Archive for the ‘Capitalist Curmudgeon’ Category
Friday, December 6th, 2013
Impermanence is eternal â Buddha
Why is it that we will wait in line for hours to lay out hundreds of dollars on the latest gadget, yet we wonât spend a minute to improve investment decisions entailing many $thousands? The difference is emotional versus rational. We want to have fun and to show off our latest toys. By contrast, investing is cerebral and can make our hair hurt. Never mind that investing helps us afford the fun stuff.
Behavioral scientists tell us that we are all hard-wired to resist rational change because we suffer from the following biases, the âyinâ:
Attachment Bias: Holding onto an approach for emotional reasons, such as âweâve always done it this wayâ
Cognitive Dissonance: The challenge of reconciling two opposing beliefs
Confirmation Bias: The natural tendency to accept any information that confirms our preconceived position and to disregard any information that doesnât support this position
Overconfidence: Works with confirmation bias to place too much emphasis on oneâs own abilities.
Status Quo Bias: The tendency to do nothing even when action is in order.
On the other hand, the benefits of improvement are expressed in the following âyangâ:
Disruptive Innovation: Our lives are made better by gradual replacement of everyday products with even better products. This idea was introduced by Clayton Christensen, who calls it the âtechnology mudslide hypothesis.â Examples include post-it notes and staplers.
Planned Abandonment: Management guru Peter Drucker taught his clients that âPlanned, purposeful abandonment of the old and of the unrewarding is a prerequisite to successful pursuit of the new and highly promising.â Druckerâs clients agreed to think as much about what they should be doing as to what they should stop doing. In other words, abandon the old adage âIf it ainât broke, donât fix it.â
Making the Change to Superior Hedge Fund Due Diligence
Advancement in hedge fund due diligence is an example of an important change that is still waiting to happen. Itâs no secret that hedge fund due diligence remains in the dark ages. See for example [Surz, 2005].
Advocates of change preach âchange talkâ, the language of overcoming the âyinâ of change. We need to hear and understand the disadvantages of the status quo, and to appreciate the benefits of a new improved future. Most importantly, people need to listen, so the message should be entertaining. Thatâs why we produced a short video on the Future of Hedge Fund Due Diligence and Fees to reframe our thinking.
In the future we wonât pay much for hedge fund exotic betas (risk profiles). Weâll pay for superior human intellect instead. Weâll know the difference because weâll abandon simpleminded performance benchmarks like peer groups and indexes, and replace them with smart science. Disruptive innovation will elevate our comprehension and contentment. Everybody will win.
Hedge funds are unique. Thatâs their main attraction. The definition of unique is âwithout peers,â so we cannot group unique. âUniqueâ and âpeerâ do not play well together. Hedge fund managers win or lose against peer groups because they are different rather than because they are better or worse.
Itâs this uniqueness (heterogeneity) that will lead us in the future to the science of evaluating hedge funds. Hypothesis testing and cyberclones will revolutionize due diligence. No one wants or needs to pay for exotic betas because they can be reverse engineered (replicated), but everyone is willing to pay for that critical factor they canât synthesize, namely superior human intelligence and wisdom that engender profitable decisions. Weâll pay for brainwork, and weâll pay a fair price. Who says â2 and 20â is the right price?
Surz, Ronald J. âTesting the Hypothesis âHedge Fund Performance is Goodâ.â The Journal of Wealth Management, Spring 2005, pages 78-83.
PPCA Investment Strategies
Monday, November 11th, 2013
Knowledge speaks, wisdom listens â Jimi Hendrix
Fundamentally-weighted indexes were introduced by Robert Arnott in 2004 and have come to be known as smart beta indexes because they are professed to outperform the market, as represented by traditional capitalization-weighted indexes. Hundreds of $Billions have flowed into smart betas, but some of that money would be better placed in new improved smarter beta indexes. Smarter beta indexes can beat the market too, plus smarter betas complete active managers, rounding out investment portfolios. Smarter betas are designed for active-passive investors rather than all passive. You need to determine how smart your beta should be.
Fundamental (smart beta) weights typically tilt toward value and smaller companies relative to their cap-weighted counterpart, because this tilt has a history of performing better, so it may be smart. The future will tell us how smart this actually is. Fundamental indexes are created for broad markets, like the U.S. or Europe; they are total market indexes.
