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Thursday, December 14, 2017

It's Not Easy to be A Successful Hedge Fund

Despite the terrible record of hedge funds in beating simple passive investing it seems that they keep trying "new strategies.

The track record of hedge funds is poor and even that database has a large "survivorship bias" . So may funds close or the managers reinvent themselves with new fund names and new strategies it is literally impossible to have reliable data on their performance.

Hedge funds have been closing particularly those with the traditional long short strategy (long favored stocks/short unfavored stocks. It also seems that some funds are using the long/short strategy based on smart beta factors.

from Bloomberg

Traditional long-short hedge funds and their managers have recently felt like an endangered species, with many giving up after finding it increasingly hard to turn a profit, as Bloomberg News detailed Tuesday. The latest to throw in the towel is John Burbank, who hit it big after the financial crisis, but this week announced he was shutting his hedge fund Passport Capital. After two years of poor returns, recently from investments in Saudi Arabia, Burbank said he needed to rethink how he invests. He may launch a bitcoin fund.

Other long-short fund managers are coming to the same conclusion. In September, Whitney Tilson closed Kase Capital, saying he no longer had a high degree of confidence he could beat the market. Hedge fund manager David Einhorn, who is famous for making public cases against the companies he's shorting, has recently said he wasn't sure if his brand of value investing could still work. And Joel Greenblatt, a long-time hedge fund manager who launched long-short mutual funds a few years ago, has recently been allocating more of his funds to indexes in order to combat losses.

But hope springs eternal new hedge funds emerge peddling new strategies and if there is a short period of success money rolls in. Hedge funds are usually limited legally to what are called "sophisticated investors". But their behavior shows they are anything but.

Some funds hit by the long bull market are switching to long only strategies based on computer stock screening...something that could be done more cheaply and more transparently with smart beta funds.

Joel Greenblatt for years a successful stock picking value investor has created a blended portfolio combining the passive strategy of part of the money invested in the S+P 500 and part of the portfolio long stocks he favors and short those that he sees as overvalued..a hybrid of passive and long short. Of course any strategy involving short positions has potential for large losses and it is unclear that the long and short positions can offset each other. Again with smart beta ETFs with fees of less than .10% and broad index ETFs with fees near zero it may well be investors are better off with a combination of a broad index combined with smart beta for lower cost and volatility with potential for higher returns as well

John Burbank who made returns of 200% betting against mortgage backed securities in 2007. Funds flowed into his funds based on that success. But not surprisingly the success of 2007 didn't translate into long term success in the stock and bond markets...and the money flowed out assets are now under $1 billion .


Passport has struggled for years to equal its crisis-era success, and now manages a fraction of what was once a roughly $5 billion war chest. Several prospective investors approached about the new venture say the firm’s flagship fund was down double digits last year, and was down again in 2017.
Passport said in a letter to investors late Monday it would close its main fund, having earlier told some investors it expected further redemptions by year-end, a person close to the firm said.

Burbank has indicated he is moving some of his assets in a fund concentrating on cryptocurrencies. It is hard to see how anyone even the most experienced trader can claim any expertise in tis area.

Other funds are moving into esoteric non stock investments according to Bloomberg such as "
litigation finance or private debt and equity, from Deere & Co. tractor dealerships to a banana plantation in Costa Rica.
It's hard to see how managers have much of a track record in this area, what kind of past data they have..and what it could mean for the future and what kind of liquidity thse asset classes have

One of the new type of hedge funds are based on

Another hot category is  algo trading.based on "big data" and "machine learning" techniques used  From the WSJ

The Future Is Bumpy: High-Tech Hedge Fund Hits Limits of Robot Stock Picking

Voleon is among investors deploying machine learning, a technology in which computers develop trading strategies. It’s harder than it sounds

