BEIJING - China Investment Corp (CIC), the country's long-awaited gigantic state investment arm set up to make use of its huge and ever-growing foreign exchange reserve for overseas investment, was inaugurated over the weekend.
The CIC, with a registered capital of US$200 billion, is a solely state-owned company, according to company sources. The state-owned Central Huijin Investment Corporation was merged into the new company as a wholly-owned subsidiary company, the sources said.
In May, the new company, while still in preparation, made its first investment in non-voting shares, valued at US$3 billion, in the US private equity firm, the Blackstone Group.
The Ministry of Finance (MOF) will keep pouring foreign exchange into the new company following issuances of special treasury bonds, according to company sources. China's legislature approved the special issuance of 1.55 trillion yuan in treasury bonds (US$200 billion) for the new investment company in June.
So far, the MOF has issued more than 700 billion yuan in special treasury bonds, with 600 billion yuan to the central bank and 100 billion yuan targeting the general public. It will issue another 100 billion yuan in treasury bonds by the end of this year.
"We will maintain transparency of company operations on the premise of safeguarding our commercial interests," said Lou Jiwei, the company's newly-appointed board chairman, who is also deputy secretary general of the State Council, or the cabinet. Lou called the CIC a "landmark in deepening the reforms of China's financial system".
Other board members include two executive directors Gao Xiqing and Zhang Hongli; five non-executive directors - Zhang Xiaoqiang, Li Yong, Fu Ziying, Liu Shiyu and Hu Xiaolian; two independent directors Liu Zhongli and Wang Chunzheng; and one director who will be elected from the company's employees.
Gao Xiqing is now vice chairman of the National Council for the Social Security Fund. Zhang Hongli and Li Yong are vice ministers of finance. Zhang Xiaoqiang and Wang Chunzheng are vice ministers of the National Development and Reform Commission (NDRC), the nation's top economic planner. Fu Ziying is assistant to minister of commerce. Liu Shiyu is a central bank vice governor, Hu Xiaolian head of the State Administration of Foreign Exchange and Liu Zhongli was former finance minister.
Gao Xiqing was also appointed the company's general manager and Zhang Hongli, Yang Qingwei, Xie Ping and Wang Jianxi were appointed as deputy general managers.
Yang Qingwei is currently department head of fixed assets investment with the NDRC. Xie Ping is now the general manager of the Central Huijin Investment Corporation and Wang Jianxi a vice board chairman of the Central Huijin.
Hu Huaibang, Commissioner of Discipline Inspection with the China Banking Regulatory Commission, took the post as chief supervisor.
Analysts said CIC's debut was a major move China had made to increase the value of its $1.4-trillion foreign exchange reserve, the world's largest.
The company will mainly pursue combined investments in overseas financial markets, and it will also take over existing businesses of the Central Huijin, which has injected capital into domestic financial institutions to support their reforms, such as shareholding reforms of China's state-owned banks, said the sources.
The CIC will operate in a completely commercial way despite its governmental backup, the sources stressed, explaining that "it will deal with its forex investment business independently by persisting in the principle of separating government functions from company management".
It will try to maximize the proceeds via long-term investments within a range of acceptable risks, the sources said.
"As a state investment institution, the company will work to ease the pressure of rising foreign exchange reserve and absorb market liquidity," said Li Yang, director of the finance research institute of the Chinese Academy of Social Sciences.
"The company's principal purpose is to make profits," said Yang. "The appointments will favor a good outcome as most of the incumbent executives are experienced investment professionals and policy makers. The company would help China realize its resource allocation on a global scale and reduce the economy's reliance on exports.
The same views were echoed by Zhuang Jian, a senior economist of the Asian Development Bank's China resident mission. He said China's central bank would be able to shake off some hedging pressures through buying forex with returns from special treasury bonds.
China's exports rose by 27.6% in the first half of 2007, exceeding imports growth of 18.2%, lifting the trade surplus to $112.5 billion.