Even Smarter Betas
Because smart beta indexes encompass entire markets, they are not intended to be used in conjunction with active managers. If smart beta indexes are combined with active managers they dilute active manager decisions by adding stocks active managers donât want to hold. Furthermore, they tilt the entire portfolio toward smaller company value, potentially undermining portfolio structure, especially growth allocations. Smart beta indexes play a specific role that does not involve active managers.
By contrast, smarter beta indexes complement active managers by serving as smarter core in core-satellite portfolio constructs â itâs even smarter than smart beta in this situation.
The smarter beta index is created by identifying the stocks that lie in between value and growth â the stuff in the middle â and by allocating to them using fundamental weights rather than capitalization. The stocks in the middle are organized into economic sectors like technology and utilities, and assets are allocated to these groups at market weights. This eliminates sector bets. Then within sector groups, each stock receives an equal allocation, which is fundamental weighting.
The benefits of smarter beta indexes are enhanced diversification and higher returns, which seems too good to be true, so hereâs how these benefits are produced. Diversification is enhanced by adding stocks that active managers usually donât hold because they donât fit value or growth mandates; these are good companies that are simply overlooked. Higher returns are generated by replacing an existing core with the smarter beta core because smarter beta core does not dilute active managers. This higher return expectation is based on the belief that the active managers actually add value, which seems right since they wouldnât be hired if that wasnât the belief.
Sometimes a good idea has its limitations. When it comes to betas, you need to choose the smartness of your beta carefully. Standard smart betas donât play well with active managers. New improved smarter betas are much friendlier playmates. Or put another way, if your investments are entirely passive, smart beta indexes may be for you. But if you use active management, you need a smarter beta index.
PPCA Investment Strategies
Friday, November 8th, 2013
Despite the evidence that active managers fail to beat their passive index alternatives, investors have not given up on alpha â they still want to beat the market. Ironically, they have decided to simplify their search, rather than intensify it, by embracing the âStreetlight Approach.â A drunk is in the gutter at night on his hands and knees under a streetlight looking for his lost keys. When asked where the keys were lost he gestures toward a park across the street and explains that the light is much better under the streetlight.
So it is with âBrainless Alphasâ, mechanical approaches that are purported to outperform their passive index alternatives. The appeal of Brainless Alpha is obvious â someone has already done all the thinking so finding it is easy; itâs under the streetlight. Brainless Alphas come in two flavors: passive and active. The passive flavor has several names, including smart beta, fundamental indexing, and small-value factor investing. The active flavor is best known as âActive Share.â
A recent Investment News article reports that Dimensional Fund Advisors (DFA) has attracted $16.7 Billion, a record year, into its factor investing approach. Similarly, MondoVisione reports that Research Affiliates Inc (RAFI) has attracted more than $100 Billion globally into its fundamental indexes.
Smart beta investing is a tilt toward smaller companies and toward value, primarily because history shows that this tilt would have beaten the market. But Dr. Michael Edesess explains that history doesnât necessarily have to repeat itself and that the RAFI promoters of smart beta âfail to mathematically prove that a fundamentally weighted index must outperform a capitalization-weighted index.â He further criticizes DFA for its Scientism Hype. In other words, smart beta will work until it doesnât. One thing is for sure: smart beta is smart for its promoters.
The active flavor of Brainless Alpha is also attracting assets, and a following among financial consultants. It all started in 2006 when Professors Martijn Cremers (Yale) and Antii Petajisto (New York University) published a study entitled âHow Active is Your Fund Manager? A New Measure That Predicts Performanceâ in which they conclude: âActive Share predicts fund performance: funds with the highest Active Share significantly outperform their benchmarks, both before and after expenses, and they exhibit strong performance persistence. Non-index funds with the lowest Active Share underperform their benchmarks.â Active Share is the percent of a portfolioâs holdings that do not match the benchmarkâs allocations.
Most readers understand that a condition for success must be both necessary and sufficient. Big bets are a necessary condition for alpha. It is mathematically necessary to deviate from the benchmark in order to produce an alpha. This deviation can be measured in a number of ways including active share, tracking error and low correlation to the benchmark. Note also that a big bet can be misidentified if the benchmark is wrong.
