Hedge Funds Are Failing: Regime Change

    A webinar by a prominent hedge-like mutual fund offered no good reason for their underperformance. I suspect they incorrectly assumed they were diversified, but they failed to realize that during a bubble, most assets have their correlation rise to be nearly fully correlated. The only quality diversification tools (especially during bubbles) are low duration Investment Grade bonds, or buying puts, etc. and thus they weren’t as diversified as they thought. They say their losses are in middle of the pack of peer group competitors but since they greatly underperformed a short term bond index (like the bond ETF AGG which lost 1.31% in 12 months, versus the 9.85% loss of a hedge-like fund in 12 months thru 9-30-2018) and they are pursuing an incorrect policy then I must avoid these funds and stay out until a new financial regime has been established. I suspect once every decade at top of a bubble the first assets to go wrong are esoteric hedge strategies, elitist luxury real estate, etc., and then the economic distress gradually trickles down to more generic assets owned by the common man such as stocks and middle-class houses, with blue-collar houses being the last asset class to drop as their occupants are the last to realize the bubble has burst. I suspect hedge funds do best during middling economic periods when the bubble is not too big or too strongly growing thus making it feasible to buy “Out of The Money” puts at reasonable prices. As the top is reached the smart money charges too much for put options thus negating the hedge funds’ ability to make a profit. When the bubble is extreme then only a few FANGs make all the gains, propping up the broad indexes, while other stocks decline (especially true comparing US to rest of world). Basically the median investment of any type has begun to go down and has lost its momentum factor, which is a key factor that hedge funds like to profit from. I suspect this fund and its peer group are fundamentally, on average, over-invested in long-only things with a strategy of simply riding along with the bubble and thus they didn’t truly hedge. To truly hedge they would need to be 50-50% balanced between long-short positions but they didn’t want to do that because of the risk of swimming against the current of a powerful bubble-caused momentum. A record strong bubble overwhelmed the financial engineering of hedge funds, so the only defense is to flee into Short Term Investment grade bonds, and perhaps a tiny amount of OTM puts. The stunning 10% loss this year of this fund reminds me of the 2000 top when the greatest experts suffered similar inexplicable failure. Thus there is no choice but to get out of these type of funds until after a good hard macro “cleansing crash” has occurred like the Oct., 2002 or March, 2009 lows. It may be that true hedged investing is an unreachable dream during a post-1987 Fed induced gigantic 30 year long central bank bubble. Also simply too many people are trying to operate hedge funds which means they are forced to overpay for things like puts or are underpaid for short selling and thus they can’t function. Additionally the industry has a severe survivorship bias problem, estimated at 7.7% lower actual returns in a CFA magazine article several years ago and thus even worse now. I feel the expensive nature of the funds and the extreme difficulty of understanding, rating, ranking, hiring and firing them means that on a risk adjusted basis one might be better off with a simple strategy of progressively reducing risk buy increasing allocations to genuine investment grade bonds as the cycle gets closer to the top.
I think as the bubble gets bigger the crowd gets more wild with enthusiasm and disrespects the cautious experts and the crowd doubles down their bets on the worst bubbly assets, thus disrupting what could have been a well thought out plan by hedge funds to make money. Investment experts can’t do well during a time when the marketplace has been hijacked by the irrational emotions of crowds. The typical investment a hedge fund makes might be to shop for a cheaply priced put option and buy it in the hopes a sudden unexpected increase in volatility or bad news makes the underlying asset drop in price so that the put option goes up in value. This will backfire if the masses are going crazy making the bubble bigger instead of acting logically and trimming down risk.
The golden age of rational investing was 1932-1980 when participants were absolutely scared to death of a catastrophic repeat of the 1929-1932 crash so they invested very carefully and no true bubbles occurred. The market was mostly efficient. But since the crash of 10-19-1987 where stocks fell 23% in a day the central banks have implicitly promised to reinflate the markets to avoid a recession. This is called the Federal Reserve put option. Investors have been spoiled by 38 years of declining rates and ever-increasing central bank stimulation designed to increase stock prices so that were done to fix recession. The problem with this is people are induced to take on “Moral Hazard” where they use new found safety mechanisms as a way to pile on more risk so they are no safer than people were decades ago.

 Stanley Druckenmiller (perhaps the world’s greatest investor) said “if there’s one thing I’ve learned, currencies probably being the most obvious, every 15 or 20 years, there is regime change. [For example] So currency is traded on current account until Reagan came in and then they traded on interest differentials. And about five years, 10 years ago, they started trading on risk-on, risk-off.”
What he is referring to is that the economy changes in a “regime change” every decade or so. I believe when a once in ten years bubble top is reached then a regime change begins quietly, at first only hurting elitist esoteric investments, making hedge funds unable to make money, and then spreading in true trickle-down fashion, down to the masses into plain basic investments. Thus the 2018 failure of hedge funds is a subtle clue that regime change is coming.
Dave Rosenberg said today that Powell is the first Federal Reserve chief since Volcker (who ruled in 1979-87) to end the Fed policy of creating asset cycles, which means he won’t be priming the pump to keep stocks from falling and will be as transformational as Volcker. My opinion is that society may not let any Fed chief do that and thus he may eventually be fired (after a deep 2009-style crash) and replaced, but only after the bubble has burst and then it will be too late to easily patch and reinflate the bubble.

   Investors need independent financial advice about the risks of hedge funds and secular cycle regime change.

 

2018-10-19T17:29:14+00:00October 19th, 2018|mayflowercapital blog|Comments Off on Hedge Funds Are Failing: Regime Change

About the Author:

mm
Donald Martin has a B.A. in Accounting and M.B.A. Finance, and has passed the rigorous CFP® exam and met the experience requirements needed to become a CERTIFIED FINANCIAL PLANNER™ professional. He has been employed in the financial services industries for 30 years and has been investing for his own account for 38 years. Donald Martin’s 19 year career in lending prepared him for fixed income analysis, Securities analysis, and macro-economic analysis used for investing. Donald Martin founded Mayflower Capital in 1993 to provide independent financial advice and implementation of advice about loans. In 2005 Donald Martin changed the company’s mission to providing independent financial advice about investments and financial planning and stopped providing loan services. Donald Martin has a B.A. in Accounting and M.B.A. Finance, and has passed the rigorous CFP® exam and met the experience requirements needed to become a CERTIFIED FINANCIAL PLANNER™ professional. He has been employed in the financial services industries for 30 years and has been investing for his own account for 38 years.