The Finance Professionals' Post

Book Review: Dead Companies Walking

Scott Fearon's Dead Companies Walking: How A Hedge Fund Manager Finds Opportunity in Unexpected Places opens with an excellent summarization of his book. He begins, "My specialty is identifying what I call 'dead companies walking' which is what I call businesses on their way to bankruptcy and a zero-out share price." Fearon is no stranger to the task, having been doing this since he started his hedge fund in 1991. Since its founding, the fund has had only one down year.

Recent Research: Highlights from October 2014

"Lightning Strikes: The Creation of Vanguard, the First Index Mutual Fund, and the Revolution It Spawned"
The Journal of Portfolio Management 40th Anniversary Issue 
John C. Bogle

“Lightning Strikes” tells the story of how Vanguard founder John C. Bogle came to create a unique mutual mutual fund structure in 1974, and how the index fund strategy almost inevitably followed. Paul Samuelson’s essay in the first issue of The Journal of Portfolio Management was published at almost the same moment that Vanguard began. In “Challenge to Judgment,” Samuelson urged that somebody, somewhere, somehow form an index fund. Inspired, Mr. Bogle accepted the challenge, and in 1975 created the world’s first index mutual fund. Vanguard’s two disruptive innovations—mutuality and indexing—have combined to make Vanguard the largest firm in the mutual fund industry. In the second part of the essay, Mr. Bogle summarizes 10 of the 13 essays he has written for The Journal of Portfolio Management and provides a perspective on his works.

Book Review: Hedge Fund Market Wizards

This fourth book in the Market Wizards series includes 15 interviews with hedge fund traders. It details many variations regarding which markets to trade in, what time frame to incorporate, and how to use information. The wizards trade in all markets, including futures, options, equities, and bonds.

Determining how great traders acquire and use their special skills has been an elusive quest. We have no shortage of cookbooks on how to trade, but only a limited number of books describe the decision processes of those who speculate as a profession. Trader confessionals exist often as testimonies to egos, but few focus on the details of decision making.

Material that does successfully capture the essence of how speculators think is the Market Wizards series by Jack D. Schwager. These books are neither cookbooks nor testimonials but question-and-answer conversations with traders who talk about their thought processes, how they entered the business, their trading styles, and market battles they have undertaken. These interviews provide a sense of realism about how traders think. The interviewees are not always extraordinary individuals; often, they are simply hard-working professionals who manage the anxieties and uncertainties of trading by developing styles that work within the comfort of their skills and personalities.

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Recent Research: Highlights from January 2014

"Hedge Funds versus Hedged Mutual Funds: An Examination of Equity Long/Short Funds"
The Journal of Alternative Investments (Winter 2014)
David McCarthy

This article offers comparative analyses of equity long/short mutual funds and equity long/short hedge funds and indices. It first identifies a universe of liquid alternative mutual funds employing an equity long/short investment strategy similar to most equity long/short private hedge funds. It then provides a general profile of these mutual funds (e.g., size, start dates, sponsorship) before comparing their equity exposure and investment performance to that of private placement equity long/short hedge funds and indices. Based on the data analyzed, the article concludes that, as a group, diversified single-manager equity long/short mutual funds offer similar equity exposures and do not perform materially differently from comparable private placement hedge funds, at least as represented by leading hedge fund indices.

Book Review: The Billionaire's Apprentice

The billionaire is Raj Rajaratnam. Rajaratnam's Galleon hedge fund had put him into the billionaire net worth group. He is currently serving a sentence of 11 years after being arrested for insider trading.

His apprentice was Rajat Gupta. Gupta was the managing director of Mckinsey & Co. He has been sentenced to two years for conspiracy and securities fraud.

Anita Raghavan's The Billionaire's Apprentice: The Rise of The Indian-American Elite and The Fall of The Galleon Hedge Fund is the detailed account of what happened—a graphic story of foolish and reckless greed.

