Special Commentary: "If it ain't hard it ain't right"*

This quarter's special market commentary begins with a quote from one of the market's most successful hedge fund managers. The quote implies that only hard decisions, or those decisions that are not obvious, create excess alpha. The topic of this quarter's piranha soup is equities and the decisions in that space are not obvious. The recovery period is behind us and as we move into the cycle of monetary based speculation, the decisions get harder.

Below I present a case for the great opportunities that lie ahead in all equity hedge strategies, including equity market neutral. For this analysis, the definition of "equities" includes the strategies of equity hedge, statistical arbitrage, sector funds, equity market neutral, and all other long short strategies that are equity stock selection oriented. It does not include equity non-hedge or short selling but some of the analysis does apply. For the sake of simplicity, I will use the same pattern of four factors I have used in prior commentaries. First, I will revisit the last six months.

Here is a quote from my last quarterly commentary in April (sorry for skipping July). "There is a mass exodus from equity hedge primarily in the US and Europe. The percentage of managers meeting investment targets is extremely low and if emerging markets are removed, it is under 5%. The exodus is so pervasive; it suggests a low point in the strategy."

Equity hedge has had a very strong reversal for the last two quarters April to October. Industry results were positive 10.5% in the period. Here is the chart of rolling returns for long short.

Please click here to enlarge this graph

Please click here to enlarge this graph

And here is the chart for equity market neutral.

Please click here to enlarge this graph

Please click here to enlarge this graph

The second chart of market neutral above shows the strategy is still producing dismal returns. The first chart of equity hedge does suggest a turning point in the strategy. But if I dissect the returns of equity hedge managers, all that has really happened is that hedge funds have been forced to lift their shorts to stop the bleeding and are now net long beta. There is really very little net alpha being produced for clients across all managers in the pool. Clearly hedge funds are being left in the dust by long side trades in just about anything.

This is about to change. My reasons for this prediction do not include an expectation of a raging bull market nor extremely strong earnings to justify current prices. My reasons all point to a normalization of market dynamics in stocks. It is a hard call now to step into equity hedge managers when there is little alpha and it is especially hard to step into equity market neutral. But this should be the core focus of portfolios as we all transition out of debt strategies. Below I present the four factors mentioned and then immediately after I present the implications for how to cycle through specific equity sub strategies in the coming two years.

Four factors that lead to strong alpha in equity strategies:
The four factors occur in a specific order and so I present them in the proper order. They are: 1. A normal range of volatility, 2. Stable economic indicators, 3. Geographic decoupling, and 4. Individual market dispersion. Some of these concepts are as hard to digest as piranha soup (which is very delicious) so I will go over them in some detail for the benefit of all readers.

  1. A normal range of volatility is a prerequisite for selecting stocks because extremely high volatility comes from factors external to companies. If we look at periods of extreme volatility in stocks as now measured by the VIX, in all cases the market is pricing high levels of economic risk. Essentially volatility is a high payment for the fact that the short seller of equity options has great uncertainty as to how to price the stock in an unstable economic environment. So by definition, the person selecting stocks does not know how to price the stock either.

    Stock selection is about companies and their unique fundamentals, not terrorism. External shocks are by their nature unpredictable. This is true even if the shock is from a company, like the failure of Enron or a blow up in WorldCom. One is tempted to point out that these extreme periods of volatility create opportunities. It is true that periods of dislocation rewrite the playbook for companies and cause miss pricing of equities. It is also true that it takes about 12 months for markets to settle down enough to give managers an environment where they can pick stocks again. Right now we are about 13 months from the peaks in volatility that occurred in 2002. Markets are stable enough for stock pickers now.

    Periods of extremely high volatility are also periods when equity managers tend to lower risk and carry large quantities of cash. They recognize their own inability to deal with the environment. Cash is poor alpha engine. During the last 18 months, we have seen a trend toward small balance sheets so whatever alpha is being produced is being eaten up in fees.

    For those that are more technically oriented, extremely high volatility is normally accompanied by extremely high correlation between equity market indices, extremely high correlation between stocks and their respective indices, high correlation across geographic boundaries, and even unusually high correlation among currency and commodity markets. While these are dealt with in points 2-4, it is worth noting that they all reach their extreme points while volatility is peaking. It is obvious that if all stocks are correlated to the general market, and all markets are correlated to each other, we are all just market timers in the same trade.

    Most stock pickers are poor market timers and it is worth noting that the equity hedge funds doing well now are those with top down market timing methods. This analysis is a commentary about the shift from the top down methods to bottom up methods. The chart below shows the relationship between high volatility and poor returns in equity strategies. Even if net beta is stripped out, the relationship holds. Specifically the chart shows a rolling return in long short against a rate of change in the Vix. A rate of change in the VIX is used to show because it more accurately predicts when the returns of the strategy are going to turn. The point is that high vol is bad for equity strategies and rapidly rising vol is really bad.

