Good book, interesting people.
The book begins and ends with something like this:
“In short, relative performance is inadequate to address the annual cash needs of pensioners, universities, or charitable organizations.”
All the rest, that for various reasons
I noted in the process of reading under the cut.
1. In short, the peasants do not aim at maximizing long-term time-averaged yield, even though that is an appropriate goal for investors not spending their earnings and just investing to pay for luxuries on a rainy day in the distant future. Instead, the peasants only maximize long-term yield insofar as that is consistent with their overriding goal of eliminating their risk of starving in any given year, and throwing in a small safety margin for that calculation. It seems to me that the Harvard and Yale endowment managers are in a position analogous to that of the peasants, and would have done better to set a goal of maximizing yield only above a certain minimal level.
2. Losing less than peers or benchmarks does not provide the annual cash flow needs of pensioners, universities, and charities.
3. “The most powerful force in the world is compound interest,” Albert Einstein is said to have declared. However, he neglected to mention that avoiding large drawdowns—which can wipe out years of performance—is an important implicit part of this phenomenon.
4. Although a university going bust or a charitable foundation closing down is tragic for those directly involved, the effect would be relatively isolated. On the other hand, a pension fund going bust has implications for taxpayers. In the United States, the taxpayer is the explicit backstop for public pension funds and the implicit backstop for corporate pension funds, the latter of which are guaranteed by the Pension Benefit Guaranty Corp. (PBGC), a federal agency. The PBGC is currently facing its own crisis, with a reported deficit of $33.5 billion at midyear 2009, a more than tripling of the $11 billion deficit reported at midyear 2008. The deficit is the largest in the agency’s 35-year history. More importantly, without confidence by workers that their benefits are intact, society breaks down.
5. David Swensen, Chief Investment Officer of the Yale Endowment, published a seminal work in May 2000, entitled Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment, in which he outlined his investment process. The book became the bible of the real money world, and dog-eared copies can be found on the desks or bookshelves of most real money managers.
6. David Swensen followed up his first book with a retail investor version in 2005, entitled Unconventional Success: A Fundamental Approach to Personal Investment, in which he addressed how individual investors can mimic the Yale portfolio using low-cost instruments available to retail investors such as Exchange-Traded Funds.
7. In a May 31, 2007 interview in Fortune, Harvard’s endowment chief at the time, Mohamed El-Erian, was asked about the major investment challenges facing Harvard Management Corporation. He had this to say: More people are replicating what we do. The endowment model is very much in vogue. There have been many articles in the press trumpeting how well endowments like Harvard’s and Yale’s have performed. And David Swensen, who brilliantly heads up Yale’s endowment with impressive long-term performance, has written a great book showing how endowment management is done. So now lots of central banks and pension funds are trying to become more like endowments. The space is becoming more crowded.
8. The crash of ‘08 highlighted flaws in the Endowment Model, namely: (1) diversification with a high equity orientation is not really diversification; (2) valuation matters, whether it applies to equities, real estate, or liquidity; (3) investing in certain limited partnerships is a form of leverage; and (4) time horizons are not as long as previously envisioned for investors with annual liquidity needs.
9. The argument that equities outperform other asset classes in the long term often fails to mention the risk undertaken to achieve that outperformance.
10. The majority of Yale’s outperformance over the past decade came from private equity and real assets, which currently make up half of the endowment portfolio (see Figure 1.8). It is worth questioning how much of Yale’s (and other endowments’) past outperformance was attributable to superior manager selection and better portfolio construction, and how much was simply a function of leverage, both explicit and implicit.
11. While troubles with endowments and universities are worrisome, endowments only represent a little more than $400 billion of capital. Pensions, however, are almost 60 times larger in terms of assets and they more directly impact a wider proportion of society because the taxpayer ultimately foots the bill for their shortcomings.
12. As a result, everyone’s portfolio ends up looking like everyone else so it is deemed okay if you lose money along with everyone else. But it does not adequately address risk. It does not adequately address inter time period funding issues whereby the 20 year horizon may work but you may run out of money in the intermediate period.