Recent Research: Highlights from December 2012

"Framework for Hedge Fund Return and Risk Attribution"
The Journal of Investing (Winter 2012)
Rob Brown

This article provides a framework for hedge fund return and risk attribution through the construction of a relevant benchmark. It is shown that volatility is a source of systematic risk, volatility measures based on equity market returns are more robust, fees have averaged between one-half and one-third of total gross returns, and high explanatory power can be achieved without the use of exotic systematic risk factors. Finally, the article suggests that alpha and systematic risk loadings are best estimated when regressed on gross returns and that systematic risk exposures are multi-dimensional and effectively modeled using a four-factor model. Hedge fund performance is determined by exposure, skill, and cost. The framework presented here provides robust attribution to exposure, skill, and cost.

Recent Research: Highlights from October 2012

"Integration of Structured Finance Exposures in Basel II Model: Analytical Results"
The Journal of Fixed Income (Fall 2012)
Kilian Plank

For efficiency reasons or because of a lack of detailed data, financial institutions frequently treat structured finance securities similar to conventional fixed-income products such as bonds or loans, which are characterized by rating, correlation, and loss-given default. Structured finance securities, however, have a specific risk profile. They tend to concentrate losses in adverse states of the systematic risk factor. This fact implies that simply adopting risk parameters of conventional bonds or loans is an inappropriate technique. The author shows that, under the Basel II framework, tranches have to be modeled with an increased factor loading. They derive an analytical calibration procedure for the Basel II model that appropriately captures the risk profile of tranches. This finding not only allows for seamless integration of structured and conventional exposures in a portfolio model, but also offers insights into the concentration effects of tranches.

Hedge Fund Due Diligence: A Source of Alpha in a Hedge Fund Portfolio Strategy

ABSTRACT

Due diligence is an important source of alpha in a well-designed hedge fund portfolio strategy. It is generally understood that the high returns possible in investing in hedge funds are somewhat offset by the relative lack of transparency on operational issues. The performance of a diversified hedge fund portfolio can be enhanced by excluding those funds likely to do poorly—or fail—due to operational risk concerns. However, effective due diligence is an expensive concern. This implies that there is a strong competitive advantage to those funds of funds sufficiently large to absorb this fixed and necessary cost. The consequent economies of scale that we document in funds of funds are quite substantial and support the proposition that due diligence is a source of alpha in hedge fund investment.

Blogs for the Buyside: Bronte Capital

The problem with many financial blogs I find is that they seem to mainly offer brief comments on the day's major headlines. While these are helpful in giving the day's news some context, I had been pining for a fellow buysider to offer a submarine-deep dive into specific stocks.

I found it in Bronte Capital.

Book Review: The Hedge Fund Mirage

If you want the truth about hedge funds and how to invest in them, The Hedge Fund Mirage: The Illusion of Big Money and Why It's Too Good to Be True is a must read. An especially important picture of a major part of financial services, this book provides insight into a field of which little information is publicly available.

Despite the increased fortune hedge funds produce, their investors barely profit. As the book reads, “investors would have made more putting their money into treasury bills instead.” Currently risks and returns favor the hedge fund managers. Of course, this was not always the case. During the 1990s, there were fewer hedge fund investors, which, to some degree, allowed for greater profitability. Owing to this shocking truth, author and hedge fund expert Simon Lack provides an in-depth inside look into the world of hedge funds in an effort to help put the investors back on top.

Recent Research: Highlights from January 2012

"Optimal Hedge Fund Allocation with Improved Estimates for Coskewness and Cokurtosis Parameters"
The Journal of Alternative Investments (Winter 2012)
Asmerilda Hitaj, Lionel Martellini, and Giovanni Zambruno

Since hedge fund returns are not normally distributed, mean–variance optimization techniques are not appropriate and should be replaced by optimization procedures incorporating higher-order moments of portfolio returns. In this context, optimal portfolio decisions involving hedge funds require not only estimates for covariance parameters but also estimates for coskewness and cokurtosis parameters. This is a formidable challenge that severely exacerbates the dimensionality problem already present with mean–variance analysis. This article presents an application of the improved estimators for higher-order co-moment parameters, in the context of hedge fund portfolio optimization. The authors find that the use of these enhanced estimates generates a significant improvement for investors in hedge funds. The authors also find that it is only when improved estimators are used and the sample size is sufficiently large that portfolio selection with higher-order moments consistently dominates mean–variance analysis from an out-of-sample perspective. Their results have important potential implications for hedge fund investors and hedge fund of funds managers who routinely use portfolio optimization procedures incorporating higher moments.

