Day three of this un-nameable hedge fund event provided a bit of pessimism for everyone. NYU professor Ed Altman got things rolling with a grim assessment of the US economy and successive speakers after lunch – namely professors David Hsieh and Harry Kat – presented research which they said was evidence that most hedge funds still weren’t making the grade.
Altman: Enjoy the Olympics America, then get ready for economic mayhem
In the conference programme, Altman’s presentation title contained over 30 words. But the straight-talking and entertaining academic said it could be summed up as simply, “A New Paradigm or a Giant Credit Bubble?”
From the sounds of it, he comes down solidly in the “credit bubble” camp. As evidence, he pointed to the massive increase in global liquidity (from petro-dollars, a growing money supply and sovereign wealth funds), an explosion in hedge funds, private equity funds, easy credit and low spreads, and growth in the CDO market (now 2 to 3 times the size of the global equity derivative market he says).
These developments, argued Altman, would lead to huge opportunities in distressed debt investing in the coming years (he’s a huge fan of distressed debt – check this out). After apologizing for being excited about what he predicts is a coming wave of corporate bankruptcies, he shared the following secret with the audience:
“My wife and I have this tradition of opening a fine bottle of red wine when there is a major corporate default. And if 3 or 4 major companies defaulted at once, we would open an expensive bottle of champagne. Let me tell you, we spent most of 2002 drunk!
“But now that default rates are at record lows, we’re on the wagon. In fact, there may be a lot of liquidity in the market, but there’s no liquidity at all in Altman household right now!”
Altman said that credit default rates have gyrated between approximately 13% in 2002 to basically zero in recent quarters. If we have a recession, he said, default rates could easily top 16% – a new record. He also pointed out that – as a proportion of overall debt issuances, issuances of B-rated securities hit a record in Q3, 2007.
Still, he felt that a US recession was not imminent. In fact, his view that a recession would probably not be in the cards until after the Beijing Olympics, was also shared by a few other panelists that day. (Beijing has confirmed that their mascots – above – are actually designed to distract and confuse investors long enough to squeeze in the Games).
Hsieh: Hedge Fund replication even better when it fails to replicate drawdowns
After lunch, hedge fund managers in the audience took a one-two punch from professors David Hsieh of Duke University and Harry Kat of the Cass Business School in London.
As regular readers will know, Hsieh is one of the founding fathers of the “hedge fund replication” movement and uses factor modeling (a la Sharpe 1992) to replicate a significant portion of various hedge fund sub-indexes.
“But wait,” I hear you say, “hedge funds have non-linear pay-offs than can’t be captured by a simple linear model.” Hsieh and long-time collaborator William Fung say that you can capture these non-linear pay-offs simply by adding them as variables in your linear factor model. As the duo said in their seminal 2001 paper on the topic:
“…in order to arrive at a linear style model like Sharpe (1992), the inherent return nonlinearity from hedge-fund strategies are subsumed in the returns of the estimated factors. This, in turn, allows for a linear combination of these factors to be used to explain hedge-fund styles…”
Hsieh went on to review some of the recent results from his newest factor model. According to Hsieh’s slides, his model seems to have performed admirably from mid-July to mid-August, appearing to blow the pants off other factor-replication strategies by simply not cratering that month. The model seems to have tracked the hedge fund index very closely for the rest of the year. So its a little ironic that Hsieh’s model actually failed to actually “replicate” hedge fund performance over that tumultuous period. So what happened? And what can be learned from this episode about factor modeling and extreme events? Is this an example of what Bill Fung recently said was a need to model not just hedge fund asset behavior, but also how hedge funds’ liabilities behave (see related posting)?
Kat: Stop calling me a “hedge fund replicator”!
Kat acknowledges that a factor-replication technique works satisfactorily at the index and sub-index level. But he argued that the approach is inadequate when trying to replicate the characteristics of a single hedge fund or fund of funds. He cited research by Hasanhodzic & Lo (see related posting) that showed factors can explain only 10% to 21% of single hedge fund variation (10% for market neutral and 21% for long/short equity). And he cited research by Jaeger and Wagner (see related posting) showing that 35% to 89% of the variation in hedge fund sub-indexes could be explained by factors (35% for market neutral and 89% for long/short equity). Finally, he said that the proper combination of factors, such as that which makes up Goldman Sach’s “ART” (Absolute Return Tracker) product can explain a very large portion of overall hedge fund index volatility.
Why is factor replication better at mimicking indexes than it is single funds? Kat says that’s because hard-to-replicate idiosyncratic risks have been diversified away in hedge fund indexes – leaving a large helping of simple equity and credit risk.
Although Kat covered a lot of his usual material, he seems to be laying the groundwork for a change in strategy. He’s apparently trying to move away from a direct attack on hedge funds and is instead proposing that his dynamic trading method can and should be used to create custom return distributions to complement existing long-only portfolios. Judging from the number of people who approached him after his speech, this message seems to have resonated with several of the institutional investors in the audience.
There was some other new research presented on the investment decisions made by university endowments (you know, the ones that seem to cream the rest of us each year – see related posting), and on hedge fund activism. We’ll tackle those topics soon with the help of the authors of those studies.