But big bets are not a sufficient condition for success because the bets can be wrong. Therein lies the flaw in reliance on the Brainless Alpha called âActive Share.â Conviction alone is an insufficient condition for success.
Simple solutions are often the best. Einstein said âEverything should be as simple as possible, but no simpler.â The problem is that Brainless Alphas go too far in their simplicity. Beating the market is much more complicated than tilts or big bets. If we really want alpha someone will have to think harder.
Covestor Investment Management
Friday, November 1st, 2013
Passive investing in market index funds has been labeled a “parasitic” business. However, re-designing index investing rules to account for corporate moves such as mergers and acquisitions could make passive the new active.
This year’s Nobel Prize in Economics was a good one for the passive investment model. One of the winners, Eugene Fama, was rewarded for his work on the efficient market hypothesis (EMH), the concept that share prices reflect all available information. His work has been supported by the fact that active funds that attempt to pick winning stocks have demonstrated that they are mostly unable to beat the market.
Investors are taking note, putting an increased amount of money into index trackers at the expense of active funds. But there’s a catch â passive funds ignore market signals resulting from corporate activity, particularly M&A, which are central to EMH.
This has resulted in lower profits for passive managers and lower returns for investors as acquisitions have destroyed shareholder value. This lack of engagement with corporate management has also generated criticism, with active managers labeling passive management as a parasitic industry.
By redesigning index rules to take account of market signals on M&A and potentially other areas of corporate activity such as executive remuneration, passive funds will be able to generate improved profits and better returns for their clients. These new index rules can generate automatic voting triggers based on each corporate action without having to build expensive teams to engage with every company. Such a revolution in index design would thus permit passive funds to play an active role in improving corporate governance.
Shareholders get what they deserve?
Corporate finance theory postulates that when a public company decides to deploy capital for an acquisition, the information released about the project is absorbed by the market which then provides a signal as to whether the proposed deployment will create or destroy value. If share prices fall, executive teams ought to shelve the project. If they continue with the project, shareholders should act to protect their investments and vote against the management team.
The problem is that these signals are ignored by passive and many active funds. As a result, value destroying deals have proceeded with the support of institutional shareholders generating lower returns to savers. Fund managers’ profits are also negatively impacted given that assets under management are lower than they would have been.
It is important to note though that not all mergers and acquisition require shareholder approval. For example, in the U.K., any acquisition that meets any of the “class 1″ tests which includes acquiring a firm that exceeds 25% of the bidder’s market capitalization must be approved by shareholders. This differs from the United States where shareholder approval is often not required for even large transactions.
Credit Capital Advisory has analyzed a number of deals since 2007 where the market signaled that the deal was expected to destroy value. They include the RBS acquisition of ABN Amro, Hewlett Packard’s acquisition of Autonomy and the Softbank acquisition of Sprint.
Who says turkeys can’t vote for Christmas?
On April 24, 2007 the RBS share price fell relative to the U.K. banks index following its initial bid of âŹ72 billion for ABN Amro. RBS sold off again on Oct. 5 when Barclays withdrew from the deal. The five-day market signal revealed a fall of over 4% in the share price. On Aug. 10, 94.5% of RBS shareholders who voted were in favor of the value-destroying merger.
Chart 1: RBS acquisition of ABN Amro
On Aug. 18, 2011, Hewlett Packard announced a $10.3 billion acquisition for Autonomy. The market was distinctly unimpressed, with a spike in volume and a 22% sell-off over five days. HP still managed to secure 87.34% of shareholders’ votes.
Chart 2: Hewlett Packard acquisition of Autonomy
On Oct. 11, 2012, rumors of a bid for Sprint by Softbank percolated through the market. The bid which was confirmed on Oct. 15 at $20.1 billion led to a sell-off of Softbank stock resulting in a 9% fall over the trailing five-day period. The deal was subsequently raised to $21.6 billion on June 10, 2013. The Softbank deal acts as a useful test case to ascertain to what extent the market generates false signals. By the end of 2012, Softbank’s share price had recovered and since March 2013 Softbank has outperformed the Japan Telecom index by nearly 35%.
