed biases of investors in hedge funds given in the Deutsche Bank Alternative Investment Survey.


Graphic 1. Net Allocation Plans by Strategy of Hedge Fund Investors

Source: 2011 Deutsche Bank Alternative Investment Survey

Asked in January this year, the respondents to the survey ranked as the top three strategies for receiving allocations of capital in 2011 as equity long/short, event driven and global macro. So it was striking that the Alternative Asset Advisors SA, the subsidiary of Syz that manages ALTIN AG, had acted in exactly the opposite way over the first three months of the year. As the fourth column in graphic 2 shows the largest reductions in strategy allocations made by 3A were in equity long/short, event driven and global macro.

Sometimes reductions in allocations in portfolios of hedge funds are effected through a passive route. That is as flows come in, net new subscriptions are allocated to preferred strategies, and the strategies or managers with sufficient allocations at that point are diluted. But ALTIN is a closed-ended investment company, so the capital available to invest changes with new capital raisings on the stock exchange and with leverage. There have been no capital raising (in fact shares in ALTIN AG have been bought back), and leverage at the portfolio level is broadly the same over the first three months of the year. So in this case the reductions in allocations to strategy are active decisions based on a number of possible factors. The factors are views on prospective returns at the strategy or individual hedge fund level, and (fund of funds) portfolio composition issues. That is reductions may be driven by bottom-up factors (marginally high allocations to a single fund that needs to be trimmed after very strong performance or changes at the firm), or driven at the highest level of management (portfolio level leverage as a function of hedge fund returns across all strategies), as well as at the intermediate level of strategy allocation. In this case the changes seem to have been made at the intermediate level because two funds have been added that invest using investment strategies that were not represented in the portfolio at year end.


Graphic 2. Breakdown of Capital by Investment Strategy of ALTIN AG

Source: Regulatory News Service of the London Stock Exchange

The two new funds are ZLP Offshore Utility Fund Ltd (an equity market-neutral fund) and Providence MBS Offshore Fund Ltd (a fund investing in mortgage backed securities (MBS), under Fixed Interest Strategy in table above). The first of the new funds is a sector specialist fund that adds value by the application of deep knowledge of one industry. The market-neutral fund, managed by Zimmer Lucas Capital of New York, should produce a return stream with a low correlation with traded markets. The managers of ALTIN know the managers of the fund very well – 3A were early backers of Zimmer Lucas Capital as far back as the year 2000.

The Providence MBS Offshore Fund Ltd is managed by Russell Jeffrey, founder of Providence Investment Management LLC of Providence RI. The $895m fund takes a relative value approach to residential MBS, and capitalizes on price dislocations in the agency MBS and related fixed income markets. The fund has a CAGR of 23.44 % since inception in 2004, and over the last 3 years it is ranked in the top 0.1% of all hedge funds for absolute returns.

The Deutsche Bank survey of investors in hedge funds showed no net interest in investing in either equity market-neutral or dedicated fixed income strategies in 2011. So it is not just in reductions in allocation to strategies that the managers of ALTIN zig when others zag, but also in new subscriptions to hedge fund investment strategies.

Working in Equity Market-Neutral – A Q&A with ABACO Financials

ABACO Financials Fund is a market-neutral equity fund with a European bias dedicated to investing in the Financial sector. The portfolio of long/short positions is structured to generate absolute returns by capturing relative value within the sector while targeting low volatility. The return stream produced for their growing list of investors has a high proportion of alpha in it, and the returns have low correlation to markets and to most equity hedge funds. Given the significance of the finance sector to the market turmoil of 2008/9 and to the prospects of European economic recovery since, the fund has been interesting to follow, not least because of the excellent market letter the managers produce.


The three investment professionals in the team have different overlapping roles: Inigo Lecubarri comes from the sell-side and spends the majority of his time on research; Louis Rivera-Camino has a background in portfolio management and works across all aspects of running the portfolio, and the following Q&A was conducted with Martin Deurell whose primary responsibilities include trading and risk control for the fund. The interlocutor was Simon Kerr.




Q. You had a very good performance in 2008, an excellent 2009 for a market-neutral fund and somewhat disappointing 2010 to follow. What happened last year?

Out of financial funds we did okay, but we were up only 2% after fees, and we are very far from happy about that. There are a number of reasons why financial funds did not do as well as other long/short equity strategies last year, and the biggest of them was the impact of the macro environment.

The over-riding theme for financials in 2010 was definitely macro, and teams like the ones we have really concentrate on financials from the bottom-up. That is where our effort is concentrated - in building our deep understanding of the individual companies and the drivers of stock returns. Yes, we'd like to think that financial specialists like ourselves would have a better chance of understanding the impact of macro factors on the universe of stocks we follow, but that is not the same as being any better at forecasting the macro-environment.

Post fund launch in 2003 the biggest macro driver was EuroLand convergence – that lasted through to 2009 in various ways. Making money for a sector fund was mostly about the attractiveness of one stock versus another up until 2009 - and then it changed.

From the environment of 2008 onwards, only the funding issue remains the same in 2010 – so the issue for financials is not the cost of funding. The markets treated stocks the same whatever their cost of funding – they all went down without discrimination.

The second headwind we faced in 2010 was the lack of consistent, strong long-only flows and outflows in our sectors of the stockmarket. These flows are important for the well-informed investors (such as hedge funds, and prop capital) to position against and take advantage of. Investors in hedge funds correctly buy into the idea that their (hedge fund) managers are able to anticipate investing institutions moving into sectors and stocks like tracking elephants moving in a forest. But in 2010 the investing institutions didn't move – flows went into ETFs and indices (country selection) dominated. If other categories of investors buy a banking ETF to take exposures that doesn't help a fund like ours which is market-neutral, and needs differential returns within sectors to drive returns. We are starting to see signs of flows out of bond funds and into equity funds as an asset allocation switch, and if that persists at the retail, or institutional level, that is going to help us.

