The domain of traditional asset management is not short on performance metrics that heavily weight in the decision to hire, compensate, retain or dismiss portfolio managers. The use of these metrics such as Alpha (out-performance to reference index) and Information Ratio (excess returns per unit of excess risk assumed) have become core elements in the evaluation of portfolio managers as well as driving much of the portfolio construction and management processes. These core metrics have imposed a culture that rewards and prioritizes out-performance (being more-right or less-wrong than the market) over and above the objective of protecting the capital (avoiding being outright wrong).
The motivated professional portfolio manager is constantly seeking to score and deliver better performance metrics than a competing and competent peer group, and/or better than a referenced index. This objective drives the decision-making process and focus on playing offense rather than defense, to score rather than blocking, to beat the averages, and to out-perform. The professional portfolio manager is in constant pursuit of superior information and thus predisposing him/herself to behavioural biases that are incoherent with the protection of capital and the generation of absolute returns.
The Loser’s Game
In his bestselling book entitled “Winning the Loser’s game”, Mr. Charles D. Ellis refers to Dr. Simon Ramo who observed that tennis was not one game but two. The one played by professionals and the most gifted being a “Winner’s Game”; whereby the outcome of the match is determined by the actions of the winner who ultimately scores or wins the most points. And the other game, played by the amateurs, being a “loser’s game”; whereby the outcome is determined by the actions of the loser who ultimately makes the most mistakes or loses the most points. Dr. Ramo then concludes that winning in a loser’s game is simply “to lose less”.
Mr. Ellis observes that institutional investing transitioned from a Winner’s Game to a Loser’s Game around the 1960’s when Wall Street eventually attracted too much attention and too many professional players. This is confirmed by Fama who suggested in 1965 that no one can continuously defeat the market to earn the excess profits in an efficient market, where the information has been exposed completely. And therefore, Mr. Ellis concludes that to better perform in investments, a portfolio manager is best to concentrate on his defenses. As well, and most importantly, he claims “It’s too hard to outperform the other fellow in buying. Concentrate on selling instead” and “In a Winner’s Game, 90% of all research effort should be spent on making purchase decisions; in a Loser’s Game, most researchers should spend most of their time making sell decisions.”
Had Mr. Ellis’ comments specifically being aimed at hedge fund managers, his words may have been the following: “It’s too hard to outperform the other fellow in buying and selling. Concentrate on monetizing gains and attending to losing positions instead” and “In a Winner’s Game, 90% of all research effort should be spent on making profitable purchase and selling decisions; in a Loser’s Game, hedge fund managers should spend most of their time monetizing gains and attending to losing positions”.
Effectively playing the Loser’s Game is acutely important and particularly critical when the objective is focused on protection of capital and absolute returns; the presumed objective sought by most hedge fund investors.
The hedge fund universe has become heavily contaminated; it can generally be classified among the following three constituents:
1. Absolute Returns: The “all weather” and “stable returns” strategy managed by the active risk managers who remain disciplined in switching to a capital-preservation mode when markets dislocate, and to the detriment of temptation in expressing high conviction ideas and themes. These managers tend to adopt a very humble and nimble style and effectively navigate between perception and reality in the market in which they deploy their strategy. As well, these strategies tend to be applied in the most liquid markets.
2. Unique Alpha Generations: The undeniable talent effectively deploying the expanded toolbox afforded to the hedge fund manager. They offer access to unique risk and return factors not available among the traditional asset management mandates. The strategies are often overlaid with an effective risk mitigation framework to reduce the impact of unwanted risks assumed in the expression of views. But beware, they should not be relied upon to protect capital or de-correlate your overall portfolio from broad equity draw-downs and market dislocations. This characteristic is evident by virtue of the fact that these strategies tend to beapplied lower in the liquidity spectrum and by virtue of the fact that they tend to be long-biased.
3. Contamination: Those that give “hedge funds” a bad name. They are often run by managers and analysts who are attracted by the overlaid fee structure and those preferring to fully express their views and opinions within an unconstrained investment policy framework. Some will explicitly or implicitly sell a “Stangle” (short a call and put option) on the market while relying on stable statistical relationships. Unfortunate to them, and their investors, correlations and volatilities do not behave like postal codes, they do change; most often violently and precisely when the managers rely on those relationships to be stable the most. Generally, there is a failure (or ignorance) in distinguishing between “risk management” and “risk mitigation”.