The reasons for this outperformance, however, have been mostly driven by Softbank’s investments in GungHo Online Entertainment and the continuous stream of stellar earnings from Alibaba. Softbank is the largest shareholder in Alibaba and is also benefitting from the interest surrounding Alibaba’s expected IPO. Furthermore the Sprint stock price has fallen over 10% against the U.S. telecoms index since mid-August. Hence from a corporate governance perspective the Sprint deal should have been noted by shareholders if their goal was to maximize shareholder value.
Chart 3: Softbank acquisition of Sprint
Is passive the new active?
Since the inception of passive funds in the 1970s, there has been little change to their basic structure, with the main focus being on driving down costs. However the failure of passive funds to take account of market signals surrounding corporate actions highlights how their profits, and the returns to investors, have been negatively impacted. This is because engaging with individual companies on corporate governance issues is a time consuming and expensive business. If passive indices could be redesigned to take account of market signals indicating destruction of shareholder value without significantly raising costs, then this would result in higher returns for investors and higher profits for fund management companies. Moreover, any increase in the level of engagement between shareholders and management teams would also have a positive impact on the way that companies are run. So how might such index rules be created within a passive framework?
The generation and implementation of rules to ensure that all M&A activity is value creating has a number of challenges. Firstly a decision needs to be made at what point the movement of the share price ought to be measured. Is it from an initial rumor of the deal or from the official announcement? The release of information to the market needs to abide by strict stock market rules, so although rumors do find their way out to the market, the announcement itself has to take precedent.
The second issue is to decide how long the market takes to digest the information and provide its aggregated view. An analysis of multiple deals suggests that between three to five business days is appropriate.
The third issue is related to the level at which the triggers would be set given the existence of statistical error. Such a rule might state that if the share price fell by more than 1% relative to its sector index then it would trigger an automatic “no” vote. Finally the issue as to whether shareholders have the right to vote on the acquisition needs to be factored in, which depends on the jurisdiction of the buyer and sometimes on the size of the acquisition. In certain jurisdictions shareholders may only have the option of selling the stock which would need to be taken into account. All of these stages can be automated, tested and implemented using basic quantitative finance techniques.
Clearly once such rules are published and functioning, they can have unintended consequences as executive teams try and game the system. Although this is a distinct probability, such rules can be changed as fund management companies learn about the consequences. Of crucial importance is that passive funds, who are nearly always the largest shareholders, will be able to take their governance role seriously without having to increase their cost base to engage with firms.
Parasitic no longer
The passive management sector has a huge opportunity to change the way it interacts with the companies it “owns,” leading to increased profits and better returns. This long overdue revolution in index design would go a long way to countering the criticisms that the passive industry is a parasitic one. The result of this increase in activity around corporate governance implies that the distinction between passive and active funds may start to blur. Passive may well indeed become the new active.
âThomas Aubrey, CEO and founder of Credit Capital Advisory, for Thomson Reuters AlphaNow
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Friday, August 23rd, 2013
CLICK HERE to watch this Oscar-worthy movie, and please pass it around. Marvel at the clones clashing with the evil genius in the battle of beta versus alpha. Itâs five minutes of futuristic merriment and enlightenment. Gene Roddenberry would be proud of this trek.
The timing of this movie is brilliant. We are on the brink of a perfect financial storm, which is why investors are seeking alternatives to conventional investing strategies built on stocks and bonds. U.S. equities have reached new highs, skyrocketing more than 100% since May, 2009 as bond yields remain near historic lows. Stir in the federal governmentâs humongous budget deficit and the imminent tapering of the Federal Reserveâs quantitative easing program and weâre looking at one rocky future. No wonder that itâs a bull market for investment alternatives, especially hedge funds. The demand for these products is sure to increase substantially in the years ahead as the crowd grapples with the harsh reality of the future. But all the usual caveats still apply, namely: separating the alpha wheat from betaâs chaff is crucial in the business of intelligently selecting hedge funds.
In the future, we wonât pay much for exotic hedge fund betas (risk profiles), but the market will continue to put a premium on superior human intellect. Weâll know the difference because weâll abandon simple-minded performance benchmarks like peer groups and indexes, and replace them with smart science. Disruptive innovation will elevate our comprehension and contentment. Everybody will win, or at least everybody who recognizes that prudently choosing hedge funds demands a higher standard. The first step is recognizing that the old traditional methods are as out of place with hedge funds as Klingons are with Starfleet Command.