13. One of the primary factors enabling global macro funds to exhibit such strong long-term performance is the avoidance of significant drawdowns. Consistently compounding positive returns leads to strong long-term performance, whereas significant, even if infrequent, drawdowns destroy performance. Because of the phenomenon of negative compounding, big losses are very hard to recover from. “Siegel’s Paradox” explains how gains and losses are not symmetric, losses are much worse. For example, a loss of 50 percent requires a gain of 100 percent just to break even.
14. Regardless of valuation metrics or the general attractiveness of an opportunity, a macro manager will always want to know how much he can lose in his portfolio at any given time. The entire portfolio construction process is anchored in risk: What will this specific trade strategy add in terms of overall risk to the portfolio? What are the true risks assumed for each position? In a worst-case scenario, how much can the portfolio or the position lose?
15. Explain what you mean by the Great Macro Experiment. Debt-fueled overconsumption has historically resulted in a depression, a deep and prolonged recession, or in the case of Japan, a very long stagnation. The common argument, put forward especially by monetarists, is that these episodes occurred and persisted because monetary policy was not eased fast enough or far enough. The Great Macro Experiment, therefore, is an attempt to use aggressive reflationary policies to overcome the effects of debt deflation after the equity bubble burst. We still seem to be in the midst of the Great Macro Experiment, although it is the next phase. It is a hyper-experiment now.
16. It is very important, however, not to neglect the role of fiscal policy. The conventional argument is that Greenspan’s monetary policy was too easy, which created conditions for the equity bubble of the mid-to late 1990s and the housing bubble of 2002-2007. But fiscal policy also played a role, especially in the housing bubble.
17. Can the Hyper-Great Macro Experiment—with quantitative easing, bank bailouts, and other creative measures—have a happy ending? Perhaps, though it may have more to do with fiscal policy than monetary issues from here. It is critical that an expansionary fiscal policy is maintained for long enough. Monetary stimulus may become less necessary over time and be slowly withdrawn, but fiscal stimulus will have to be maintained for longer to make sure overall demand growth is sustained as household debt repayments proceed.
18. You cannot hedge illiquidity in any way other than staying liquid. I suppose you can sell correlated liquid variables to cover the illiquid assets that you own, but that creates additional risks. This, by the way, was another reason why I had the confidence to buy equities: I knew that some people were selling to hedge illiquid holdings, which meant that equities were probably overshooting to the downside.
19. The correct way to measure the return on cash is more dynamic: cash is bounded on the lower side by its actual return, whereas the upper side possesses an additional element of positive return received from having the ability to take advantage of unique opportunities.
20. Holding cash when markets are cheap is expensive, and holding cash when markets are expensive is cheap.
21. In the large tail events for risk assets, government bonds have always gone up. Of course, it is impossible to say if this was due to a flight to quality or if it was a rational expectation that anticipated a weaker
22. In the large tail events for risk assets, government bonds have always gone up. Of course, it is impossible to say if this was due to a flight to quality or if it was a rational expectation that anticipated a weaker economy and lower interest rates.
23. It is also important to realize that diversification only works when you have assets that are valued differently; when some things are cheap and other things are expensive. If everything is expensive, everything will go down, so it doesn’t really matter if you own different things for diversification’s sake. Some things might go down less than others, but that does not give you any positive benefits in terms of making money. The key is finding cheap things that will go up in scenarios where everything else is going down. And historically, the only asset that has really done that is government fixed income.
24. A good analogy is trying to forecast the weather. If you ask me today, on October 15, what the weather will be like going forward, I can tell you with confidence that on January 15, it will probably be colder. I don’t know if it will be a really cold day on January 15, and I don’t know if January 10 or January 20 will be the really cold day. I have no idea if there will be a lot of snow or no snow. But I do know that the average temperature in January is highly likely to be lower than the temperature today. Forecasting returns is similar. You are not saying that the stock market tomorrow or next week will be higher or lower, but over the next 7 or 10 years, there is value. If you can do that, then you can orient your portfolio toward the cheaper areas of the market and put yourself in a position to capture that value. And if you cannot find cheaper areas of the market, then you should have more cash. That is basically what it boils down to.