(Asia Pulse/Xinhua)
Tuesday, October 2, 2007
No such thing as a Sure Thing
By Julian Delasantellis
In the 1955 movie musical Guys and Dolls, romantic rogue Nicely Nicely Johnson , (Stubby Kaye) sings the eternal tale of the inveterate gambler, the siren song of hope over experience, the ever illusory dream that at long last one has discovered The Sure Thing, in the famous Fugue for Tinhorns:
"I got the horse right here, the name is Paul Revere.
And here's a guy that says that the weather's clear
Can do, can do, this guy says the horse can do
If he says the horse can do, can do, can do."
As we are able to put some distance between our current time and the worldwide market histrionics of August, and as CNBC's Jim Cramer's apparently much stronger sedatives kick in, we are beginning to learn that, in many ways, a lot of the crisis was brought about by large market participants thinking in ways very much reminiscent of Nicely Nicely Johnson, people who thought that they had discovered A Sure Thing.
In the circles that Nicely Nicely Johnson traveled in, if you bet a lot of money and lose, you are most likely to get your legs broken by that market's existent self-regulating authorities. For the gamblers of August, that won't happen; most will still have ambulatory capacity sufficient to hit the ski slopes at Gstaad in the upcoming months. What did get broken was the market itself, along with, if they were unfortunate enough to get a margin call at the height of the selling that forced them to bail out of losing positions, the hopes and dreams of countless numbers of small- and medium-sized investors who only after that financially shattering experience would they realize just how fixed against them the investing crap game they were playing really was.
There probably are no more slide rules at the campus offices of the Sloan School of Management at the Massachusetts Institute of Technology (MIT), but one wonders if there still exists one last pay telephone booth. That would perfectly suit the needs of Andrew W Lo, the Harris & Harris group professor of finance and the director of the MIT laboratory for financial engineering.
A few days a week, he's like Clark Kent, mild-mannered MIT professor teaching such courses as "Quantitative Investment Management" or "Empirical Methods In Finance", dealing with addlebrained numbskull goofball students (but enough of my courseload this semester, now back to Lo), correcting papers, sitting through mind-numbing meetings with the deans etc. Then, all of a sudden, he must rush into the phone booth, change clothes, turn into ...
Turbofinance market man!
Lo has had ongoing consulting relationships with various Wall Street trading desks for many years, and he recently sold his own US$550 million assets under the management hedge fund, AlphaSimplex to the French financial firm Natixis, for unreported megabucks. Lo's unique gift is his skill in bestriding both the worlds of academia and modern finance, for most hedge fund types would gladly let the world sit in howling darkness and ignorant philistinism rather than give up the chance to make a few more million in the hours that teaching would take them away from the trading desk; as for the academics, no matter how they can dazzle a room full of 19-year-olds, it's a totally different set of character skills needed to keep your wits about you when you're watching the losses mount on that billion dollar calendar spread you just put on British government gilts options.
There's good news and bad news about making money in the stock market. The good news is that there are two ways to make money. The bad news is that there are two ways to lose money.
You can buy a stock, and hope that it rides up along with the general rise in stock prices. Thus, if the general stock market (as usually measured by the S&P 500 index) rises 5%, and your stock rises 5%, you have neither out- nor underperformed the market; it is said that you have captured the market's "beta".
This is the reasoning behind the many index-based mutual and exchange traded funds that are designed to return performances that mirror the market averages. These instruments are said to be "passively managed", for all the manager must do is assure that the portfolio's components always match the index.
In contrast to capturing beta is capturing alpha, generating stock market returns in excess of the general market averages. This is the leprechaun's pot of gold of the investment game; proponents of the "efficient market hypothesis" say that it can't be done at all, not over any type of extended time frame. If your stock market investments are up 10% and the general market is up 5%, you are said to have captured five points of beta and five points of alpha.
Money or hedge fund managers that consistently generate alpha returns are the superstars of the investment game, and their frequent nine figure paychecks certainly reflects their rarefied status. In contrast, beta capturing money managers, those who run index mutual funds, are considered by Wall Street to be not much more than intelligent toasters, since, comparatively, their jobs are so automatic and easy.
Alpha and beta work on the downside as well. If your investments go down 3% while the market goes down 10%, you've captured 7% of alpha. That may be of some psychological comfort to you but, of course, you've still lost 3% on those investments. The worst possible situation is if you're getting whacked with both alpha and beta, say, the market is down 10% and you're down 20%.
