Man FRM Early View - December 2020

Farewell. A reflective note from the author, his retirement knitting, on 40 years in the industry.


Notwithstanding that experience makes it easier to explain why older men develop a taste for hats than it does to explain why, as retiring finance professionals, they write woolly pieces on what they learned in the job, there is this: it’s neither easy to admit that through all those years one learnt nothing, nor to say exactly what it was one did learn. So here, in my last contribution to this series, emerging from 40 years in alternative investing as analyst, trader, fund allocator, portfolio manager, CIO and salesman, is my own bit of retirement knitting. (A hat?)

The concept of a career carries with it notions of structure and progress. More often, each step is driven by a minor crisis rather than an active choice. Plans don’t hold more than 18 months out: it’s just one damn thing after another. But even so, we still expect life stories to be told otherwise. They should follow a progressive logic. With this game, it is one of the great fascinations that there is in everything the same persistent tension between the patterns we manage to perceive and the more natural state of chaos (or efficiency, as finance academics call it). First you learn the rules of the market, then you flounder about discovering how much of which ones are true at any given time.

In recent years the industry has favoured a preparation in maths or sciences. Those thought processes have a crystalline, rigorous feel and the conclusions have a satisfying finality. We also look for people who, faced by the unknown, have the spirit to ‘have a go’. Both approaches carry their dangers when confronted by the world of investing in which truths are soft, pale and transient. The predictive power of many useful signals is all but indistinguishably close to zero. (Whether machine learning compounds the strengths or the weaknesses of the favoured personnel, we shall see.) But whoever you are, alternatives investing (actual investing) offers a life-long contrary lesson in scepticism and humility.

What came of mine?

  1. ‘Never let the truth get in the way of a good story’ they say, and indeed, we don’t, whether it be a life story, a fund or a piece of research. So, look on all good stories with the beadiest of eyes. It must be something odd about the way our brains are organised that we should so strongly favour the fiction of narrative coherence over evidence.
  2. Be similarly fearful of extended chains of reasoning. Each step in an argument about investments is rarely much more than 50% probable, so the chance that an argument holds over more than a couple of steps is uselessly low. It’s common enough to be right for the wrong reason or at the wrong time because things turn out one of only two ways (either up or down). That’s called luck. To be right for the right reason at the right time is a hen’s tooth.
  3. No back-trading. The use of hindsight to re-write history is boring, intellectually bankrupt and has no place in civilized life. (Don’t re-write the rationale behind a trade that’s losing money either).
    There is a place for ‘could’ve’ and ‘should’ve’: genuine mistakes or errors consist in doing something badly that you could realistically have done better. It’s true that tight process reduces the frequency of these errors, but tight process is asphyxiating to all but weird characters. Perhaps that’s one reason why good investors tend to be weird.
    For most of us, about half (or as near half as makes no psychological difference) of all trading decisions have bad outcomes. The trick is to internalise the grim odds, recognise a problem early and dispatch without remorse. (Don’t get into wars of attrition with the market: they’re immiserating and the opportunity cost is incalculable). There’s no shame in being wrong if you admit it quickly. This is how good traders become such nice people.
  4. It’s hard to engage creative energy and scepticism in equal measure. Most people are naturally better at one than the other. The skills sit in different parts of the brain, and personal temperaments play a role. Good analysts don’t necessarily make good decision makers; creatives don’t make good critics. So collaborate more, compete less. It’s a culture not an injunction.
  5. While diversification across alternatives strategies is itself critically important and choices between them are notoriously difficult, in practice if the choices are not made it will all drain into the sand.
    Over diversification is a real thing, though what kind of a thing makes for an interesting discussion. One version says it’s merely a failure to set the bar on content high enough.
  6. In alternatives these days, if you don’t take risk you almost certainly won’t make money, so if you can’t see the risk, either you missed it, or the game isn’t worth the candle.
  7. The risk you want to know about is not the volatility, it is the amount you can lose. You can lose a lot in small amounts continuously for long periods, or you can lose a lot in one go. Neither need register in a high volatility estimate, but volatility is still the industry standard measurement of risk because it’s easy.
  8. The other statistical concepts we use so freely are also dangerously simplified answers to difficult questions. Perhaps ‘beta’ is the worst because it compounds problems with both volatility and correlation: it is highly unstable, and it saves its worst for the times we care most. And yet we lean on beta estimates all the time because we’d rather have a simple answer we can understand than either a better answer we can’t understand or no answer at all.
  9. In alternatives, you mostly try to isolate investment exposure to a specific effect because that effect is likely to be quite weak and is easily swamped by influences on which you have no view. While good returns represent the successful fruition of a plan, very good returns may speak of an unacknowledged risk in the book: right for the wrong reasons. Could be market direction, flows, a tail, anything – but it will reverse, leaving you with, at best, the cumulative deficit of fees and transactions costs. Big performance swings in either direction promise the big reveal, so a failure to investigate is a cardinal sin.
  10. Measuring risk is not managing risk. Measuring should be a preparation not a substitute. Many risk ‘managers’ are subordinate to the PMs and have been hired for their analytical and quantitative skills, not their judgement. Risk reports develop over time, numbers proliferate and the real dangers drift even further out of focus. For big books this focus has to predate the point at which fear forces you to take it seriously: most of the time we stare at the stress loss report and just hope it doesn’t happen.
    Hope to an alternatives investor is simply the exposed surface of a suppressed fear. Never forget that while markets are exquisitely cruel, their ingenuity in eviscerating big gross market neutral books is positively diabolical. If you run one of those and the rope round your neck is sitting comfortably, its only because you paid out enough to make the drop dangerous when it comes.
    Good risk management is an embedded cultural practice. It’s about what we actually do, not what we say. Ultimately, risk is much easier to forecast than return and we should use this knowledge exhaustively.
  11. If you have a risk in the book you don’t like, don’t hedge it, sell it. If you can’t sell it, then hedge it, but know that you almost certainly won’t be willing to pay enough for the hedge. Whatever you do, don’t leave open a risk that could kill you. Judging by the demographics of alternative PMs one suspects that most risk takers either luck out and clear out or get fired trying. It’s not age that stops most of us.
  12. Investment management is not a science, nor an art, but a service. (The servants are apt to miss this point from time to time.) If over years to come the chaos does slowly engulf the patterns which drive the alpha, and if the alpha comes to be seen as the strange obsession of a few odd decades around the turn of the century, our game should have moved on long before. Demand for outstanding skills in portfolio mobility, diversification and risk management will be abundant if only we care to recognise it.

