Crowd-dead trades

“Free men cannot start a war, but once it is started, they can fight on in defeat. Herd men, followers of a leader, cannot do that, and so it is always the herd men who win battles and the free men who win wars.” – John Steinbeck.

“Welcome to the Great Falling,” writes Tony Jackson for The Financial Times in a plea, effectively, for contrarian investing (“The safest form of diversification is to avoid the herd”). But contrarian compared to what ? Stocks, bonds, oil, gold, property, private equity, hedge funds and infrastructure funds are all, to a greater or lesser extent, having difficulty generating any kind of positive returns this year. This would appear to make a mockery of the principles of diversification as identified and promoted by Nobel Laureate economist Harry Markowitz during the 1950s.

But appearances can be deceptive. While it is probably true that an environment of wholesale deleveraging, courtesy of the banking and credit crisis, accounts for much of this year’s losses across multiple asset classes, the headline figures – as always – disguise significant dispersion among investment returns within the same headline asset class. Take the UK stock market. You will have made money year-to-date if your portfolio comprises industrial engineers (c. + 13%) or the shares of oil equipment services businesses (c. + 6.5%), or pharmaceutical and biotechnology stocks (c. + 5%). You will have lost money, and lots of it, if your portfolio (or your fund manager’s) heavily comprises the shares of general retailers (c. – 33.5%), (somewhat bafflingly) fixed line telecoms (c. – 33%), or leisure goods companies (c. – 31.7%). Shares of banks, life insurers, media and travel and leisure companies have also been roundly battered. Given the widespread and increasingly visible problems surrounding the UK’s financial services infrastructure, its inability to extend credit, and the knock-on effects on consumer spending and the High Street, none of this year’s losing sectors from the UK stock market has exactly proven to be much of a surprise. The market’s current pangs were forecastable last year by any who had eyes to see. On the basis that current financial instability persists, investors would be well advised to concentrate on high conviction themes – value-added stock-picking, for want of a better phrase – or those that are primarily defensive. Simply allocating to “the market” – especially with the added fee burden of an actively managed but otherwise index-tracking fund – looks like a fast way to dissolve capital.

Or take hedge funds – an increasingly broad and unhomogenous church. You will have lost money from “the market” (as defined by the Credit Suisse / Tremont Hedge Fund Index) year-to-date, but will have made money from Dedicated Short Bias (hardly a surprise), up 15.3%, and also from Equity Market Neutral (c. + 3.7%), Global Macro (c. + 6.3%) and Managed Futures (c. + 10%). On the other hand, you will have lost money from strategies including Convertible Arbitrage (- 7.6%), Emerging Markets (- 6.3%), Fixed Income Arbitrage (- 4.5%) and Multi-Strategy (- 4.5%). But such sectoral coverage is difficult to achieve, and of dubious value to begin with. It will be more accurate to say, then, that your year-to-date returns from hedge funds will be largely dependent upon the quality of your underlying managers – and in this respect, nothing is different in 2008 from the years that have preceded it.

Oil and gold are worthy of special treatment, not least as tangible and non-financial assets. Notwithstanding the slow rise of alternative energies, oil will have economic utility at any price. Gold is probably better treated as currency than commodity – as well as the most perfect insurance against ongoing financial crisis that we have.

Which brings us to one positive response to Tony Jackson’s otherwise gloomy assessment of the financial landscape: advice to invest in quality and scarcity. There is no shortage of hedge funds, for example – but there is evidently a dearth of managers capable of living up to the promises implied by the label on the ‘absolute return’ tin. And it is in the somewhat opaque realm of hedge funds that the winners and losers of 2008 and 2009 are likely to be most polarised by returns, not to say ongoing survival. Cassandra cites David Goldman, former investment strategist at Asteri Capital, in an interview with Bloomberg’s Tom Keene: the majority of hedge fund performance (writes Cassandra) “will not be able to weather the volatility caused by the continuing deleveraging and the catastrophic blow-up of so-called crowded trades that this will cause..” The quantitative hedge fund implosion of August 2007, and the relatively limited fallout amongst alternative managers, was an early signal of what to expect on a larger scale, when multiple crowded trades – long and short across oil, financials, other commodities – get reversed in a hurry. Note that this does not necessarily invalidate the fundamental hedge fund proposition, only the relevance of traders (or fund of fund managers) who believe they can survive independently of the Wall Street mothership and whose flaky return profile lately is indicative of now unsustainable or inaccessible leverage passing itself off as alpha. As regards financial assets, that the markets have been uniformly poor throughout 2008 is not, of itself, a disaster – but it does represent a buying opportunity, at some stage, for financial assets (including stocks, bonds, property and infrastructure investments) at much cheaper levels than prevailed during the explosion of easy credit that hit what is likely to be acknowledged as a secular brick wall in the summer of last year.

The frustration articulated within the FT piece is no doubt widely shared. Tony Jackson hints that institutional investors may now be sufficiently active across international markets for correlation among those markets to be ‘baked in’. In equity terms, that is a conclusion difficult to avoid, at least in the short term. But the ubiquitously disappointing returns across asset classes this year cannot realistically be extrapolated indefinitely into the future. And herding among institutions – particularly those late to the diversification party – is also an opportunity for investors capable of being more fleet of foot. And an objective observer might wonder to what extent all sorts of institutional investors have become closet momentum traders over the past 12 months, simply buying what works for as long as it works. That points to the prospect of money being left on the table for investors with the emotional discipline (and less dependence on leverage) to pursue secular themes once the hot money has left the building. Not all investors’ time horizons are necessarily identical – which would make rapid-fire trading undertaken by pension managers, for example, even more indefensible.

One other logical response to Tony Jackson’s suggestion that asset class diversification isn’t working and is potentially both disappointing and positively dangerous, is to ask how dangerous asset class concentration might be. In bank stocks, say.


Originally published at The Price of Everything and reproduced here with the author’s permission.