That's when it's time to stop taking those tech company stock tips from Zephyr, the ponytailed Bohemian barista in the lobby.
What Lo, working with Amir E Khandani of MIT, discovered was that what happened this August was caused by a unique situation in which a specific hedge fund strategy utilizing both the alpha and beta concepts was being employed on an unprecedented scale due to the massive borrowing inherent in hedge fund operations. Their paper [1], is the first real academic attempt to analyze what happened to the markets in August; it is a huge improvement on the Fox News analysis blaming the whole thing on banks giving mortgages to undocumented Mexican immigrants.
How do you find good stocks to buy, stocks that are going to beat the market, going to generate Alpha?
Well, if I knew that answer I probably wouldn't be dealing with my classroom full of blockheads and dunces, but one way to find stocks that will outperform in the near future is to look for those that have underperformed in the recent past.
At the horse track, this is called the "this nag's due for one good race before getting shipped off to become next week's Sloppy Joes at the cafeteria" strategy; in investing, this is more delicately called "reversion to the mean".
"Mean" is just a fancy word that math nerds use in place of the word "average". "Reversion to the mean" alludes to the belief that, since a stock has been recently trading below the average of all its recent closing prices, it's bound to pop back up, to rise back to its average, or moving average, price, if only by virtue of the laws of probability and statistics.
In and of itself this technique is not all that earth shattering; it's actually very similar to something that was a fad in the early and middle 1990s, the "Dogs of the Dow" strategy popularized by Michael O' Higgins and others who possessed a whole lot fewer high falutin' academic initials after their names than today's high powered hedge fund traders.
The rise of cheap, high-capacity computing power has allowed "Dogs of the Dow" to be extensively back tested to determine its profitability; like the vast majority of all investment strategies, sometimes it'll make you money, sometimes it won't.
These types of investment strategies are often called "value strategies" since the underperforming stocks are said to represent good "value".
Even if you've got a strategy that gives you some market outperformance, there's no guarantee that you're going to make good money if you get the "beta" wrong. If you could only separate out alpha from beta, individual stock risk from general market risk ... "Can do, can do, this guy says the strategy can do."
If you look to find underperforming stocks to buy, then, the logic goes, shouldn't you try to find outperforming stocks to sell? They're above their averages, their means, so, for them, reverting to the mean will lead to price declines. If you "short" sell these stocks (all "shorting stocks" really means is that you're reversing the normal time sequence of "buy low-sell high") in the hopes of buying them back later so as to take your profit, theoretically of course, you have the perfect hedging complement to buying the underperforming stocks. This is particularly true as - once again, theoretically - selling the outperforming stocks also should generate alpha. Since these stocks have already outperformed and outpaced the general market, they're due for a greater than average pullback should the general market falter.
There you have it, an alpha generating strategy that is shielded, protected, from general market risk, from beta. Surely, if this wasn't A Sure Thing, what was?
"If he says the horse can do, can do, can do."
What Lo and Khandani discovered was that this strategy, called "long/short equity-market neutral", was employed on a massive basis in the period leading up to the market meltdown. In a July 6, 2006 Asia Times Online piece, Hedge funds - playing dice with the universe, I wrote,
Get a lot of players all doing the same thing, putting in huge orders to buy or sell the same instrument at about the same time, and you can move the price of that instrument tremendously in a short time ... On June 1 the European Central Bank (ECB) warned of the risks to market stability from what it called the "correlation of hedge-fund returns" If all the hedge funds are doing the same thing - such as placing huge leveraged bets on the Indian stock market, a major casualty of the post-May 11 global selloff - then all their returns will be "correlated" or, in non-economist terms, similar. ECB vice president Lucas Papademos stated: "The increasingly similar positioning of individual hedge funds ... is another major risk for financial stability ... With all of them investing similarly, the risks of the market turning against their positions, resulting in a tremendous destruction of global capital liquidity, have also grown apace."