Risk Management versus Risk Mitigation
The hedge fund investor has somehow sought and found comfort in allocating capital to hedge funds that apply and embed an array of risk mitigation tools to their strategy while hoping to derive absolute returns. Examples of such risk mitigation tools include: long and short positions (the Jones Model), paired positions, market neutrality, targeted volatility level, or diversification.
None (absolutely, none) of these risk mitigation tools offer a guarantee to absolute returns. Evidence does exist that a portfolio manager may insist on ignoring or avoiding all of these tools and derive absolute returns nevertheless. Risk mitigation tools may offer a reduction in the volatility level of a return profile, but none contribute to protection of capital and absolute returns.
The evidence supporting the above bold statement lies in the fact that there is a market participant that has remained an ongoing concern through bull, bear, benign and rather violent market environments while effectively protecting capital and generating absolute returns in the process. This market participant ignores each and every one of these risk mitigation tools; he is forced to ignore them. The market participant is referred to as the Market Maker. Granted, the Market Maker enjoys the benefit of a free lunch in the form of the bid-offer spread but this spread is vastly inferior to intra-day or even intra-minute price volatility.
The Market Maker is an admirably effective risk manager. While maintaining an orderly market within the rules and regulations of the exchanges and generating a profit in the process, he is forced into the following predicament: (1) No asset allocation and (2) no diversification. He is forced to include only one position; either long, short or flat. (3) No hedging. There are no paired positions and no beta, fundamental, factor-specific, sector hedge, or systemic hedges.
The Market Maker is not allowed the time or luxury of benefiting from deep due-diligence research. But then again, right or wrong, they are not allowed the luxury to express a directional view or opinion. The market is a “collective perception of reality”; its behavior and path are the results of the actions of many, each expressing their interpretation of facts, their views, their tolerance to risks, utility functions, within different timeframes and objectives, rational or not.
So, how do they protect capital and generate absolute returns? The Market Maker has no choice but to accept this “collective perception of reality”, respecting it, and navigating in it. To remain a going concern and generate profit, he must avoid two specific behavioral biases: “overconfidence” and the “disposition effect”.
As human beings, acting “rational” persistently and consistently without biases is impossible, even though we may usually self-perceive ourselves capable of rationality. The Disposition Effect claims that investors are eager to sell stocks of value and willing to hold stocks that have lost value; they are unwilling to suffer or realize losses through disposition. The factual evidence through academic research is abundant. As demonstrated by Goetzmann and Peles (1997) who found the speed of cash inflows towards a better performing mutual fund is faster than that of cash outflows from a worse performing mutual fund. Numerous studies reveal the same phenomena also occurs amongst institutional investors.
Overconfidence reveals an investor’s unwillingness to discount available information while overestimating their private and hard-earned superior information. The concept is particularly applicable among professional investors who consider themselves competent experts.
By necessity, the Market Maker escapes all temptation in succumbing to any of the above-mentioned behavioral biases. The Market Maker will generally operate according to the following rules: As buyers overweight sellers he will allow both the bid & ask prices to trend upward and accumulate a net long inventory in the process. Conversely, as sellers overweight buyers he will allow both the bid & ask prices to trend downward and accumulate a net short inventory. As well, and most importantly, as the volatility of the relevant security increases and/or liquidity is reduced, he will reduce or flatten his inventory and increase the spread between the bid & ask prices.
The Mechanics of Absolute Returns
The Market Maker, i.e. the ultimate risk manager, effectively navigates in the market’s perception of reality and abstains to the temptation of behavioral biases; no matter the information (superior or public) he may possess that may be relevant to the specific issuer, sector, or overall market. Simply, he has to accept the current market action as “the reality”. This abstinence is the discipline that he objectively applies to protect his capital and generate returns.
Bearing in mind the Market Maker’s predicament and results begs for the following claim: “the propensity to absolute returns is increased when allocating capital to ideas or views currently receptive to the market, and reducing or retrieving the capital when the market is no longer receptive to these ideas and views.” There is no room for the behavioral biases in the quest for absolute returns.
In reality, and in the context of a multi-security portfolio, one cannot expect every position to be a winning trade, i.e. currently receptive to the market. It is a question of sizing. The active and disciplined risk manager will size up positions as the market acknowledges his views and size them back down (or remove them) when the market is no longer receptive.
The “discipline”, as described above, is the endeavor to abstain from behavioral biases.