Recent Research: Highlights from July 2011

“The Role of Speculators During Times of Financial Distress.” The Journal of Alternative Investments (Summer 2011). Naomi E. Boyd, Jeffrey H. Harris, and Arkadiusz Nowak.

One of the best-known and largest hedge fund failures was the 2006 failure of Amaranth Advisors, LLC. The authors use detailed, trader-level data to examine the role of speculators during times of financial distress—in this case, the failure of Amaranth. They find that speculators served as a stabilizing force during the period by maintaining or increasing long positions, even while prices fell. The authors develop two testable propositions regarding liquidation versus transfer of positions and conclude that the probability of transfer was more likely for distant contract expirations and for contracts more dominantly held by the distressed trader. The article also examines the role of speculators in providing liquidity and mitigating the effects of liquidity risk by evaluating the change in the number of traders, the size and time between trades, and a Herfindahl measure of speculative trader concentration during the crisis period.

Adventures in Hedge Fund Recruiting

Recruiters working with hedge funds often have a difficult job. When big money’s at stake, employers and employees can be a rather demanding lot.

One Los Angeles-based financial recruiter says hedge funds are notorious for having strong personalities at the helm. A visit to a well known player gave the recruiter a peek into the high pressure environment that some of the employees work under. One chief portfolio manager routinely threw computer monitors, and so much so that his staff kept a ready supply on hand for just that occasion.

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Commentary: The King’s Ransom

This week, Galleon hedge fund manager Raj (“King”) Rajaratnam was found guilty on all 14 counts of insider trading. The wiretap evidence incriminating “the King,” including (incredibly) tips from inside the Goldman Sachs boardroom by the former head of McKinsey, was overwhelming and created the specter of a gangster trial. The defense’s strategy suggesting it was all “public information” was insulting to common sense, even more so to market professionals, and was clearly unpersuasive to the jury.

Hedge Fund Resume Rule: Dot Every “I”

When it comes to their attire, hedge fund professionals are able to be a lot more casual than most Wall Streeters. Shirts and slacks are the norm; suits and ties are not required.

But dressing up your resume is another matter altogether. You want to include as much detail as possible and leave very little to the imagination.

“I’d say the resumes of eight out of 10 of our candidates need some work,” advises Kyle J. Ramkissoon, principle and founding member of hedge fund recruiter IJC Partners in New York.

Continue reading "Hedge Fund Resume Rule" »

 

Recent Research: Highlights from April 2011

“The Impact of Illiquidity and Higher Moments of Hedge Fund Returns on Their Risk-Adjusted Performance and Diversification Potential.” The Journal of Alternative Investment (Spring 2011). Laurent Cavenaile, Alain Coën, and Georges Hübner.

This article studies the joint impact of smoothing and fat tails on the risk–return properties of hedge fund strategies. First, the authors adjust risk and performance measures for illiquidity and the non-Gaussian distribution of hedge funds returns. They use two risk metrics: the Modified Value-at-Risk and a preference-based measure retrieved from the linear exponential utility function. Second, they revisit the hedge fund diversification effect with these adjustments for illiquidity. Their results report similar fund performance rankings and optimal hedge fund strategy allocations for both adjusted metrics. They also show that the benefits of hedge funds in portfolio diversification persist but tend to weaken after adjustments for illiquidity are made.

Hedge Fund Hiring, Apprentice-Style

With all the Wall Street types who are looking for jobs, and those eager to jump ship, Aram Fuchs, a partner at Fertilemind Capital, figured it’d be no problem filling a senior and junior analyst position at his hedge fund. But when his networking, interviews and other efforts didn’t yield the kind of candidates he was looking for, he decided to take another tack: hold a contest à la Donald Trump’s the Apprentice and award the gigs to the winners.

Book Review: Hedge Fund Alpha

Generating and understanding performance are two distinct processes that often require different skill sets and are typically performed by different arms within a hedge fund organization. The former falls under the realm of the portfolio manager; the latter is often provided by the CFO, COO, or investor-relations functions at the hedge fund. Editor John Longo skillfully combines explanations of both processes in the Hedge Fund Alpha: A Framework for Generating and Understanding Investment Performance.  The essays in this book elucidate what the alpha-generation process is, as well as how the outcome of that process is assessed, evaluated, and monitored. While these are separate questions, there is a feedback mechanism between the two, which reinforces the importance of understanding both topics.

