A Study To End All Studies
You don’t have to be a rocket scientist to recognize that the first person to figure out a new trading or investment strategy will make more money than the folks who copy the strategy. Whichever way you lean on the Efficient Market Theory, we all understand that a strategy loses its edge as more and more people follow it. In portfolio manager jargon we say a trade is “getting crowded.”
Smart trades rely on no one else recognizing what you are doing, which allows you to buy and sell at favorable prices, and with easy liquidity. Crowded trades mean everyone sees how well the strategy worked and they all want in. Once everyone is rushing to get into the same trade, there’s no one to buy from — prices go up, liquidity goes down. And no one to sell to — prices plummet, and sometimes bid vanish altogether leaving investors holding a very pricey bag.
One of our Broad Street Irregulars recently sent us a note about what has to be the ultimate academic study — an article from the Chronicle of Higher Education (on-line edition) dated 1 November titled “Academic Research Destroys Stock Values.” The Crowded Trade phenomenon is familiar to all traders and managers worthy of the name — a statistically insignificant number since the hedge funds sector is now about 93% correlated to the S&P 500, and about as highly correlated internally as well.
Different methodologies yield different numbers, to be sure, but the trend is unmistakable. Earlier this year Morningstar Research found the correlation between hedge funds and the S&P 500 had reached “an all-time high” of 82% (MorningstarAdvisor, 14 August, “The Rising Correlation Between Hedge Funds And Stock Markets.”) Meanwhile, a year ago the Wall Street Journal already reported that “the correlation between hedge fund returns and the S&P 500 has risen to nearly 100% in the past couple of years” (WSJ.Com MarketBeat, 21 November 2011, “Hedge Funds Kiss Their Alpha Goodbye.”) The Journal piece reproduced a chart from Morgan Stanley showing the HFRI Equity Hedge Funds Index correlation with the S&P 500 had risen from about 56% in 1995 to 90%, and that Annualized Excess Return — that magic “Alpha” — of the index had fallen during the period from about 15%, to close to a negative 2%. The article says “extreme correlation has made it nearly impossible to pick stocks well, hurting the ability of many hedge funds to generate much alpha.”
Indeed, the degree of internal correlation within the sector is also staggeringly high, as the majority of hedge funds engage in roughly identical trading, all chasing not merely similar ideas, but frequently the very same idea as they sniff out what the most successful managers are doing.
Certain hedge fund managers are viewed as the Gold Standard, and other managers aspire to mimic them. Uninitiated investors may be surprised to learn that meetings among the strategists managing your wealth often consist of the portfolio managers (“PMs”) not reviewing their trading algorithms, but frantically asking each other “do you know what so-and-so is doing?” The most valuable information for many PMs is not the next big strategy, but what trades did Big Fish Number One and Big Fish Number Two do today.
“Soros is buying gold,” the head PM will say, “why are you short it???” as though riding the coattails of billionaires will automatically make you successful.
How, you may ask, do they know that Soros is buying gold? Well, if you are a low-profile genius, known only to a few PMs, they have to skirt the law and wangle it out of your traders, or of your prime broker — the investment banking firm that has custody of the hedge fund assets and processes its trades. But for the likes of Soros, it’s much simpler. He is on television telling not just your PM, but the whole world when he is buying or selling gold.
Now the veil has been rent asunder and even you know how profitability is eviscerated in your portfolio. How about an academic study to back it up?
David McLean, visiting associate professor at MIT’s Sloan School of Management, and Boston College professor of finance Jeffrey Pontiff studied 82 profitable investment strategies that were written up in 68 different papers in academic journals. They compared the performance of each of the 82 strategies before, and after the papers were published and recorded an average decline of 35%. “That means,” says Professor McLean, “that if your strategy was growing your portfolio at 1 percent every month before the paper was published, it dropped to 0.65 percent after publication.” The paper also reveals the stocks in question “experience higher volume, variance, and short interest.” Because of the high costs of arbitrage, “post-publication return decline is greater for anomaly portfolios that consist of stocks that are large, liquid, and have high dividend yields, and have low idiosyncratic risk.”
This is just part of how your money gets mangled as it rotates out of, then back into your own pocket. Between sub-par professionals trying to mimic “the smart money” and academic journals outing smart strategies as soon as they hit the street, how are you supposed to survive as a private investor? How, indeed.
As we go to press, the Financial Times reports that one of the most recherché of sectors is about to go retail (FT, 12 November, “KKR Opens Funds Aimed At Private Investors.”) The world’s biggest private equity funds were once the exclusive domain of the wealthiest. Think, the Saudi Royal Family. Now, reports the FT, “firms are finding it harder to identify reasonably priced companies to take private,” and are accepting investments of $1 million or even less.
This follows what we have identified as a familiar road to retailization, as trades have become so crowded there is no profit left in them. Now, the private equity behemoths are trading on their past records, taking in retail investors who will pay a 2% annual management fee for the privilege of whispering “KKR!” at cocktail parties. McKinsey & Co says the alternative investment industry is “rapidly moving into the mainstream retail market and are expected to account for one-quarter of retail revenues by 2015.” Those “retail revenues” would be fees and commissions, not investor returns.
It was not immediately clear how the Saudi princes feel about rubbing financial shoulders with owners of plumbing supply companies in Iowa. One thing remains obvious: the more people know about how you make your money, the less money you will be able to make.
If you didn’t know, now you know.
from: Slouching Towards Wall Street… Notes for the Week Ending Friday, 9 November 2012
Copyright © 2012 by Hedgeye Risk Management, LLC