Hedge funds, after all, are unique. Products in the same strategy are usually galaxies apart when it comes to management details. Uniqueness is the main attraction of hedge funds, of course, and itâs also the primary reason why a robust due diligence process in this corner is essential. The definition of unique is âwithout peers,â which means that a distinctive hedge fund canât be squeezed into an artificially defined group. âUniqueâ and âpeerâ simply do not play well together. Hedge fund managers win or lose against peer groups because they are different rather than because they are better or worse than quasi-comparable strategies.
Itâs this uniqueness (heterogeneity) that will lead us in the future to the science of evaluating hedge funds. Our Oscar-worthy hedge fund movie predicts that hypothesis testing and cyberclones will revolutionize due diligence. No one wants or needs to pay for exotic betas that can be reverse-engineered (replicated). In sharp contrast, everyone is willing to pay for that critical factor that canât be synthesized: superior human intelligence and wisdom that engender profitable decisions by way of savvy investment choices.
Yes, we should be prepared to pay a fair price for brainwork, commensurate with the level of brainwork rather than the typical â2 and 20â fee. But first weâll need a robust model for deciding whoâs truly delivering the equivalent of Oscar-winning performances in the hedge fund universe.
ABOUT THE PRODUCER
PPCA, Inc. (San Clemente CA) provides advanced analytical services to investors and their consultants in the areas of asset allocation, market research, performance evaluation, style analyses and target date funds. PPCA president Ron Surz is a pension consulting veteran. Further information is available at LinkedIn and www.PPCA-Inc.com and HedgePOD.
ABOUT THE CREATORS
Kathy Tarochione (Harrison, AR) is a digital artist providing life stories for individuals and their pets â digital memories in pictures and art. She is also the Founder & Partner of Picture A Moment Pet Productions LLC with its divisions, The Canine Community Reporters News and WCCR.TV, designed to help animals in shelters. Kathy has mastered digital productions of all sorts. Further information is available on LinkedIn.
Jim Bumgardner (Harrison, AR) is a professional broadcaster, videographer, marketer, all-around nice guy, and partner of Kathy Tarochione (see links above). Being a true believer in the entrepreneurial spirit and always rooting for the underdog, Jim prides himself on his personal philosophy of “If you dream it, I can build it.” Further information is available on LinkedIn and www.jimstv.com
PPCA Investment Strategies
Sunday, August 18th, 2013
Many are familiar with the “January effect,” which is the tendency for the stock market to perform well in January. Thereâs a less well known “September effect” that is just the opposite. Will September of 2013 conform to a history of disappointment?
As shown in the table and graph below, the month of September stands out as being the most likely to disappoint. Here are some observations:
- âą Septemberâs -.8% average return is not only the lowest; itâs the only month with a negative average return.
- âą Unlike the other 11 months, September is more likely to produce a negative return (44 months is 51% of the time) than a positive return (43 months is 49%). All of the other months have a history of positive returns 60% of the time.
- âą Septemberâs worst return â losing 29.7% in 1931âis the worst of the worst.
- âą Septemberâs best return â earning 16.7% in 1939 â is far below the average of the best returns, at 21.27%, although it is median.
So why is September such a nasty month? I’d like to hear your opinions, especially regarding your outlook for the upcoming September. Here’s my opinion. I think it’s due to the fact that investors are done with their vacations, so they’re back at their computers trading, and mucking things up. In his 1999 book, “The Beast on Wall Street,” Dr. Robert Haugen documents the fact that market volatility is mostly driven by investor behavior. Specifically he shows that there is only a weak connection between major events and market swings. Little has happened historically on the days of big market swings, and the market response has been ho-hum on big event days.
A related explanation is that investors start their tax loss harvesting in September, to get ahead of the end-of-year crowd. This would represent the flip side of the “January effect” which is caused by investors buying back the stocks they sold for tax purposes.
If my explanation is correct, this September is likely to disappoint because investors will be back at their trading desks, but history tells us that it is a coin-flip probability â worse than the other 11 months but not all that predictable.
