Tuesday, August 24, 2010

Some thoughts on the Druckenmiller exit

There is a great article over at CNN Money about the implications of the Druckenmiller exit for the hedge fund industry:

From our skunk-works of chaos theory here at Hedgeye in New Haven, CT, here are some deep simplicities associated with hedge funds that manage to consistently drive absolute returns across bull and bear markets:

1) Hedge funds that consistently find alpha in their idea generation.
2) Hedge funds that maximize that alpha (spreading their wings) when they find it.
3) Hedge funds that truly hedge
In other words, Druckenmiller truly had alpha. Many other hedge funds are just levered beta players, e.g. a levered long-short in emerging markets does not give you much alpha, it's mostly an emerging market beta.

Quants are dying
We can see a similar alpha effect with quant funds. Equity quant funds, which were incredibly innovative back in the 1980s (!), are now in a crowded trade. The cost of entry to being a quant has fallen dramatically over the decades. Everyone went to the same schools and learned the same techniques and they all use the same databases. What's more, I can now create a relatively primitive quantitative equity research platform using free internet resources.

Is it any wonder when the results are similar? Were the events of August 2007 enough of a warning?

Looking for "reasoned" queasy investments
Consumers of alpha have to realize that true alpha requires innovation and some maverick thinking. This means investment approaches that:
  1. Make sense, i.e. have some economic basis
  2. Untried, or largely untried
In particular, (2) means that the investment theme or process might make you uncomfortable, or even queasy, because you are so far away from the consensus. Here are a couple of "old" invesment approaches that deserve a second look in the current environment:
  • Stock picking with a long-term perspective: One of the secrets of Warren Buffett's success was that he wanted to own the whole company. While we all aspire to his track record, the Buffett approach also meant a significant degree of 1) tracking error risk; and 2) short and intermediate term drawdown risk. These kinds of risks make institutional investors and their managers uneasy, (dare I say "queasy"?) Maybe it's time to return to those basics.
  • Dynamic or tactical asset allocation: I believe that this is another oldie but goodie. Investors have it hammered in their heads that market timing doesn't work and this approach can also be termed "uncomfortable" for investors. Managers who practice this art are practically extinct these days. In an era of macroeconomic uncertainty, however, these kinds of top-down macro techniques can yield a surprising level of alpha, according to research from First Quadrant. I am biased, of course, as my Inflation-Deflation Timer model belongs in this class.

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