25. Today we can buy 10-year, 10,000 strike S&P calls for 14 basis points and hedge out any hyperinflation risk over the next 10 years. We think it’s unlikely that there will be any inflation in the next year or two. But in five years, who knows? For 1.4 basis points a year for 10 years, I am perfectly happy to buy hyperinflation protection. The lesson to be learned here is that equity indices are priced in nominal dollars, not inflation-adjusted real dollars, which means that a long-duration call option on the local equity index implicitly includes an option on future inflation.
26. The most interesting one to me is buying really long-dated out-of-the-money equity index call options for cheap. You can even break up the equity market into subindices and make long-dated bets on natural resource-linked equities, oil services stocks, or foreign stock markets that are more natural resource driven to get more of a direct inflation exposure. The point is that equities are a good hedge to inflation over the long term.
27. The most obvious advantages of a pension fund are its balance sheet and its credit worthiness. Pension funds have a very long-term investment horizon and a great deal of liquidity, although I am not sure they fully appreciate it. There are very few pension funds that take full advantage of their liquidity position.
28. The most obvious way is to get paid for pockets of illiquidity in the market, and the easiest way of doing that is by investing in safe but less liquid securities. This is one way of being what Myron Scholes calls a liquidity provider to the market, something difficult to be if you are a leveraged player with redemptions, like a hedge fund.
29. To capture the profits over the investment horizon, you need to be able to withstand mark-to-market losses along the way. Real money players who have a long-term time horizon are best suited to do these types of trades. These are excellent risk-reward trades, and everyone with a long-term time horizon should have these types of trades in their portfolio.
30. For example, many people think the expected return of an asset is determined by its risk. That is getting it the wrong way around. The right way to look at it is: The expected return is a function of the risk premium of the asset at a given price. This is different than saying return is a function of risk, unless you are naïve enough to think that all markets are perfectly priced all the time.
31. A risky asset priced with a small risk premium is just a bad investment. For example, buying equities listed on Nasdaq in 1999 was not a good idea. These shares certainly had high risk but were not priced to compensate for that. Rather, they were priced for a low future return. We had a repeat of that in credit markets in 2007, when people could not get enough of risky bonds that were clearly priced for very poor long-term returns. Saying that equities or other risky assets will always deliver high returns in the long term is just incorrect. Price matters. Valuation matters.
32. The following is an amusing story about sloppy thinking and bad assumptions. I heard about a pension fund that bought a chunk of inflation-protected government bonds, locking in a real return of 2 percent for the next 30 years. However, in their asset and liability model, they simultaneously assumed that these were going to deliver a 4 percent real return since this was the return these bonds had delivered historically. What happened to common sense?
33. In modern portfolio theory (MPT), there are five basic statistical measurements: beta, alpha, standard deviation (volatility), R-squared (correlation), and the Sharpe ratio (return/risk).
34. Is alpha extraction a zero-sum game? Alpha, by definition, is a zero-sum game—or at least by my definition. Before costs, that is. I don’t think there is that much alpha in hedge fund indices. Some hedge funds extract true alpha rather consistently, while others generate none, or even pay alpha. Then they hide it through beta, sometimes through difficult-to-see exotic betas.
35. Yes, always, always, always keep dry powder. That is one of the most important things in the money management business, and in all risk management. Never allow yourself to be painted into a corner, whether by the market, a regulation, a counterparty, or anything. You never want someone else to decide your fate. You must retain some flexibility at all times, and this comes at a cost that may include paying premium for option protection or leaving a certain allocation to low yielding cash or cash-like instruments.
36. How would you protect yourself from high-impact, unforeseen events in a real money vehicle? I would start by defining an overall acceptable level of risk, which would come from my stipulated statutes and from the specific mandate that I have been given by the fund’s trustees. I should be able to construct a portfolio that is fairly close to that risk level not only in terms of volatility and value-at-risk, but also from a maximum drawdown perspective, which may in fact be a better measure of risk.
37. Am I expected to perform at least in line with my peers at other pension funds, or can I deviate for a few years? This last part is important because I need to be able to underweight expensive assets that may be in a bubble, which often means underperforming in the short-term. But avoiding owning overpriced assets obviously pays off in the long term, and also provides a hedge against bad times since you will not be in trouble at the same time as others.
38. You always need to have some kind of insurance on to make sure that you never end up in a scenario where someone else makes a decision for you.
