Do Hedge Fund Managers Have Stock Picking Skills?

Via SSRN (paper by Wesley R Gray):

I study novel data from a confidential website where a select group of fundamentals-based hedge fund managers privately share investment ideas. These value investors are not easily defined: they exploit traditional tangible asset valuation discrepancies such as buying high book-to-market stocks, but spend more time analyzing intrinsic value, growth measures, and special situation investments. Evidence suggests that the managers’ long recommendations earn economic and statistically significant long-term abnormal returns. Oddly enough, these managers share their profitable ideas with other skilled investors. This evidence is puzzling in a world where there is an efficient market for fund managers and asset prices.

Read the paper here

Trust Behavior: The Essential Foundation of Securities Markets

H/T to Simoleon Sense:

Here’s the most important lesson from this paper (via ssrn):

“This suggests another fundamental difference between rational expectations investors and trusting investors. Where the former look to “the shadow of the future,” the latter care about “the shadow of the past.” Put differently, a rational expectations investor expects others to exploit her whenever possible. Accordingly she will always be forward-looking, trying, just as a chess player might, to anticipate other players’ opportunistic future moves. In contrast, trusting investors look to the past. If someone or something has always behaved in a particular way in the past, trusting investors assume that that person or thing will continue to behave similarly in the future, without worrying too much about understanding what drives the behavior in question.”

Click Here To Learn About The Role Of Trust In Securities Markets

Abstract (Via SSRN)
Evidence is accumulating that in making investment decisions, many investors do not employ a ‘rational expectations’ approach in which they anticipate others’ future behavior by analyzing their incentives and constraints. Rather, many investors rely on trust. Indeed, trust may be essential to a well-developed securities market. A growing empirical literature investigates why and when people trust, and this literature offers several useful lessons. In particular, most people seem surprisingly willing to trust other people, and even institutions like ‘the market,’ in novel situations. Trust behavior, however, is subject to history effects. When trust is not met by trustworthiness but instead is abused, trust tends to disappear. These lessons carry significant implications for our understanding of modern securities markets.

Great Introduction (Via SSRN)

Burt Ross graduated from Harvard University in 1965. After working several years as a stockbroker, he ran for and was elected mayor of Fort Lee, New Jersey. Then Ross turned to commercial real estate. In 2003, he decided to sell some of his buildings and invest the proceeds, which amounted to more than five million dollars. Ross thought he was prepared for retirement. At least, he thought he was prepared until December 11, 2008, when he learned that his nest egg–which he had invested almost entirely in funds managed by the now-infamous Ponzi schemer Bernard Madoff– was gone. (Pulliam, 2008)

Read the Paper Here

Overcoming Frustration in Trading

Via TraderFeed:

If I had to name one emotion that causes the greatest losses among active traders, it would be frustration. Overconfidence is certainly high on the list, but the market has a way of smacking sense into the heads of people who start feeling invulnerable. Frustration, on the other hand, leads traders to compound their errors by sticking to wrong opinions and overtrading markets that offer little opportunity. Overconfident traders will generally stop trading once they’re humbled; frustrated traders generate more frustration and trade larger, with more risk.

Read the full post here

Adapative Asset Allocation

Via Abnormal Returns:

One of the tenets of modern portfolio management most damaged due to the financial crisis has been asset allocation.  We have discussed how during a bear market correlations tend to one, the myth of the all-weather portfolio and how investors may need a more dynamic approach to asset allocation.  It seems we are not alone in our opinion(s).

Noted finance professor Andrew Lo of MIT has a piece in the Financial Times discussing how the practice of portfolio management has been upturned in part due to the financial crisis – asset allocation included.  While we recommend you read the entire piece, the bottom line is that the investment world is now much more complicated post-crisis.  Lo writes:

Diversification is still a good idea, but it has become much harder to achieve. Thanks to the increasing competition for additional yield, every type of investment vehicle and strategy has experienced substantial growth in assets under management.

The asset classes (and dynamic) strategies that have been touted as portfolio diversifiers have seen an influx of capital and managers.  Lo cites the case of the “carry trade” that has become popular enough to have spawned an ETF that follows the strategy.

Read the full post here

How to Turn a 100% Gain into a 1,400% Gain

Via Growth Stock Wire:

It never was my thinking that made big money for me. It was always my sitting. Got that? My sitting tight!” – Jesse Livermore

Jesse Livermore was one of the most respected traders of the 1920s. He built one of America’s largest fortunes at the time with his skills in the stock and commodity markets. The classic book Reminiscences of a Stock Operator contains his story.

“Sitting tight” was Livermore’s term for not selling when he was up 20%… 50%… or 100% on a position. Sitting tight is the art of not taking quick profits.