That appears to be exactly what happened in August. It's not that long/short equity-market neutral is an inherently bad, or an inherently good strategy. It's just that, with so much of the global wave of liquidity, the same force that so stoked the subprime mortgage crisis, being directed at hedge funds all taking a similar positions, things were bound to get grim if these positions suddenly turned bad and everybody had to get out fast all at once. It's not that there weren't enough exits to get out when the panic started; it's rather that these hedge funds were trampled to death just getting to the exits.
Lo and Khandani put it in more academically desiccated prose. "Likely factors contributing to the magnitude of the losses of this apparent unwind were: the enormous growth in assets devoted to long/short equity strategies over the past decade."
Why did the strategy fail? Think back to its basics, to buy stocks that had been underperforming the market. By July, many of the stocks that had been doing the worst all year had been the ones most exposed to the troubles in the US real estate sector, the banks, the mortgage companies, the homebuilders. If one loaded up on these stocks thinking you were due for a bounce you were in for an unpleasant surprise this summer. The S&P Banking stock index lost over 13% of its value from the July highs to August 7, the days that Lo and Khandani centered their analysis around; the stocks of the HBM Homebuilders ETF lost 18%. These stocks had been weak all year; rather than revert back to the mean in August, they instead packed up and raced away from it like the Road Runner being chased by Wile E Coyote.
If the laggards who got bought got clobbered, what about the leaders who had previously got shorted, got sold? They didn't do all that badly; over this period the Amex XCI technology index only declined 6.4%, and it has now surpassed its July highs. Many observers have noted that tech stocks and the NASDAQ did not fare that badly during much of the August turmoil and this is the reason: besides having minimal exposure to the subprimes, nobody had to sell this sector to bail out of a huge losing long/short equity-market neutral position.
Panic selling that arose out of these continuing and deepening losses intensified the damage; press reports at the time were stating that many of the hedge funds that were utilizing these strategies lost up to 30% of their value in a few weeks. In essence, in mid-summer you would have been much better off swimming at a shark infested beach rather than of using borrowed money to take on huge positions buying banking and real estate and then shorting high tech.
The banking stocks essentially bottomed out on August 3, but, for the general market itself there was still much hard slog to come, nine tough trading days ahead, before the general market would bottom on August 16, the day before the first Federal Reserve discount rate cut. Over that time the Dow Jones Industrials would lose another 700 points, about 5 % of value.
Lo and Khandani do not look much at this period, but, a continent away from where it was happening at Hedge Fund Cosmopolis, in Greenwich, Connecticut, I could feel what was going on as it occured.
Most hedge funds are started by, and still run by, great traders who, for the most part, have given up trading. The frenetic pace of modern trading is very much a young (overwhelmingly) man's game; besides, if you're shopping around for a hedge fund to park a few million in, whether you're a sheikh from Dubai or a pension official from California, you expect to be wined, dined and schmoozed by the big name Great Trader who started the fund, not some shiny blow dried salesman who a month ago was selling annuities to gingham-jumpered farm state widows.
So who's running the store down at the hedge fund trading desks? The Great Trader has found he must delegate this responsibility to new, up and coming great trader wannabes.
Traders are human, they're just like everybody else, only a lot more so. They hate to admit that they're wrong. Research has found that, if an investor's stock position turns against them, they'll hold it far longer than prudent, just so as to not have to sell out of the losing position and admit the finality of the loss, admit that they're wrong.
It's one thing for a small investor to hold on too long to a 100 share position in Countrywide Financial or some other recent market victim; the couple of thousand dollars of losses he takes from it might actually eventually come to be seen as a learning experience.
It's a whole other story when a hedge fund trader sits by and watches as a few billion dollars of the fund's borrowed money goes down the drain because the trader let his ego get in the way of selling out of the position. That does not come to be seen as a learning experience; it's more like an insolvency experience, a bankruptcy experience, and a threat to integrity of the financial system as a whole experience.
Over at the hunt club, and in between canapes and Pouilly fuisse with the rich and famous, the Great Trader who runs the hedge fund gets a daily marked to market profit/loss report on the firm's trading position, and it is then, when seeing what trouble the firm actually is in, he lets out a string of colorful invectives certainly not customarily heard at these fine locales.