Machine learning, a set of techniques that empowers computers to find patterns in data without using rules prescribed by humans, has been producing advances in a range of fields, from robotics to weather forecasting to language translation. The technique is at the heart of efforts to build self-driving cars.
Why not use it to crack financial markets? The notion has led to an arms race of sorts, as multibillion-dollar investment firms that already were mathematically focused have been signing up the smartest computer scientists and statisticians they can find.
The gambit seems to be working for two of this year’s top-performing hedge funds. Quantitative Investment Management LLC, up 68% this year in its biggest fund, attributes its success to the technique. Teza Capital Management LLC credits machine learning in part for its more than 50% gain so far this year.
Yet instances of parlaying machine learning into investing success over a sustained period are rare. Much of the reason can been seen in the yearslong struggle of Voleon, one of the first investment firms to commit itself fully to the kind of machine learning that is producing many advances in other fields.

These computer experts discovered what anyone in the financial markets could have told them. Markets are complex and dynamic with patterns, particularly shorter term which constantly change. Nothing based on past data could have predicted the 2008 financial crisis..although a few people such as those profiled in the movie the Big Short did so through rolling up their sleeves with old fashioned research. Not only is there lack of consistency in returns even in those years of high returns it is unclear what the volatility is and if leverage is used. Ultimately leverage is the downfall of many strategies that show eye popping short term returns.

The WSJ continues

The basic problem they faced was that markets are so chaotic. Machine-learning systems have been best applied so far to situations where patterns are more of a repeating nature, and thus easier to discern, such as in playing the ancient game of Go or even guiding a driverless car. The financial markets are “noisier”—continually being affected by new events, the relationships among which are frequently shifting.
The protean nature of the markets also means yesterday’s relationships can vanish as investors figure them out and move to take advantage of them. This isn’t a problem faced by machine learning in other fields, such as converting human speech to text; computer engineers can count on human speech continuing to have the same basic characteristics

George Soros the master trader who eschewed such techniques wrote of the reflexivity of markets years ago. And Richard Brookstaber who worked for years in financial derivatives for major investment banks makes arguments for the complexity of markets in his recent book .The End of Theory which focuses on the influence of human interactions on financial markets...the exact opposite of combing through machine learning

It's hard not to look at the constantly changing hot strategies among hedge funds and not conclude that individuals are not better off not fitting the category of "sophisticated investors" and getting access to these funds. Anyone remember Long Term Capital with its Nobel Prize winning and top Wall Street brains at the helm ?

Tuesday, December 12, 2017

More Apple is Likely Coming Into Your ETF Portfolio

On this Friday December 15 the recompositions of both the S+P 500 and the Nasdaq 100 will be announced

MSCI will do its index recomposition early in 2018.

Given the 17%+ gain in AAPL since the last S+P recomposition in June and its large weighting in the major indices that weighting is likely to increase after the recompositions. Meaning holders of ETF portfolios will like find more AAPL in their portfolio.

AAPL his the largest holding at just under 4% in the largest ETF SPY which has over $250 billion in assets under management

 AAPL 17% weighting in the Nasadaq 100 and it QQQ has just under $60 billion in assets under management.

Iinterestingly for "smart beta" investors AAPL is the top holding in QUAL, the third largest holding in MTUM (these are based on MSCI indices)

It is also the larges holding in the S+P 500 large cap growth ETF IVW

The net result is that the % of your ETF portfolio  invested in AAPL is likely to go up. Whether or not that is a good thing is up to the individual investor. But it does show that it there is merit in looking "under the hood" of an ETF portfolio.

I am not a stock picker but I will point out thast AAPL has over $250 billion (!) in cash much of it abroad. Given the tax incentives for bringin in cash for abroad it is likely that a portion of that will be brought back to the US. And given that AAPL does next to no manufacturing in the US it is next to impossible it will shift production (which it outsources to Chinese manufacturers) back to the US.

That means the cash will likely go to dividends, stock buybacks and acquisitions (netflix has a market cap of around $80 bln...just sayin).. Yesterday Apple announced its acquisition of music identification service shazam for $80 million obviously a tiny dent in its cash.

Thursday, December 7, 2017


Not only do I view this idea as crazy this bitcoin "trust" regularly trades at a premium of 30% and more than the "cash" bitcoin.

