By Michael Oliver Weinberg
The S&P Total Return index finished 2013 up 32%, compared to the HedgeFund Intelligence Composite gain of 8.77%, and its constituent indices ranging from -7% to 16%. Journalists who we know and think highly of (though gladly not those writing for the publisher of this article) are constantly writing articles disparaging hedge funds for their low absolute and relative returns, not only in 2013 but during the past five years. Similarly there are categories of investors such as family offices, other than the most sophisticated ones, and such as the one we previously worked at, who are spurning hedge funds for long-only equities.
We have spoken with successful Wall Street non-investment professionals who selected equities that out-performed the market in 2013, likely due to higher beta, and are now emboldened to believe that there is no need for shorts or to allocate capital to professional managers. The last time we recall hearing similar anecdotes was when we were at one of the top macro funds during the technology bubble, and one of the world’s best Chief Investment Officer’s told us he was accosted frequently with stock tips from taxi drivers and baby sitters.
These days, when we espouse a fund that we think highly of that is up half of the market, net of fees, obviously in excess of that gross of fees, on less than half of the market exposure on both a dollar and beta basis, which thereby implies positive alpha from some skill (i.e., security selection, exposure management, sector allocation, risk management, etc.) there is no reciprocal interest. Never mind that we personally know hedge funds that are up in excess of the market, net of fees.
Similarly we are so heretical as to espouse investing in a hedge fund manager who was down marginally last year. We know both institutional and family office investors who have redeemed from that manager en masse. Though the manager technically runs market neutral, the portfolio is typically tilted towards long value oriented equities and short frauds, over-valued growth equities and other heavily shorted equities. During the past year the most heavily shorted and expensive, on a valuation basis, stocks have out-performed the market and value stocks. It is therefore not surprising that the manager is under-performing. We would argue the manager’s style is out of favor. We believe when today's frothy market subsides, and we enter a more value focused market, or experience a correction or bear market, this manager will continue to do well, as it has in almost every other previous year in the past decade, and its performance will invert to the top decile from the bottom decile.
To quote Michael Steinhardt, an industry legend who has written a book on this very subject that we highly recommend, how does one explain our variant perception that these returns are acceptable and to be expected versus the market’s perception that these negative or lower relative returns are unacceptable? For the answer to that question and why we believe hedge funds are superior to long-only we recommend an article we previously wrote for the same publication this past summer, "Hating on hedge fund fees is bad for your retirement."
Then the next obvious question is why we are writing this now, after not too long ago having written that article already espousing hedge funds. The answer to that is two-fold. First, hedge fund indices, though not top decile managers, have under-performed stock indices over the majority of the past five years. Second, the argument against hedge funds has evolved (or devolved) to focus more on the low relative returns, from the previous focus on excessively high fees (also discussed in our prior article).
Though we have had some good market calls in our career, i.e. bearish in late 1999 and early to mid-2000, bullish in 1Q2009, when we converted a successful short biased fund to a no bias long/short fund, we do not portend to have every macro manager's dream: a binary (buy/sell) market timing indicator. And if we did, we would do what Jim Simons does with his algorithms at Renaissance: share them with no one (as Medallion is now closed to outside investors) and harvest the out-sized returns for ourselves.
To repeat a previously quoted statistic, we are now five years into a bull market. We could run statistics on what the S&P has done after five years in prior bull markets following bear markets, and based on those statistics prognosticate expected market performance or allocation recommendations. However, we have some more intelligent colleagues with PhDs in mathematics who for sport run a website that exposes forecasters who make erroneous statistical assumptions and representations, and we tremble at the thought of falling into their cross hairs.
If we look back on our two decades of investing, among the more memorable major crises and commensurate market dislocations we had Orange County in 1994, the Asian Crisis in 1997, the Russian Default in 1998 when we remember late one night pulling a fax from a seller looking for a buyer of one of the world’s largest most illiquid relative value security portfolios, the tech bubble collapse in 2000, September 11th in 2001, and the global financial crisis in 2008. The 2000 bear market ended three years later in March of 2003. Again, without portending that there is anything scientific about this, as our statistically superior vigilante colleagues would debunk our assertions, we had a bear market or market crisis every few years. Five years into this bull market, we believe we are probably due, or overdue, for a crisis within the next year, and if we are wrong, two years.