S&P500 Returns for the 1,044 months from
January 1926 â December 2012
PPCA Investment Strategies
Wednesday, August 14th, 2013
Kudos to Rob Arnott for coining the phrase “Smart Beta.” Everyone wants to be smart. Indexes that use fundamental weightings, rather than capitalization weightings, are deemed to be smart by Mr. Arnott because they are predicted to perform better. For the first time ever, we have indexes that are designed to outperform. All other indexes are designed to match the performance of an entire market or a market segment.
Fundamental (smart beta) weights typically tilt toward value and smaller companies relative to their cap-weighted counterpart, and this tilt has a track record of performing better, so it may indeed be smart. Fundamental indexes are usually created for broad markets, like the U.S. or Europe, but PowerShares recently introduced fundamental style indexes called âFundamental Pure Style Indexes”, or FPS.
FPS indexes are indeed smart on one count. They are mutually exclusive and exhaustive, mirroring the familiar 3 X 3 structure of the Morningstar style indexes, which are derived from the Surz Style Pure Âź indexes I developed in the 1980s. Mutually exclusive and exhaustive is smart for both returns-based and holdings-based style analyses, and also for portfolio construction. They make good building blocks. There are only three such families of style indexes: FPS, Morningstar and Surz. Yes; fps indexes are indeed smart on one count - they are mutually exclusive and exhaustive, mirroring the familiar 3 x 3 structure of the Morningstar style indexes, which are derived from the Surz Style Pure Âź indexes I developed in the 1980s. Mutually exclusive and exhaustive is smart for both returns-based and holdings-based style analyses, and also for portfolio construction. They make good building blocks. There are only three such families of style indexes.
Not So Smart
Style indexes are used in portfolios as completeness funds and to make style bets, like style rotation approaches. They are used in tandem with other investments, like active managers, to add value. As such, you’d prefer your indexes to be different from one another. Therein lies the flaw in FPS. The FPS indexes are tilted toward value, so they are more clustered than Surz Style Pure indexes, as shown in the following exhibit. Also, FPS core is not in between value and growth, which is puzzling.
FPS might beat my indexes on occasion, but they don’t provide the benefits that most expect from style indexes, namely completeness or style concentration. The fact is that the FPS value-core-growth indexes are almost identical. The value tilt pushes them all to the left, toward value.
Sometimes a good idea has its limitations. Extending fundamental weightings to style indexes is not a good idea.
Tuesday, August 13th, 2013
Fear and greed are powerful motivators, especially when it comes to investing. In this blog, I speak to those who are fearful, and are looking for safety, potentially outside the US. I look for the regions of the world that are currently priced as “Value”, defined as low Price/Earnings and high dividend yield. The following graph shows the current situation.
As you can see, the US is currently not the best “Value”, having the highest P/E and the second lowest dividend yield. But it’s not clear from this graph which is the best value. On a P/E basis, Emerging Markets and Asia X Japan are the better buys, but Australia-and-New Zealand and the UK are the higher yielding.
To resolve the confusion, I’ve created a composite measure that adds earnings yield (the reciprocal of P/E) to dividend yield, and come up with the following scores:
And the winners are Australia-and New-Zealand and Emerging Markets. If you’d like to stay closer to home, Canada looks good. The run-up in US stocks has made them expensive relative to the rest of the world. 18 months ago Japan would have been the best value play, but its recent performance has changed that.
Now you know. I hope you find this useful.
PPCA Investment Strategies
Tuesday, July 9th, 2013
Here we take a look at the year-to-date through May 2013 risk-adjusted performance for the top dedicated short bias funds in two categories - all funds and U.S.-only funds - as tracked by Lipper’s hedge fund database. To see more analysis, including assets under management and domicile information for the top 10 funds in each category, click here for all funds and here for U.S.-only funds. To be truly connected to all the Lipper analytics available on HedgeWorld, become a HedgeWorld Premium Plus member. To find out more about how to do that, visit hedgeworld.com/membership/.
Tuesday, April 23rd, 2013
Ponzi king Bernard Madoff swindled investors out of $14 Billion, yet four years later little has changed to prevent another occurrence of this painful and debilitating disease. Just two years ago, in a press interview from his prison cell, Madoff himself expressed bewilderment in his ability to pull off the crime and the continuing absence of safeguards, stating âThey had to know.â Allen Stanford pulled off his scam in the face of heightened concerns caused by Madoff.
