Unhedged Commentary

Tuesday, May 26, 2015

How an Inefficient Hedge Fund Market Works for Investors

There has been a lot of talk in the financial media about hedge funds recently. The discussion has not been characterized by glowing optimism. The media’s primary complaint — that average hedge funds don’t add enough value to justify their fees — is legitimate. We’ve been saying this for years. But it’s not true for the reasons that most media critics give. And it’s not universally true: Sophisticated and careful investors can create portfolios of hedge funds that add substantial value.

Much of the criticism stems from a comparison of nominal hedge fund returns with equity market returns. This misses the point. Nobody buys ten-year U.S. government bonds with 2 percent yields because they love the expected returns; they buy them to diversify their portfolios. For this reason, bond investors aren’t criticized for failing to keep up with equity markets. Similarly, hedge fund investments make sense only if they add value to a broader portfolio. Sophisticated hedge fund investors call that added value alpha: skill-based returns that don’t depend on passive market exposures to other asset classes.

Why are hedge funds subjected to this odd comparison with equities? Mostly because benchmarking them isn’t easy. Individual hedge funds differ widely, and the industry just isn’t that tightly correlated with any single asset class.

Luckily, introductory finance classes offer students a basic tool for finding a more reasonable benchmark for hedge funds. Using a linear regression, an investor can measure the passive return a fund achieves from persistent exposures to equities, credit and fixed income (or whatever mix of risks seems sensible for a given track record). The difference between a fund’s return and the return of this customized benchmark can be thought of as the return attributable to manager skill. A simple approach like this really isn’t enough. It ignores all kinds of information about current market opportunities, manager differentiation and nonlinear risk exposures. But it’s a good start.

When we evaluate hedge funds this way, we learn a couple of things. First, hedge funds as a class aren’t underperforming that much. Second, recent results for average funds still aren’t great. Their alpha has steadily declined over the past decade. Although the average alpha for the HFRI Fund Weighted Composite Index of hedge fund performance was about 5 percent from 2003 to 2007, it has been zero for the past five years. This shouldn’t shock anyone. Alpha is a negative-sum game after fees, frictions and financing. Over the past couple of decades, we’ve seen the development of a much more sophisticated professional investment community and the flow of a lot more money into hedge funds. A more competitive and efficient market is good for the world, but it’s a tougher environment in which to add value as an investment manager.

So should we all just pack up our tents and head back to the land of the 60-40 portfolio? Probably not — or at least, not all of us. Though the average investor will (by definition) buy average hedge funds, more-careful investors can do better. Why? Because the market for hedge funds is still not efficient.

The Efficient Market Hypothesis has various flavors, but the basic idea is that under certain conditions investor decisions will result in efficient prices and the expected return on expertise will be zero. For this mechanism to work properly, the market needs lots of well-informed investors making frequent decisions.

The hedge fund marketplace has relatively few investors, limited and variable access to information, and modest liquidity. Accordingly, expert investors should be able to add substantial value.

How? Smart hedge fund investing requires access to an investment team with the skills, resources and experience to identify attractive opportunities across a wide array of complex strategies, to differentiate among managers with varying levels of skill and to evaluate risk management in normal and shock scenarios. More generally, it requires an organizational culture of accountability for measuring outcomes with sensible benchmarks.

Doing this well is hard, but it’s not impossible, and it is important. The payoff from adding alpha to a portfolio can be very substantial: Raising a portfolio’s annual returns by just 1 percent a year can materially improve ultimate outcomes. To achieve this, investors need to be disciplined about selecting only the best managers. As the data shows, average is no longer good enough.

Benjamin Appen and James Hall are founding partners of New York–based Magnitude Capital. Readers interested in exploring this idea further can do so at www.betterbenchmarking.org, a website developed by Magnitude Capital.

