Friday, September 29, 2006

Managing expectations

Kindler, gentler hedge fund manager Barry Ritholz writes about the Amaranth blowup. He puts some of the blame on investors, for not understanding that Amaranth had to be taking huge risks to generate recent outsized returns. The way the game is structured, managers are incentivized to describe their strategy and expected returns as follows:

"We expect gains of 35-45%, with minimal risk or leverage. Our black box algorithms have been backtested, and generate better numbers than that, but we would rather under-promise and outperform."

Before you roll your eyes, hear me out on this. I have some very specific experience with this, as I have spent the past 18 months or so traveling around the United States, speaking with my limited partners (i.e., investors) and with potential investors for our hedge fund.

My experience with this is why I have been watching the unfolding debacle at Amaranth Advisors’ with some bemused detachment.

Now, without revealing any specifics, I will tell you we have had conversations with some very intelligent people who were a pleasure to meet with; Brilliant, fascinating, successful folk with interesting lives and of great accomplishment. However, once we sat down with their financial advisors - lawyers - accountants, things became, well, repetitious. In every meeting, there were some variations on the same conversations; Its like there is some hedge fund due diligence form that makes everybody ask nearly identical questions:

What's your track record? (Good)
How much skin do you have in the game? (alot)
How is Alpha generated (our models keep us on the right side of the major trend, and avoid big counter-trend moves)
What do you think will happen to the economy and the market?
(I don't know, but here's an underappreciated possibility . . .)
What is your Gamma ? Sharpe Ratio? (I neither know nor care; This isn't a B-school exam)

Then comes the exact same question, which I (foolishly) answer honestly:

"What sort of performance are you looking for?"

I usually start with: "It depends upon what the market offers us; If we remain range-bound, it will be difficult to put up great numbers without a lot of leverage or a lot of risk (or both), and we don't do that. We do particularly well, however, in major dislocations or strong rallies."

My initial answer is rarely accepted, and I am forced to go to a 2nd and 3rd option:

"Give us more details on what you want to do. What performance would you be happy with?"

Answer two: "What we want is irrelevant; Its what we can reasonably do while still managing risk, and not overleveraging. Our goal is to outperform the S&P500 with less risk, and in the event the SPX is negative, still have positive expectancy (i.e., be up when the indices are down)."

"So you are a relative (rather than absolute) performance fund?"

Answer 2b: "Well, most funds actually are, despite their claims of absolute performance regardless of market conditions. Consider the mediocre performance numbers from most funds recently when the market's been range-bound. Its been pretty weak, and that's no coincidence. There are only a handful of true absolute performance funds with great long term track records (and if you are talking to me, its because you cannot get into them)."

Now comes THE QUESTION. This is the one that gets people into trouble:

"We are looking for a number. What should we expect from you in the first 2 years?"

What they want to hear is "I am going to do 30-40% annually, fully hedged."

I don't say that, because it isn't true. (God bless Jim Simons, who actually can honestly say that). That's what too many investors are looking for; its nothing more than the greed factor at work. They don't say it explicitly, but its true: We want you to outperform the long term S&P500 benchmark by 300-400% annually (and we don't care about mean reversion). We really don't care how you do it. We want outsized profits. WE WANT THE LATE 1990S AGAIN.

Money raisers and some GPs have long ago figured this out. You have a few choices: you can answer the investors' questions honestly -- or to quote Ray Davies, you can give the people what they want (or think they want):

"We expect gains of 35-45%, with minimal risk or leverage. Our black box algorithms have been backtested, and generate better numbers than that, but we would rather under-promise and outperform."

Of course, that statement will be nonsense for 99.8% of the people who utter it. The vast majority of funds will not out-perform the indices dramatically year after year. We were fortunate -- we ended up with investors who understood this; Then again, we are a small fund, and not a $9B giant.

There are some funds that aim to fill this niche. They use lots and lots of leverage, play the highest beta moves, load up on derivatives, put up good numbers for a stretch. Eventually, they do one of two things: They take on some risk management -- lower their volatility plays, reduce leverage, aim for more sustainable gains.

Or they blow up.

Not all of them, but enough. Something like 25% of all hedge funds every couple of years dissolve, go away, reform, pop up elsewhere. That's not a coincidence, either.

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