You see, most traders and investors get tempted to sell their winners after they see a modest profit… like, say, 33%. They get fidgety. They tell themselves that, “You can’t go broke taking a profit.” They always feel like they should be doing something, so they take action and jump out of the winning trade.

This strategy will kill your long-term trading performance.

…When you are right on a trade – whether it’s tech stocks, biotech stocks, oil, or gold – ride it for all it’s worth. Don’t cut your profits short. Don’t sell until you see a legitimate reason for concern… like a decline of more than 15%… or an asset’s refusal to rise on bullish news. One of the best ways to get rich in the stock market is to get in early on a big trend and ride it for years… You can’t ride a trend if you don’t sit tight.

Read the full article here

The Myth of the All-Weather Portfolio

Via Abnormal Returns:

For quite some time now financial advisers of all stripes have been in search of the elusive “all-weather portfolio.”  That is, an asset allocation that serves to protect investors in bad times (bear markets) and performs well in good times (bull markets).  Does an all-weather portfolio really exist?

Prior to the economic crisis many would have answered in the affirmative and would have pointed to the large university endowment funds as examples of investors who had achieved this goal.  However the aftermath of the credit crisis and ensuing bear market indicate these funds have failed to achieve this goal.

Maybe it isn’t that case that asset allocation models are broken.  It may simply be the case that we are asking too much of asset allocation as a discipline.  In what other investing endeavor do we expect to have the best of all possible worlds?

Read the full article here

Which Sectors Look the Best

David Rosenberg has an answer:

We ran screens looking at three variables:

• Equity sectors that have seen the least pronounced jump in price-earnings multiples (a sign of neglect).

• Equity sectors that have seen the most pronounced increase in earnings revisions in recent months (signs of improved fundamentals).

• Equity sectors that have the lowest analyst earnings growth estimates for 2010 (a low hurdle to jump across).

The envelope please …

…the winners would be consumer staples, health care and technology.

Note that these three sectors should also benefit from a weaker U.S. dollar (currency translation effect) given their relatively high share of foreign-derived revenues. We may not be bullish on the overall market, but it does not mean that investors should completely shun the space … there are specific opportunities out there.

What Is the Optimal Number of Managers In a Fund of Hedge Funds

Via SSRN: I came across an interesting academic paper from State University of New York (SUNY) professors Greg Gregoriou and Razvan Pascalau. Diversification is often the mantra of hedge fund investors, but this paper suggests that the optimal number of underlying hedge funds within a fund of hedge fund portfolio may actually be as low as 6-10.

From the Abstract:

This paper investigates the level and the determinants of the optimal number of hedge fund managers in a Fund of Hedge Funds (FOFs). The paper also analyzes the impact that this level has on the performance and the volatility of returns of the typical FOF. Several important findings emerge. First, we find that the number of underlying hedge funds (HFs) included into a FOF has a negative and significant impact on the volatility of returns but less of an impact on the actual returns. However, if we properly classify the FOFs into several larger categories of interest, we find evidence that the FOFs having between 6 and 10 hedge fund managers perform the best. On average this group of FOFs has assets under management of around $200 million. Second, further evidence shows that there is a positive relationship between the size of the FOF portfolio and the lifetime of the fund. Third, several factors that influence the number of HF managers into a FOF include, but are not limited to the amount of leverage, the redemption frequency, the size of the fund, the total number of assets managed by the FOF manager, whether the fund issues a K-1 schedule for tax purposes, the currency in which the fund trades, the geographical focus, and the strategy pursued.

From the Introduction:

Many institutional investors, having no experience in hedge fund manager selection are willing to pay the additional layer of fees of owning a pre-packaged and diversified FOFs rather than setting up an in-house FOF. The number of underlying hedge fund managers in a FOF can play a primordial role in its performance and its survival. We believe this is the first paper to our knowledge that examines the optimal number of underlying hedge fund managers in FOFs. Numerous papers have stated what the optimal number of hedge fund managers in FOFs should be, but none have used an actual dataset to examine this.

Read the paper here

Eight Mental Traps to Avoid

This is a great article by Paul Larson of Morningstar.com on how investing is as much an exercise in controlling emotions as harnessing the intellect. Mr. Larson covers eight emotions. I provide a summary here:

Anchoring
Anchoring is the act of latching on to a given piece of information and using that as a point of reference for making decisions. Unfortunately, many investors anchor on things that are irrelevant to a business’s value, such as their own personal cost basis in a given stock or the 52-week trading high. Rather, we should focus on the thing that matters the most, the estimated future cash flow of a company.

Availability Bias
This mental shortcut concerns the relative importance of information. The importance our minds attach to information is correlated to how often we see the information. If we see and think about something often, our brains attach greater importance to it.