Q. Was there anything you could have done differently last year to take account of this macro dominance?

If I was being hyper-critical I would say that we didn't put enough effort into tracking the impacts of macro factors in real time - you know, looking at the CDS market and what they say about our stocks. I have traded options in the past, so I know that looking at the implications of CDS pricing is like a put option determining the pricing of the underlying equity. The CDS market says something about where a stock might trade, but the CDS is structured around extreme events, and in any event the CDS market is a lagging indicator. So yes the equity has tended to move in a 1:1 relationship with the CDS, but that type of relationship may be unique to the time we have just been through.

At this point it seems the analysts who follow the financials sector are putting a lot of emphasis on their own take of the macro environment. This could even be at an extreme. There is so much emphasis being put on the macro component that the macro may still drive the individual equities in the first half of 2011.

Q. Does this have any implications to how you shape your portfolio?

Well it doesn't mean that I want to take a directional net long posture to equities, or the equities of financial stocks. As a generalisation, exposure to equity in financials is less attractive than fixed income at this point.

I think you can look for a rights issue to be a trigger for individual stocks. From the time when banks raise new equity they seem to outperform – Deutsche Bank is a case in point. It has out-performed since it raised fresh equity capital. The capital-raising by Nordic banks certainly helped their stocks to perform, though admittedly the operating environment they faced was not as adverse as for banks in some of the other territories. There is going to be a lot of issuance of capital in financials – some big equity raisings are coming in the next few months because they have to happen.

Q. Is capital raising good or bad for the bank stocks then?

The capital raising helps in a couple of ways. In raising fresh capital the banks are taking positive steps to meet the tougher capital adequacy rules. Also when banks raise equity they take big write-offs – so the asset value of the remainder of the assets is perceived as a harder (more credible) number. That said a number of the banks with investment banking business are still tight on capital – Barclays, Deutsche Bank and the French (universal) banks – the Swiss banks are probably okay for capital.

There are cross currents in looking at investment banks. There are negative regulatory impacts for them – they have to raise fresh capital and/or cut the levels of leverage they employ. The margins in trading have to come down – not just outsourcing of trading, but the intermediation of exchanges in OTC will bring down margins through increased transparency. Where they do lending, the net interest income may be softer looking forward. But their commission income should be up, and the prospects for M&A are good so long as they don't get too competitive on fees. We have them in the Fund, but I don't have a strong view on them myself. I don't have to – my colleagues Inigo (Lecubarri) and Louis (Rivera-Camino) sponsor the investment holding-period positions in the investment banks into the Fund. I do trade them quite often, but as the trader of the team I can tap into the expertise of the others for a strong fundamental view.

Looking at universal banks with significant investment banking operations like Barclays is difficult – they have an investment banking operation as well as retail banking and an SME business. You can't look at your DCF model and say this is what Barclays Bank is worth. There are just so many parameters changing all the time, and such a balance sheet that you never quite know about the quality of assets. It is very difficult to pin down a risk/reward on a trade and say that this is worthwhile taking a position here, even doing peer group comparisons.

There are a lot of (sell-side) analysts working on investment banks, but they all seem to do the same thing. They want to understand how the business is doing in the next two quarters – but that only seems to be used to justify the current share price. And talking to management and reading Dealogic about issuance seems to be about as far as they go. Yes the deal flow is the gravy in the business model, but in the present environment in particular, investors have to understand the balance sheet. No -one pushes the management on the balance sheet, and management is reluctant to talk about it on a current basis.

Q. Given the American investment banks report quarterly, do they give you insight into the European banks, or they too much outside your scope?

For our scope of fund it is valid to look at Morgan Stanley and Goldman Sachs. Goldmans has proved to be a different animal than the others – it always bounces back. Their network amongst politicians is first class, and they deal for so many clients that they are right on top of what is happening in flows in sectors. So the trading record is outstanding for good reason, but then again proprietary trading will be wound down, and some top people there seem to be leaving. I have successfully traded GS shares last year, but I felt I was a child playing with fire in doing it, and I have less confidence in my risk taking there this year. In general we are not massive experts in trading things on that side of the pond.

Q. How do you work with the sell-side as an information source?

We use the sell-side analysts for generating and testing ideas on a theme, and for tactical level trading. The hedge fund world is not like private equity – so we don't have the luxury of fixing a fair value for a stock and waiting four years for that value to be realized. We have to deal with regular valuation and marking our P&L to market. That means we have to be more aware of what the market is doing to valuation in the shorter term, and what the market is thinking on a stock.

So we tap into what the sell-side comes up with for ideas – sometimes the brokers' analysts will highlight something that we have missed in our screening. Our role then is to filter what is a good idea and what is a bad idea, and do more work on them. Sometimes what you initially think of as a good long idea can turn into a short position once you have checked out the market positioning on a stock - if the idea reflects the consensus on a stock we might consider going the other way. So then it's a "Short" not a "Long" and we can investigate the timing of taking a position.

Q. So if you are not taking many recommendations what do you use the brokers' analysts for?

We think you have to know all the analysts in the sector to know where the consensus on a company is. They can tell you where "the market" is on a stock, analytically and in terms of market positioning (holdings). The brokerage analysts can plant a seed of an idea – something that could be developed. And if you can find a good analyst it is good to test our ideas with them – to bounce ideas off them. If you can find an analyst who takes the opposite view from you, that is also useful to an investor. You need to test your argument – if you are a bull you need to test out the case of a bearish analyst by talking through his thinking. So then you know whether it makes sense to go against him. That is very very useful for a sector specialist fund manager.

To give you an example in a tactical sense, when we are approaching a company's results announcement- say consensus is at one level and an analyst comes along with a forecast outside the consensus. We might look at it and say to ourselves that the non-consensus analyst is right and the consensus estimates are wrong. In that case we can go long, say, and when everyone upgrades their forecasts the stock will go up. Or maybe the nasty figures are already discounted, and again the stock will go up on the earnings release.