    Please click here to enlarge this graph
    Please click here to enlarge this graph

  2. Stable and trending economic indicators are also needed in order to select stocks. This is separate from a decline in volatility. Stock pickers need an economic environment that they can predict. The most obvious reason is that economic factors lead directly to the prices of companies. Across international borders a revaluation of currency directly affects the competitive value of a company. If currencies are unusually unstable and/ or turning in trend, equity hedge fund managers have a harder time.

    In the case of many market neutral systems, economic factor loads are the main source of price prediction models. Obviously this primarily affects statistical arbitrage but it also affects other valuation systems. A factor load is a factor that explains of price behavior in stocks. Beta is one example but all stocks are affected by factors unique to their region, sector, and company. For example oil drilling stocks are affected by the price of oil far more than a company like EBay. When the factors themselves become unstable, the models that predict the prices become unstable. Instability comes in many forms including statistical outliers. In recent times like 2002 there were so many statistical outliers creating "new" factors, models would need to be rewritten to keep up. An obvious example is accounting fraud. This has contributed and continues to contribute to instability in some of the systems that have been reliable in the past.

    One way to tell that equity funds are going to have a difficult time is to see how currency predictive systems are doing. If those systems are suffering, it is not yet time to assume equity hedge alpha will be better. Once those systems turn, alpha should follow. These systems have turned.

    Economic indicators need to be somewhat stable within an economy as well. We all know for example that this US recovery cycle is unusual. Productivity is off the chart. Employment is absent. Capacity utilization is weak. Interest rates are at historic lows. Corporate earnings leverage is at an all time high. Trade deficits are soaring. There was no consumer recession. All of this adds up to a complex picture. One might say that hedge funds are in the business of doing a better job of predicting a complex picture and that is why we pay 20% performance fees. This is naïve and of course we must say the whole purpose of our quarterly research is to find managers with the wind at their backs, not in their faces. We are trying to predict which type of manager will have the wind at his back next year. Most equity hedge funds are not very good at predicting these complex pictures. Computer programs are completely lost in space. It follows that the picture needs to be simplified for stock pickers to do well.

    So the second piece of the puzzle that follows the decline in volatility is stabilization of the economic factors that lead to the price of stocks. It can only happen after vol has come down. Said another way, after markets stabilize economies can stabilize. There is strong research to support this view that markets are a better predictor of economies and events than the reverse. There is even a new futures market that uses market based or idea futures to predict outcomes.

    For equity bottom up strategies, the length of the run for equity alpha is dependent upon this economic stability piece. Politicians and fed governors must behave with great insight to keep the peace in the economy. This is why I have stated above that the decisions are getting harder. Stable equities and growing markets are now dependent on specific actions of our leaders, including our corporate leaders. Still if my theories hold up, we will not be dependent in the coming two years upon higher equity markets. We can invest in market neutral. We can make good alpha without much market risk and leverage it.

  3. The third necessary market change is geographic decoupling. Prices of stocks should depend on the specific decisions being made by leaders or consumers in a region or country. We are beginning to see decoupling now as Asia decouples from Europe for example. Technically it shows up as a decline in correlation among global stock indices. See the correlation below. Correlations were low on a rolling basis during the time equity long short performed well. Correlations soared at the same time returns collapsed. The correlation is now declining and returns are picking up.

    Please click here to enlarge this graph

    Please click here to enlarge this graph

    Stock pickers need to be focused on the intimate details of a company; its products, its quality of management, its competitive base etc. If these factors that they spend their whole day on do not result in changes in the price of that stock, poor alpha is the result. In today's market there is specific decoupling. In Australia rates have moved up, there has been a large change in the Aussie dollar, and there is massive impact from trade with China. Companies affected by this should not be moving lock step with the NASDAQ. We are in the early stages of decoupling and this is presenting enormous opportunities to pick stocks globally.

  4. The fourth and final change that must occur is for individual markets to exhibit more dispersion. Simply stated, if stock pickers are going to make money picking stocks that are miss priced from their expected future value, there needs to be quite a few stocks that are miss priced to choose from. Dispersion can be defined as a situation where it is possible to buy all the stocks in an index and sell the index against the stocks resulting in a profit. It is a measure of miss pricing. Some will point out that there has not been much dispersion since 1988 and I agree. But still some dispersion is better than none and that is what we have now. Dispersion will reappear but I argue can only reappear after all of the above changes have appeared in their proper order.