Enough. No one lives by another’s rules, and however they may be drafted, these aren’t really forward-looking rules but reflections on experience and the reverberating chatter of a community I have greatly enjoyed. Thank you.



Hedge Funds

Hedge funds continued their strong end to the year with another positive month in December. For many hedge fund indices, this leaves the whole year for 2020 in modestly positive territory, which belies the turmoil experienced throughout the year. Returns were helped by a continued rally in risk assets, due to catalysts from positive outcomes to the UK/EU trade deal and US fiscal stimulus. The rally was all the more impressive given the increase in Covid-19 cases globally, and the emergence of new, more virulent, strains of the virus in both the UK and South Africa, which have raised the possibility of more stringent lockdowns in the near term. Managers with net long exposure to risk assets therefore enjoyed a good end of the year; primarily, this covers managers in the Equity Long-Short and Credit Long-Short strategies, but also Trend Following Macro managers, who have generally built a long equity and short USD position since the start of November.

Within equity markets, there was more choppy behaviour from individual factors. In particular, the interplay between Value and Momentum was considerably more mixed than the snapback seen in November. Concerns over the need for tighter restrictions meant that for much of the month Momentum stocks (including many of the Covid ‘winners’) had managed to recover some of the losses seen in November, whereas the beat-up Value sectors in hospitality, consumer and travel had their recovery checked by the renewed concerns. This more varied landscape for equity factors seems to have been a positive environment for hedge funds, with factor driven Equity Market Neutral managers generally posting positive returns in December after a difficult first 11 months of the year. Similarly, lower net Equity Long-Short funds also did well across the board, with less distraction from factor rotations and more alpha from stock selection in general.

Credit managers posted positive returns for December, with returns correlated to the riskiness of securities and High Yield outperforming Investment Grade credits. December continued to be a very good month for capital structure normalisation trades, with further positive returns to Convertible Arbitrage capping off an extraordinary run of performance in the second half of 2020. Structured Credit managers also performed positively.

In the Relative Value space, there were further positive returns for Event Arbitrage managers, with continued spread compression in the face of the general risk-on sentiment, as well as continued high levels of SPAC activity leading to gains for hedge fund exposures in this area. On the whole, we found other Relative Value strategies also did well, with positive returns for Fixed Income Arbitrage, whereas there was mixed data from Statistical Arbitrage, with some machine learning strategies seeing losses. As noted earlier, Alternative Risk Premia approaches to Equity Market Neutral were generally positive in December on a more varied factor landscape, which also helped the more fundamental Quant Market Neutral strategies finish a difficult year with something of a positive.

For Trend Following managers, the bulk of the gains in December came from long equity positioning, although several managers also benefitted from FX (short dollar) and Commodities (long energies). In general, managers came into December with a long government bond position which detracted from performance during the month. Alternative Trend strategies in less liquid markets also enjoyed a very strong December, with further gains from Credit and less-liquid Commodity positions. Discretionary Macro managers were more mixed in terms of performance during the month, with those managers taking more trend-focused signals into account performing better, whereas the contrarian and risk-off managers generally lost money during the month.