Q. How do you differentiate between the analysts?

Of course the longer you have been in the game the better you know which are the good, and which are the bad, amongst the sell-side analysts. Also with experience you can trust a certain analyst – I know he is good on that stock, and someone else is really good on that bank. To find the analyst that is the expert on the Street on a company is very powerful. If you know the one that has done the most work, that knows the company intimately from following them over a long period of time, it is worth a lot. You may be able to ignore the other analysts on the company. I admit that it is a rare thing, such confidence in an external analyst, where they are the clear number one or two in knowledge on a company. But it can have a good pay-off. It can put you as an investor in a psychological disposition where you can comfortably take bigger risk.

We are fortunate in that we have such an analyst working in our own team. Inigo has been the number one ranked analyst on Portugese and Spanish banks, and to some extent he can tell others about what is really going on! This gives us a genuine edge in some stocks compared to the market.

Q. Would you say there are differences between how a hedge fund would use a buy side analyst and a sell-side analyst?

There is a substantial difference between the buy-side and the sell-side analysts on the risk/reward for a view on a stock. The sell side analyst has to live with his recommendation for a lot longer period of time. We have the luxury on our side of being able to moderate our view, as expressed in our position size, as we go along.

Q. Your presentation shows you as having specific responsibility for risk control. Are you the one that has to place the stops on positions?

It is not just my input on this. I carry out the dealing for the Fund but my colleagues put their own ideas into the Fund, and they propose how wide the stops should be. I don't apply a blanket hard stop. What I prefer to do is to place the stop in proportion to the volatility of the stock. So a more highly volatile financial stock will have a wider stop on it than a stock which acts in a less volatile way.

Also it is not as straight-forward as it sounds - looking at one position in isolation. We have related positions in our portfolio, so we may have put on two (hedging) short positions against one long position. So the catalyst for action can't be one share price in isolation, even if the P&L on that may be negative – there could be a long position down 40% and the shorts are down 35%, for a net loss of 5%. So the trigger level of an 8% loss has not been reached and so the stop would not be effective even if the three stocks are each down more than 30%!

There is another factor in the frequency of taking losses - the size of the P&L of the whole Fund has an impact. When the fund is doing well, and the P&L is positive, it is natural that the balance sheet of the fund is higher than when we have had to take losses. So it is much easier to run the profitable positions, and not be compelled to close the losers when the whole fund has a positive P&L (for the year).

Investors in the fund should also appreciate that there are some exit tactics to be deployed. So even where there is a stop level, not the whole of the position is changed all at once. I prefer to sell, say, half a long position at a level and then wait to see how it reacts for the remainder.

Q. Thanks for your time, Martin. You have given us a good insight into how you work with the Street, and how you manage the volatility of your fund so well. Good luck with the alpha harvesting in 2011.


Thanks.



Terms: Management Fee: 1.5%, Performance Fee: 20%, Redemptions: Monthly, Lock Up: No


The interview was conducted on the 12^th January 2011.
Another article on ABACO Financials Fund can be found here.

Cevian Capital II Ranks High on 2010 Returns

Europe's largest activist fund, the €3.5bn Cevian Capital II, has had a(nother) banner year – up over 34% in 2010, after a return of 35.7 percent in 2009. This puts the Fund very close to the top of the ranking for hedge funds of any style, ahead of almost any other equity hedge fund, and given that most of the other top-ranking funds are a fraction of the size of Cevian II it again confirms the quality of the management. Without doubt founders Christer Gardell and Lars Förberg are amongst the most impressive managers of capital I have met. So I thought I would share some thoughts from Lars Förberg that were elucidated during a session in October last year under the auspices of The Greenwich Roundtable.



First here's a bit of background on the firm and what it does, and the talk should illustrate the principles outlined.

Cevian Capital was founded in 2002 by with the launch of Cevian Capital I, a fund dedicated to activist investments in the Nordic region, and in which Carl Icahn was a significant investor. In 2006 Cevian raised its second fund, Cevian Capital II which had a remit to invest in companies in Northern Europe. To put the wider remit into practice Lars Förberg moved to Zurich, whilst Gardell remained in Stockholm.

Cevian Capital's version of active ownership creates value by (i) acquiring substantial ownership positions in undervalued public companies and (ii) realizing their long term value potential through change. Cevian generally invests in companies overlooked or misunderstood by the market and in many instances out of favor with investors. Cevian targets investments where there is a meaningful opportunity to enhance the long term value by improving corporate governance, operational performance, corporate strategy and structure.

Cevian manages a concentrated portfolio of 8-12 companies at a time, with significant ownership positions in a limited number of publicly listed companies and is typically one of the largest shareholders in its portfolio companies. Consequently, Cevian maintains a strong commitment to oversight of each of its investments.

The investment process of Cevian is in two stages. Prior to investing, Cevian commits considerable time and resources to evaluating and analyzing prospective investments. All investment decisions rely on a well established and rigorous proprietary due diligence process, including comprehensive financial, commercial, operational and legal analysis. In the second stage Cevian looks to work constructively together with the management and board of directors of its portfolio companies, aiming to increase the company's long term competitiveness and create value for all shareholders. Cevian frequently participates on boards and nomination committees of its portfolio companies.

Lars Förberg

Three Questions for Lars Förberg

Question One: Is Europe Falling Apart?

To the first question, is Europe falling apart, the answer is clearly no. Sure, there are immense macroeconomic issues in many parts of Europe, notably in the south, what many people call Club Med or the pigs. That is Portugal, Italy, Greece, and Spain. These countries are over-levered. They have big deficits. They're not easy to run politically.

Having said that, the most difficult countries -- Greece, Portugal and Ireland -- only account for 6 percent of GDP of Europe. If you add Spain to that, you go 10 percentage points higher. This is still a small part of Europe, and it's not big enough to bring the more healthy northern and central Europe down. And what is interesting is that fiscal and labour market reform of almost unprecedented scope in the problem countries is going roughly according to plan.

Question Two: Can Europe Compete?

On the second question, can Europe compete -- a common view is that Europe is ridden by Euro-sclerosis, an inability to grow and compete based on regional labour markets, militant unions, punitive taxes, and generous social security. In some countries this is true. But when I look at our home market, Scandinavia, and German speaking Europe, i.e., Norway, Sweden, Finland, Denmark, Germany, Switzerland, Austria, you see a different picture. Look, for instance, at the statistics over which countries are the most competitive in the world, and I'm now using the World Economic Forum's global competitiveness statistics. You'll find Switzerland number one, Sweden number two, Germany number five, Finland number seven. As in parenthesis, U.S. is in the middle of these being ranked at number four.

