Coggan’s Chronicle

Coggan's chronicle

Philip Coggan
Originally published in the September 2006 issue

The big story of the month was the final settling of the case against Philippe Jabre, formerly of GLG Partners. What was most striking about the case was how long it took to decide; it was three and a half years between the offence and the final judgment. That time period needs to be shortened.

The heart of the story, as always, was a matter for tricky judgment; it surrounded what Mr Jabre perceived he could do after he had been informed of a possible convertible issue by Goldman Sachs. He thought he could maintain his existing trading pattern; the FSA decided he should not have traded at all.

While the hedge community will not appreciate the fining of one of its stars, it is probably good news in the loing run that the FSA succeeded. First it restores the authority of the UK's regulator after some past difficulties. Second, it means that hedge funds are subject to the same rules as everyone else. That will make many institutions feel more comfortable about investing in the sector, not less.

Another poor month for hedge funds

July turned out to be another poor month for hedge funds. EurekaHedge's index shows that the average fund lost 0.5 per cent on the month, and the average fund of funds lost 0.42 per cent.

Merrill Lynch, which takes an average of three different indices, suggests that the average fund lost just 0.09 per cent on the month. But the most popular strategies lost money; global macro fell 2.05 per cent, equity long-short 0.84 per cent and managed futures 2.38 per cent.

On the Merrill basis, macro funds are down on the year to date, while global macro and long-short funds have barely earned a positive return. The problem seems to have been the way that market trends have developed over the year. In the first few months, emerging markets and commodities performed very strongly; an easy trend to take part in. But then both asset classes fell sharply in May. Momentum-following investors then started to short the assets, only for both to rebound; emerging market debt was the best-performing bond category in July. Currency funds also struggled with their short positions in July.

All this indicates that hedge funds find choppy markets very difficult since they risk being whipsawed by changes in trend.In a bull market, they have the time and the imagination to get behind some of the riskier bets; in the bear market, they have the time to get short, a strategy denied the long-only funds. But in a choppy market, their tactics (and their fees) work against them.

Thought of the month

On the same lines, the thought of the month for me came from Julien Garran, head of asset allocation at Legal & General, who talked about hedge funds have learned to play the carry trade over the last three years. He described it as a Darwinian process; if managers didn't adopt the strategy, they would not survive.

That got me thinking about the difference between stock market evolution and the natural kind. Most species have millions of years to adapt to their circumstances. The process of natural selection ensures that those best suited to the environment get more food, avoid predators etc so that their offspring survive; those that are poorly adapted (polar bears in the jungle) die out.

But in the stock market, circumstances change much more quickly. Every three to four years, some catastrophic regime change seems to happen, the equivalent of the asteroid strike that wiped out the dinosaurs. The best way to adapt in the short term is to constantly change tactics.

However, by doing so, fund managers adopt precisely the kind of tactics (high portfolio turnover) that can damage their prospects in the long term. Evolution does not really benefit the clients.

No stopping enthusiasm

Poor returns have not stopped the enthusiasm for new hedge funds. In the first half of 2006, a record 170 European hedge funds were launched, compared with 150 in the first hal;f of 2005. Although the level of assets raised was lower, at $11.4bn compared with $13bn, the numbers attest to the continued enthusiasm for the sector.

In part, this is a case of catch-up with the more vigorous US hedge fund sector. But it also shows that investors are looking for alternative assets; particularly those that do not correlate with the rest of their portfolios. If hedge funds can just get the returns right, there is still plenty of scope for the sector to grow.

Synthetic funds

Harry Kat is an academic who should by now be well known to the hedge fund industry. He is a regular critic, having pointed out at his old haunt in the ISMA centre at Reading that investors should be looking at the unusual properties of hedge fund returns (such as fat tails and negative skew) rather than at measures such as the Sharpe ratio.

At his new home at the Cass Business School, Kat has been focusing on the concept of replicating pension funds with other trading strategies using derivatives to create what he calls synthetic funds.

In his latest paper (Synthetic Funds and the Mongolian Barbeque, details from, he argues that "synthetic funds avoid the many drawbacks that typically surround alternative investments, including the need for extensive due diligence, liquidity, capacity, transparency and style drift problems as well as, very importantly, excessive management and incentive fees."

Back-tested, these synthetic funds can deliver the kind of returns investors want, most crucially a low correlation with the existing portfolio. Over the period March 1997 to April 2006, the synthetic fund delivered, relative to cash, an excess return, of 6 per cent a year. All this was done by trading just seven contracts (S&P 500, Russell 2000, Eurodollar, the two year note, the 10-year note, the Treasury bond and the Goldman Sachs Commodity Index).

All this sounds very impressive but we all know that, with enough back-testing, we can produce strategies that look like Warren Buffett's record. The key is doing it in real time. If synthetic strategies are going to pose a serious threat to hedge funds, it is time for Professor Kat to find someone to put their money where his mouth is.

Turn up and crank the handle

Another academic who writes a lot about investing is James Montier, the bearish Dresdner Kleinwort strategist with a background in behavioural finance. But his latest note should be encouraging to some of the managed futures fund managers, given that it proclaims the superiority of models over human judgment. Typically, Montier draws his examples from a range of other fields, indicating, for example, that a model produced better diagnoses than professional psychologists. Another model was better at predicting criminal recidivism than parole boards.

Montier cites LSV and Fuller & Thaler as two quant funds with outstanding track records. But he cites a number of reasons why such funds are not accepted. the first is that fund managers are overconfident about their skill levels; they do not want to believe a mere computer can do better. Second he says "quant is a much harder sell, terms like black box get bandied around, and consultants may questioning why they are employing you at all, if all you can do is turn up and crank the handle of the model." A lot of CTA managers will know exactly what he means.