Wednesday, December 6, 2017

Is Factor Investing Driving the Market ?

Bloomberg had a fascinating article pointing to the influence of factor investing in the market.

The popular narrative is that stock pickers are selling tech after the massive runup this year and are piling into companies set to benefit from U.S. tax cuts. But observers such as Andrew Lapthorne of Societe Generale SA don’t buy it. They look at the contours of the selloff over the past few days and have a different take: A few heavy hitters are dumping factor positions that incidentally hurt chipmakers and software companies and once they’re done, the rally will resume.

Two factors stood out last week. First, the plunge in the momentum trade (betting on past winners to continue winning), and second the gains in value (seeking out underpriced stocks) to near-record proportions. Because the moves were severe in U.S. stocks and occurred across sectors, macro forces aren’t causing a rotation from technology to financials, strategists reason. Rather, computer-driven funds liquidated or readjusted factor exposures, they say...

“The ‘momentum unwind’ effect is observable even within sectors,” Chintawongvanich wrote in a Tuesday note. “We find that they tend not to portend much for the market; once the unwind has run its course, typically the ‘long momentum’ stocks resume rallying.”

But more than momentum, the culprit here was probably value, according to Lapthorne, who notes that last week, the strategy betting on the cheapest stocks had its biggest daily rebound since March 2009.

What is fascinating here is that large numbers of computer driven traders are employing factor trades...and doing it on a long/short basis in the case of momentum going long stocks with positive momentum and short stocks with negative momentum. Such a trading strategy would need to be quickly unwound if it reversed. Given the underperformance of value stocks it is likely that many value stocks were on the short side.
Once short term players with leverage all follow a similar strategy the moves can be abrupt and not just driven by fundamentals.
With regards to factor investing it seems that the short term traders took the insight that factors influence stock movement and turned it into a strategy for leveraged trading,
In other words they are turning what should be a long term asset allocation strategy and using it for tactical trading.
Long term investors should do quite the opposite of what the traders do. They should have a portfolio balanced among factors holding both value and momentum since the two are generally not correlated. Therefore the combination of the two helps diversify a portfolio.
In fact the moves of short term traders is "noise" for long term investors best to be ignored or seen as opportunities to implement long term strategies.
Three month chart momentum (mtum)  etf vs large value (VTV)
VTV (brown) MTUM (black)

Tuesday, December 5, 2017

Getting Ready For a Bitcoin Crash ?

Bitcoin as of Dec 5 2017

Bitcoin futures beginning trading December 10 on the CBOE (Chicago Board Option Exchange)

From CNBC:

Bitcoin futures will allow institutional investors to buy into the digital currency trend, and likely pave the way for a bitcoin exchange-traded fund in the U.S., analysts say. The digital currency is prone to sharp gains and losses of several hundred dollars in only a few hours, and enthusiasts say bitcoin futures will help investors feel more comfortable with buying bitcoin since they can use futures to protect against major losses.
"The prospective introduction of bitcoin futures has the potential to elevate cryptocurrencies to an emerging asset class," Nikolaos Panigirtzoglou, a global markets strategist at JPMorgan, said in a Friday report.
Bitcoin has surged more than 1,000 percent this year to above $11,000, helped by increased interest from institutional investors. Twenty-four hour trading volume in bitcoin was $6.6 billion, according to CoinMarketCap.