Why Hedge Funds Don't Call You Back and What You Can Do About It

Okay, you’ve scored and aced an interview at a hedge fund, but you didn’t get a call back or even an e-mail to say “Thank you, but no.” That’s the case for a number of people, including some senior level traders who recently interviewed at BlackRock.

According to Adam Zoia, chief executive at Glocap Search, it’s not much of a surprise. “It’s more common not to hear back from a hedge fund than it is from a bank or investment firm,” he says. If you have an intermediary—like an executive recruiter—they will often have to chase down the hedge fund client to find out what went wrong, he adds. “They often like to keep their options open.”

Click here to read the full article. 

Solutions for Hedge Fund Managers Considering the GIPS Standards

Although the GIPS standards do not address the particular challenges of hedge funds, claiming compliance is possible and increasingly important for hedge funds. Creation of a client presentation, the process and frequency of portfolio valuation, and net performance stream calculation methodology are some of the issues hedge funds tackle in claiming compliance.

Interview with Sebastian Mallaby, Author of "More Money Than God"

Sebastion Mallaby is the director of the Maurice R. Greenberg Center for Geoeconomic Studies and Paul A. Volcker Senior Fellow for International Economics at the Council for Foreign Relations. He's just written an amazing book on the history of hedge funds called More Money Than God: Hedge Funds and the Making of a New Elite.

I highly recommend this book. It's long no doubt at 400 pages, but that includes the 60 pages of notes in the back of the book that are worth it alone.

Small World, Big Globe: Globalization in the Financial-Services Job Market

Today’s job market in financial services presents a radical dichotomy. In the developed West, many jobs in banking are disappearing. Yet many of the institutions that are shrinking their workforces in New York and London continue to expand elsewhere—most visibly in Asia (particularly China) and the Middle East. Eastern Europe, India, and Latin America are benefiting, too. While comprehensive data on financial-sector job growth in emerging markets is hard to come by, a plentitude of anecdotal evidence suggests that investment banks are increasing their presence in those markets.

Book Review: Managing Hedge Fund Managers

Edward Stavetski’s Managing Hedge Fund Managers provides a thorough analysis of the factors to be considered when investing in hedge funds. The book is particularly relevant now, at a time when less capital (due to deleveraging and redemptions) is chasing more alpha (due to market dislocations), making the hedge fund space more attractive. It is all the more compelling in our post-Madoff environment, as due diligence gains new significance, and investors are forced to play detectives.

Danse Macabre: The Banking and Brokerage Sectors Reel from Crisis to Crisis

The financial services sector is caught in a death waltz, spun around by bad loans, trapped in the embrace of plunging stock prices, and dizzied by embarrassing scandals. And like Hans Christian Andersen’s little girl with the red shoes, it’s driven to keep on dancing. Nearly a trillion dollars in government bailouts have sunk almost without a trace, leaving global stakeholders desperate to stop the music.

What kind of future can possibly be in store for us? Chastened executives may wince at the thought of government regulators and outside forces reshaping the industry, but transformation is by now a foregone conclusion. The only questions are what types of institutions will live to see another sunrise, and what attributes executives must cultivate to ensure that their companies are among those that endure.

Book Review: Restoring Financial Stability

When it comes to the causes of the current financial crisis, Restoring Financial Stability (also known as the “NYU Stern Report”) takes a multifaceted perspective. The book features 18 papers, written by 33 New York University and NYU Stern faculty members. Taken together, the papers give a system-wide context for the meltdown and offer insights into the role played by market participants—banks, the shadow banking system, rating agencies, regulators, and government. Each paper also suggests reforms intended to minimize the possibility of similar future crises.

The Greater Fool Theory: Managing and Modeling Risk

The most dramatic financial meltdown since the Great Depression occurred despite recent advances in risk management techniques. Because of a fervent but unfounded belief in some quarters that VaR (value at risk) measures worst-case scenarios, financial institutions were exposed to crippling losses when VaR models failed to anticipate the extent of potential price movements, in some cases by whole orders of magnitude. 

