investment style that permanently focuses on risk management − the preservation of capital under difficult market circumstances − is something that endures.


“The essence of investment management is the management of risks, not the management of returns.” — Benjamin Graham (1894-1976), British-born American investor and securities analyst


In the institutionalization of the equity market, as with aviator Ray-Bans, there were pioneers, early adopters, and late-comers. The pioneers are typically a small group. For reasons that are beyond the scope of this report, it was the English-speaking economies that developed an equity culture of some sort very early on. In the US, the idea of investing 60% of assets in equities with 40% in bonds held for many years, decades even. Over the past 10 to 15 years, these pioneers and early adopters moved away from this 60/40 formula. One reason to invest in alternatives 10 to 15 years ago was to diversify the allocation to equities as valuations were historically high and prospective returns, therefore, low. Now, the same is true for bonds. Bond valuations are currently stretched and it is the same investors who are currently diversifying their bond allocations with allocations into alternative investments. The most important take-away is that these investors are motivated by considerations related to portfolio risk.


Tail risk, Murphy’s Law and running a casino “A safe investment is an investment whose dangers are not at that moment apparent.” — Lord Bauer (1915-2002), Austria-Hungary-born economic adviser to Margaret Thatcher


Occasionally, alternative investments are bad- mouthed as having tail risk with their return distributions, colloquially referred to as having “fat tails.” The stigmatization, for example, of hedge funds having fat tails implies that other investments do not. Hedge funds, especially managers involved in arbitrage strategies, are “picking up nickels in front of a steamroller,” it is often argued. This line of argument is nonsense for two reasons. First, the normal distribution has no meaning in the real world of social phenomena, in general, and investment management in particular. A weekly loss of, say, 4% can be a one standard deviation event for a long-only manager but a four standard deviation event for a hedge fund. Second, all investments have fat tails. You never know. Fat tails are not a distinguishing factor of alternative investments compared to other investments. Many bond markets ceased to function during 2008. In the previous decade, equities lost 50% twice. Hedge funds, by comparison, “only” lost 20% once.


Accidents happen and sometimes Murphy’s Law applies A long period of no accidents can lead to a false sense of safety, complacency, and an underestimation and under-appreciation of risk. This is true in life in general — both business life and investment life. Things just always can go wrong. In addition, sometimes Murphy’s Law applies. Sometimes it happens that you have a weak economy and are hit by an earthquake and by a tsunami and have a nuclear disaster all at the same time, as was the case in Japan in March 2011. Accidents happen and sometimes Murphy’s Law does indeed apply. Being risk-ignorant is perhaps the most risky, least conservative investment approach of all.


“We are not a casino.” — Institutional investor around 2000, Ludgate Communications, March 2000


Around the year 2000, an institutional investor was quoted saying: “No, we don’t [currently invest in hedge funds]! It is completely obvious that hedge funds don’t work. We are not a casino.” Hedge funds are still often portrayed as speculators, or worse, as gamblers. However, we argue that hedge funds resemble more the entrepreneur running a casino than the gambler losing money to the casino. Running a casino or a lottery is a very attractive business. We could call it “statistical arbitrage.”


For instance, in roulette the casino collects all the money on the table when the ball stops at zero. If the wheel has 36 numbers and one zero, the casino wins on average with every 37th spin of the wheel. There is no need to win with every spin of the wheel. The odds are in favour of the house.


“People think I’m a gambler. I’ve never gambled in my life. To me, a gambler is someone who plays slot machines. I prefer to own slot machines.” — Donald Trump


The more a business generates its revenues from a predictable source, the better. To understand why a lottery has stable cash flows that are sustainable over time and, therefore, are predictable, we need to understand the “investment case.” The reason lotteries and casinos work is because there are so many fools. (Some research suggests that the gambler is not a fool but has a utility function that is non-monetary or has an extremely asymmetric utility towards large gains that makes it “rational” to “invest.”) The expected return is — in monetary terms — negative for the gambler, but positive for the operator, i.e., the statistical arbitrageur. It is more attractive to invest with the operator of such a game, rather than with the gambler.


Running a lottery operation is a licence to print money The reason why the cash flows are sustainable is because the world is not going to run out of fools any time soon. Neither will the buyers smarten up as they already (presumably) know that their purchase is uneconomical from a probability- weighted expected return (rational expectations) point of view. Given that the entrepreneur’s returns are stable and sustainable, they are fairly predictable (especially in the absence of competition). A licence to run a lottery is a licence to print money. Note that we have ignored social/ethical considerations while discussing lotteries and casinos. Lotteries and casinos are potentially government-controlled to mitigate cash flowing from a loser (the gambler) to a winner (the operator). Given that active asset management is often perceived as being a zero- sum-game, a transfer of cash flow from losers to winners, active asset management could one day be “government-controlled” too.


Speculative techniques for conservative ends The misconception that hedge funds are speculative comes from the myopic conclusion that an investor using speculative instruments must automatically be running speculative portfolios. One of the aims of this article is to challenge this misconception. Many hedge funds use “speculative financial instruments” or “speculative techniques” to manage conservative portfolios. Popular belief is that an investor using options, for example, must be a speculator. The reason why this is a misconception is that the “speculative instrument” is often used as a hedge; that is, as a position offsetting other risks. The incentive to use such an instrument or technique (for example, selling stock short) is to reduce portfolio risk: not to increase it. This is the reason why most absolute return managers regard themselves as more conservative than their relative return brethren.


It was Alfred Jones who popularized this idea in the 1950s by merging two speculative tools: short sales and leverage. Jones used leverage to obtain profits, but employed short selling through baskets of stocks to control risk. Jones’s model was derived from the premise that performance depends more on stock selection than market direction. He believed that during a rising market, good stock selection will identify stocks that rise more than the market, while good short stock selection will identify stocks that rise less than the market. However, in a declining market, good long selections will fall less than the market, and good short stock selections will fall more than the market, yielding a net profit in all markets. To those investors who regarded short selling with suspicion, Jones would simply say that he is using “speculative techniques for conservative ends.”


15


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