Also interestingly, these numbers go hand in hand, leaving the U.S. aside, with where you will find the most fiscal sound countries. These northern European countries, I imagine, have limited budget deficits, if at all. And a country like Sweden, as an example, has been running budget surpluses for almost every year since the mid-nineties. Another characteristic of these countries is that they all have a strong industrial base geared towards exporting and being the home of a number of successful global companies with strong market positions, excellent product and services, and wide ranging distribution capabilities. These companies benefit from the global economic growth driven by emerging markets, and they have shown an ability to adapt to the changing market environment. I will come back to these companies a bit later.

So, the somewhat short answer to the second question, is Europe competitive, is two-fold -- a strong competitive northern Europe and a somewhat weaker south. One thing I'd like to add here, though, is that when you look at most of the countries that are now successful and most competitive, they went through major reform to get there. Germany did that in the early 2000s after the reunification of the problems that that led to in Germany. Scandinavia did that in the mid-nineties following the financial crisis in a number of Scandinavian countries. These reforms, many times orchestrated by the social democratic governments, led to labour productivity growth way above peers, many times at the level of 5 percent year after year.

Many of these same measures are now being undertaken in the currently weak countries - the fiscally problematic countries in southern Europe. This is being forced by the financial crisis. Examples of these efforts are major deregulations of labour markets, fiscal savings of up to 10 percent of budgets, restructurings of the pension systems, and VAT hikes of 5 percentage points. It's difficult to tell, but in a rosy scenario, these changes can lead to pretty benign environments in southern Europe and have attractive effects in the medium term. But that's something I wouldn't bank on, though, because the political situation is difficult and will continue to be difficult and uncertain over a couple of years, in my estimation. But what should be noted is that the financial crisis is used as a tool to move through structure reforms that are well needed in many parts of Europe, especially in the labour market.
 

Question Three: Attractive Opportunities?

So, on to the third question -- where do we see the most attractive investment opportunities in Europe right now? Well, we are an activist fund operating primarily in northern Europe, buying into equities, so I will back up the earlier comments by what we're doing. What we think are the most attractive investment opportunities right now are the companies I mentioned before -- the equities of the globally oriented companies out of Scandinavia and Germany.

You can still buy these companies as they are for double digit cash on cash yields, and get companies with excellent products, strong market positions, and full exposure to the emerging markets. Prices vary, though, and I don't believe there's going to be an over the line bull market, but I believe that with selective stock picking there are immense opportunities. I'll give you a couple of examples that we have put on into our concentrated portfolio of ten companies.

One example is the German crane manufacturer, Demag Cranes AG, in which we bought more than 10 percent of the share capital over the spring. Demag is the global leader in its field and has the largest installed base of industrial cranes globally. This is important because that means a great opportunity for stable earnings servicing this installed base. The company was undervalued because of its late cyclical nature, but also because there were some question marks over its strategic -- future strategic direction. Therefore, we could buy the company only paying for the service business which is 35 percent of the business, and getting 65 percent of the business - the equipment business - for free.

Another way to see it is that we bought the company paying an enterprise value equivalent to 50 percent of sales. This is for a company that we think will make 10 percent EBIT margin on a sustainable basis.

Another example is Panalpina World Transport, one of the global leaders in freight forwarding, which is based in Switzerland. This company we could buy early this year for a price reflecting the difficult conditions of the logistics industry during the slump. If the company comes back to its normalized earnings level, it will mean a doubling on our initial investment. If we manage to close the company's underperformance to its peers, which is our job as an activist, it will be a 3x investment.

On top of having these sound companies with attractive valuations, I think Europe has offered and continues to offer great opportunities for restructurings. Many companies have been unexposed to active ownership due to a legacy of passive shareholdings, unengaged board members, and value destroying cross share holdings. I believe there is a tremendous value potential in the existing unwieldy corporate structures, operational inefficiencies, underutilized balance sheets, and entrenched boards and management teams that are not pressured to perform. And in most parts of Europe, the corporate governance framework is there to unlock these inefficiencies. The restructuring opportunities, the low valuations, are coupled with one of the greatest opportunities that is not in the share prices today, and that will soon come to fruition, which is restructuring in terms of M&A.

If you are on the right side of M&A, there is tremendous opportunity to make great returns. And I point to a few factors that is driving this. One, corporate restructuring has been absent over the last two years. We all know why. So, there is a pent up demand and appetite. Two, the debt financing is there, both for industrial companies and private equity firms, and corporate cash is at all time highs. Three, the ability to make these M&A decisions is back in the boardroom: markets have stabilized; there's better visibility, and you don't have to focus on your short term crisis anymore. If you as a CEO had brought a big acquisition to your board a year ago, you would have gotten no traction. Now it's a totally different story.

When this M&A boom will happen is difficult to know. It's going to happen. Will it be three years ... three months from now, six months from now, or within a year, I can't say, but it's going to happen.

So, I think these three factors in terms of low valuations, restructurings, and the M&A opportunity, have created some very attractive opportunities in Europe from our vantage point in what we think, at least in northern Europe, is going to be a relatively benign macroeconomic environment.



Q&A


Q1. To marry what you're seeing in terms of micro opportunities with the macro, I was wondering, have you come across situations in your portfolio where macroeconomic or regulatory risk that one of these companies, say the crane company, in the tough economic environment, dwarfed what you saw as the micro economic opportunity. So what you thought was a great value turned out not to be because of macroeconomic risks?

A. (Lars Förberg): You're saying with a macroeconomic environment is it too tough for these companies? Well, when we buy companies that are cyclical, like at Demag, the crane manufacturer, yes, it was a cyclical company. But we would not buy it if we had to rely on a macroeconomic upturn. I think this is the attractive thing. We could buy it paying only for the servicing business. That servicing business is really something, and this was in a slump. So, this servicing business is typically something when you're a core manufacturer or, which Demag sells to, you need these things to function.

