Trimming the Hedges

 When Brevan Howard Asset Management LLP announced the closure of one of its funds last week, it crystallized a reality that has been lurking in the minds of investors and asset allocators for many years.  With around $40 billion in assets under management, Alan Howard’s 2002 foray into hedge fund management has been struggling mightily against a perplexing and unfavorable set of market conditions.  Unlike the hedge fund busts in the late 60s and early 70s, this one is somewhat more disconcerting based largely on the fact that what was supposed to be a pathway to downside market risk management is, itself becoming too great a risk in its own right.  And Brevan Howard is in good, albeit unfortunate, company with managers like Bridgewater Associates, Man Group and Och-Ziff who are all finding it more difficult to manage market complexity.  In a recent interview with CNBC, Luke Ellis, President of Man Group stated that, “The backdrop is more of the same and computers are much better at putting up with more of the same.  Humans always want to call a change in the markets.”

This underhanded compliment to people who didn’t flunk out of math and computer science on the one hand is a long overdue shout out to smart guys.  Well done there!  But whether you take the approach of shuttering a fund like Brevan Howard or turning more investment decisions over to “machines” and algorithms like Man and Bridgewater, there’s a rather ominous implication in what’s become a bloated market choking on correlated assumptions.  Hedge funds, like every other part of the market ecosystem, played a role in the formation of considerable paper wealth – mostly for those who had a lot to start with or got there with the generous fees and commissions they collected during the heady years.  There’s no question that the over $2 trillion of assets committed to these funds, if they were actually deployed per investor expectations, could still be an important part of a healthy investment environment.  However, the aforementioned foreboding is what the Ellis quote suggests about the market direction.

I’ve had the fortune of counting among my valued clients and partners some amazing luminaries in the hedge fund and quantitative trading environment.  I’ve had the dubious privilege of meeting with far more.  And far and away the consensus that I’ve seen is a dearth of appetite to learn and understand the macro conditions that are violating the assumptions upon which hedge fund logic, math, and methodologies were built.  Whether its long/short equities, credit arbitrage, distress, fixed income, or macro, the problem is that when everyone looks at the same data through the same lens polished by the same expertise at the same few credentialed great former performers, the susceptibility for consensus performance suffocation is inevitable and catastrophic.  And having mathematicians, physicists and computer scientists add precision and velocity to consensus-informed human logic patterns is a short-term (and dangerous) fix.  While the speed-of-light decision making algorithms enriched the select few who got into “black box” algorithm funds when things were going well, their undoing has been quiet albeit painful.  And, since the demise of these frothy return engines has been largely known only to those intimately involved in the funds, behemoth managers are following into the abyss their bloodied pioneers like saber tooth tigers trying to catch mammoths in the La Brea Tar Pits.  (Yes, for those of you who track my metaphors, this is one of the best lately!  Look up the exhibits at the La Brea Tar Pits and check out the Ice Age fossils!).

What we need in today’s crazy markets is NOT machines to take what we do and do it faster.  We do NOT need to remove the human from the investment decision.  We gain NOTHING by exterminating those who are experiencing markets from which the wise will learn valuable lessons.  Rather, what we need is the recognition that the current market unease is proportional to the dearth of human inquisitiveness that rewards uncorrelated, non-conforming hypotheses and data.  China data and Black Friday sales are NOT a surprise.  Any expert who wrings their hands with the “who would have seen that coming” defense to being steamrolled by the market is merely admitting to their own sloth (get it, another fossil pun) and conformity.  And while it may not be a deadly sin anymore, sloth still should enjoy no quarter among fiduciary managers.  Bottom line – don’t trim hedges by pulling out the roots.  Don’t replace them with algorithms that will be subject to the illusion disguised as “Moore’s Law” only more volatile and shorter in utility.  Re-engage the love of inquiry – the intrepid capacity to question and learn – and you may get a windbreak to shield you from the coming storms!

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