Generally, this “discipline” represents exactly what the Systematic Global Macro managers are seeking to replicate. They will identify a trend according to pre-established rules, timeframes and algorithms, and implement a position in line with the directional trend and apply a trailing stop. This trailing stop spread essentially represents the premium they are willing to assume to participate in the trend, upward or downward. At the portfolio level, they will dynamically adjust the margin-to-equity level (implied leverage) inversely with the level of volatility in the underlying assets, and inversely to the correlation among the assets. The Systematic Global Macro manager represents a replication of the disciplined and dynamic risk manager, but systemized and applied across multiple assets while avoiding the behavioral biases.
An understanding of the basic principles and mechanics applied by the Market Maker and the Systematic Global Macro provides compelling insight in the process leading to the generation of absolute returns. This disciplined and dynamic process is without doubt the reason why most Systematic Global Macro managers generated very good returns in the midst of the financial crisis of 2008. Evidence also suggests that in the midst of the financial crisis, or any market environment, there were no headlines pertaining to Market Makers going out of business or losing significant capital.
It is a fact that Systematic Global Macro managers undertake no fundamental analysis, the Market Maker undertakes very little, if any. And therefore, Alpha-seeking or Winners’ Game initiatives such as deep due-diligence fundamental research, catalyst-driven and high-conviction allocation of capital provide no guarantees in the generation of absolute return and protection of capital. The same observation is applied to risk mitigation initiatives such as diversification and hedging.
An active and disciplined risk management framework and philosophy tends to suppress the behavioral biases whereas risk mitigation tends to subsidize the behavioral biases.
Risk mitigation, such as diversification, hedges or paired positions add an element of comfort or “suppressed urgency” when faced with losing positions that tend to be held static or grossed-up (double-down) in price weakness, further accentuating the behavioral bias effect.
Active risk management explicitly directs and prioritizes the attention of the asset manager to attend to losing positions; they are un-welcomed distractions in the portfolio management process and ultimately compel the manager to reduce or remove them from the portfolio and then focus his work on better ideas.
What about Alpha?
There is absolutely nothing wrong with hard-earned Alpha derived from fundamental and/or quantitative research and analysis. Out-performing peers and/or the market does not necessarily derive absolute returns; something is missing in the equation. Part of the problem, in part, lies when portfolio inclusion coincides with idea generation. As well, there is another problem when sizing of positions is coherent with the underlying conviction level; the typical Alpha-seeking modus operandi.
Research, portfolio management, risk mitigation, and risk management are four distinct disciplines. And when the hedge fund managers and hedge fund investors fail to distinguish between them, they are setting-up themselves up for a very disappointing experience if they are aiming for absolute returns; and in particular within a Portable Alpha mandate (a misnomer described later in the article).
The hedge fund investor applying traditional asset management principles in the assessment of hedge funds should therefore expect traditional asset management return profiles. Traditional asset management principles allocate importance on the concept of “Alpha”, typically derived from an impressive idea generation process overlaid with “deep” fundamental analysis to identify non-consensus and yet-to-be discounted embedded valuation opportunities. The terms contrarian, non-conventional, deep value-oriented, hidden values, misunderstood, overlooked, deep due-diligence, etc, are often appreciated concepts that tend to seduce the potential investor.
The Alpha seeking exercise, playing the Winners’ Game, imposes an undeniable predisposition to swim against the market’s current, as well as the prevailing perceptions of reality. This characteristic is deliberate and calculated.
The deeper the due-diligence and the more non-conventional the ideas to identify hidden and misunderstood valuation, the more time required for the market to recognize, digest and eventually discount these valuations. And therefore, the most time required for the monetization of the time and effort invested by the portfolio manager and his team.
Meanwhile, before these ideas can be monetized, other events and issues may impact the specific issuer or market as a whole. The long and expensive process required to validate and build conviction among these themes and ideas becomes “emotional”. And as the market fails to acknowledge and discount these high-conviction and significant valuation gaps, the portfolio manager working on his Winner’s Game will, for the lack of a better term, “disrespect” these market forces and most likely gross-up on his high-conviction ideas. “The market is wrong and I am right” stubbornly admits the manager.
At this juncture, irrational investment decisions and behavioral biases now dominate the portfolio decision-making process. Information deemed as superior leads the investment professional experts to become overconfident. They tend to over-rely on their financial models and private information and tend to neglect available information. Academic work has been published on the subject; Griffin and Tversky, 1992 and Daniel et al. 1998, for example.