    Before moving on to the implications for sub strategies, let me mention several things wrong with the above simplistic analysis. Some will point out that the rising volume of exchange-traded futures is causing permanent damage to dispersion and any form of decoupling. High volume in index trading does create a situation where the people doing that trading are not trading individual stocks and therefore they are not creating dispersion. This is an important consideration as studies show that 15% of the traders in any market take money away from the other 85%. We are supposed to be the 15% smart money taking excess alpha. But if the dumb money is not trading with us any more then we are trading smart money against smart money in the same trades. Clearly some of this is occurring. At Wolf we make the case that we can pick the 15% of the smart money managers within the new massive smart money pool. On the market side we believe this is creating some drag on all managers' performance but not enough to say the game is over.

    Another problem is Reg FD. Hedge funds have lost some of their information edge. Hedge fund managers typically spent more time and money on a more concentrated portfolio and thus produced a better result on that information. This is still possible in emerging countries and may be one reason higher levels of alpha are being generated.

    In systems trading, there is no doubt that excess money in the strategies combined with razor thin costs are taking their toll. It is hard for smaller managers to compete. Again this may cause some slight drop in rates of return but it is not the core reason for low results.

    Last I must acknowledge that low interest rates do cause a drop in the rates of return for equity hedge strategies. But when all of these extra factors are considered together, they do not explain the lack of alpha. I believe our four factors explain the bulk of the problem and that we are about to see better times ahead. Let's now turn to exactly how this plays out.

Starting with the decline in volatility mentioned above, clearly during this time the best source of return comes from the worst companies. The worst companies have the most financial leverage. They benefit the most from reductions in rates of distressed and high yield. The rule of thumb is that when volatility begins to decline from very high levels, buy the garbage. We did this last year only to experience a double peak in volatility. This second peak gave us a chance to add to holdings. Our combined "worst companies" portfolio peaked at 29% in March and is now down to about 8%. The opportunity in this segment will end by April.

Moving to the second item, economic stability, we can say that the best performers in that time frame are companies with high earnings leverage. This can be defined as a company where a small change in revenue causes a large change in earnings. The period for this began in about May and should last well into next year. I stated above that earnings leverage is at an all time high. This implies opportunity. So let me take the time to explain.

Economic stability implies stable growth not a stable depression. Stable growth chews up excess capacity and so each incremental sale results in bottom line revenue without attending new fixed costs. The company does not need to invest in a new plant. The company is already eating high fixed costs and so as its sales recover, earnings appear quickly. Our current low capacity utilization in the western economies implies this very high earnings leverage. Of course it also implies no need for investment.

When looking for high earnings leverage, one does not need to look beyond the NASDAQ. We can debate whether it is expensive, but we should not debate whether it has explosive potential in both directions. I will borrow a mortgage word and say these companies are "cuspy". One should not underestimate how quickly these companies can turn around if the global economy keeps ticking.

Our portfolio has a good quantity of these kinds of companies though I will say that our net long is pretty small. We are making money being long and short. It is more pure alpha than bullish bias. The principal reason we do not have more net long is that we think we can make more money in item one above and item three below. We can only take so much risk.

During phase three above, geographic decoupling, it is best to focus on specific regional markets. This period started this summer and should last a full two years. Regional is the right word but some may prefer the word emerging markets. We are invested in both and do not think Hong Kong is an emerging market. India is an emerging market and we are increasing our holdings there.

Right now we are in the thick of an example of how economic decoupling works. Asia in general has been cheap while the west in general has been expensive. As perceived risk of the world coming to an end wanes, capital rushes to the cheap stocks. Right now this is Asia. People are buying Asia more than specific companies. There is dumb money flowing in and I predict that stock pickers in hedge funds will have a field day.

It has been well reported in our prior commentaries that we are loaded down in Asia. Our best funds are all closed and we are having trouble keeping up with the daily load of new Asian fund launches. All this suggests that we are in the early stages of another Asia asset reflation bubble. Given the whole Asian topic is complex, I will not take it on here. Instead I will promise that my next quarterly piece will contain a lot about Asia. The piece will be on my favorite subject, global trade. I will examine the impact of China, the impact of high freight costs, the impact of commodity stockpiling, and what a weak dollar does to global trade.

Let's move now to item four, equity dispersion. Each month I am checking returns in dispersion based strategies and making our option manager send me dispersion reports. There is no sign of life and we have no exposure to dispersion dependent managers. The dispersion period is the period of greatest calm. The individual stocks that do best are those with the most stability. Companies with stable franchises may already be expensive by the time this period rolls around, but the market's relative calm causes people to pay even more for these reliable earnings streams. In some sense it is a move to all that is market neutral. Stated simply, when there is free money in dispersion, why do anything else.

During this phase one would expect for rates to be rising. Our portfolio will be out of any company with high financial leverage. It will be nearly out of the phase of earnings leverage oriented companies. It will still hold a good amount of regional plays that are benefiting from "economic leverage" as these tend to have a lot of momentum and last well into the dispersion phase. We are in the beginning stages of research now in these dispersion strategies.