39. The problem with buying those types of hedges is if the option becomes worth a lot, it is unlikely that the counterparty who sold it to you would still be around to pay. We almost saw that with AIG. Correct, absolutely. You can mitigate this to some extent by moving collateral back and forth daily, but you would still have counterparty risk. We put them on with exactly that thought process in mind and thus exited the trades well before that became an issue.
40. We are not engaged in what I describe as “vision macro,” whereby one tries to work out some kind of single truth about how the world works. Rather, we form a probabilistic set of hypotheses about how the world could look and what might drive markets going forward, focusing on the market impact in all scenarios and looking for good risk-versus-reward trades around these hypotheses. A great book that describes this process is The Alchemy of Finance by George Soros, in which he describes and demonstrates how he uses hypothesis formation and testing, ideas that come from the philosopher Karl Popper.
41. What gets you fired? Does losing money get you fired, or does underperforming your benchmark get you fired? If underperforming your benchmark gets you fired, then do not be surprised if people act according to this incentive structure and eventually have a huge absolute return drawdown. The only way to avoid the drawdown catastrophe is to get out early, and getting out early means you have at least some period of underperformance, which can potentially be long. If you do get fired, someone else will be hired to take your place who will chase the benchmark, which is why blowups like 2008 happen.
42. A classic example of false discipline is something like this that happens on trading floors all the time: Boss: What have you got on? Trader: I’m long USD/JPY, but don’t worry, I’ve got a stop 1 percent lower. A day later Boss: How’s it going in USD/JPY? Trader: Oh, I got stopped out. Hit my limit. I’m out. Boss: Okay, fine. A day later Boss: What are you doing now? Trader: Long USD/JPY. Boss: Oh, really? Trader: It’s okay. I’ve got a 1 percent stop on it… And they do the same trade over and over again. The trader had a stop loss, but did not really believe in it and never felt he was wrong being long USD/JPY. This type of trader has the illusion of discipline, which they read about in trading books. They will talk about stop losses, discipline, all those good trading habits and methods. But running stops off of pain thresholds is a terrible way to run money. If a trade goes to your pain threshold stop level, you will get out because you told yourself you should, because you are disciplined. But because all the fundamentals and technicals still look okay, and often even better, there is nothing to prevent you from doing the trade again once the pain has subsided. This is why I prefer hypothesis testing. To stop out of a trade, you have to believe you are wrong, that your entire rationale for the trade is wrong. I always think in advance about what it will take for me to believe I am wrong. Then I can work backwards to determine my conviction and how much I am willing to lose on the trade, which leads to the potential sizing of a position.
43. Many factors can play out in terms of evolving fundamentals and changing perceptions in the marketplace in a one- to three-month horizon. Less than one month can be too random, whereas horizons beyond one year fall more into the vision or held-to-maturity category.
44. My overriding ambition is to never have a career-ending trade, so the opportunity cost ones tend to be the worst. I have a long list of trades that perhaps I should have done which I did not, and I try to learn from that. With a hit ratio of 50 percent, I am full of trades that lost money, and they, too, are learning experiences.
45. If you went to play golf for the next 10 years and had to put all your money in one trade, what would it be? That would be a terrible punishment but I would probably buy inflation-linked debt. I do not believe in a free lunch in that you can earn excess returns risklessly. Therefore, I will take the risk-free rate unless I am allowed to manage it actively myself. There is nothing that I can predict over the next 10 years.
46. I take it you do not believe that diversification is the only free lunch in finance? No, of course not. Diversification is mainly a method for reducing volatility and the confusion comes from the fact that finance professors teach that volatility and risk mean the same thing. Diversification is not an effective method of reducing drawdowns. Moreover, diversification as a strategy can make you complacent, leading you to believe that you have mitigated certain risks that you really have not.
47. Hypothecation Hypothecation is the pledging of securities or other assets as collateral to secure a loan, such as a debit balance or a margin account. For example, hedge funds hypothecate securities to their prime brokers in exchange for margin or leverage. Rehypothecation is the pledging of securities in customer margin accounts as collateral for a brokerage’s bank loan. Rehypothecation occurs when a bank takes securities that have been pledged to them as collateral and uses them as collateral to obtain further loans for the bank. For example, broker dealers rehypothecate customer securities to commercial banks in exchange for loans or credit lines.