To effectively win at the Winner’s Game, i.e. out-perform the market and peers requires sustainable and impressive Alpha generating capability. Alpha stems from persistence in talent and/or persistence in luck. Sooner or later, they both run out.
In particular, talent and luck do systematically run out when markets dislocate, behave irrationally, exhibit contagion and exogenous events. Valuation gaps are now wider; the newly proposed risk-return payoff profile now seems even more compelling. It becomes even more tempting to deploy more capital to express and capture the opportunity set. Rational or irrational as the market or “perception of reality” may be, its overwhelming forces dictate prices; not the underlying true valuations. We are all familiar with “there are two rules: #1, your boss is always right; #2, when your boss is wrong, go back to rule #1”. The same applies to the market.
Playing the Winners’ Game forces the hedge fund portfolio manager to spend most of his time on the idea generation and validation process. The portfolio manager becomes an extension of the research department. “Portfolio Management” activities consist mainly in risk mitigation activities. Very little, if any, time is spent on risk management activities, i.e. effectively and actively attending to losing positions.
In the quest for absolute returns, capital is much too precious to be allocated to ideas while waiting for the market to realize that these ideas are right. As well, in the quest for absolute returns, one is not allowed the luxury to size positions in line with underlying conviction, whether or not these views and opinions are endorsed by quality fundamental research and superior information.
What good is a leveraged negative 18% when the market and peers have lost 22%?
A Portable Alpha mandate seeks to enhance a portfolio return profile, usually overlaying a passive portfolio allocation with a stable return generator through leverage.
In order for this leveraged allocation to be effective and contribute positively to an overall portfolio, it must be stable and absolute. This characteristic is particularly required and vital when markets are dislocating, when liquidity is being withdrawn, and when the rest of the long-only (active or passive) portfolio is bleeding.
An effective Portable Alpha mandate dwells on absolute returns. However, as we have realized already, absolute return does not dwell on Alpha. It dwells on a consistent, disciplined and active risk management framework of attending to losing positions and effectively navigating in the market’s perception of reality. Capturing some Alpha along the way will help, but it is not a means of protecting the capital; those are two very distinct ingredients to a portfolio’s activity.
The term “Portable Alpha” is extremely misleading. It has led consultants and hedge fund investors to include the wrong constituents of the hedge fund universe in their overlaid and leveraged portfolios. They have been seduced by the impressive Unique Alpha Generators and some elementsof Contamination in a portfolio that could not tolerate any significant correlation to broad equity draw-downs and market dislocations. And to make things worse, this leveraged mandate was less liquid than the core portfolio. So when the core active and passive portfolio was bleeding, so was the leveraged portfolio, and it could not be relied upon to honor margin calls and other liquidity requirements. This is exactly why most Portable Alpha mandates failed miserably.
The missing link
The missteps in distinguishing the between absolute return and traditional asset management styles explains in large part the decline of the Fund of Hedge Funds (FoHF) model. However, there are now more FoHFs than ever before. This is by virtue of the fact that institutional investors are now deploying internal resources to execute proprietary diagnostics on hedge funds in order to make direct allocations, and thus build their own FoHF. There is little evidence, or it remains to be demonstrated, that the disintermediation has resulted in a different philosophy and framework than previously applied within the FoHF model. Therefore there is no evidence to claim that they will not repeat the same mistakes. The next market dislocation shall provide the evidence.
It’s not being right or wrong that matters, it’s properly applying and embedding an active and disciplined risk management overlay to protect capital when the market fails to acknowledge or agree with portfolio views; precious capital entrusted to the asset manager by the beneficiary.
Absolute return strategies are the results of the application principles that are vastly different and alienated from those applied in traditional asset management mandates. Failure to distinguish the two has led to confusion, contamination, and disappointment. However, if there is a single concept that applies to both, it is the adherence to effectively play and win the Loser’s Game: the core element to the successful quest for absolute returns.
Note: Permission was obtained by Mr. Druckenmiller and Mr. Ellis for referring to their respective quotes in this article.
Rene Levesque founded Mountjoy Capital that offers independent hedge fund diagnostics with respect to their propensity to derive absolute returns. Mr. Levesque has worked in the capital markets for over 25 years and has interviewed about 4,500 hedge fund managers.