Don't Be Long and Wrong

Active Investing: Managing Risk

Don't Be Long and Wrong

David Serchuk
Thursday, April 30, 2009EmailIMBookmarkdel.icio.usDigg

Think like an institutional investor in order to avoid being either all long securities or all in cash.

Recently we laid out strategies for better ways to buy and hold securities, the idea being that even though the markets have taken a pounding over the past year, you don't have to lose your shirt should you stay long.

Now, however, we are showing the other side of the argument, which is how to avoid being long and wrong. The idea being that while buying and holding--or conversely moving to cash--may be good strategies for some, markets investors should realize that there are other ways to manage portfolios. Just as it can be a mistake to trade in and out of positions as the wind changes, it can also be a mistake to feel that during tough times, you either have to stay long, or move all your assets into savings.

But how to do it? Here is where the Forbes Investor Team steps in. Stephen Roseman, the head of hedge fund Thesis Capital, says that investors should look to have some kind of diversity among their assets. During a downturn, or at least during this most recent downturn, the correlation between all asset classes becomes especially strong, so you want to get out of this trap. The key for individual investors is to try and take a page from institutional investors, who have a large arsenal of tools at their disposal.

Individual investors can follow this model by employing asset managers with a more institutional focus, who look for opportunities in more sophisticated areas including merger arbitrage, statistical arbitrage and venture capital. These would be hard areas for the average investor to tap into, so it's best to seek professional help in order to invest here. Roseman says he expects to see more asset managers offer this type of guidance in the coming quarters.

In total, Roseman recommends investors have between 10% and 30% of their portfolio in something other than long stocks or bonds. Often homeowners already have this base covered in the form of real estate.

Ken Shubin Stein, of hedge fund Spencer Capital Management, adds that a basic but under-appreciated way to lessen the impact of being long and wrong is simply to pay off outstanding debt. Combine that with living beneath one's means, and it can give individuals the emotional fortitude to stick to an investment plan through volatile times. This is key because investors are prone to abandoning their rationally hatched investment plans during turbulent times--not because the plan is failing, but because the investor panics. They pay for this fear when markets rebound, and they miss the upswing.

John Osbon, the head of Osbon Capital Management, makes his living by investing primarily in indexes and exchange-traded funds. He says a diverse portfolio of ETFs can help protect investors through times good and bad. He also says that even though U.S. equity markets have been not done well in the past 10 years, other markets like Latin America have.

One way to play this diversity is through the iShares S&P Latin America 40 Index Fund ETF (ILF). This ETF tracks firms in Mexico, Brazil, Argentina and Brazil. Over the past decade it's up 240.1%, although its down 50.0% over the past 12 months.

One intriguing play noted by Osbon is the new IQ Hedge Multi-Strategy Tracker ETF (QAI), an ETF that seeks to mirror the performance of hedge funds. This is an exciting investment because hedge funds represent a potentially lucrative yet dangerous place to invest. On the one hand, hedge funds have shown strong recent performance as the markets have stumbled, and through mid-March they were down 1.1% versus 18.2% for the S&P Total Return Index.

On the other hand, hedge funds have onerous expenses, are lightly regulated, require large investments and can go out of business. So owning a hedge fund index allows you to tap into an exotic world with few of the obvious downsides. Having said that, the ETF has only been in existence for less than a month, so you might want to wait a little while to see how it actually does before taking a step in.

Diversify Like A Pro

Forbes: What are some ways that traditionally long-only individual investors can use the strategies employed by places like, ahem, hedge funds to diversify their risk, and lower their correlations between stocks and bonds? Stephen laid out a few, what do you think? What can individual investors be expected to reasonably crib from more sophisticated players to diversify?

Stephen Roseman: The biggest impediment that the individual investor has faced is an inability to be anything other than "long and wrong." What I mean by that is that the individual investor has historically had two choices: 1) to be long stocks and bonds, or 2) to make a market call and move their assets into cash. Of course, many individual investors are also diversified in the form of some real estate holding, typically a primary residence.