Great Trader doesn't give a damm about the little trader's ego; all he's interested in is keeping the firm solvent before he's summoned to the offices of the president of the New York Federal Reserve Bank like an errant schoolboy sent up to the principal's office. He finds a guy, gives him a fancy title such Audit Control Officer (ACO) or Compliance Affairs Manager (CAM); what mission this fellow is really being given is the same task given to Pontius Pilate by Tiberias - go and restore order in my provinces. In Pilate's case it was Judea, in this guy's case it's down at the trading desks.
What this ACO or CAM does is go down to the trading floor with his mighty gladius sword and just lays the place to waste. He tells the traders to sell everything, take the losses, just raise capital in order to keep the fund solvent, and "don't give me any of your sob stories".
Everything gets sold, no matter what the price. Thus, the heavy mid-August selling.
Lo and Khandani stress that it was not long/short equity-market neutral, a strategy that falls under a new class of mathematically back-tested stock investing strategies called "quantitative", or "quant", that failed, it was just that the existent market structure was insufficiently broad and deep to allow everybody that wanted to sell out of the strategy to do so simultaneously in an orderly fashion. On paper, the strategy could have worked well.
"The losses were more likely the result of a resale liquidation of quantitatively constructed portfolios rather than the specific shortcomings of quantitative methods."
This observation is true, but misleading. Investing is not a game like fantasy baseball, it is not meant to be done on paper, but with real money being invested by real, emotional human beings. Paper gains are just that, paper, and worth just about as much. You, or more likely your data-mining software, may think up a great investing strategy; maybe, if you load your program with enough data fields, you'll find that in the past it was a good idea to buy stocks whose CEOs put beer on their corn flakes, and sell stocks whose CEOs talk in a pirate brogue and walk around with parrots on their shoulders. That may work for a while, but if you can't sell out of it when you need to your paper gains are just that - paper. In the final analysis, at least in this life, it's not the paper that counts, it's what's in your wallet, what's in your bank account, what's in your house or garage, what's in your toybox.
If Lo and Khandani's analysis is right about this being the cause of August's market turmoil, to me, it just once again proves the point that greedy people are too busy and preoccupied to study history. Twenty years ago, as what would become the Crash of 1987 drew ever closer, canny investors thought that they had discovered their Sure Thing too. Back then it was hedging their individual stock positions with the then newly created stock index futures; this was called "program trading". Much like this August, this strategy collapsed when everybody tried to sell out of it at the same time; the worldwide stock market holocaust of October 19 of that year, was the result.
Former CNBC anchor Ron Insana identifies the most dangerous phrase in stock investing by the initials TTID - "This time it's different." Long/short equity market neutral is not that much different from program trading, which was not that much different from the bucket shop trading that precipitated the 1929 crash, which was not that different from the South Seas bubble of the early 18th century, which was not that different from Tulipmania in 1637 Holland, all the way back to the beginning of human history. The players and techniques do change, but mindless greed trumping reason and good judgment is always the same.
Once again, it is Charles Mackay's astounding 1841 book, Memoirs of Extraordinary Popular Delusions and the Madness of Crowds, that said it first, and still best.
"Money, again, has often been a cause of the delusion of multitudes. Sober nations have all at once become desperate gamblers, and risked almost their existence upon the turn of a piece of paper."
We're over a month past the gymnastics of August, and some semblance of order has returned to many of the markets. The Shanghai and Hong Kong stock exchanges, which weren't hurt all that much in August, are once again moving higher; US stock exchanges are back near their highs, even with the actual precipitant cause of the selloff, the subprime mortgage crisis, looking as bleak as ever. The US Fed has aggressively cut interest rates to support equities, and will probably cut again. Perhaps more importantly, a whole lot of people who had huge positions in quant strategies such as long/short equity market neutral have been blown right out of this market. Maybe we're safe for a while - until the next numskull comes up with an investing sure thing that subsequently blows up in everybody's face.
In the meantime, perhaps it's time for Lo's class to take a field trip. A couple of miles from his sparkling classrooms in Cambridge lies the local thoroughbred racing track, a tired, wheezing old place called Suffolk Downs.