Tuesday, February 10, 2015

Unhedged Commentary: Putin Will Never Back Down

   Bill Browder, Hermitage Capital Management (Photo credit:
Peter Lindbergh)

Nearly every investor, world leader and concerned citizen is looking at Vladimir Putin right now and wondering if he will back down or escalate Russia's military involvement in Ukraine. That one outcome will determine the future of European security and economic stability for years to come.

I'm afraid that, based on the reasons behind Putin's motivations for invading Ukraine in the first place, there is no chance that he will back down. To understand this, all it takes is a simple analysis of how this crisis unfolded.

First, Putin didn't start this war because of NATO enlargement or historical ties to Crimea, as many analysts have stated. Putin started this war out of fear of being overthrown like Ukrainian president Yanukovych in February 2014. Yanukovych had been stealing billions from the state over many years, and the Ukrainian people finally snapped and overthrew him. Compared with Putin, Yanukovych was a junior varsity player in the field of kleptocracy. For every dollar Yanukovych stole, Putin and his cronies probably stole 50. Putin understands that if he loses power in Russia, he and his underlings will lose all the money they stole; he will lose his freedom and possibly even his life.

Putin may not have been at risk of an imminent revolution in February of last year, but he could see the writing on the wall. So in March he took aggressive preemptive action. His 1999 invasion of Chechnya, which led to his presidential election, had taught him the value of war in shoring up his popular support.

As Putin and his colleagues evaluated their options, they realized they didn't need to launch an expensive and deadly invasion anywhere. Russia already had 12,000 troops in Crimea stationed at a naval base in Sevastopol — they could reclaim Crimea with almost no effort. In March 2014, using irregular troops and mercenaries, Russia retook Crimea with almost no loss of life. At the same time, Putin ran a propaganda blitz at home to convince the Russian people that the Ukrainians were fascist Nazis who were going to kill the "good Russians" living in Crimea.

Putin's plan worked perfectly, with his approval rating shooting up from 55 percent to 88 percent. Unfortunately, he couldn't just stop at Crimea. If he had, a more strident nationalist would have come along and accused Putin of being weak, taking his spot and putting him in the position he was trying to avoid by starting the war in the first place.

So Putin had no choice but to escalate by going into eastern Ukraine. Unfortunately for Putin, this didn't work out nearly as neatly as in Crimea. There were no Russian troops stationed in eastern Ukraine, and Russia had to send in much bigger groups of mercenaries, criminals and secret policemen. This group didn't hold up well when the Ukrainian army finally came in to challenge them, and to maintain the effort, Putin was forced to send in regular Russian troops and heavy artillery last summer. The shooting down of Malaysia Airlines Flight MH17 was the turning point for Putin. Europe imposed devastating sanctions on Russia.

The sanctions forbid Westerners from lending to Russian companies. This means that the $650 billion of hard currency debt owned by Russian companies can only be refinanced inside of Russia. This has led to massive capital flight, a devaluation of the ruble of more than 50 percent and a monumental recession, which is only just beginning.

Putin has never dealt with economic chaos before. Though some may argue that this will bring him to the table to negotiate with the West, in my opinion any negotiation would be seen as a sign of weakness and is therefore the last thing Putin would want to do.

Putin's only likely response is to escalate in Ukraine and possibly open up new fronts in other countries where there are "Russians to protect." But doing so will only harden the sanctions, leading to further economic pain in Russia — and further military adventures to distract Russia's people from that pain.

I cannot imagine a scenario in which there is any compromise, because for Putin compromise means being overthrown. Judging from all of his actions to date, he is ready to destroy his country for his own self-preservation.

We should start preparing ourselves for a war in Europe that may spread well beyond the borders of Ukraine. The only Western response to this has to be containment. This all may sound alarmist, but I've spent the past eight years in my own war with Putin, and I have a few insights about him that are worth knowing.

Bill Browder is the founder of London-based Hermitage Capital Management and the author of Red Notice: A True Story of High Finance, Murder, and One Man's Fight for Justice.

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