I began this analysis section with a quote from a great hedge fund manager and will end with that same thought. It is hard to enter equity strategies when most think of them as long side trades in an expensive market fraught with risk. Equity strategies are far more complex than that. Right now some people in our industry seem to be stepping into these strategies but I can say this is being done with little conviction. People tell me it is more of a panic as their dull arbitrage portfolios under perform equities. I believe this move will pay off. Let's now turn to current events.

Current Hedge Fund Industry Events:
Given all the focus on equities above, one would think that we never look at fixed income. We are watching the rise in volatility in fixed income closely. June's violent moves occurred when there was no chance of rates actually rising in the short end. It is rare for the long bond to fall 20 points and every time it does, it signals trouble ahead. In Japan, we nearly had a failed government debt auction. Imagine the kind of volatility we will get when it is time for rates to go up. This risk is something we see coming about 9 months from now and it is causing us to reduce or pull out of anything exposed to short side fixed income volatility. We are already out of anything that is just long high-grade fixed income. We are now beginning to add strategies in some size that will benefit from high fixed income volatility.

Lots of people are asking about mortgages. They were temporarily cheap in the summer and we did not add money to the strategy. Mortgage hedge funds are effectively short fixed income volatility. This is true even if they do not employ a long mortgage/short treasury strategy. Generally the portfolios are long complexity and short simplicity. They are long either lower credits or harder to price securities. No matter how you add it up, the funds struggle to keep up if fixed income volatility is very high. Their leveraged yield just cannot keep up with their cost of hedging. Since we expect surprises in fixed income volatility, it is the wrong part of the cycle to add money. Said another way, mortgages are only cheap if volatility of fixed income securities does not rise.

High Yield is near a price top/yield bottom. We have said we would exit high yield at an 8% yield on the Merrill Index and we are doing it through heavy dilution. Under 8%, our managers will get short or we will not have them.

We should mention the importance of the price of oil. It is too high and looking top heavy. We are watching it closely because it is outside a normal range. In general we think the long side of natural resources is a great place to be. We are expecting (read hoping) for a retracement to increase holdings there.

In April we talked about a temporary top in trend following CTA's. Below is the chart showing the corrective action in the rolling return. One new factor in the market is the trend following equity CTA. Most big CTA's now have a meaningful equity component. This was not a big factor in the last bull phase. A combination of large longs in stocks and future large shorts in long duration fixed income will reverse an historic trend of negative correlation in CTA's. We saw the first signs of this in the summer. CTA's are going to be very positively correlated to stocks for a while. Any historical CTA data should be regarded as yesterday's news. Related to this is the rise of the commodity based CTA. After under performing for three years, the commodity CTA's are making loads of money while the financial CTA's struggle. Again, any historical data is worthless. All the action will be in commodities.

Please click here to enlarge this graph

Please click here to enlarge this graph



Current Portfolio Changes:
During the summer we took a step back and reduced both portfolio risk and leverage. We are now pushing leverage back up but are not increasing portfolio risk. We are simply shifting from debt to equities. We are shifting from long side bias to a more long short bias. We are actively adding everything with a discretionary trading focus.

Convertible Bond Arbitrage: We added some in September but are generally avoiding this bonds up, stocks down strategy, vol up strategy.

Distressed Securities: We are holding onto some residual distressed. It is largely non US. Our portfolio has moved down the capital structure to equity of distressed companies. The book is much smaller as a result.

Emerging Markets: We have diluted the debt side of the portfolio but still hold a long bias in debt. We think spreads to worst in emerging markets have another 100 basis points to move. We expect that to happen quickly. Our equity portfolio is in Asia and we continue to add to it. We have some exposure to Argentina. We missed Russia on the way up and are missing it on the way down. I once spent considerable time traveling through the former Soviet Union and was shocked by the corruption. It is a very difficult market to be in.

Small Caps: My favorite manager of the moment is investing in micro cap companies in Japan.

Event: We are diluting our very successful event portfolio. It is important to point out that just because high yield is tapped out, we do not need to exit our event managers. Our event managers are running funds that are balanced long and short. Our manager pool in particular knows how to be short. If we examine the event chart on the next page, we can see that event funds often show strong returns for long periods of time. This 2003-4 cycle is likely to experience a shorter period of sustained returns than the three years from 95-98. That period has stronger fundamentals for corporations. We can expect perhaps another year of strong results.

Please click here to enlarge this graph

Please click here to enlarge this graph


Fixed Income: Wait two years and then reinvest.

Macro: We are actively adding to short term oriented trading macros. We prefer those that trade all markets and with tight stops. We are avoiding long-term trend following macros.

Market Timing/Systematic: We have no systematic long-term trend following CTA's. We should get a reentry point in the spring of 2004.

Merger: Our exposure is near zero. Our event managers can more than cover the space.

Short Selling: Short selling is hitting an entry point. We still have no exposure.

* Publication of Wolf Advisors - Any reproduction is prohibited