The good news is that investors can immunize themselves against Madoff-Stanford disease, but they wonât find the medicine in the media. The real deal is described in this blog. You should take a dose.
An Ineffective Prescription
For months following the discovery of the Madoff rip-off the media trotted out experts — financial intermediaries, for the most part — to advise people on avoiding the likes of Bernard Madoff and Allen Stanford. That’s like asking gun manufacturers to weigh in on ways to lower homicide rates. Predictably, the real issue –lax due diligence — was lost to such sterling insights as be suspicious of good performance and insist on financial audits.
Beside the Point
These insights are bad placebo prescribed by those who spread the disease. Skepticism about performance is the province of financial intermediaries, not investors. Investors rely on their consultants and fund-of-fund managers to scrutinize performance for potential fraud. Similarly, financial audits are not designed to validate reported performance; audits verify procedures and pricing.
The best defense against fraud is a strong offense in the form of real due diligence rather than the sham that has been played upon investors by their advisors. Hedge-fund due diligence has, by and large, been a big fat fakeout. The gun in Madoff-Stanford’s hands was advisor complacency; the fallout from Madoff-Stanford should be greater scrutiny of advisors by their clients.
But before we go too much further, itâs worth noting that Madoff and Stanford are completely different diseases, other than their proclivity for infecting the âsmartâ and wealthy. Madoff is an inaccessible recluse with two small operations, one legitimate and the other not. By contrast Stanford is a flamboyant persona with dozens of companies, thousands of employees, and a single hidden deception in the form of mispriced international bank CDs. The lesson here is that bandits come in all shapes and sizes. Madoffâs mystique was the whisper referral while Stanfordâs was bravado hiding in plain sight. In both cases, the ability to set their own prices created the opportunity for deception.
Shortly after Madoff confessed, Yale endowment manager David Swensen set off alarms throughout the investment community with the following remarks, which he provided in a January 13, 2009 interview with Wall Street Journal reporter Craig Karmin:
WSJ: What about fund of funds and consultants? Can they be a solution?
Mr. Swensen: Fund of funds are a cancer on the institutional-investor world. They facilitate the flow of ignorant capital. If an investor can’t make an intelligent decision about picking managers, how can he make an intelligent decision about picking a fund-of-funds manager who will be selecting hedge funds? There’s also more fees on top of existing fees. And the best managers don’t want fund-of-fund money because it is unreliable. You need to be in the top 10% of hedge funds to succeed. In a fund of funds, you will likely be excluded from the best managers. [Mr.] Madoff also relied enormously on these intermediaries. He wouldn’t have had nearly as much resources were it not for fund of funds.
Consultants make money by giving advice to as many people as possible. But you outperform by finding inefficiencies most of the market has not yet uncovered. So consultants ultimately end up doing a disservice to investors.
Mr. Swensen goes too far when he suggests malicious intent by consultants and fund-of-funds. Cancers never intend anything good. Nick Diamos, author, advises the following in these situations: âNever attribute to malice what can adequately be explained by stupidity.â
Fortunately there is a cure for Madoff-Stanford Disease. Developed over the last decade, Simuliacin is a process rather than a pill that has proven extremely effective at detecting fraud as well as identifying legitimate investment professionals.
The Madoff-Stanford Disease exposes our vulnerabilities: (1) Weâre too trusting, and (2) Fraud viruses are spread by advisor and regulator complacency. Itâs time to protect our investments with a potent due diligence inoculation, as prescribed in this opinion.
Due diligence can be distilled down to two crucial questions:
- Do we like the strategy that this manager employs?
- Does this manager execute the strategy well?
Common hedge fund due diligence, as it is practiced today, answers the first question with hot performance, and accepts conceit and concealment as answers to the second.
This is a shame because investors have been shammed by fake due diligence. The Madoff-Stanford scams were enabled by the due diligence sham. To remedy this sham we prescribe Simuliacin, a simple 2-step due diligence approach that is rigorous and sham free.