Institutional investors often have a much more "complete" view of the world. They position their assets across disparate and typically less correlated asset classes and strategies. So while they may have exposure to stocks and bonds through traditional asset managers who are long-only, they also have exposure to less correlated strategies like activism, merger arbitrage, statistical arbitrage, convertible arbitrage, short-biased, private equity, venture capital, real estate, etc. They also tend to give some thought to geographic exposure and investment duration.

In the coming quarters, you will see more asset management companies offer institutional-type products, with the aforementioned strategies, to the retail investor. Retail investors, and their advisers, will come to realize the benefit of diversifying away from long-only strategies. While this won't necessarily be a panacea for a world in which correlations all converge toward "one" as they did over the course of the last 18 months, these products will help investors mute portfolio volatility and contribute to more consistent returns.

Ken Shubin Stein: I agree with Stephen, but to date, the market does not yet offer good alternatives for individual investors.

Another risk for individuals is their view on volatility, risk and investment time horizons. The psychology that makes people chase returns is deeply rooted and probably impossible to change on a population basis. This leads to abandonment of sound strategies during inevitable periods of disappointing returns and is why the average investor earns returns well below the average mutual fund returns.

One alternative is for people to seek out expert help from financial planners and wealth managers, and follow a disciplined plan. This should include managing their liabilities as well as their assets.

Roseman: While, in theory, individual investors can, on their own, emulate some of the strategies that hedge funds use, in practice, it would be very difficult if not impossible. This is because of a smaller asset base, access to the tools needed to execute some of these strategies and ability to focus on strategies that are not well understood.

Even most institutional investors (pensions, endowments and the like) allocate out to specialists in their respective areas of expertise and don't try to emulate the myriad approaches on their own.

The average investor will be better served by seeking out fund managers that employ some of these strategies in an open-end fund format (i.e., a mutual fund). The typical investor can achieve the benefit of meaningful diversification by having some percentage of their assets, probably between 10% and 30%, in something other than long stocks and long bonds.

Of course, it also bears mentioning that most institutional allocators use little to no leverage, or borrowed money, in their own portfolios (although those they allocate to may). The individual investor can emulate that portion of the institutional approach by paying down any outstanding debt. This is especially true of high-cost debt like credit cards, which really undermines good financial planning on the portfolio side.

Shubin Stein: Exactly. I think it is under-appreciated that paying down debt and generally living below one's means allows investors to have the emotional strength to stick to a plan, even during periods of extreme volatility.

John Osbon: It is a nicely flung gauntlet, so let's examine it ... Let me begin by asking Stephen two questions, and then I will weigh in:

1. Which institutional investor do you admire, or think has done a good job, who you would like to see manage money for individuals?

2. What's your after-tax return on such a strategy?

Obviously, I have loaded the questions in my favor because I respectfully and resolutely believe the institutional route is the wrong way for individuals. "Completeness" does not seemed to have redeemed even the shrewdest professional investors, such as Harvard, Yale, et al., nor has it prevented the purveyors of knowledge, like Wall Street banks, from arranging their own funerals from the piles of research they produce.

Nor has non-correlation been a refuge because suddenly ... everything is correlated and heads straight down at the same time. When you most need it, correlation vanishes as quickly as your capital. In fact, Rich Bernstein, formerly of Merrill Lynch/Bank of America, showed how equity correlation is now over 80%, from 60% in the '80s, and that correlation in down markets approaches 95% for all asset classes. There is literally no place to hide. That's no wonder in an investment world dominated by shadow banking.

Lastly, taxes matter, and are likely to matter more the way our government is spending money. There is a big difference between agents of money (institutions) and owners of money (individuals), and that difference is the owners of money pay taxes on their investments, while institutions defer taxation forever. A pre-tax strategy may look quite attractive--and could belong in your IRA or 401(k)--but after-tax the return story is quite different when you have to give up 20% to 40% of the gain.

Stephen is mining a deep and rich lode with diversification, however, which is the one proven way investors can manage risk and return. As an indexer, we pick index materials via ETFs. But it is the architecture of the portfolio--the diversification of "glass, steel, wood and plastic" ETFs that dominates the risk and return. I would look at the whole building of one's portfolio, not just the components. Not all markets have done poorly in the last 10 years. High-quality fixed income has done extremely well, as has most of Latin America. China has positive returns, too, as you might expect.

