This post originally appeared on the Bronte Capital blog, run by Sydney fund manager John Hempton. More details below.
I run a hedge fund which means I am meant to hedge risk. However if you hedge away all your risk you hedge away all your returns.
So you have in your head (or computer) some model of how the world works and what things should be correlated and what should not and you make your bets accordingly.
If your model is good and your position (stock) picking is good you should outperform some market (maybe a 40% bonds, 60% equity portfolio) at lower risk than the above portfolio.
But alas the hedges are necessarily imperfect hedges. [Perfectly hedged portfolios make cash returns – which at the moment is zero before fees…]
And with imperfect hedges sometimes the hedges don’t work.
It doesn’t matter how famous you are or how clever you are – you still have to deal with the time when your hedges don’t work. It happens to all of us. [Truly – if you find a hedge fund manager who says they have never had “model failure” then find another fund manager.]
Its in this context (and noting his massive returns last year) that I remind my readers of a Bloomberg news interview with Tepper less than two months ago.
In this interview Tepper restates his case for equity markets being cheap enough and cheap compared to (say) bonds. I don’t think it is a bad case – I don’t think large caps are expensive. But they are more expensive than a few years ago. [See previous Bronte comments on the state of the market here and here.] [For the record I think there is a bubble in biotech and non-telecom stocks that are purchased primarily for their dividends and English language small caps that are not financial institutions.]
The real action in the above interview happens about four and half minutes in where Tepper outlines his short case for bonds. He is not short them because he thinks that there will be inflation (in fact he doesn’t think there will be). Rather he is short them as a hedge against the consequence of the Federal Reserve trying to exit QE policies.
Bluntly that hedge did not work this week and particularly on Friday.
Equity markets had their worst day in yonks. The airlines (Tepper’s biggest position) were not exactly good either (as they were typically off over 4 percent – double the market).
Bond markets however had a very good day. Long bond indices rose several percent in value.
In other words Tepper was long the bad stuff, short the good stuff and the short was meant to be his hedge.
His hedge did not work. Badly. I suspect he was down more than 4 percent on the day – maybe double the equity market.
As I said every single decent manager will have days when the hedge does not work. There is no implied criticism of Tepper here. [I watched that interview because I admire him…]
And I doubt his clients would be worried either. I have never watched Appaloosa pitch to clients but I suspect the risks are accurately described and I suspect David Tepper would say to his clients that if they cannot handle a low-single-digit down day or two they should not be clients. [I know Bronte would want to dissuade such people from being clients…]
But I also know what David Tepper is feeling. At Bronte we also had the worst day in our history (although it was not as bad as I think David Tepper’s day was).
First you feel a little beaten up. But at some stage you need to (seriously) examine the possibility you are wrong. And at that point the emotion turns to self-loathing. It is surprising but many of the best asset managers I know really hate themselves. It’s an occupational hazard – and indeed may be a pre-requisite to being really good at this game.
That said, self-loathing is not a very productive emotion. You shouldn’t just stand there like a deer blinded by headlights.
The thought pattern (and this thought pattern can be ex-ante programmed into a computer if you want) has to turn to risk management – how do we behave if we continue to be wrong? At what point should we pull-the-plug and accept that we just don’t get it.
The purpose of this blog post is to explore what to do with the portfolio when the hedge is not working. That is a discussion we are having at Bronte because this week it has not been working (although not in a very serious way). And I have written this from the perspective of a stock-picking long-short equity manager. [The discussion has the same intellectual components from the perspective of a computer driven trading shop – but I can’t speak to the specific detail.]
Bronte’s portfolio positioning
Because I don’t want to give away all the tricks of the trade I am going to describe Bronte’s portfolio in an idealized position. [Day-to-day situations vary.]
We have a long book which is mostly large cap like Verizon (although includes a few disclosed mid-caps like Herbalife) which should have a beta of roughly 1. On a day-to-day basis Herbalife is our highest beta stock.
We have a short book which is full of the widest and wildest range of scum, villainy, stock promotes and general nonsense we can find. The typical short position is a biotech scam stock or something like that. Some of these are very high beta indeed and the short book has a beta of about 2.
We may typically be 130 percent long, 50 percent short – but beta-adjusted we are only a net 30-40 percent long. Day to day movements usually reflect this. On a day when the market is up 1% we are typically only up 0.3-0.4 percent. When the market goes down a percent we typically go down a similar amount. To keep the maths simple I presume an ex-ante portfolio beta of 0.4 for the rest of the discussion.
As we have been right a fair bit of the time in our specific stock picks we have accumulated returns that are way better than equity market returns even though we believe we have been taking less than equity market risks.
This week however our performance has been bad. We have tracked down roughly 150 percent of equity market returns. Friday was – as I said – the worst day in our history – but the loss was only 150 percent of equity market returns…
But whilst Friday was the worst day in our history this month has not been the worst month in our history. We have only had one month where the model looked truly broken – and that was January 2012. We wrote it up at length for our clients. In that month we went down roughly 6 percent when the markets went up roughly 5 percent.
As our day-to-day beta is roughly 0.4 we should have been up roughly 2% in a 5% up market. Our 6 percent loss was about 8% of under performance – by far the worst month we have ever had.
In January 2012 we got both ends of our portfolio wrong. Some of our longs went down in a good market. Our shorts ripped up in our face. The letter we wrote at the time noted the largish losses we were taking on Google. [Google was one of our biggest positions and it fell from $660 to $580 or so that month. As discussed in the letter we purchased a tiny amount more…]
However Google wasn’t where the action was. Our shorts ripped up in that month – some costing us more than 30 percent. Ex-ante we estimated their beta wrong.
Lets model how this looks.
Our ex-ante position was
Total position 180 – ie gross leverage of 1.8 times.
At the end of the month our longs had gone up say 2 percent (substantially less than market).
Our shorts had gone up 18 percent (substantially more than market).
Our position would thus be:
adding up to 191.6
However we have had losses – on these numbers adding up to 6.4 percent. Our capital has decreased from 100 to 93.6.
Our gross leverage has thus increased to 191.6/93.6 – or roughly 205 percent.
This is kind of shocking – we had 6.4 percent of losses but our gross leverage increased by 25 percentage points.
This is a real hedge isn’t working situation. We had no choice but to cut positions – and we cut them fairly aggressively. We would have loved to add more Google into that slide – we really would have loved it. But we couldn’t. We were forced to cut positions – and could only add more Google because we chose to cut other positions.
Now let’s compare this to this week. Our shorts have been going down – but our longs have been going down far more. (Witness Herbalife’s big decline and Herbalife is not our only bad stock this week.)
Our aggregate position size has been shrinking more or less in line with our capital. We are not becoming dramatically more leveraged. And because we are not becoming dramatically more leveraged we can sit it out.
David Tepper’s leverage probably* won’t have changed by more than a couple of percent either. He can sit it out too.
And so we can examine (and will examine) individual positions but the market hasn’t pointed a gun at our head and forced us to take off positions. Inaction is thus an acceptable policy.
So I can just go back to self-loathing then. I guess David Tepper can do the same (but I suspect he hides it better than me…)
*I am not privy to Tepper’s aggregate positioning. All I know is from the above interview – hence the word “probably”.
This post originally appeared at Bronte Capital. Republished with permission.
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