re: Getting Past the Gate: Capital Introduction at Prime Brokerage Firms

Thursday, December 18, 2014


As I return, I present to you my favorite quote of all time:

Billy: You remember the stories John use to tell us about the the three chinamen playing Fantan? This guy runs up to them and says, "Hey, the world's coming to an end!" and the first one says, "Well, I best go to the mission and pray," and the second one says, "Well, hell, I'm gonna go and buy me a case of Mezcal and six whores," and the third one says "Well, I'm gonna finish the game." I shall finish the game, Doc. ( LINK from Young Guns II)




Picking up from Section III...

quote:

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III. STRATEGIES FOR GENERATING ALPHA

A. Hedge Funds and Hidden Beta
B. High Frequency Algorithmic Trading Strategies
C. Other Quantitative Strategies: The EMH vs. Fama-French & Shiller's CAPE
D. Recent Work of Clifford Asness and Others
E. Current Trends

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III-A. Hedge Funds and Hidden Beta (revisited)

I wanted to return to this sub-category for a bit due to a really interesting piece Clifford Asness of AQR Capital wrote on his hedge fund's website on October 24, " Hedge Funds: The (Somewhat Tepid) Defense." There have certainly been a lot of articles in the financial media over the past couple of years decrying the sub-par performance of hedge funds in recent years, such as by that arrogant blowhard Barry Ritholtz. Asness, however, rebuts the argument quite well, and explains from basic points of portfolio theory why hedge funds are still a quite useful investment class, despite the apparent lack of alpha given the level of beta in recent years. Specifically, he notes with very useful charts the correlation part of the equation that critics like Ritholtz miss, and shows that although, yes, hedge funds oversell their ability to generate alpha, there is a huge service to investors for them being able to generate whatever paltry levels of uncorrelated alpha they are still able to do.

III-B. High Frequency Algorithmic Trading Strategies (revisited)

I was going to revisit this sub-section to illustrate a link to a QuantNet thread highlighting pros and cons to using Fortran vs. C for algorithmic programming, which just tickled me pink because I learned to code using Fortran in high school, but somehow I can't find the link anymore, and I guess it's not really that relevant anyway... just something that was personally noteworthy to me in a funny kind of way.

III-C. Other Quantitative Strategies: The EMH vs. Fama-French & Shiller's CAPE

You know, there are a bunch of different approaches one could take to this topic, but at the risk of going to the same well too many times, I will once again defer to a recent piece by Cliff Asness, because his December 17 post on this subject, " Our Model Goes to Six and Saves Value From Redundancy Along the Way," addresses cutting-edge research on this topic so well, and in such a widely accessible way to the general (somewhat sophisticated) investing public, that you really can't do any better.

In particular, he focuses on recent (September 2014) academic journal publications of Eugene Fama and Ken French on their famous three-factor model, which everybody learns in business school, and which they now expand to a five-factor model. Hence the Asness title about taking the five-factor model to 6 factors, since the entire career of Asness is mostly based on his PhD thesis research on the use of momentum as a valid factor in this model, and explaining to all who will listen how it is best used in conjunction with the value factor due to the benefits deriving from the negative correlation of the premia from those two factors under differing macroeconomic conditions. Really cool stuff.

III-D. Recent Work of Clifford Asness and Others

Because I just cited Asness twice to make points in 2 of the subsections above, this is now mostly irrelevant, although he has made quite a good living from his original PhD thesis that value and momentum work best as investment strategies when used in tandem. In any case, I highly recommend reading his Cliff's Perspective section on the AQR Capital website, which is similar in a way to Bill Gross's monthly outlooks, except that Cliff's is much more quantitative, high-brow, and educational with regard to the elite levels of sophisticated hedge fund investors.

As for "others", well we just covered Fama & French above too, and most everything else besides that (at least on the quantitative side of things) is algo trading, which is just not that interesting to me.

On the activist side of things, Ackman & Icahn & Soros offer some interesting perspective. From Ackman, that he is better at what he does than what you might suspect by reading how the financial media portrays him. From Icahn, that shareholder democracy is a false ideal. From Soros, that many great investors purposefully make profits by riding momentum on the upside of bubbles, knowing full well that the underlying assets are being mispriced for the long-term by the transitory investing environment.

III-E. Current Trends

You know, the more I think about it, the more I realize that I just don't understand a lot of what goes on in the industry, most especially what goes on related to short-term trading prop desks. I know that several of the posters here are traders of some form (a few energy traders, right?), and there are interesting stories out there (see e.g., how Andrew J. Hall managed to make money in 2014, despite being long oil LINK, because he was also long on the US dollar), and there are great historical stories and advice, like how George Soros won big betting against the Bank of England on the value of the British pound (and about how Soros claims that betting WITH bubbles on purpose during the run-up is how he makes a good bit of his profits), but really, prop trading is still a foreign world to me.

But I do understand basic trends and concepts related to the trade, such as the carry trade related to the Japanese yen, and event-driven M&A investing, or activist investor LBOs (a topic near and dear to my heart, especially as it relates to dudes like Carl Icahn, Kirk Kerkorian, and William Ackman), and I do certainly recognize the current bloat in the hedge fund industry.

Regarding the current bloat, and the concomitant sub-par returns that we have been witnessing in the industry, it seems clear that a major shake out is in the cards, whereby the wheat will be separated from the chaff, and a lot of clown impostors will go bust once the era of disinflation and easy money starts to come to an end. That much is well known.

What is (slightly) less well known is the degree to which the big fish are eating the small fish in the hedge fund world. So not only is the industry bloated and producing a lot of mediocre funds, but there is also a clear trend towards superior alpha being generated by the behemoths of the industry rather than by the smaller fish. Does this mean that being nimble and imaginative and fresh will no longer work going forward? I wouldn't say that, but it does give me pause as someone who is trying to break into the hedge fund industry as a small-time entrepreneurial player. The data seem to be saying that the world already has enough people like that as it is.