48. I run a macro fund, and I reserve the right to be wrong. My hit ratio is only 50 percent. I get things wrong, change my mind, and move on. Central bankers are not allowed to do that—it is very hard for a central banker to say, “That rate cut last year, that was a mistake. I shouldn’t have done that.” When people hear that, central bankers lose credibility. People want to believe in some wise old person that gets things right all the time.
49. Because we did not have the three issues I just mentioned, we were able to start 2009 without any legacy problems or positions, and this gave us a clean slate to operate in a market with less competitors. You have an advantage if you are not plagued with the same issues as your competitors.
50. What is the time horizon of the overall fund? My time horizon changes with the market environment, but it always depends on pricing in the market. A few years ago, you could take a very long-term view because that was what the market was doing. Today, the market does not care about something six months from now—more market participants tend to be shortsighted. It does not mean that they are wrong—not at all.
51. Real macro involves understanding macroeconomic developments at a fundamental level and then expressing these viewpoints using the appropriate instruments. Frequently this involves identifying disequilibrium situations in which asset prices do not correctly reflect macro fundamentals or identifying or anticipating structural shifts in the economy. Real macro always comes back to the true underlying macroeconomic fundamentals, which serve as primary inputs to your macro forecast, which, in turn, drives your risk allocation decision.
52. I tend to get about 55 to 65 percent of trades right and my winners tend to make three or four times what the losers cost me.
53. What do most investors miss when approaching portfolio management? Most investors miss the implicit risks they are taking. Many very skilled investors insufficiently deconstruct their trades down to their core bets.
54. In other words, the question to always ask is: After making all the necessary adjustments, what are you actually betting on? A surprisingly large number of people miss this point.
55. Looking back on 2008, the cyclical and secular were very much in alignment during the first half of the year. But then crude spiked, and the cyclical process of demand destruction, commodity reversion, then substitution or incremental supply, led to a negative trigger. Emerging market countries went from current account surpluses to current account deficits as U.S. demand collapsed with the destocking trend. The trend in the broader macro bias then turned negative quite quickly. So you tend to go through these interesting cyclical and secular phases and at the extremes, people tend to confuse the two, mistaking cyclical for secular and vice versa. At the end of the first quarter of 2009, for example, most market participants extrapolated an Armageddon scenario indefinitely. Fear blinds market participants to the self-correcting mechanisms at the extremes.
56. Traditionally, investors participate in commodities by taking either a macro approach or a micro approach, but rarely do they effectively combine the two. An example of the macro approach would be where a macro hedge fund sells copper on the view that global growth is slowing. Although this approach can work, it has its faults. For example, many years ago, everyone became wild about corn because of the whole ethanol story. The macro hedge fund community thought ethanol would usher in a structural demand change in the grain markets. But all these macro funds bought the front month corn contract, and corn turned out to have a bumper crop that year, causing prices to fall. Meanwhile, the ethanol story would take another one to two years to have any material impact on the supply and demand balances. So ethanol did induce a structural change in the corn market, but the micro did not justify a front-end position at the time ethanol was introduced. Combining the macro backdrop with micro expertise allows an investor to more optimally position a trade on the term structure of the forward curve. (See Figure 9.1.) Conversely, being too micro-oriented has its downside as well. A year ago, many thought that copper was cheap based on stocks, use, and other micro fundamentals, but they missed the macroeconomic expertise that signaled a massive collapse in credit, which caused epic destocking. We believe that integrating the macro and micro is really the only way to go in the commodity markets.
57. This cyclical/secular, macro/micro thought process is very important. Sometimes one leads, sometimes the other leads.
58. Most people have their biggest drawdowns, myself included, when cross-correlations are misunderstood. Whether the correlations are a function of macro factors or between macro and micro factors, it doesn’t matter. Failing to adjust for correlations and changes in volatility often carries people out of our markets.
59. For example, let us assume that I am running a pure commodity fund, leaving aside the equity component for a moment. If I am 60 percent long commodities, I am really just a currency fund in drag because commodities have a high correlation to the U.S. dollar at the moment. In this sense, I am essentially running a 50 percent dollar short position.
