The Perils of Trying to Time the Market III

I just read an article about a big alternative mutual fund that is facing redemptions due to poor performance last year.  And it got me thinking again about a recurring theme on this blog about the perils of trying to time the markets.

I know it's preaching to the choir here, but it is something I am always thinking about.  And this got me thinking about risk overall.

As I was reading the marketing material and articles about this particular fund, I realized how hard it must be to run a fund with the purpose of earning equity-like returns but with lower volatility and smaller drawdowns.

You Have to Be Right So Many Times
Many of these funds take a completely top-down approach to asset allocation.  For example, they will look at the economic outlook; interest rates, inflation etc.  And then from there, they have to choose investments that will benefit from and get hurt by the trends in this outlook.  They have to choose how much to allocate to each investment/trade, and then they have to time it well.

That's a lot of decisions they have to get right.  For example, just on the outlook itself, how hard is that?  We all know how accurate economic forecasts are.  How many people last year predicted higher interest rates?

What are the odds of getting that right?   So that's decision number one.

And then you have to go and find investment ideas that fit that particular theme (rising rates, higher inflation, for example).  I guess you can just go and find the stocks or investments that are the most leveraged to these particular factors and not care at all about management etc.  Or you can pick the best managed companies in the respective sectors.  Or maybe you want the highest cost producer to maximize operating leverage, or the most levered company for maximum financial leverage.  Or maybe a combination of both.  Or you might want the lowest cost producer (but you may get less bang for the buck if you are right).

Or you can go out and look for the things that will be most hurt by the trends you predict.   See?  This is already getting pretty complicated.

Obviously, you can be wrong about this stuff.  You can get the macro right, but you might pick the wrong stocks.  I remember how people forecast higher gold prices and then bought a bunch of gold stocks and got clobbered.  They got the macro call right (gold prices went up) but got the stock picks wrong (most went down due to higher production cost etc.).

And then you can actually get the macro call right and maybe even pick the right stocks.  But if you are an active manager, you are at risk of getting stopped out of positions that are good at the wrong time.  Even if you make two right decisions,  they might go down far enough to trigger stop losses and push you out before you are proven right.  So you can get two things right and get the timing wrong (investors might flee too forcing you to sell potentially winning positions before they turn) and  lose money.  We all know, the markets can remain irrational for a lot longer than your prime broker or margin clerk will allow you to hold the position.

So think about the many layers of correct calls that an active, top-down alternative manager has to make.  They have to be right on so many levels, it's almost ridiculous.  And they have to keep being right over and over again. (Oh, and as complicated as the above is, think about the fact that they have to think about when to get out.  You can be right on all of the above, and the scenario may unfold exactly as you predict, but then if you don't get out at the right time, you can easily give up all of your gains (as markets reverse etc...)).

Simple
That's why people like Buffett ignore that stuff and just try to focus on the two questions that they think they can answer:

1. Is it a good business?
2. Is it a fair price? 

If it's too hard, you move on.  Munger has said many times that you only need to be right a few times (or less) in your lifetime to do very well. 

Contrast that with these macro-based alternative mutual funds; they have to be right so many times on so many decisions constantly to keep putting up good numbers.  (I contrast these funds with macro hedge funds as macro hedge funds tend not to be so much asset allocators, but very active, highly leveraged traders.   No macro-based alternative mutual fund will ever reproduce the sort of returns that Soros had in the 80's and 90's, for example, as they were very different). 

Risk

These alternative mutual funds sell well after bear markets because people suffered so much that they don't want to experience that sort of pain again.  So they look for people who promise a lower drawdown. 

But anyone who has managed risk professionally knows that you can't really reduce risk in the financial market (OK, well, actually you can by staying away from crappy stocks and not doing stupid things; not overpaying etc.  But bear with me for a second).

Long Term Capital Management was a good example of that.  For many years, they had equity-like returns with lower volatility and low correlation to the overall market.  They were able to hedge out all sorts of risks by taking various long/short positions.  But by eliminating market and interest rate risk, they instead took basis and liquidity risk.  And that's what killed them in the end. 