I once visited this locale to do some investing, and was stunned to see what a depressed place it was. The smell of stale beer greatly overpowered that of fresh horse droppings, and the walls looked like the last paint applied to them came from World War II US Army surplus. The fixtures were rusted and dirty, as, of course, were the offerings at the snack bar.
My fellow investing clientele looked no better. They, much like the horses they were wagering on, appeared tired, wizened and wheezing - a few actually had taken their oxygen tanks with them. (The bettors, not the horses.) Their faded, torn working-class painters' or carpenters' attire was all they had to protect them from the New England cold in the unheated grandstand, and if it was near the end of the month they had to limit their betting until their next Social Security pensions check arrived.
Thirty or 40 years previously, when they first arrived at the track, they probably thought they had a Sure Thing as well.
Note
1. What Happened to the Quants in August 2007? September 20, 2007.
Julian Delasantellis is a management consultant, private investor and educator in international business in the US state of Washington. He can be reached at juliandelasantellis@yahoo.com.
(Copyright 2007 Asia Times Online Ltd. All rights reserved.)
In the 1955 movie musical Guys and Dolls, romantic rogue Nicely Nicely Johnson , (Stubby Kaye) sings the eternal tale of the inveterate gambler, the siren song of hope over experience, the ever illusory dream that at long last one has discovered The Sure Thing, in the famous Fugue for Tinhorns:
"I got the horse right here, the name is Paul Revere.
And here's a guy that says that the weather's clear
Can do, can do, this guy says the horse can do
If he says the horse can do, can do, can do."
As we are able to put some distance between our current time and the worldwide market histrionics of August, and as CNBC's Jim Cramer's apparently much stronger sedatives kick in, we are beginning to learn that, in many ways, a lot of the crisis was brought about by large market participants thinking in ways very much reminiscent of Nicely Nicely Johnson, people who thought that they had discovered A Sure Thing.
In the circles that Nicely Nicely Johnson traveled in, if you bet a lot of money and lose, you are most likely to get your legs broken by that market's existent self-regulating authorities. For the gamblers of August, that won't happen; most will still have ambulatory capacity sufficient to hit the ski slopes at Gstaad in the upcoming months. What did get broken was the market itself, along with, if they were unfortunate enough to get a margin call at the height of the selling that forced them to bail out of losing positions, the hopes and dreams of countless numbers of small- and medium-sized investors who only after that financially shattering experience would they realize just how fixed against them the investing crap game they were playing really was.
There probably are no more slide rules at the campus offices of the Sloan School of Management at the Massachusetts Institute of Technology (MIT), but one wonders if there still exists one last pay telephone booth. That would perfectly suit the needs of Andrew W Lo, the Harris & Harris group professor of finance and the director of the MIT laboratory for financial engineering.
A few days a week, he's like Clark Kent, mild-mannered MIT professor teaching such courses as "Quantitative Investment Management" or "Empirical Methods In Finance", dealing with addlebrained numbskull goofball students (but enough of my courseload this semester, now back to Lo), correcting papers, sitting through mind-numbing meetings with the deans etc. Then, all of a sudden, he must rush into the phone booth, change clothes, turn into ...
Turbofinance market man!
Lo has had ongoing consulting relationships with various Wall Street trading desks for many years, and he recently sold his own US$550 million assets under the management hedge fund, AlphaSimplex to the French financial firm Natixis, for unreported megabucks. Lo's unique gift is his skill in bestriding both the worlds of academia and modern finance, for most hedge fund types would gladly let the world sit in howling darkness and ignorant philistinism rather than give up the chance to make a few more million in the hours that teaching would take them away from the trading desk; as for the academics, no matter how they can dazzle a room full of 19-year-olds, it's a totally different set of character skills needed to keep your wits about you when you're watching the losses mount on that billion dollar calendar spread you just put on British government gilts options.
There's good news and bad news about making money in the stock market. The good news is that there are two ways to make money. The bad news is that there are two ways to lose money.
You can buy a stock, and hope that it rides up along with the general rise in stock prices. Thus, if the general stock market (as usually measured by the S&P 500 index) rises 5%, and your stock rises 5%, you have neither out- nor underperformed the market; it is said that you have captured the market's "beta".