60. What do you consider more important, coming up with trade ideas or mitigating downside risk? Both capturing the upside and limiting the downside are essential. I know some people who are phenomenal on the idea side but cannot make money. There are three types of people in our business: those who are great analysts, those who are great portfolio managers, and those who can do both. This last category is very rare. Closing the gap between having a high Sharpe ratio on your ideas and the translation of those ideas into profits is a never-ending quest for all of us. It is really what this business is all about.
61. For some time, we have held a very high-level macro view that the move to just-in-time inventory management would at some point be destabilizing for the commodity markets. There is an exceptional book on this called The End of the Line by Barry Lynn, a manufacturing specialist. Its simple premise is that the move to just-in-time inventory and global outsourcing forced all of the volatility of output and debt associated with production onto a much less well-capitalized supply chain.
62. I would separate this trend into two phases, where phase one was the post-WTO entry and the build-out of Chinese infrastructure to create commodity supply. During this time, China was importing steel to make steel mills, whereas now they run a substantial domestic steel surplus. Phase two—the present—is something very different, characterized by the diversification of China’s foreign exchange reserves and a global resource grab. The Chinese will spend half a trillion dollars in the next six years acquiring resources through diverse means, such as buying an iron ore mine in Australia, developing port infrastructure in Brazil in exchange for off-take rights, or taking direct control of a company like Rio Tinto. The net effect of China’s push for resource security will be a lower tradable float of commodity supply going forward, which is a very important and underappreciated factor impacting the commodity markets. Spending $500 billion will allow China to exercise monopolistic control of the supply in certain markets. Perhaps the most extreme example will be in the rare earth metals, which are the components that go into magnets, lasers, and high-tech strategic production. This is part of a much more important thesis that some have termed “resource nationalism.” Resource nationalism means if you have it, you are going to keep it. Countries will keep commodities to control domestic inflation, a phenomenon we saw in the grain markets in early 2008 when dozens of countries put tariffs on exports. Also, instead of exporting raw material and giving the production benefits away to another country, raw materials and their value-added processing will increasingly be kept at home in efforts to bolster job growth. It’s a strategic decision. Russia and certain African countries have already begun to do it, and the Chinese will start to do it as well. Again, due to the emergence of China, the tradable float of commodity supply will be lower over the next three to five years.
63. What about increased supply from alternative energy sources? If the spike in energy prices during the last two or three years proved anything, the ability for renewables to impact the market will remain limited, leaving only a small volume of high-cost marginal alternatives. We learned at $140 crude that the market could only supply an additional 400,000 to 500,000 barrels a day of ethanol to an 86 million barrel-a-day market.
64. What was the worst trade of your career? There have been so many bad trades. It really comes down to discipline. It’s similar to what Vince Lombardi said about winning: “Winning is not a sometime thing; it’s an all-the-time thing. You don’t win once in a while; you don’t do things right once in a while; you do them right all the time.
65. As business cycles become more truncated, economic volatility will rise and markets will reflect this. This tactical ability is the most important skill a liquid markets hedge fund manager could offer to a long-duration pension fund. Tactical expertise associated with the knowledge of flows and asset allocation expertise could be quite a robust combination for “real money” businesses.
66. When the liquidity base is so large, no one truly knows how the translation mechanism between velocity and liquidity actually occurs. For an idea of magnitude, $13 trillion has been printed or injected globally, including asset purchases. If we believe that we can achieve the typical money multiplier of four times once again, this would mean $52 trillion, or roughly 60 percent of global GDP. But can a money multiplier of four times be achieved? I don’t know. No one knows. You cannot model it because there is no historical precedent. That is the real challenge for us all.
67. Risk Collars Risk collars are an investment strategy that employs options to limit both the potential gain and loss of a position to a specific range. This strategy is employed by writing (selling) a covered call option on an owned asset and using the premium earned from the sale to buy a put option on the same asset; vice versa for assets sold short. Portfolio managers will attempt to employ this strategy at no cost by matching the cash flows of the call options and the put options.
68. What lessons did you learn in 2008? There are two important parts to running a hedge fund: the business part and the trading and investment part. It is very important that the two are in sync with each other. You may have a great trade with great valuation, but if you are running a business on quarterly liquidity, it’s crucial that your portfolio liquidity matches the liquidity offered to your investors.