It's almost like an elevator business. So, we could buy into this company only paying for this business which is very stable. An elevator business has to go there. You know, it has to run. But we've got the equipment business - 65 percent of the business for free - so we're covered on the downside because we're not paying for the macroeconomic upside, but we're getting that if it comes. I think it's going to come, but it doesn't need to come for it to be an okay investment. If the macroeconomic environment swings up, which it's doing, it's going to be an excellent investment. So, that's the way we think about it.


Q2. Have you thought about playing on the fixed income side at all - corporate fixed income?

A. You know, there isn't much corporate depth in that. I think if you have a credit fund in Europe you have a lot to do two years, and then you have nothing to do for five years. It was a great opportunity two years ago. Then there were many of the convertibles trading maybe at 35 percent of par - very attractive opportunities, companies that you know would survive maybe with equity infusion but they were not going to go dead. But I think that opportunity is gone from my perspective. I think the opportunity in (European) corporate bonds is not there now.

I think when you look at the macro there are a number of issues in terms of how Europe is going to grow, and I think a common view is that Europe is not going to grow that much. When I painted a pretty positive picture of Europe, I was not talking about the GDP growth numbers. I pointed to the Export-oriented companies that have global market positions. If we do something in the domestic oriented sector, which we do limited of but if we do, we only do situations where we can increase the profits of the company by, say, 50 or 100 percent by cost-cutting, typically, or by restructuring in terms of selling off non-core assets because I don't think you should expect in Europe domestic demand to drive growth.

The joker could be Germany, actually, which has been a laggard for many years in terms of domestic demand - consumption demand being very low for many years. But you have a situation in Germany where the unemployment is at its lowest for probably 20 years, and so there could be consumption growth coming in Germany, which would surprise the markets, I think. But it's not going to make a huge lot of difference if you go from 1 percent growth to 3 percent growth. You're not going to make much money from that, so in the domestic economy you have to find special situations.


Q3. There's been a concentration on bank debt in Europe, as opposed to corporate fixed income. So there's not enough in play in the distressed and high yield and corporate bond markets. Does that make it difficult for an activist to get purchase to force through labour reforms in target companies? Europe needs labour reform to make the economies more flexible. That's what the activists need isn't it, flexibility?

A. I think restructuring in Europe is much easier than generally perceived from a legal/cultural perspective. There are countries in Europe where the companies have already restructured. In Germany it used to be impossible to restructure a company ten years ago. It's completely different now. After the agenda 2010 laws that were passed by the social democratic government in the early 2000s, you can restructure in Germany.

And you have to remember that these companies, and many of the countries of Europe, are very dependent on exports. And the governments and the unions know that the companies have to be successful, otherwise it's going to be a problem in terms of employment. They're subject to global competition from China, from the U.S., from everywhere. And therefore many times you have a consensus among the stakeholders (the boards, shareholders, unions, and governments) in cutting costs.

In the countries where I operate (Germany, Sweden, Finland, Denmark, Norway) you have, by law, unions on the boards of companies. And you would think that's going to be problematic in terms of restructuring a company. It's actually the other way around because the unions understand that if we don't do anything to improve the company we're going to be out of business. They hate underperformance more than shareholders do or as much, I should say.

Now, southern Europe is a different thing ... if you look at Spain and Italy and so on. But I think we're seeing labour reform there, and in Portugal as well. And I think that that's the good thing, that the crisis is used to reform labour laws. I think in terms of Greece, we should recognize that it's not that relevant. We talk a lot about Greece, but it's like in a discussion about the U.S. talking 50 percent of the time about North Dakota. It's not that significant.


Q4. So can Europe split – into a fast-track Euro with a slower Euro for certain countries? There are countries that were thinking of leaving the EU, though there are a lot of logistical issues with that?

A. I think politically it's a no-starter. When Europe looked this spring at the budget problems in Greece it took some time for Germany to come around and help bail Greece out. That was a purely political calculation, and I think rightly so. What they did was to wait to endorse a bailout package until Greece had committed to more far reaching reforms. So, it was more a political process than anything else. I don't think a two-speed Euro is going to happen.

I should say, though, I personally voted as a Swedish citizen against the adoption of the Euro a few years ago. I'm a Euro skeptic - there are a lot of problems with it that we're seeing in a country like Greece where they should have a lower currency. But look at Estonia, for example, a country which was not with the Euro, but they were locked in terms of parity with the euro, and they made an internal devaluation by lowering the salaries of government employees by 25 percent an incredible process to adjust their economy to staying with the locked in currency rate with the Euro. They managed through that, and hopefully they will manage through that in Greece as well.


Appendix- Key terms of Cevian Capital II 

A full profile of Cevian Capital can be found at The Hedge Fund Journal

Consulting One - Team Working in Hedge Funds

There is no such thing as a perfect hedge fund – we are all trying. So in my role as a consultant to hedge fund portfolio managers (PMs), I am usually carrying out remedial work in some dimension. Sometimes it can be about the positioning of hedge funds commercially, but usually it is about what the portfolio managers are doing. I'm going to write a series of articles about my consulting work – this is the first.

One of the key elements I have to investigate in my consulting work is the relationship between team members. I'm going to discuss one project I did with two joint-portfolio managers of an equity long/short hedge fund. This discussion is to raise issues and to describe ways of working. The team in this case comprised two members, PM "A" and PM "B", and they ran reasonably successful long-only products. There are three topics in this snapshot – the ground rules were not well established in this example, there were some important differences in style (personal and investment style) that got in the way of successful team working, and one of the portfolio managers had an unusual trait which had a bearing on his money management style. Finally I have included some of the solutions I gave to the portfolio managers and their boss.



Ground Rules

It is not unusual for a team to move from running long-only money together to managing a hedge fund. In doing so there will, of necessity, have to be new rules of engagement. Clarity of the decision making process is very important, for internal purposes (for accountability and reward), and for external parties like potential investors. It is important that there is agreement about the specific roles to be taken, and that there is a buy-in from the off of the structure adopted. A successful agreement or understanding will have a level of detail in it that may surprise some.