Poll: The Goldman Sachs Ruling

On April 16 the SEC filed charges against Goldman Sachs for defrauding investors in a mortgage-backed collateralized debt obligation. The SEC alleged that Goldman Sachs omitted and misstated crucial facts about the CDO, most importantly the role of the hedge fund firm, Paulson & Co.’s direct involvement in the selection of the portfolio and bet against the deal. Three months of uncertainty over the case ended last week when Goldman Sachs agreed to make a $550 million settlement with U.S. regulators. While some watchdogs are disappointed that the settlement is much lower than the estimated $1 billion, others believe that $550 million is enough to stir a change and influence other institutions to employ better business practices. Tell us what you think. 

Book Review: Hedge Funds Humbled

What went wrong? The hedge fund industry had seen tremendous growth in the last decade with assets coming close to three trillion dollars. Hedge fund managers were the kingpins of the investment world—but in 2008, the industry collapsed. Only one in five hedge funds had a positive year, more than 1,400 hedge funds closed, and investors were clamoring for the doors. In Hedge Funds Humbled, Trevor Ganshaw, a partner at a multistrategy hedge fund in New York City, explores the reasons for the dramatic turn of events and describes an industry definitely in need of some humbling.

Book Review: Confidence Game

Christine S. Richard's new book, Confidence Game, tells the controversial story of how hedge fund operator Bill Ackman shorted municipal bond insurer MBIA. The short selling was done with credit default swaps, and the ultimate profit for his Pershing Square Capital Management was $1.1 billion. The controversy arose from first shorting the stock, then issuing a negative research report. Ackman engaged in what the book describes as “perhaps the most aggressive 'short' campaign in Wall Street history.”

Book Review: More Money than God

More Money than God: Hedge Funds and the Making of a New Elite, the catchy title of Sebastian Mallaby's new book, highlights the increased importance of hedge funds. The author documents their rise to prominence, describing some of the key players, huge profits and losses, and their impact on currencies and governments. The potential of incentive compensation continues to make hedge funds an object of fascination for financial professionals.

The CDS Market Goes Straight

Media reports in recent months have been filled with accounts of CDSs (credit default/derivative swaps), those complex, opaque instruments sold by AIG that nearly toppled the global financial system. They are the cornerstone of a $700 trillion worldwide industry that has sliced, diced, and shifted astronomical amounts of risk around the financial services sector at dizzying speed and—according to critics—within a regulatory vacuum. On the subject of disclosure, for instance, Fed chairman Ben Bernanke recently lamented the insufficiency of contract-for-difference regulation, noting that few regulators, investors, AIG employees, or AIG shareholders ever knew that the once-mighty AAA-rated insurance behemoth was actually a giant hedge fund that happened to be strapped onto an insurance company.

Book Review: Diary of a Hedge Fund Manager

“My hockey philosophy kicked in full force,” Keith McCullough writes at the beginning of Diary of A Hedge Fund Manager. “I clung to the concept that only harder work could separate me from the rest of the pack. ” This is the story of a Canadian Junior A hockey player who, after failing to make it to the NHL, went on to captain the hockey team at Yale, where he earned a degree in economics. McCullough then spent a decade on Wall Street, enjoying greater success than he ever had on the ice.

The Three Most Common Biases of Hedge Fund Managers

An upcoming NYSSA forum will be exploring the opportunities, risks, and challenges of investing in emerging hedge fund managers. In the absence of a long track record to review, the field of behavioral finance may offer particularly effective tools, not only for identifying the best emerging talent but also for detecting manager biases that may translate into future blowups.

Cynthia Harrington, a former large-cap value manager who now uses behavioral finance principles to coach hedge fund managers, has observed that their three most common biases are confirmation bias, herding behavior, and overconfidence.

Investing in Troubled Times

In these troubled times, with investors unsure of when or where to place their funds for maximum benefit, one investment tenet should be clear: bet on entrepreneurs. Our research of 27,000 publicly traded global companies, employing more than 12 years worth of data, demonstrates that entrepreneurial companies consistently outperform peer nonentrepreneurial companies by a wide margin. With very few exceptions these results remain true even after adjusting for year, market cap size, region, and sector. And, following the tumultuous market collapse in 2008–2009, it appears that entrepreneurial companies are now poised to perform better than ever.

Byron Wien: Man of Many Years

Byron Wien is having an especially good year. Not only has the long-time strategy guru received a Lifetime Achievement Award from the New York Society of Security Analysts, Inc., he has also enjoyed a higher-than-normal batting average on his signature Ten Surprises.

