Avoiding failure in fundland April 9, 2008 at 1:58 pm
What is working for hedge funds in the current climate? Bloomberg has a discussion of what isn’t:
Hedge-fund titans James Simons and Stephen Mandel are showing the biggest losses of their careers in the $1.9 trillion industry’s worst start in more than a decade.
Simons’s $18 billion Renaissance Institutional Equities Fund declined 12 percent since its value peaked last May, investors with direct knowledge of the situation said. Mandel’s Lone Cedar Fund dropped about 10.6 percent from its high in December, according to people familiar with the fund.
What is interesting is that Simons and Mandel are very different kinds of manager: Simons is a quant whereas Mandel is an old-fashioned stock picker, albeit a highly respected one. Just to add colour, elsewhere there has been some discussion of hedge fund attrition and the evolution of models in quant funds. Where does this leave us?
- Model risk has always been with us but with gapping markets, expensive funding, a renewed focus on counterparty risk, and a flight to quality now is not the time to be highly leveraged or to rely on any strategy which assumes short- or medium-term mean reversion. History, for a while at least, will not be repeating itself.
- Your leverage should be calibrated on the assumption that asset prices can jump without you being able to trade, then your leverage provider will make a fundamentally wrong but just about justifiable margin call based on the most conservative mark to market they can come up with.
- There is good money to be made in picking up fundamentally solid companies cheaply but again you can lose money in the short term so having enough capital and patience to wait it out is key. Do as Warren did and buy solid forward earnings for cash.
- Remember that even if a model backtests well the very act of using it in any size changes the market dynamics. And the chances are that even if you aren’t using it in size someone else will be: see for instance Have we quants been brainwashed by Barra here.
- Keeping your leverage low is important, but so is reducing both ordinary and alternative beta. There are a number of funds who are close to the edge at the moment, at least if we believe this source. Personally I prefer a more glib but funnier source here. But in any event, ensure the portfolio is well hedged until the chaos has subsided and bear in mind that there will be more bodies on the slab before this is over.
The first rule of the game is staying in the game, and the market really can remain irrational for longer than you can remain solvent. [It appears that Galbraith did not actually say this, but he ought to have done.]