One of the most basic areas not made explicit in this case was the fund's objectives and the consequences that follow from that. The two portfolio managers did not have a common, agreed understanding of what returns would make the fund they both ran commercially attractive. Therefore they did not feel the need to measure their portfolio level risk and monitor it - where they taking too much or too little risk? They just didn't know.

Another consequence of this lack of commerciality in terms of return profile is that they had no notion of what was a the worst monthly loss they could sustain without putting themselves out of active consideration by investors. The worst monthly loss is a key metric both internally and externally. Internally the metric gives an implication of where portfolio level stops should kick in. Externally it is one of a number of measures that give investors an idea of what the whole risk profile should be like – number of winning-to-losing months, drawdown, recovery period, and what is a good and bad month for the style of investment.

One of the issues which provoked some tension in the relationship between the managers was how they split between them the sectors of the equity market they worked on. It was fine, and indeed seen commonly elsewhere, that the market was split into two – one half invested in by one portfolio manager. The tension, such as it was, arose because PM B did not want to be excluded from investing in some of the sectors covered by PM A. It was never satisfactorily covered in discussion at inception in the mind of manager B, and that oversight hung over discussions in the ensuing two or three years.

It is quite usual for a PM in a team of portfolio managers to be able to initiate positions without reference to their partners. But how the team will react to change for the positions (in size or price) does need to be covered in the ground rules. Is there any right of veto, is there a different scale of decision made when the partners don't agree? Once a position is owned is it subject to hard or soft stops – do both partners have to adhere to review and exit levels? For the fund and team under discussion one of the partners was much more engaged in challenging the positions initiated by the other partner. Whilst the partners whose positions were under discussion saw this as a personal style point (one partner was just more vocal/forthright than the other), the other partner saw such challenging discussions as part of the investment process. This difference in perception and therefore activity could easily undermine a relationship under pressure because of returns.



Differences Between the Portfolio Managers

Having had some preliminary discussions for an overview, and discussed at some length how the two portfolio managers spent their time and what structure they had in place in their investment process, some clear points of difference came through. To explore these further I conducted separate structured interviews – asking the same questions to each portfolio manager gave a chance to compare attitudes, preferences, and perceptions of the two team members. To put the following list of differences into context I quote from my written report on the managers: "The managers have fantastically complementary philosophies on the market. They get on very well on a personal basis. In fact they have worked incredibly well together with some quite significant differences in tactical approaches (strategy being broadly agreed)."



Differences in Time-Frame

PM B is more comfortable with the shorter term time-frame that running a L/S hedge fund usually requires. Specifically B is much more willing to incorporate the current implications of market action into his market view by stock than PM A.



Differences in seeing Companies and Stocks

They have a similar level of respect for each other's views on companies (specifically differentiating between stocks and companies). However, when looking at equities of companies (shares) portfolio manager B can be as dispassionate about shares as he can about companies. This is in contrast to PM A – who is still prepared to argue with markets when he likes the company, even when the share price action is saying that the market does not agree with the positive (or negative) view of the company in the short term. So the feedback loop from owning the shares – the P&L – is negative for the position and getting worse (e.g. if it is a short the shares are going up) and that message from the markets, even if it is just about short term timing of the position, is being ignored.



The Fall-back Input - is it Technical or Fundamental?

(or to put it another way "short-term or long-term" or even "stock market or real world")?

Through the structured interviews of the portfolio managers it is possible to tease out where there are differences between the team members on research time. For example, in this case PM A suggested that they needed to have 300 company meetings a year, PM B thought that 100 meetings a year with company management was enough. The different perceptions of what was needed fed through to the weighting given to the fundamentals. Or, as likely, reflected the biases the managers brought into the discussion. Under pressure PM A will rely on the fundamentals to win out, whilst PM B will listen to the message of the markets and will be prepared to cut losing positions.



Conviction or Confidence?

Operators in markets, particularly traders, but to a significant degree portfolio managers as well, bring with them the baggage from their previous life experience to their decision making. So sometimes in analysing a team it is not that there are subtle style differences so much as one of the team is coming from somewhere else attitudinally (or characteristically). There can be a one-sided difference, if you like. Portfolio manager X brings with them epsilon, whilst portfolio manager Y has acquired a trait of zeta.

Through the structured interview it came through very strongly that PM A (or the Alpha member!) had a strong conviction that the most important characteristic of a successful portfolio manager was confidence. It is true that someone operating in markets has to have the belief in themselves sufficient to take on the markets, but the very strong emphasis on confidence manifested itself in the investment process in this case. This happened in two ways.

The first expression of individual confidence, if you like an assertion of confidence of an investment view, was in position sizing. Having done the analytical work PM A would take what I would consider a large position for his initial holding in a stock. Almost by definition the stock was bound to be perceived as under-valued by the market at the point of taking the initial position. If the market further under-valued that (long) position by marking the shares down (causing a loss) this would create a "better" (cheaper) buying opportunity, so PM A would have some bias to expressing confidence in his initial view of the shares by buying more. But the more important point is the size of the initial holding – he may or may not add to the position. Portfolio manager B would take an initial position of less than half the size of that taken by PM A, and look to add to it.

The second expression of confidence was the maintenance of positions of large size. PM A would always look for a further up leg in longs he owned for fundamental medium-term reasons. PM B would have a bias to trim successful positions as the positive momentum waned (to top and tail the positions). There was clear anchoring by PM A in sticking to previously successful positions, and to cut them would, in his mind, be an expression of a lessening confidence in the initial research.





Recommendations and Suggestions to Address the Issues Raised

In this particular case I wrote a 30-odd page report to the CIO of the firm as well as presented my conclusions to the portfolio managers that ran the equity long/short hedge. In the report I made a series of tiered written proposals – key recommendations, other recommendations, and finally at a more elective level, some suggestions. In response to the issues raised above here are some of the Recommendations and Suggestions forwarded:

• You should select what you consider to be "high potential" company meetings for both PMs to attend. This will enable higher conviction positions to be established at an earlier stage with a common background on the company.
  