If you run an options book, for example, you can hedge out all sorts of stuff.  Market makers do this all the time.  They buy IBM calls, for example, and they have to hedge out their delta.  So they short IBM stock against their long calls.  But now they have volatility and theta risk.  So they can short IBM options against it to hedge away their vega (volatility risk) and theta.   Then you might end up with some gamma risk.  You can hedge that out too. 

In more or less efficient markets, the more you hedge away, the lower your returns are going to be (as you are paying the market to take away this or that risk from you). 

So in the end, you might as well just sit on T-bills if you don't want any risk.    That's what happens in a perfectly hedged S&P 500 index portfolio, right?  Buy the index and short futures against it.  Your return will basically be T-bill-like as you are not accepting any risk (well, you are taking futures exchange clearing risk; if a huge counterparty defaults, you can actually lose money even in a centralized futures market without direct counterparties).

So back to alternative portfolios. When people say that they will keep an eye on the economy, interest rates and things like that and promise you that they will use that information to structure the portfolio in such a way to maximize returns and minimize risk, you have to understand that they are not actually reducing risk. 

They are reducing risk in one area and taking risk in another. 

So instead of taking temporary mark-to-market stock market volatility risk, they are taking on macro-forecasting, investment selection, market-timing and other risks. 

The only way they will actually reduce risk is if they own a large, S&P 500 correlated portfolio and then short futures against it.  In that case, your exposure is going to be their portfolio outperformance "alpha".  And judging from how long-only mutual funds usually perform, the expected alpha will most likely be negative anyway.   If the portfolio is not correlated, and the fund uses S&P 500 index futures to reduce market risk, then you have tracking error risk; your portfolio can go down and the S&P 500 index can go up.  You can still lose money. 

In that case, you are better off (if you don't want too much equity risk) allocating, say, 50% to stocks and then just keep the rest in cash.  Sure, your return might be 4%/year (8%/year stock return, 0% on cash), but I bet it would be better than most long/short mutual funds over time, even volatility adjusted.   Why bother with all that other risk?  

So you can't really reduce risk by all of these tactical maneuvers.  You are just trading one risk for another.

All Cash?
Even if you stay in cash, for example, you are replacing one risk with another.  By being 100% in cash, you have eliminated stock market volatility risk.  But then now you are sitting on inflation risk.  If you are an equity investor, there is a risk that the market might not come down to where you like for a long, long time.

I remember reading about a prominent bear that got bearish in 1982.   I think he was calling for a market crash.  The Dow was at 800 in 1982.  And he was right.  The market did crash.   So it was good for him to have stayed out (and short) until then, right?  The problem is, the market crashed from 2,700 or so in 1987.

Staying in cash has some risk too that even if the market tanked and got cheap, would you actually have the courage to get in?  And if you did, would buying in at a 20% or 30% discount (or even 50% off) make up for the time you were out of the market?

Or you can convert your cash to Bitcoins and avoid Fed-and-Congress-destroying-the-dollar risk (which is inflation risk).  I'm sure the technology is incredible.  But then sometimes Bitcoin operations get hacked and the Bitcoins just disappear.  Sure, the Fed can't mess with Bitcoins, but I'd sort of rather have the Fed inflate away the value of my dollars at 2-3%/year.  And if my bank failed, I know I can get some cash back from the FDIC.   The factors that impact the dollar are visible to me to some extent.  If the dollar is devalued, I sort of know why.  I can see the inflation.  I can see the budget deficit.  I can see the Fed balance sheet.

But what about Bitcoin?  If the price of it goes down 50%, what can I look at to help me understand that fluctuation?  As far as I know, there is nothing.  So sure, you are immune from central bank and congressional incompetence, but there are many other factors that I don't understand.

So even for the Bitcoin folks, by getting out of the dollar, they are eliminating one risk but then are accepting another. 