69. What do most investors miss when analyzing your fund or investment opportunities more generally? Investors focus on asset class, geography, and strategy way too much. To me, it’s manager, manager, manager. Finding someone that regularly makes money and runs a good business is much more important than what instruments she trades, what strategy she employs, or what regions of the world she specializes in. The key is to find someone that could make money trading nuts and bolts in a hardware store if she were forced to. Investing based on some quantitative analysis of a strategy, asset class, or geography is imperfect. Again, it’s the rear-view mirror. It really does not make any difference what you invest in; the key is with whom you invest. Try to understand a manager’s ability to make money, and don’t focus on the specific assets or instruments traded. It is more important to focus on how someone manages risk, whether she has the ability to preserve capital.
70. I always remember this one because it beautifully illustrates that stocks are driven by supply and demand, and can go absolutely anywhere regardless of what you think the business might be worth.
71. As things get cheaper, people tend to want to buy more of them because the value seems better; but they are often trying to fit long-term judgment onto a shorter-term mandate.
72. We also try to be open minded enough to buy back a stock at a higher price. Sometimes, although the price is higher, the risk/reward can be even better.
73. Is it better to go after momentum trades with options or to chase something after it cracks? You have to do both because timing a big position before something turns is difficult. It’s important to have on some position, whether it’s a small short or a small put option, to force you to keep an eye on it. Then once it turns, get more aggressive and try to stay with the trend. This is what happened when dot-coms finally popped in 2000. The initial moves were huge, with some stocks falling from 300 to 150 in a month. But while catching these initial moves proved to be great trades, the key was recognizing that the game was over for many of these companies and staying short until they went to one or zero.
74. The ability to adapt to different environments is probably the most important thing in the markets. If I look back at the guys with whom I traded over the years and compare the guys who are still around today and doing well to those that have dropped out, the ones that drop out typically are much more focused. They had a particular style, a particular strategy, something that worked for a period of time, but when it stopped working, they did not adapt their style and their strategies. If I am an investor looking at someone to invest with for the next 5 or 10 years, I want to know that the person is capable of adapting.
75. Choosing your investors wisely can help mitigate this problem. Emotional, momentum investors can really exacerbate the psychological issues. Very good investors who understand your process and believe in what you are doing can be a countercyclical influence. When you are having a drawdown and you speak to them, they encourage you in such a way that you walk away from the conversation with confidence. These are the best investor relationships to have.
76. Instead of deciding how much risk should be taken overall, which is the ideal way to approach investing, the allocator begins by deciding how much capital to allocate into each bucket. Not nearly enough focus is spent on the overall correlations and overall risk levels. Rather, bucket allocations are tweaked by a few percent up or down, but the most fundamental question of how much overall risk should be taken is largely ignored.
77. The equity markets had their final bull run, peaking in October 2007, but that was an aberration. Aberration or not, you still have to play the game because there is a big difference between being bearish and being right. There is always a lag.
78. Different fund managers have different dimensions of thinking, different levels. Many investors have one, maybe two dimensions, although the best probably have five. Managers with five dimensions will still buy, but they will have a hedge to save them if they are wrong. The basic value funds are one-dimensional managers, and they lost 50 or 60 percent in 2008 because they only know how to buy stock and buy more as it gets cheaper. The worst one-dimensional managers, however, were the hedge funds that exploded early in the crisis, due to leverage, counterparty risk, liquidity risk, prime broker risk, and client risk. Their clients wanted their money back, and they were unprepared for that. Because they had never experienced such a series of events, they thought: “My assets are cheap, so I will hold onto them.”
79. Dick Fuld had many opportunities to save Lehman, to do something like Merrill Lynch did. So the Lehman short was not such an obvious short.
80. Do you consider yourself an optimist? Every fund manager has to be an optimist in order to survive in the long term. In the short-term, however, people like me survive by becoming a different fund manager every six months.
81. I use psychology to try to understand why markets are not reflecting what I think they should. But knowing the fundamentals of a stock is very important because that is what ultimately bails you out if you are wrong on timing, scenario, or position sizing.