• Be very clear and explicit (shared between you) on the reasons for having a position in a stock. Indeed there may be five potential drivers for a stock to go up (or down), but you must be clear why you own it (are short of it). The stock position should be in a portfolio for reason of how it will contribute to the portfolio characteristics (factor bets) as much as any stock specific reason (factor). This allows you to control portfolio shape in an informed way. Drift in any one position may not matter, but when aggregated across a portfolio, factors like capitalisation effects will turn you into heroes or zeroes promptly in the hedge fund format. Own positions for a reason and stick to it.
  
• You both have to have the capacity to invest in all sectors of the market.
  
• You need a few mechanistic rules that you can apply to take even more of the emotion out of decision making:
  

1. Automatic locking in profit/reducing exposure after a stated return. So a trading position that gives a 15% plus return in two weeks is completely sold, an investment position that gives 25%-plus return in a couple of months is halved automatically. The trading position can be bought again if it is equally attractive at some point. If the fundamentals still justify a larger position (they have improved since original position taken) then the investment position can be made larger.
   
2. You need a review level and hard-stop level per position. I suggest a 10% loss on book should be a review level, and 15% is a hard stop level (sell whole position, no exceptions). As a reminder the ABC Large Cap Fund has a hard stop at 8% for non-core positions and a hard stop of 10% for core positions, and the ABC Europe Fund has 5 and 10% respectively.
   

• Either can initiate a position, as at present. However there must be a vote before ADDING to a position – both PMs must agree.
  
• Just as you need to know yourself to be an investor, you need to know your partner if you have joint and several decision-making, rather than having a presiding genius. Because you demonstrate some differences in personal style, there are times when you don't understand where your partner is coming from. I suggest that you complete a Myers-Briggs Model™ (Extravert, Introvert, Intuitive, Sensor, Thinker, Feeler, Judger, Perciever) questionnaire. This is particularly relevant for times of stress – we each revert to a fall-back way of operating and this is the kernel of what you need to know of each other for managing money as a team. If you understand more about where each other is coming from (not intellectually but in personal style) then you will be able to tolerate the differences more easily.
  

Two Sides of a Short Position - A High Quality Argument on Netflix

During my time as an analyst of hedge funds in 2000-2002, and later as a consultant working on portfolio management and risk management issues with hedge fund portfolio managers, I have been granted the privilege to hear the fundamental cases for positions taken by very good managers. Hearing about a single position in detail gives a potential investor or investment advisor some insight into how managers think about their positions. When consulting I would always ask how typical the sort of position is, as there is no structural insight given in hearing about something that is outside the usual style for the manager.

I look for several key points during discussion – how did the idea arise; what made the manager devote the scarce resource of research time to the company/industry; did the manager procure or carry out primary research on the company; at what level of the company has the hedge fund manager met management and how often; what sort of catalysts does the PM like to see, and has the hedge fund manager identified a catalyst for a change in fundamentals or for a change in (stock) market perceptions? All of these points will enable an outsider to gauge whether there is an edge in research. Consideration of the edge (if there is one), along with the breadth and depth of human resources in analysis, and a view on the creativity/fertility of the manager's mind, will feed into an assessment of the quality of the manager's alpha source and the potential for consistency in the alpha stream.

So it is I read with interest the published debate about Netflix between Whitney Tilson, the value-oriented founder and Managing Partner of T2 Partners LLC (www.T2PartnersLLC.com), and Reed Hastings, CEO of Netflix Inc. You can find Tilson's full rationale for his short position in Netflix at http://seekingalpha.com/article/242320-whitney-tilson-why-we-re-short-netflix, and the response by the Netflix CEO at http://seekingalpha.com/article/242653-netflix-ceo-reed-hastings-responds-to-whitney-tilson-cover-your-short-position-now. Most unusually for such a dialogue, it is a very high quality argument.

In this case the Netflix short is smaller than any of the top ten longs in the T2 portfolio. The fund manager does not have to be right on any one position, but how he (or she) deals with being right/or wrong in money management terms is important.

Bob Prince, Co CEO of Bridgewater, on Alpha and Beta in HF Portfolios

Bob Prince

Now, if you look back at the history of Bridgewater, for the average market that we trade, we made 1 percent return with 3 percent risk. We've had a .3 ratio for each market. Our overall ratio is about 1. The difference between these two is diversification and portfolio structuring. So, two thirds of our performance has come from balancing risks well, and only one third has come from trying to get the bets right. Of course, if you don't get the bets right, you don't have anything to balance, so you have to start there, right? Okay. So, that's point number one. You can get a lot more mileage out of risk reduction than return enhancement.


Number two is don't believe the numbers. Now, I'm going to make an assertion here. I don't know if you've ever heard this assertion before. My assertion is that correlation is unknowable. So, we talk about portfolio mean variance, about, correlation. My assertion is that correlation is unknowable. I'm talking about the correlation of any two assets – it is unknowable. Now, I'm going to try to prove that to you on a chalkboard.


So, let's just say that I have stocks and I have bonds. Okay? And the question is, what is the correlation between stocks and bonds? Well, correlation is the way that the returns co-relate. It's how the returns relate to one another. In order to understand how the returns relate to one another, you have to really understand something about what drives returns. Okay? Well, there is more than one thing typically driving the return of any one asset. Let's just say I've got economic growth here as a factor that drives the return of stocks and bonds. Now, if the economy is strong, that will be good for stocks - generally speaking if the economy is stronger than expected. If the economy is strong, it will generally be bad for bonds. But the economy's not the only thing that drives their returns. Let's say I've got inflation here as the factor that drives their returns. If inflation falls, that will generally be good for stocks. If inflation falls, that will generally be good for bonds. So, inflation is working the same direction for stocks and bonds. Economic growth is working opposite directions for stocks and bonds.