You can index virtually anything these days via ETFs, even hedge funds with the new QAI, the IQ Hedge Multi-Strategy Tracker ETF. I am not necessarily recommending it, but it's there, and sub-strategies such as the ones Stephen mentions are also coming in ETF form.

I have to say that ETFs are superior to mutual funds for individuals in our view, because with an ETF you own your own basis, whereas with a mutual fund you own everyone else's tax bill.

Ken, what is your recommended debt-to-capital ratio for an individual? I suspect most people would be very interested to hear your notion applied to them personally.

Shubin Stein: I think it is difficult to have one ratio for all individuals. What may be conservative for someone with a very stable income source, say a dentist or doctor, may be aggressive for an artist or advertising executive or finance professional. A principle-based approach is easier to discuss--live life realizing that sudden, and sometimes severe, reversals can happen to any of us, and try to be as immunized to this risk as possible. For some, it means no debt, for others it may mean moderate levels.

The common mistake is to extrapolate near-term experience into the future. When times are good, lots of people assume the good times will last forever and behave accordingly, and when times are tough, like now, it is a challenge to realize that things will get better.

John, given how poorly diversification worked this year, have you changed your opinion on the importance of diversification, or do you think it is important but nothing works all the time?

Osbon: Your principles are widely applicable, and hopefully will be applied!

I do believe some numbers add insight, however. If you run your financial life like Me, Inc., and subject it to discipline and guidelines just like you would any company, your results, and your happiness, might improve. Think, for example, if you limited your total debt to no more than 50% of your capital--ever, including real estate, how much trouble could have been avoided. Likewise, limiting debt service to no more than 20% of cash flow would be a conservative, prudent limit to observe. In fact, these two limits would make Me, Inc. look quite attractive in today's environment. One would also be free to lower those limits with the passage to time so that by age 65, there would be zero debt and zero debt service.

Ken, just so I understand, why do you say diversification worked poorly? Treasuries of all types and stripes did fabulously last year. Are you referring to equities only?

Shubin Stein: Not just equities. Credit, real estate, hard assets of all types did poorly. The bubble in Treasuries did offset the pain in all other areas unless someone had a very large percentage of their assets in them.

Also, I agree some numbers are helpful. This why people need wealth managers! I would probably advise even lower ratios than the below, but that is just because I am very conservative.

Osbon: More clients should come to you!

I believe, and it can be shown, that the added value of non-correlated equities is approaching zero. Common sense explains why: globalization and the Internet. It is no exaggeration to say that almost any company, no matter how small, competes globally. Why? Because you can get it cheaper on the 'net, and your customers will buy it there unless you give them a reason not to, like service, reliability, quality, status or others.

The real non-correlation and its value as expressed in diversification, I believe, comes from truly equity-unalike assets--bonds, commodities, and real estate.

Roseman: In an attempt to speak to all of John's points I will touch on them in order.

I think any conversation needs to begin with the definition of investing "success." While Harvard, Yale et al. suffered declines in the value of their endowments, I would point out that they outperformed the respective underlying asset classes handily in an environment where, to your point, correlations were converging to one. I think it's also important to remember that one year does not a track record make, and these endowments have extraordinary long-term returns. That's a fact, not opinion. Most people are investing for some horizon that exceeds one year so, again, I think the conversation about success first needs to be framed by the definition of "success."

It probably also bears mentioning that we have just suffered the fastest and most catastrophic destruction of wealth since the Crash. This has been the 100 year flood.

As for ETFs, they are appropriate when and if they are used by individuals with the tools to divine how and where they should be positioned. Moreover, many of them suffer tracking errors. I am not suggesting they don't have a place in someone's portfolio, but the point of investing (in any asset class) is to do one's homework and carefully and judiciously allocate capital to the highest return opportunities. As it relates to investing successfully over the long term, an ETF is a shotgun approach to what I believe requires a scalpel.

As for which investors I admire, since many of my competitors are also friends of mine, I am going to refrain from naming names for fear of insulting anyone by omission.


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