Published August 29, 2014
The period of “The Great Moderation” (1983-2008) was one resulting in massive assumption and prerogative. Long gone were the silly fears of the “Great Depression” – bankers and brokers were immortal - above reproach and certainly beyond correction. Technology created both speed and choice – this dynamic encouraged a whole new breed of investing mind thought and subsequently pushed equities into a quick-and-easy mainstream investment. Stocks were no longer reserved for the ultra-affluent – the generations who lived at ease on the hard sweat of a relative they heard of yet never knew. The advantage became more balanced – more stock markets, more volume, cheaper commissions and narrower bid-ask spreads. Buying or selling a year’s salary of XYZ; something that used to take minutes could now be done in less than seconds in the comfort of your pajamas.
There was a time in America that young men and women were admitted to college without creating highlight videos of themselves and without pledging their teenaged years to an extracurricular cloister. College arrived, and college led to graduation (four years), a cubicle, modest debt, spouse, offspring, real estate, health insurance, trips to Disneyland. Nurses and math teachers did not need resumes. Single-family homes increased in value every year. That’s etched in stone somewhere. People in their 50s and 60s owned homes that were paid off. If you had been working somewhere for 20 years or more you could safely hide in your office until you turned 65, and at that point, with your golden years ahead, Social Security would be waiting patiently. Forever would Americans buy Kodak film, books at Borders, tools and trousers at Sears Roebuck & Company.
When recession did arrive (the non-Great kind) a company like Circuit City might dally with Chapter 11, but only long enough to get reorganized and draw enough investment capital to return to health. If a developer was stuck with an office tower or apartment project that was still unfinished when economists announced that the downturn had started, the investors pushed to finish the property anyway, and then made an effort to find tenants. Walking away from a property with rebar sticking out of the top was unimaginable. And regardless of the economy, talk of Chapter 11 for icons like General Motors (GM) or Bank of America (BAC) was the province of conspiracy theorists with greasy hair and smudged glasses.
Different Soil Produces Different Plants
By and large, we are grounded by context - what we believe to be true. A young kid growing up in Philadelphia during 2007-2011 would rightly assume the Phillies were always good and always in the playoffs. However, what a Baby-Boomer Philadelphian pictures inside the frame is a scene vastly different altogether as they freshly recall the “Collapse of ’64” (6 1/2-game lead in the NL East with only twelve games remaining). Indeed, pains memory fades quickly, but it does, somehow, score our brains with a deeply personal perspective – for better or worse.
I recall making my first stock purchase (Niagara Mohawk Power ticker: NIA) as a senior in high school. My grandparents warned me of the evil unknowns of the market. “Don’t buy what you can’t see”, “it’s good till it’s not,” “leveraged and illiquid” they would clamor. These familiar phrases seemed exaggeratedly homespun at the time, however, would prove remarkably prophetic in future years. As an 18-year old boy, I thought buying equity (especially given the rich dividend) was a judicious thing; something worthy of praise. I subconsciously chalked their cautioning as podunk - nattering from a generation of old irrelevant crepehangers. Little did I realize they were first-hand witnesses to the full-blown destruction of an investor base less than 50 years prior and, more personally, recently and specifically, the wipeout of Penn Central (PC stock fell from $86 - $15) – decimating neighborhood families – their presents and futures.
I learned about market supply/demand and momentum dynamics at a very early age. My uncle owned a scrap yard and my father, who worked their part-time, would take me along. I still remember the earthy scent of stale oil and rusting metal from cars – once full of families – now sitting derelict, awaiting the car crusher. It fascinated me that a New Jersey trash-picker could play a tangible role in supplying the world’s demand. He could drive into the scrap yard with a trunk full of copper, place it on a scale and walk away with a wad of cash. A few weeks later, the trash-picked copper would be refined, melted down, and sold to a bonded warehouse and shipped to perhaps China, ending up deep beneath a railroad bed 7,000 miles away. Better lesson yet was witnessing the daily price action and trend. I distinctly recall and was forever impressed by pig iron and how, during a short period in the early 1970’s, the market abruptly became so abundantly oversupplied that scrap yards went from paying for it (pig iron) to being paid to keep it!