(1) Take a Dose of Profiling to Identify What the Manager Does
Possible Side Effects: Dizziness and Confusion
The adage âDonât invest in what you donât understandâ is particularly relevant to hedge fund investing. To address this issue we recommend that the researcher complete a fairly straightforward profile like the following:
Sample manager profile
- Approach long: Exposures to styles, sectors, countries, etc., as well as exposures to economic factors.
- Approach short: Exposures to styles, sectors, countries, etc., as well as exposures to economic factors.
- Direction: Amounts long and short
- Portfolio construction approach: Number of names, constraints, derivatives, etc.
If we canât complete this profile, we donât invest. Thatâs the deal. If we can complete this profile we can move on to the question of manager competence. The profile gives us the option of replicating or hiring (make or buy), so we want to know that value added exceeds fees. The traditional approaches to this assessment of skill are peer group and index comparisons, but these are unreliable backdrops for evaluating hedge fund performance. See [Surz, 2005 and 2006] for details on the problems with peer groups and indexes. In a nutshell, because hedge funds are unique we need better skill assessment approaches than indexes and peer groups, such as the second part of the prescription.
(2) Perform Scientific Tests of Manager Competence:
Thereâs nothing worse than a mediocre doctor or a mediocre hedge fund manager.
Albert Einstein once said “The problems we face today cannot be solved at the same level of thinking that created them.” A corollary is that itâs unlikely that the people who created the problems can succeed at fixing them.
The solution to the problems with peer groups and indexes is actually quite simple, at least in concept. Performance evaluation ought to be viewed as a hypothesis test where the validity of the hypothesis âPerformance is goodâ is assessed. To accept or reject this hypothesis, construct all of the possible outcomes and see where the actual performance result falls. If the observed performance is toward the top of all of the possibilities, the hypothesis is correct, and performance is good. Otherwise, it is not good. In other words, the hypothesis test compares what actually happened to what could have happened.
Using the profile described above, a computer simulation randomly generates portfolios that comprise a custom scientific peer group for evaluating investment performance. A reported return outside the realm of possibilities is suspicious, and can be explained in one of three ways: the return is in fact extraordinary, the return is fraudulent, or we do not understand the strategy. Of course the test itself cannot tell us which of the three possibilities the reality is, but it does give us motive to look. In other words, the hypothesis test either validates the credibility of reported performance or provides the wherewithal to question the incredible. Financial audits are not designed to provide this validation. Thereâs a good chance that a true due diligence researcher would have reacted to the Madoff hypothesis test with acknowledgement of not understanding, which under the rules of Step 1would have kept us away from him. That is, we might not have detected fraud but we would have been spared the harm anyway. The reader can ask himself if, in light of the scientific evidence, he would have ascribed Madoffâs incredible track record to extraordinary success without first exploring the other two possible explanations.
Simuliacin has undergone extensive clinical trials over 5 years conducted by RCG (Risk-Controlled Growth) LLC, a Boulder Colorado fund of hedge funds. Actual performance results confirm that Simuliacin eliminates Madoff-Stanford Disease while simultaneously increasing the occurrences of good investment managers. Itâs like Resveretrolâs success in lowering bad cholesterol and elevating good.
Fool Me Once âŠ
Sociopathic fraudsters like Bernie Madoff are keen to capitalize on our complacencies. But there is a defense â medicine for the Madoff-Stanford Disease. Hypothesis testing sets off fraud alerts that cannot be achieved with antiquated due diligence approaches, and this testing also puts an end to the due diligence sham.
Madoff and Stanford are no garden variety bandits. Few appeared to be more trustworthy. So some say that the important lesson from this mess is that no amount of due diligence can protect us from violations of trust. I disagree, and advocate a âtrust but verifyâ approach rather than resolving to be tricked by the next Madoff or Stanford. Fool me once shame on you. Fool me twice shame on me. Simuliacin is good immunization against deception.
Surz, Ronald. âA Fresh Look at Investment Performance Evaluation: Unifying Best Practices to Improve Timeliness and Reliability.â Journal of Portfolio Management, Vol. 32, No. 4, Summer 2006, pp 54-65.
___________. âTesting The Hypothesis âHedge Fund Performance is Goodâ.â The Journal of Wealth Management, Vol. 7, No. 4, Spring 2005, pp 78-83.