Endowment Effect
People place a higher value on things that they already own than things they do not own. Meaning, we would sell our possessions at a much higher price than at which we would buy the very same possessions if we did not already own them.

Sunk Cost Aversion
Sunk costs are costs that cannot be recovered once incurred. Once something is paid for in either time or money, our instinct is that we must soldier on and get some benefit for the expense, lest we feel like we are wasting resources. This is a variation of loss aversion, which is a concept that says people feel the pain of a loss at double the magnitude they feel the pleasure of a gain of the same amount. Two tips here. First, if a stock is clearly worth far less than what we originally paid for it, we should be willing to sell if today’s price is above our estimate of current value; that we are realizing a loss should be irrelevant to the decision. Second, if we spend several hours to research a given opportunity, we should still be willing to walk away. Our instinct will be to like the opportunity since we just spent time on it, but our goal should be to have rationality outweigh instinct.

Herd Behavior
Our deepest instincts tell us that there is safety in numbers. Beyond having a desire to do what is perceived to be socially acceptable, we often believe others have useful information from which we can take cues. After all, we all like to be liked, and the bigger group may know something we don’t. Simply, if “everybody’s doing it,” we feel the pressure to take that same action, whatever it may be. Plus, with investing being an activity where having incomplete information is the norm, this instinct to take cues from others can be amplified.

Recency Bias
We live in the here and now, and the ability to contemplate things far in the past and/or future is a uniquely human ability that requires higher cognitive functions. Yet our instincts can still get the better of us on occasion. Recency is the tendency to weigh recent events much more heavily into our decision-making than more distant events. It is a sort of mental short-sightedness where we think much more about our current situation than the much broader historical perspective. This can cause us to assume that the current state of the world–good or bad–persists into the future, rather than reverting to a long-run mean.

Confirmation Bias
Our brains inherently do not like conflict; they prefer to have a consistent, harmonious view of the world. They are wired to avoid cognitive dissonance–having two different ideas that are incompatible with each other. Our instinct is to search out information that confirms our existing views, accepting data that plug neatly into our preconceived biases, while rejecting data that do not support what we already think. Information that is consistent is processed more easily and does not increase stress.

Overconfidence
It’s an unfortunate fact that people tend to believe that their skill level is much higher than what it is in reality. For instance, the vast majority of drivers believe their driving ability is above average, even though this is statistically impossible. Unfortunately, Lake Wobegon is but fiction, and there is not a place where “all the women are strong, all the men are good-looking, and all the children are above average.”

This positive illusion we carry about ourselves allows us to be, as the famous book is titled, “Fooled by Randomness,” and attribute positive outcomes to our personal skills rather than luck or a trend over which we really had no control. Overconfidence can help us get through the stresses of our lives, but it can be deadly in the world of finance by causing one to overplay his or her hand.

Read the full article to learn more about each emotion

Related: Why Smart People Make Big Money Mistakes And How To Correct Them: Lessons From The New Science Of Behavioral Economics

You Can’t Handle the Truth About Stocks

CNNMoney.com interviews Boston University School of Management professor Zvi Bodie. I do not totally agree with Mr. Bodie, but he does have some interesting points. Here are some highlights:

The advice rolls off the tongues of financial planners and appears frequently in the pages of financial magazines such as Money: To have any shot at retiring well, you need to invest a good portion of your money in stocks.

But mention this to Boston University School of Management professor Zvi Bodie, author of “Worry-Free Investing,” and you’ll get a stern reminder of how equities often betray investors. And you’ll get an earful about how millions of us are taking too much risk with our nest eggs.

……….

But don’t you need the growth that stocks provide to combat the risk of inflation?

Inflation is exactly what Treasury Inflation-Protected Securities (TIPS) and I bonds were created to protect against. Even if equities did perform well in periods of inflation, you’re exposing yourself to an even greater risk of a stock market decline. And as it turns out, anytime there’s been significant inflation, equities have been a terrible investment. Just look at the 1970s.

So you’d tell an investor to have 100% of his retirement money in TIPS?

Yes. In fact, I have 100% of my own retirement money in TIPS. I do have a small account of nonretirement funds in which I invest in bonds, options, and stocks.

Currently, long-term TIPS earn just 2% after inflation. How is anyone going to be able to retire on so little growth?

If you look at most online retirement calculators, they make two assumptions: one, that you want to retire at age 65, and two, that people will be able to save only a certain amount — say 10%. As a result, they spit out risky portfolios to get a higher return. Well, who says we all want to retire at 65 and can save only 10%? What if I retire at 70 or 75? What if I save 30%? Suddenly, you don’t need to take so much risk in your portfolio. Now, if you put 100% in TIPS, you will have to save upwards of 20% of your annual pay, even if you’re young, to retire at age 65. But I think it would be more reasonable to expect to retire at a later date.

Read the full interview here