   
So, now the question is, what is going to be the correlation of stocks to bonds? I don't think you can possibly know. You can't know unless you know what kind of environment you're going to be in. Will I be in an environment that's dominated by inflation? If I am, they'll probably have a positive correlation. If I'm in an environment that's dominated by economic growth, they'll probably have a negative correlation. But if I knew what kind of environment I was going to be in, I'd just go bet on that. But if I'm trying to passively structure a portfolio that's balanced, I don't have any idea what the correlation between stocks and bonds is going to be. And what it was in the past really has no bearing on what it will be in the future. So, now what do you do? How do we do mean variance optimization when you can't possibly know the correlation of two assets?



So, what I'm saying is you can't do this. So, what we try to do is we don't pay any attention to the numbers. We never try to look at the correlation between any two assets. What we try to do is balance our exposure to economic growth and inflation. So, given the structural characteristics of assets, they will perform a certain way given a certain economic environment. And you can look across your assets and start to think about how you're balanced against the economic environment through your asset holdings.

   
The last point is that you need to understand the fundamental characteristics of the returns that you're operating with. And the most important characteristic of those returns is the derivation of the return: is the return derived from beta or from alpha? Beta means the return is derived from the risk premium embedded in the asset. Risk premiums over time will be positive in order for the capital system to function. Risk premiums will be positive over a very long period of time, but it's very easy to buy a risk premium, so it's not a really good returning source of return. It's not a very consistent source of return because it's very attractive. A lot of people buy it and they bid up the prices, maybe has a ratio of .25 return to risk ratio. So, beta is one kind of return. It's one type or category of return. There are lots of betas.

Alpha

Alpha is totally different. Alpha is a bet. I've got a view. There's timing involved. I'm long. Now I'm short. Now over time, people might make bets, but they might on average be long. Then on average they have a beta in their return, right? But ... so the question is, are you generating your return through beta or through alpha, through risk premiums or through timing of bets? Because the characteristics of those is radically different, and the ability to produce a very high return is inherently limited if you're basically holding betas because betas tend to be pretty expensive. You've only got about a .25 ratio. No matter what the historical numbers are ... don't believe the numbers. No matter what the historical numbers are, the return to risk ratio of a beta is probably not above .3. It may have an option characteristic that makes it look that way, but it's not above a .3.

   
And they tend to be very highly correlated because betas are all related to the same economic environment, so it's hard to get a lot of diversification in betas. Therefore, it's hard to get a really high ratio -- high consistent return -- from betas. On the other hand, alphas are very uncorrelated, but you never know if you're going to make or lose money because alpha is a zero sum game. So, it's entirely a bet of can you bet on and find the right manager who can take money from somebody else. And if you know ... if you think you can, you probably should ... as a test, you might want to think about who they're taking money from as a cross check on your process because somebody's got to take money from somebody else when it comes to alpha. For every winner there's got to be a loser.

Beta in Hedge Fund Returns

Now, I just want to show you a quick example of the importance of understanding the composition of beta in the returns of a manager that you might hire. One of the things that we did was that we looked at our database of 2,700 hedge fund managers - we ran the calculations for how much beta is approximately in the returns of these various managers. Well, we did that up to the beginning of the crisis in July 2007, quantified how much beta was in every single one of these 2700 managers. And then, we looked at how those managers then performed over the crisis period.


And so, what this work shows is the managers with more beta lost a lot of money, and that those with not very much beta in their portfolio up to July 2007 lost less. Hardly anybody made money. And the observations are right on the line of best fit (though you should also look at their return to risk ratio).

So, the amount of beta in a hedge fund's portfolio was something like, 96 percent correlated to what their performance has been since July 2007. So, if you just knew that one thing -- how much beta is in their portfolio -- you would have been able to identify with a 96 percent correlation how they would have done it through the financial crisis. The same thing is happening going forward because if you actually monitor this through the crisis for those managers, that beta hasn't changed. They still have that beta.

Now, so if their particular beta does well now, they are going to look good. But it's because that beta is in there. So, are you betting on the manager or are you betting on the market that they're involved in? It's absolutely crucial for you to understand that. And if you're betting on the market they're involved in, no matter what their historical ratio is, the beta ... the ratio of the beta is inherently limited, so something like .25, .3.


So if you look at what Bridgewater does, right now we're long bonds. There's risk premium there that we're earning today by being in a long bond position. But if you look back at what we've done historically, we're long half the time and we're short half the time. There's no systematic bias to be long bonds. And if you understood our process, you would know how hard we try to make sure we don't have that in there, right? So, literally indicator by indicator, market by market, we are approaching it with an expressed purpose of not having beta in our alpha. And we try hard to not let it get in there.

At any point in time, we could be long or short a market. Funds don't have to always be market neutral. But what I'm referring to is a systematic orientation toward beta. What I'm saying is that the amount of beta that was in those 2700 manager's returns was measured by a statistic, that a static holding of asset classes over many years was 80 percent correlated to their return, so that they are, over time, largely in a beta position.


 

Bridgewater Equity Mandates

I think the question of relative versus absolute is always trying to get at the real question of "what is value added?". And there's a lot focus on the industry on the quest for alpha, so to speak. But I think if you were to ask three people in a room of experts what the definition of alpha is, you'd probably get about four answers.


So, the real question is, what are you trying to do in getting value add other than exceed a simple passive benchmark? And, secondly, how is that going to influence people behaviorally?


That tend to lead you in a couple of directions, one in terms of more complexity -- I'll give you an example of that- our equity mandates. Our benchmark not against an overall equity index, but every security selection decision is against a sector in a country. So, you get six major countries, ten S&P sectors. So, we have something called a 60 cell matrix; you can imagine the operational complexity behind that. But every active choice is done against a very specific subsector so that the sector's taken out.


The question is, though -- and it gets back to that behavioral one -- how is that going to influence people, and can you even think intuitively about that when you're in 60 different dimensions? And so, there is something to be said for simplicity because the reality is that the very best tech fund manager in 2002 might have exceeded his peer group by 5 percent, but that meant they were only down 90 percent as opposed to 95 percent. And that's not going to solve anybody's problem.



Edited Transcript from The Greenwich Roundtable