daily volatility, non-correlation …and beta (ii)

This post is about hedge funds.

hedge funds:  a purist’s view

To a purist, a hedge fund is about hedging.  That is, it’s about running a portfolio with offsetting long and short positions.

Conceptually, this can be done either by assembling pair trades (one long, one short, often both in the same industry) or by creating opposing portfolios of good ideas and clunkers.  By using the money obtained from borrowing, and then selling, the hoped-for clunker stocks to fund the hopefully strong-performing good ones, the hedge fund manager ends up with no net exposure to the securities market he’s working in.  His return consists in the spread, if any, between the performance of the aggregate long portfolio and the shorts.  In a perfect world, he never loses money, although the amount he makes in a given year is up in the air.  It depends on the relative valuations of the “good” and “bad” securities that his market gives him.

(By the way, I worked on, and briefly ran, a very successful short-only portfolio for an innovative institutional client in the early 1980s. We pruned “bad” stocks from an S&P 500  index fund and reinvested the money in the rest of the index.)

today’s version

In today’s world, hedge funds are a motley group of mostly strongly net long, mostly highly concentrated portfolio strategies.  They do have common characteristics, though.  They charge very high fees, and as a group they’ve underperformed the S&P 500 pretty continually for more than a decade.  Also, many times it’s hard to get your money back if you no longer want to participate.

why institutional support, despite weak returns?

Why do pension funds continue to support hedge funds with a tolerance for weak performance they would never exhibit with long-only managers?

Two reasons:

–the claim of non-correlation with stocks and/or bonds.  This is basically a rerun of the fallacy of gold as a zero-beta asset, and

–the low expected return from stocks and bonds.  To pluck numbers out of the air, let’s say that over the next five years we can expect returns of 2% annually from bonds and 6% from stocks.  A portfolio made up of equal portions of both asset classes would have an expected return of 4% per year.  Suppose the actuarial assumption of a plan sponsor is that the plan is fully- or mostly-funded if the plan can achieve of 5% annual returns–or maybe 6%.  The plan managers, who hire outside portfolio help, have no way of get to either goal using conventional long-only investments.  That’s even going all in on stocks, which sponsors find too risky.  So the managers can either tell the sponsoring organization to add more money to the pension plan   …or they can hire hedge fund managers with pie-in-the-sky stories of high potential returns.  Until very recently, my observation is that they’ve by and large chosen the latter.

 

 

 

 

daily volatility, non-correlation …and beta

My wife and I are in the process of hiring a financial planner.  While I think this is important to do, our search has brought me back into vivid contact with some of what I consider the nonsensical jargon of academic finance.  I want to write about the general idea of “non-correlated assets,” but I’m going to start by writing about beta.

beta…

In the early days of computer-driven finance, just after WWII, economist Harry Moskowitz proposed beginning to assess the risk of a portfolio by analyzing the interrelationships among individual stocks in it.  That task proved too daunting for the computers of the day for anything but small numbers of stocks.  Others suggested correlating everything to one standard, an index like the S&P 500, for instance, instead.

The regression that would do this has the form of y = α + β(S&P).  This is how beta, the correlation between a given stock’s price movement and that of the market, was born.

So far, so good.

…and gold stocks

One day, people discovered that there was a class of stocks–gold stocks, in particular– that had a beta of 0.  This spawned the idea, encouraged by the gold-bug prejudices of the day, that one could lower the beta of a portfolio just by adding gold stocks.  One could add, say, technology stocks with a beta =2 and offset the risk by adding gold stocks in the same amount.  Simple math said the combination had a beta = 1, or risk exactly equal to that of the market.

Some institutional investors actually bought the theoretical argument about the “magic” property of gold and altered their portfolios in the way I just described.

By doing so, they exposed themselves to the 20-year bear market in the yellow metal that lasted from 1950 to 1970.  They lost their shirts.

They realized only afterward that a beta of zero did not mean that the asset in question had no risk.  It meant instead only that the zero-beta asset did not rise and fall in price in line with the stock market.  In this case, the “uncorrelated” price went straight down during a period when the S&P gained 500%+.  So much for non-correlation.

More tomorrow.