This will be the first time there is a central place for "investors" to purchase and sell bitcoin . Actually the futures contract will "cash settle" based on the settlement price set by the exchange. This makes trading in bitcoin accessible to institutional investors and others that can only trade on a regulated exchange. It will make the pricing of Bitcoin transparent..all transactions on and off the exchange will look to the futures contract as the definitive exchange rate.
The futures contract means it will be the first time for "bitcoin skeptics" who see a bubble to go short the contract. It also opens up trading to futures market participants who already have sophisticated systems to access market information and execute trades.
My guess is that some of these sophisticated participants will trade the futures from both the long and short side taking advantage of the large price swings in the current market.
 Initially I would not at all be surprised that all the skeptics who have looked at the massive increase in value and said "I wish there were a way to short bitcoin" to take advantage of this opportunity, go short and push the price sharply lower with all the self reinforcing price movements we see so many times when an asset price falls precipitously.
It may well be "watch out below" as the futures contracts make their debut 
In an article on Bitcoin Jason Zweig in an article entitled Bitcoin Ignorance and You observed that in the case of those that have made money "investing in Bitcoin they may be falling into a behavioral pitfall (my bold)l:
David Dunning, a psychologist at the University of Michigan, the co-author of research on what has become known as the Dunning-Kruger effect: the state of being ignorant of your own ignorance.
That seems to be a fundamental part of what it means to be human. “We don’t have an index or catalog in our heads that says, ‘You know this, you don’t know that,’” says Prof. Dunning. “So we’re left to guess.”...

 investors can fall into what Prof. Dunning calls “the beginner’s bubble.” New to the task, “they over-read the significance of the first few successes they have,” he says. “They base their ideas of their competence on much too little experience.” Not recognizing that they shouldn’t draw sweeping conclusions from only a handful of outcomes, “they think they got it right immediately.”
A quick hot streak can give beginning investors a jolt of confidence unwarranted by the evidence.
The bitcoin futures and the entry of experienced investors/traders into the market may give those confident beginners a rude awakening.

More on the prospect of bitcoin shorting from Bloomberg

Hedge Funds Prepare to Trade Against Bitcoin

A bitcoin big short is building.
The planned introduction of bitcoin futures contracts at CME Group Inc., Cboe Global Markets Inc. and Nasdaq Inc. will make it much easier to bet on a decline. Hedge funds, which have largely stayed on the sidelines, are waiting for the Chicago Mercantile Exchange’s futures market to open for a fresh opportunity to bet against the cryptocurrency, according to more than a half dozen people trading the assets.
“The futures reduce the frictions of going short more than they do of going long, so it’s probably net bearish,” said Craig Pirrong, a business professor at the University of Houston. “Having this instrument that makes it easier to short might keep the bitcoin price a little closer to reality.”....
Some see the bitcoin market as “one of the greatest shorting opportunities ever,” said Lou Kerner, a partner at Flight VC who invests in the cryptocurrency. “You have a lot of zealotry, and a lot of people, including me, who think it’s the greatest thing to ever happen in the history of mankind. You have a lot of people who think it’s a bubble and a Ponzi scheme. It turns out both of them can’t be right.”.....
on the other hand:
Ari Paul, co-founder of hedge fund BlockTower Capital and former portfolio manager at the University of Chicago endowment, said people are mistaken if they think the famously volatile cryptocurrency is a clear-cut short.
“While some traders are eager to be able to short bitcoin and will do so when the futures are launched, there is a far greater amount of money eagerly awaiting the futures as a vehicle to go long,” Paul said.
The important impact in my view to the futures is the ability to trade in amounts that would be meaningful to hedge funds and other professionals. The size of the existing market is simply too small to be of interest to them...leaving the field open mostly to those individual investors many of the type Zweig describes above.
There are limited ways to short bitcoin today, said Michael Moro, chief executive officer of Genesis Global Trading. The cryptocurrency trading platform has lent about $20 million to investors to take bearish positions, which were mostly to hedge existing bets, he said. Companies like GDAX, BitMEX and Bitfinex allow investors to buy assets on margin for short periods.
“With the existing exchanges, no one can get in and short $1 million,” Moro said. “It’s really small potatoes on what you can do today. The CME guys open up a new frontier.”
The trading starts next will be interesting

Tuesday, November 28, 2017

Actually An Active Manager is Worse than A Coin Flip

The WSJ recently ran  article about another financial professional who has seen the light and now advocates index investing.

Is Your Stockpicker Lucky or Good?