Moreover, at age 75, he is fulfilling his three most important goals: he is alive, he is healthy, and he has friends. Boy, does he have friends. Called by some the Perle Mesta of Wall Street, Wien continues to collect people all over the world—people who give him ideas and feed him information, helping Wien develop the kind of insights that have long nourished his popular year-end forecasts.

Book Review: The Future of Hedge Fund Investing

In The Future of Hedge Fund Investing (Wiley Finance, 2009), Monty Agarwal addresses with clarity and candor the passivity of hedge fund intermediaries in confronting the frauds and crooks they were duty-bound to detect. The Bernie Madoff scandal was merely the latest in a long and undistinguished line. Agarwal remains bullish on the promise of hedge funds and offers thoughtful ideas on how that promise can be realized. In his decade-long career as a trader and hedge fund portfolio manager, he observed firsthand the institutional investment processes the book critiques and aims to improve.

Cluster Analysis as a Funds of Hedge Funds Portfolio Tool

Constructing a diversified portfolio of managers in a fund of funds requires a method for determining how the different exposures complement each other. We show how cluster analysis can be an important tool in this process, especially during a period of market turmoil. Cluster analysis complements the qualitative assessment of a manager’s style and can be used to develop a view of changing markets and manager responses to these changes.

Figure 1: Cluster Analysis Results

 

Book Review: The Only Guide to Alternative Investments You’ll Ever Need

In the classic approach to portfolio construction, just three types of assets suffice to fulfill all investment objectives. Common stocks produce long-run capital gains that are taxed at comparatively favorable rates, while also constituting a hedge against inflation. Bonds serve as a bulwark against recession and they come in tax-preferred varieties. Liquidity needs can be satisfied with ultra-safe money-market instruments such as Treasury bills. By utilizing these building blocks in proper proportions, individuals can position themselves as desired along the risk-versus-reward continuum.

Outsiders and Outperformers: Women in Fund Management

The gender gap is a wide one in the world of investment management. Women manage only 3% of the assets in the $1.9 trillion dollar hedge fund industry, and only 10% of mutual fund managers are women (NCRW 2009). While the number of female CFA® charterholders has risen in absolute numbers from 5,719 in 2000 to 15,992 in 2009, the percentage of charterholders who are women has hardly budged—from 18% to 19%—over that period, according to the CFA Institute.

The Great Divide: Talking to Lee Cooperman

Leon G. Cooperman, CFA, is uniquely situated to discuss the gulf between Wall Street’s buy and sell sides. Cooperman has presided as founder and chairman over the hedge fund Omega Advisors, Inc., since he left Goldman Sachs & Company in late 1991. He was a general partner at Goldman for 15 of his 25 years there, and he spent more than two decades as the partner-in-charge of the research department. For nine straight years he won honors as the top portfolio strategist in the Institutional Investor All-America Research Team survey. In 1989, he founded Goldman Sachs Asset Management, serving as its chairman, its chief executive officer, and the chief investment officer of its equity products. He is the former president of the New York Society of Security Analysts, Inc.

Mending the Seams: International Regulatory Reform

As the global economy begins to find its way back from the brink following the financial crisis, the impetus is shifting from the day-to-day efforts to keep the system afloat to the long-term fixes that are needed to maintain and increase its stability and flexibility. All eyes are on the national governments and regulators who continue to shape a structure that either will be up to the task of managing an increasingly globalized economy or will fall short of the mark, resulting in the lack of a sustainable recovery, further crises, or both.

Best Practices in Hedge Fund Management

With so much uncertainty and a great deal at stake regarding the future of hedge funds and what constitutes “best practices” in management, NYSSA’s Alternative Investments and Institutional Asset Management Committees recently held an event to address such issues, bringing together representatives from every corner of the industry.

Results of Survey on Government Financial Market Intervention

On October 9, 2008, NYSSA launched a survey on the Government Financial Market Intervention plan. The survey was designed to gather feedback from our members and some nonmembers on their opinions about the effectiveness of the Intervention and if the bailout was sufficient to meet the need. Other information gathered included the changes in investment habits of respondents firms, reaction to proposed regulation changes and the availability of cash.