By the way, many view Buffett as sort of timing the market because of the huge amount of cash he keeps on hand.  First of all, we know that $20 billion will be there no matter what; he wants that amount of cash for liquidity (paying out insurance claims etc.).

So when he has $40 billion on the balance sheet sitting there, it's actually just $20 billion that is investable.   With close to $200 billion in shareholders' equity, that's a 10% cash balance; hardly a dramatic market call (plus cash accumulates quickly and sometimes he has to let it build up to get ready to bag an elephant!).  Of course I considered comparing the $20 billion to BRK's equity portfolio, but since we know that Buffett would rather buy whole businesses rather than stocks (and one is not more risky than the other in his eyes) it makes sense to compare it to BRK's shareholders equity.


Buffett's Risk Management

OK, I know most of us are not Warren Buffett, but I just use him as a great example of someone who manages risk in a smart way.  First of all, the difference between Buffett and the rest of the professional investment world is how he defines risk  (This is not just Buffett, of course.  Howard Marks, Seth Klarman and many others view risk differently than the street).  

Buffett does not define risk as beta, volatility, drawdowns or anything like that.  He doesn't care about temporary reduction in the value of something (based on Mr. Market).  He is only concerned with the permanent impairment of value (bankruptcy, for example). 

These two risks are very, very different and one is much easier to manage than the other.  

If one wants to eliminate the risk of temporary reduction in value, then equities is simply the wrong investment vehicle.  Even an investment as rock solid and indestructible as BRK has gone down by 50% a few times in the past.  Any stock you buy can go down 50% or more simply due to the silliness of Mr. Market.

But to try to gauge the risk of permanent impairment is far easier. 

If you asked someone which stock over the next year will or will not go down 30%, the odds that they will be correct will be very low.  I don't think even Buffett would be able to pick stocks that will or won't do that. 

However, if you ask people which companies will still exist in ten years, and will actually be doing more business then than now, it would be far easier.  OK, maybe it won't be so easy.  Who knows where, say, AAPL will be in ten years.  

But however hard that is, it would be far easier than trying to figure out which stocks will not go down 30% in the next twelve months.

So Buffett's risk management is to simply focus on questions he can answer and only think about the long term.  Is it a well-managed company with a good business model?  Is it fairly priced?  It's just two questions, basically, that you need to answer.

Compare that to the top-down macro guy: "What will interest rates do?   We think rates will go up.  If rates go up, will that hurt the economy?  If it hurts the economy, should we own defensive names and short cyclicals?  Should we short highly levered companies and buy cash rich companies?  When should we buy such companies or short such companies?  And when do we cover?  How do we know when we are wrong and when do we have to reassess the scenario and rebalance our portfolio?  When do we admit we are wrong?".   What if we are right and there is a recession?  When do we reverse course and start to cover and go long? etc...  The questions are endless, and most of them have to be answered accurately or else you end up losing money.

With Buffett's approach, you don't care about any of that stuff.  Interest rates go up or down?  Who cares.  The management at these companies that we own are good enough and are financially literate so they will refinance if rates go down and won't borrow more if rates go up.   They are not so overlevered that rising rates will kill them.  What will happen to the stock market?  Who knows.  But we know that we own good companies with good managements so if the stock market goes down, maybe they will repurchase shares or maybe they will find an attractively priced acquisition.   If the stock market rallies, maybe they do a stock for stock deal, or maybe they issue stock to raise capital.

In good times they will do a lot of business.  In bad times they will manage costs and find ways to grow the business (acquisitions on the cheap etc.).  If we own the low cost producer, bad times will hurt us less than others.

So whatever the scenario, you don't care.   Things will work out.

Pzena Commentary
Richard Pzena has talked about the fact that risk of owning equities can be reduced by extending the holding period.   His third quarter commentary updates some figures.

It is an interesting read that most of us understand intuitively, but it's nice to see a study that quantifies this stuff.  Yeah, you might say this is marketing material for a value fund.  True.  But it's still interesting and there is still a lot of truth in it.

