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“Minds of
moderate calibre ordinarily condemn everything which is beyond their range.”
- Duc de La Rochefoucauld.
In ‘Fooled by
Randomness: the Hidden Role of Chance in Life and in the Markets’, Nassim
Nicholas Taleb – to demonstrate why we are often our own worst enemies – uses
the example of a retired dentist with a penchant for playing the markets. This
hypothetical pensioner is guaranteed to earn a 15% annual
return, but also to incur volatility of 10%. (We have alluded to Taleb’s
dentist before and make no apology for doing so again. There are only so many
good ideas.) The one thing we know about markets is that they fluctuate. If
Taleb’s dentist tracks his portfolio in real time, at any given second he has
only a 50.02% probability of experiencing a positive (i.e. profitable) outcome.
There is a 49.98% probability of him incurring either sorrow or regret. If
Taleb’s dentist spends his whole day tracking his portfolio, he is going to
become psychologically exhausted.
If, however, our
imaginary pensioner restricts his frequency of portfolio observation to once
per day, his chances of experiencing a pleasurable outcome rise to 54%. If once
per month, that probability rises to 67%. If once per quarter, that probability
rises to 77%. And so on.
What makes
Taleb’s story so compelling is that nothing is changing about our hypothetical
investor’s portfolio (he still makes his 15% profit per year) – only the
frequency with which he monitors it. But human nature being what human nature
is, the likelihood of this – or any investor – being panicked by losses (or
lured into taking profits) simply by voluntarily exposing himself to price
variability is extremely high. So Taleb’s thesis really involves multiple
dentists. Those with the discipline to leave their portfolios alone will get to
reap that 15% profit. Those with the lack of foresight to suspend their
inquisitiveness will be lucky to garner any kind of positive return. We cannot
blame the market for our own inability to conquer our lizard brains. The fault
is not in our stars, but in ourselves.
Le marché, c’est
moi. (In the case of Jerome Kerviel, that was almost
literally true.)
The challenge
for the aspirant retired dentist is compounded by external influences. In the
example above, the hypothetical investor is merely confronted by the influence
of price. In the real world, he will also be assailed by newsprint, by airtime
abhorring a vacuum and by talking heads – all trying to tell a story. And since
the basic commodity of the markets – price – is practically free to access,
especially after just a token delay, the talking heads will feel obliged to
cloak the price beneath thick layers denoting extremes of either bullishness or
bearishness. It is to all practical extent impossible to answer the question
“Why did the market go up ?” with the admission, “I don’t know, and I don’t
much care.” Our culture obligates us to seek causality, and then to answer the
implied second question, “Where now ?” with either extrapolation or rejection
of the trend.
The sudden
collapse of Peloton Partners’ $2 billion hedge fund has been widely attributed
to a combination of calling the bottom of the ABS / ABX market too quickly,
using an imprudent level of leverage to do so, and to this voluntarily imposed
‘hard place’ coming into rapid collision with the ‘rock’ of heightened margin
requirements imposed by increasingly panicky prime brokers. What has not
featured as a factor, though it has surely played a role in the failure of
other large funds, is the impact of waves of selling (redemption orders)
triggered by investors reacting to disclosure of the fund’s first significant
losses. Since hedge funds typically price their funds on a monthly basis but
often restrict investor inflows and outflows to quarterly or worse, there is a
mismatch between valuation and available liquidity. Although the first investor
to redeem may be reacting to a purely temporary or ultimately survivable hit to
the fund’s capital, by the time the redemption flows turn into an orgy of
speculative terror, there may be insufficient liquidity within the fund to
cater to investor demands, and a perverse form of Gresham’s law works its
inexorable gravity on the fund’s value – ‘bad money’ (redemption orders) drives
out the ‘good money’ (profitable positions, or even loss-making positions that
might well turn out good were they only given the time to do so) to such an
extent that the fund is fatally wounded. Combine this obvious unattractiveness
in structure with the strategy opacity that has come to suffuse the hedge fund
sector and it is a wonder that any of these vehicles ever got funded in the
first place. As the phrase goes, marry in haste, repent at leisure.
The irony is
that funds investing into illiquid, hard-to-trade instruments must report
monthly prices that in some instances surely become red rags to a bull –
invitations, in some cases, to “take the fund down”. Would managers involved in
implementing such trades not be better served by offering two separate fee
structures – high fees to those investors “demanding” monthly pricing, and
lower fees to those investors comfortable with less frequent but just as
accurate pricing ? If you really wanted to ram the point home, you could give the
investors with less frequent pricing more timely access to their capital. Private
equity investors seem to cope with less regular pricing without incurring a
conniption fit. The very concept of liquidity is overrated (though this might
not be the environment exactly to labour the point). As Yale’s David Swensen
has remarked, investors – particularly those with long time horizons – pay far
too much for it.
There is,
however, one investment structure that offers both manager and investor a
number of advantages over an open-ended fund. It’s called a closed-ended fund.
Because both hedge funds and private equity funds invest into variously
illiquid assets, the fixed (permanent) capital structure of the closed-ended
fund gives the manager freedom to invest at will without the inevitable
constraints that come with the provision of daily, weekly or even monthly
liquidity to existing unitholders. The ability to buy or sell shares on a
recognised market helps to resolve liquidity-related issues for investors more
easily than in the traditional open structure. And – in the current
environment, this could be the clincher – the closed-ended fund offers enhanced
transparency as to underlying investments, not least with a requirement to
provide quarterly disclosure of significant holdings. It is therefore hardly a
surprise that many of the better closed-ended London-listed (funds of) hedge
funds trade at a premium to their net asset value. But less well-disciplined
investors should beware: the market will give you a daily price on these funds,
whether
you want it or not. That the London market also offers closed-ended
long-only funds investing into emerging markets at a significant discount to
net asset value looks like one of the investment bargains of the year.
Notwithstanding
the correction to temporarily overheated commodities markets mid-week, it would
take nerves of steel (and, we think, imprudence) to bet actively against them.
That is, in light of the fact that the underlying drivers of the bull market –
demand from developing nations; insufficient capacity investment over the last
two decades; distorted supply due to political manipulation of the energy
market; ‘safe haven’ buying of instruments reliably free of
mark-to-make-believe and financial “innovation”; ‘safe haven’ buying of hedges
against fiat currencies and notably the US dollar – seem to be utterly intact. Not
only are those trends intact, but so are those afflicting financial assets that
are triggering the run into so-called alternative assets – ongoing deleveraging
and debt contagion. (Ambrose Evans-Pritchard has written a useful
commentary on the inflationary / deflationary impact and political
implications of the existing market dysfunction. On the topic of spreading
credit contagion, Ed Steffelin of GSC Group provided the quote of the week:
“People are calling it financial Ebola.”)
The bull market
in commodities has quickly climbed a wall of worries, the most prominent of
which has been the presumption that institutional investors were already sitting
wedged firmly on the bandwagon. Perhaps not. Bloomberg’s Saijel Kishan
(“Calpers to boost commodity investments through 2010”) reported
on February 28th that the largest US pension fund was considering
increasing its exposure to commodities investments 16-fold. The fund is
apparently contemplating an allocation of some $7.2 billion by 2010. Its first
investment into commodities was, apparently, last year.
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