A Tourist in Monte Carlo – the fourth moment of a deformed normal distribution, conditional probabilities and Gaussian blurs.
What I learned is markets are often driven by human emotion and unexpected events. Predicting that market movement is mystifying to say the least and the same can be said of defining precise return expectations. Portfolio theory is grounded with the conviction that traditional asset classes will rise in value over the long-term. To date, that theory holds true, however, at the end of the day, our traditional long-only portfolios, our nest eggs, are assuming risk without any of us having any clue about what the risks are! Investors need to be willing to probe beyond traditional stocks and bonds if they want to be truly diversified. Investors need a differentiating component that, over time, has shown to be non-correlated to the traditional market and will help mitigate the crushing blow of volatility.
Unfortunately, many are attracted to alternatives purely for the perceived outsize returns they believe these investments can deliver. They attend parties and are held hostage to loud, grandiose stories from acquaintances who can afford a pre-war apartment in Gramercy Park – not to mention garaging their convertible in Manhattan – all in-part to the huge returns from their alternative investments. No matter how toxic or highly exotic this alternative investment is – it is too tempting to pass up! Yet, we reside in a world of compact probability distributions, where expectations – the mean – and the deviation from that expectation – or the volatility – matters the most and influences all investment outcomes. That said, the investor, when analyzing alternatives with the intention of reducing volatility and truly diversifying, should carefully consider divergent hedge fund strategies such as: global macro, event driven, diversified/systematic and managed futures. Strategies designed to capture upside during extreme events, market shocks and volatility. History has shown that these strategies flourish when the world doesn’t make sense.
Phony Diversification and Systematic Risk in Returns
The chief philosophy supporting divergent strategies is simply the short-term momentum (direction) of markets is often a direct response to corporate, geopolitical and economic data. The inherent flexibility and liquid nature of these strategies means that positions can be swiftly reversed as one trend ends and another begins, which is clearly different from the “buy and hold” nature of our traditional long-only investments and most hedge fund strategies. Subsequently, what makes divergent strategies so particular is that they often demonstrate a low or negative correlation in times of market stress. This suggests that an allocation to divergence could actually counter, rather than simply cushion, the impact of extended market liquidation.
In short, it simply boils down to convergence (long-only equity, fixed income and most alternative hedge fund strategies) complemented by divergence (global macro, event driven, diversified/systematic and managed futures). A convergent investment thesis is one built on the notion that the core value of an asset can be measured using analysis. This analysis will result in a conviction on whether an asset is over or undervalued, based upon the belief that the price will “converge” to its core value over time within a normal market environment. Divergent strategies seek to profit when fundamentals are ignored by the market. Divergent strategies have performed their very best when they can exploit market price dislocations, often epitomized by successive price movements around asset classes “domino effect” reflecting the realities of changing market sentiment.
Despite the best of intentions, too many of us incorporate a litany of funds, styles and strategies – whether main stream and/or alternative – and yet, simply fail to properly diversify the underlying risk exposures of the portfolio. It is true that alternatives in the form of hedge funds have generally reported higher Sharpe Ratios than standard asset classes and yes, alternative beta (i.e. returns generated from exposure to volatility, credit or liquidity risk) can add value to a portfolio, however, “true diversification” critically hinges on the underlying risk and covariance characteristics of your overall portfolio. In a perfect world, you would select a universe of investments that spans a spectrum of risks in search of a balanced portfolio. You would then correctly forecast (econometrically of course) short-term asset volatility and correlation - rebalancing as changes in short-term forecasts suggest. However, in the real world, tails can be really fat and variance can persist and get blown out of proportion. In other words, there are always sharks in the ocean – not just when they are sighted and beaches are subsequently evacuated. We simply don’t know what we don’t know. Risk is a verb – it’s a moving target.