Here's the commentary:

Pzena Investment Management Third-Quarter Commentary

And here are some tables from it that are very interesting:

This table is self-explanatory.  Buffett's secret weapon risk management method is simply a long holding period (he has said that his favorite holding period is forever):

While some mutual funds try to dance in and out of markets, hedge or unhedge their equity exposure based on all sorts of things, Buffett simply commits to a long holding period and therefore eliminates all the things most other investors worry about.   As I have said here many times before, more money is usually spent (lost) on trying to avoid temporary losses than the losses they try to avoid (which are usually just temporary anyway!  Their losses are permanent, though).

Hedge Funds
Pzena talks about how hedge funds promise to lower volatility but doesn't even achieve that over time.  Equity volatility can be reduced by extending the holding period, but the volatility incurred by owning a hedge fund is not at all reduced through longer holding periods:






Anyway, I am not all that against hedge funds in general.  When I started in the business, the main hedge funds were Soros, Tiger and Steinhardt (in terms of funds focused mostly on equities).

Today's Funds versus the Legendary Funds of the Past
Not too long ago, Stanley Druckenmiller was ranting about the mediocre hedge funds these days.  He said that you had to be an idiot to be paying 2%/20% to hedge funds with single digit returns or low double digit returns.  In his time, hedge funds were expected to earn 30%+ in good markets and bad markets (well, I forget which figure he used; it might have been 20-30% or 30-40%).   Nowadays, he complained, funds still charge high rates with much lower returns claiming that they have good returns on a risk-adjusted basis.

Well, a lot of this is due to the institutionalization of hedge funds in the past couple of decades.  Back in the 1980's and 1990's, hedge funds were for wealthy individuals and maybe European institutions.  If you had a drink with a hedge fund money raiser, they would have told you that you need to put up 30-40%/year returns (or promise to do so) to have any chance of raising capital. This figure may be lower for fixed income arbitrage and other strategies, though.

But since then, U.S. institutions like pension funds started investing heavily in hedge funds and they actually wanted lower volatility and most importantly, I think, non-correlation to conventional asset classes (basically the S&P 500 index).

Presentations were usually filled with tables showing how a 10% or 20% allocation to hedge funds can increase the Sharpe ratio of traditional pension fund returns.

So I think a lot of this low vol / low return stuff comes out of that.  Plus, I guess many managers realized it's much more fun to earn 10%/year with $10 billion AUM (and earn $200 million/year just in management fees) than to try to shoot for 40-50% returns with $500 million.  If they can get to $20 billion AUM, they can earn $400 million just on management fees.  And if you get 20% incentive fee on a 10% return, that's another $400 million/year.

How many percent return do you need to make $800 million/year on an AUM of $500 million?

And how do you get to $20 billion AUM?  You need the big institutional money; pensions and insurance companies etc.  And how do you get that?  By reducing volatility!

And by the way, in defense of the younger, new generation of hedge fund managers, we have to remember that a lot of those old legends put up those impressive return figures in the 1980's and 1990's (well, Soros and probably Steinhardt did very well in the flat 1970's too).  The younger generation had to perform in a market that so far has been pretty flattish since 2000; that's like 15 years of nothing in the market!

Anyway, I do like some of the hedge funds I talk about here, especially the equity focused guys, activists etc.  And of course Oaktree too.

Conclusion
Wow, this is another one of those meandering stream of consciousness-type posts.  What I wanted to say, basically, is the same as what I always say here.

But I realized there is another way of putting the risk of market timing.

When someone tells you that they will earn equity-like returns with lower volatility and low correlation to the stock market, and they say they are going to do it mainly in the stock market, I think it's a good time to run.

You can't really earn high returns with lower volatility without taking some other risk to compensate.  When someone offers you something like that and they say you will have lower stock market risk (and returns are still going to be high), you have to think hard about what kind of risk they are going to take instead.  Most of the time, they are just reducing one risk to take another kind of risk.