Investors pick active funds based on performance, but the long-term success of those managers is no more dependable than a coin flip

Is it luck or skill? Picking a fund manager who can beat the index is tough, but picking one who beats it through actual ability is far more difficult.
Victor Haghani, a co-founder of one of the best-known investment firms in history, says the most surprising thing is that people have great confidence that they can pick these super-talented fund managers. Currently the chief executive of Elm Partners, which espouses index investing for wealthy clients, Mr. Haghani will try to prove that to you with a simple test.
He and two colleagues told several hundred acquaintances who worked in finance that they would flip two coins, one that was normal and the other that was weighted so it came up heads 60% of the time. They asked the people how many flips it would take them to figure out, with a 95% confidence level, which one was the 60% coin. Told to give a “quick guess,” nearly a third said fewer than 10 flips, while the median response was 40. The correct answer is 143.
Mr. Haghani’s belief in indexing means he has a vested interest in the outcome. His earlier experience as an active investor gives him perspective on how hard it is to beat the market. Mr. Haghani was a co-founder of Long Term Capital Management, the hedge fund that had spectacular results from exploiting real market anomalies before its failure nearly took down the global financial system in 1998.
The research applies directly to picking fund managers. We already know that most active managers fail to beat an index fund in any given year, yet many people pay up for managers they believe have the skill to do so.

In fact most active managers perform worse than a coin flip. We are often told that the bulk of the returns from the market come from a few stocks. That fact is then is seen as implying this is an opportunity for stock pickers. They just have to overweight those stocks and they will outperform. Most actively manged funds are "closet indexers" meaning that the "active share" the part of the portfolio that differs from the rindex is small in many cases as low as 20%. That means the stock picker "just" needs to pick outperformers for the active share of their portfolios to beat the index

Of course they fail to do so and there is no persistence among those that do.

An interesting explanation of the underperformance of active managers and how they actualy do worse than a coinflip comes from the material presented in this article entitled Skewered

Consider the chart below. The returns of stocks are skewed

What is the significance of this chart ? It is pointed out that in the recent market (election day since  to the end date of the research data April 2016) in that right hand tail there were 6 stocks that returned over 50%.. But stock returns are almost always skewed the majority of stocks fall on the right side of the tail even if not as much as in the current market of FANG stocks (facebook, apple, Netflix, google) which so dominate the market gains.

The distribution of returns as seen above is  skewed to the right a "fatter tail than the standard deviation. With that fatter tail composed  above average perfoming stocks.

That means that the task of the active manager should be "simple". As we always hear "it's a stock pickers market", All that an active manager would need to do is to oild most of his portfolio in an index hugging portfolio and add to that portfolio an active share of stocks he has picked made of of stocks  among those in the right tail.

In fact looking at the chart there are more stocks to the right of median return  than below it. So the odds are actually better than 50/ get a stock performing above the median in a coin flip. It is like picking to get a high card from a deck where money of  the cards wth low values  have been removed from the deck.

Yet we know the statistics. Active managers consistently fail to beat the index they do worse than a coin flip.

Is this an argument for the momentum factor

Here is the description of the methodology for MTUM from ishares:

The iShares Edge MSCI USA Momentum Factor ETF tracks an index of large- and midcap US equities, selected and weighted based on price appreciation over 6- and 12-month periods and low volatility over the past 3 years.

Not surprisingly the portfolio is quite concentrated  by sector with 32% of its assets in technology and 25.6% in financials .The portfolio is also  highly concentrated by stocks  42% of the portfolio is in its top ten holdings. In other words, at least in terms of recent performance the ETF is owning mostly stocks in the right tail. Barring shap reversals in the stocks within the period between of rebalances the portfolio should have structural potential to ourperform. And the portfolio rebalances more frequently during periods of high volatility as explained the Morningstar analysis:

In order to improve performance when volatility spikes, the fund's benchmark rebalances in between the scheduled reconstitution dates if market volatility significantly increases. When this rebalancing is triggered, the index focuses on more-recent momentum to construct the portfolio. This adjustment may help, but it isn't a panacea. There is also a risk that momentum may become less profitable as more investors attempt to take advantage of it. That said, the momentum effect hasn't gone away even though it was first published in the academic literature in 1993. Like any strategy, momentum can underperform for years. This risk may limit arbitrage and allow momentum to persist.