82. Does it embolden you when people tell you you’re wrong? Absolutely. I love it. But it cannot be the only point in your analysis because sometimes they are right. It depends on who is telling you and what is going on in the markets. Sometimes I take others’ views, sometimes I don’t. It is similar with pundits like Nouriel Roubini; sometimes you incorporate his view, sometimes you dismiss it.
83. If you read Edwin Lefèvre’s book, Reminiscences of a Stock Operator, the fictionalized version of the early years of Jesse Livermore, he gives a great account of this kind of behavior. Livermore goes long before he goes short. That’s genius. He would buy because he wanted to experience the thrill of owning something. Taking a position changes the chemical balance of the body and the brain and you start to understand what it is you were missing. Likewise being subject to the risk that it might go down opens up neuro passageways in the mind which you perhaps didn’t see. So you begin to understand and articulate what you’re fighting against, which you wouldn’t have known had you just gone short straight away. It is like touching a hot plate; as the plate gets hotter, your sense of timing gets heightened by the fact that you have risk on.
84. Even a true contrarian is only really contrarian about 20 percent of the time; it’s all about choosing the right moment to fight convention. The rest of the time is spent trend following. So I guess I am a trend-following contrarian.
85. The key is choosing your moments to fight with the market, and I’m beginning to learn when to avoid a fight. The wonderful thing about life and getting older is learning from your mistakes. If you don’t learn from your mistakes, you get kicked out.
86. The same “upside down” logic prevailed in 1979 when Volcker became chairman of the Fed. You had this new sheriff in town who was honest and tough. He was going to raise interest rates to make the economy very weak in order to parch the system of its inflation. He was a dream come true for a bond bull, and yet bonds got destroyed whilst gold doubled to $800 in three months. (See Figure 13.8.) The problem was that Volcker had to come clean on the Fed’s dirty little secret. In order to have the legitimacy to be so hawkish, he had to admit that the problem was inflation; investors panicked and scrambled to protect themselves with gold. A hawk produced a melt-up in gold. Could the dovish Bernanke produce a similar melt-up at the long end of the bond market?
87. I contend that the surplus nations are nothing but a leveraged play on the U.S. economy. China is a very deep out-of-the-money call option on the U.S. economy,
88. The Pensioner says real money investors, on average, are led astray at the beginning the portfolio construction process by focusing on a return target. Managing to a stipulated return target means that the level of risk assumed to achieve that target becomes secondary. Taken to an extreme, “if the return requirement were 20 percent, then you would have to put all your money in microcap stocks and just pray like hell.”
89. What do you mean by “dollar notional thinking”? Dollar notional thinking refers to the common practice of allocating investments based on dollar value as opposed to allocating based on a risk budget. Oftentimes, this can lead to asset allocations that appear diversified but really are not. To give an example, consider the common U.S.-based 60-40 stock-bond portfolio mentioned earlier. This portfolio may appear to be reasonably balanced and thus well-diversified to a dollar notional thinker. However, given that stocks are approximately five times more volatile than bonds, in risk terms the allocation equates to approximately 90 percent in stocks and 10 percent in bonds.
90. As I alluded to earlier, we also need to distinguish between accounting leverage and economic leverage. Accounting leverage refers to leverage that shows up directly on a fund’s balance sheet. If a fund were to repo out securities or engage in a derivative transaction, that is accounting leverage. Economic leverage, on the other hand, is leverage born indirectly by the fund through some other entity. For example, if I invest in the stock of a company, that company has itself financed its assets through borrowing.
91. The 1% Effect If CalPERS were able to generate returns of just 1 percent more per year for the past 25 years, the pension plan would currently have an additional $55 billion in assets. Since 1984, the public pension plan has grown from $28 billion to a peak of $260 billion in 2007, and at the end of 2009 it stood at about $200 billion. Given their current annual compensation expenses of about $180 million, even if CalPERS spent an additional $100 million a year for the past 25 years to attract talent capable of generating that 1%, assets would still have increased by $46.5 billion.
92. I would argue that the time horizon for pension managers depends on the tolerance of plan members and sponsors for shorter term periods of poor performance. Which is to say it may be shorter than you think.
93. In short, relative performance is inadequate to address the annual cash needs of pensioners, universities, or charitable organizations.