That said, what could possibly go awry and derail this glorious five year equity bull market? We are not likely smart or lucky enough to rifle shoot what will prospectively be the precise catalyst, rather we prefer to scatter shoot, with a brief list of material macro potential catalysts. Moreover, it might not even be one of our catalysts that derails the market. That said, we believe the next market crisis is likely to be financially driven, rather than politically driven (i.e., not a nuclear Iran, Asian territorial aggression, etc.)
* China. We believe China has four excesses, and believe Japan in 1989 is an appropriate analog. Those excesses are: 1) Housing, 2) Infrastructure, 3) Manufacturing capacity and 4) Natural resources. Moreover, these excesses have been fueled by excessive debt, much of which will ultimately be written off. We believe this impending crisis is likely to be akin to or larger than the U.S. subprime crisis. Resource dependent countries, both developed and emerging. If we are not wrong about China, countries that are resource export driven, will suffer on the back of China, including Brazil, Australia, etc.
* The U.S. Bond Market. We believe the more than three decade bond bull market is over and that rising rates could have massive adverse repercussions on the economy and the financial markets. We believe this is likely to be exacerbated by the Federal Reserve’s zero interest rate policy (ZIRP), and record $4 trillion balance sheet, which despite the taper is still growing by $75 billion per month. With traditional and unconventional monetary policy already ‘maxed out’ (not unlike consumer balance sheets preceding the global financial crisis in 2007), and based on the law of diminishing returns, it is tough to fathom what policies the Fed has left in its arsenal should another crisis hit.
* Japan. We believe Japan is closer to a currency and debt crisis than it has ever been due to record fiscal debt, adverse demographic trends, a record Bank of Japan balance sheet, and other factors. That said, we are of course aware that betting against Japan is the 'widow-maker' trade, and for a good reason, as investors have been unsuccessfully prognosticating this to no avail for many years.
* Europe. Though spreads have come in and are at or near multi-year lows, our variant perception is that this is unwarranted. The structural imbalances and issues have not been solved and we are likely to see spreads widen dramatically as they did prior to 2013.
In summary, based on the frequency of historic market dislocations and crises over the past two decades, after a strong five year bull market, we believe we are likely much closer to the next crisis than farther from it. To use a baseball analogy, as the preeminent macro manager we used to work for always did, we are now likely in the 7th, 8th, 9th innings. We have suggested some impending crises that we believe are likely and could catalyze a market dislocation or bear market. Consequently we believe now is a good time to overweight more hedged and uncorrelated strategies, and underweight the opposite.
It is not easy being a contrarian in a trending, momentum oriented market, recommending increasing allocations to a strategy that on average has under-performed in the past five years. Moreover, the indices by definition are averages, and therefore assume no alpha from manager selection, which we believe is not the case for better allocators or at the hedge funds we have worked at and invested in historically as an allocator. What comforts us even more about this reallocation is that the herd and performance chasers are doing exactly the opposite, selling down under-performing strategies, including hedge funds overall and specific hedge funds that are down, and buying out-performing strategies, such as long-only and more beta-oriented managers.
In our view, this is akin to buying technology stocks in the back half of 1999, when the inflows were largest, which resulted in more capital subsequently lost than what had previously cumulatively been earned. The great macro portfolio manager we once worked for taught us that markets over-shoot and under-shoot, so we are aware that we might be early, but that is a risk we are comfortable taking, to preserve capital in a market dislocation or bear market and thereby compound at a higher rate of return with less volatility over the long term. Caveat emptor.
Michael Oliver Weinberg is an adjunct associate professor of finance and economics at Columbia Business School and the chief investment officer of MOW & AYW LLC, a family office. He was formerly global head of equity and event allocations at FRM, the multistrategy fund of hedge funds, where he was also on the investment and management committees.