Intersentingly with a p/ef of 23.7 the portolio is slightly lower in valuation than the SP 500. Not surprisingly the SP 500 is less highly concentrated with 20% of ts holdings in its top ten holdings.

Also note that the portfolio only holds large and midcap stocks  This limits the likelihood of owning "shooting star" stocks which are small cap high valuation and large upside momentum--and subject to sharp downward momentum. It is also important to note that MTUM is simply a large cap growth strategy..the methodologies for stock selection are far different.

My interpretation of the potential of outperformance of momentum stocks vs the market :

  • :Because of the high concentration in a few stocks the MTUM is likely to be more volatile than the overall market.
  • But by concentrating its holding in stocks in the right least by recent momentum ...its likelihood of outperfromance is greater than 50/50 and greater than an active manager.
  • A reversal of upside momentum does not necessarily mean underperformance by MTUM the market could reverse direction but the highest upward momentum stocks could retain their value more than the overall market
  • Despite what is regarded as conventional wisdom it does not necessarily follow that the high momentum stocks will lead the market down. Furthermore as the MTUM s rebalanced the opposite will be the case the negative momentum stocks will be eliminated from the portfolio.
We don't have much data on MTUM since it only began trading in late 2013 but here is the data we do have vs the S=P 500.

Total Returns

Mtum Blue SPY (S+P 500 Green)  June 2013- present

Returns top volatility below.

Remember that volatility is a measure of both up and downside volatility. Investors care much less or not at all about upside volatility. And if you look at the total return chart you can see almost all the high volatility for MTUM was on the upside.

Monday, November 20, 2017

This is Not good For Investors


A Tax Provision That Would Exempt Mutual-Fund Firms but Not Individuals

Mutual funds now exempted from proposal changing tax rules for some share sales

The provision would prevent investors from minimizing taxes, when they sell part of a position, by choosing the specific shares being sold. Instead, investors would have to sell their oldest shares first.
As first proposed, the change would have applied to fund companies as well as individuals.
But senators exempted fund firms after some of the largest ones, including Vanguard Group and Eaton Vance Corp. EV 0.56% protested by saying the proposed change would tie their portfolio managers’ hands, make markets less efficient, and raise taxes on investors. 
If the change is enacted for individual investors, “it will take tax planning out of the hands of investors and advisers,

Interestingly it will take a big hole out of the marketing proposition of the robo advisors who make their tax loss harvesting a major part of their sell:

It would also affect firms like Parametric Portfolio Associates, a unit of Eaton Vance, and online financial advisers Betterment LLC, and Wealthfront Inc. These firms offer computerized tax-efficient investing strategies to individuals that typically use sales of specific groups of shares, or lots, to help boost after-tax returns.
It's rather amazing to me that the fund companies would lobby in their own interest but not in the interest of their clients. Could it be that they care more about juicing their returns and attacting assets rather than their clients after tax returns. Also this exemption will almost exclusively affect active fund managers since they do so much trading and would be keeping track of tax lots. I am not sure even this would apply to ETFs and even if it did , since they do little of such trading the impact would be minimal.
An explanation from the WSJ
Although the change would no longer affect securities sold by managers of active or passive mutual funds and exchange-traded funds, it would affect individuals who sell part of their investment in such funds.
Here’s how. Say an investor owns two lots of a sector fund bought at different prices, and they are in a taxable account rather than a tax-deferred retirement account. If the fund is trading at $90 per share now, each one acquired five years ago for $65 would have a $25 taxable gain.
But each share bought two years ago for $110 would have a $20 loss.
Under current law, investors can choose which fund shares to part with. So selling the ones that cost $110 would produce a loss to offset other gains, while selling the ones that cost $65 would produce a taxable gain.
If the provision is enacted, the first shares sold would be assumed to have a cost of $65 each, and the investor couldn’t sell the $110 shares until the $65 shares were gone.