This is the reasoning behind the many index-based mutual and exchange traded funds that are designed to return performances that mirror the market averages. These instruments are said to be "passively managed", for all the manager must do is assure that the portfolio's components always match the index.
In contrast to capturing beta is capturing alpha, generating stock market returns in excess of the general market averages. This is the leprechaun's pot of gold of the investment game; proponents of the "efficient market hypothesis" say that it can't be done at all, not over any type of extended time frame. If your stock market investments are up 10% and the general market is up 5%, you are said to have captured five points of beta and five points of alpha.
Money or hedge fund managers that consistently generate alpha returns are the superstars of the investment game, and their frequent nine figure paychecks certainly reflects their rarefied status. In contrast, beta capturing money managers, those who run index mutual funds, are considered by Wall Street to be not much more than intelligent toasters, since, comparatively, their jobs are so automatic and easy.
Alpha and beta work on the downside as well. If your investments go down 3% while the market goes down 10%, you've captured 7% of alpha. That may be of some psychological comfort to you but, of course, you've still lost 3% on those investments. The worst possible situation is if you're getting whacked with both alpha and beta, say, the market is down 10% and you're down 20%.
That's when it's time to stop taking those tech company stock tips from Zephyr, the ponytailed Bohemian barista in the lobby.
What Lo, working with Amir E Khandani of MIT, discovered was that what happened this August was caused by a unique situation in which a specific hedge fund strategy utilizing both the alpha and beta concepts was being employed on an unprecedented scale due to the massive borrowing inherent in hedge fund operations. Their paper [1], is the first real academic attempt to analyze what happened to the markets in August; it is a huge improvement on the Fox News analysis blaming the whole thing on banks giving mortgages to undocumented Mexican immigrants.
How do you find good stocks to buy, stocks that are going to beat the market, going to generate Alpha?
Well, if I knew that answer I probably wouldn't be dealing with my classroom full of blockheads and dunces, but one way to find stocks that will outperform in the near future is to look for those that have underperformed in the recent past.
At the horse track, this is called the "this nag's due for one good race before getting shipped off to become next week's Sloppy Joes at the cafeteria" strategy; in investing, this is more delicately called "reversion to the mean".
"Mean" is just a fancy word that math nerds use in place of the word "average". "Reversion to the mean" alludes to the belief that, since a stock has been recently trading below the average of all its recent closing prices, it's bound to pop back up, to rise back to its average, or moving average, price, if only by virtue of the laws of probability and statistics.
In and of itself this technique is not all that earth shattering; it's actually very similar to something that was a fad in the early and middle 1990s, the "Dogs of the Dow" strategy popularized by Michael O' Higgins and others who possessed a whole lot fewer high falutin' academic initials after their names than today's high powered hedge fund traders.
The rise of cheap, high-capacity computing power has allowed "Dogs of the Dow" to be extensively back tested to determine its profitability; like the vast majority of all investment strategies, sometimes it'll make you money, sometimes it won't.
These types of investment strategies are often called "value strategies" since the underperforming stocks are said to represent good "value".
Even if you've got a strategy that gives you some market outperformance, there's no guarantee that you're going to make good money if you get the "beta" wrong. If you could only separate out alpha from beta, individual stock risk from general market risk ... "Can do, can do, this guy says the strategy can do."
If you look to find underperforming stocks to buy, then, the logic goes, shouldn't you try to find outperforming stocks to sell? They're above their averages, their means, so, for them, reverting to the mean will lead to price declines. If you "short" sell these stocks (all "shorting stocks" really means is that you're reversing the normal time sequence of "buy low-sell high") in the hopes of buying them back later so as to take your profit, theoretically of course, you have the perfect hedging complement to buying the underperforming stocks. This is particularly true as - once again, theoretically - selling the outperforming stocks also should generate alpha. Since these stocks have already outperformed and outpaced the general market, they're due for a greater than average pullback should the general market falter.
There you have it, an alpha generating strategy that is shielded, protected, from general market risk, from beta. Surely, if this wasn't A Sure Thing, what was?
"If he says the horse can do, can do, can do."
What Lo and Khandani discovered was that this strategy, called "long/short equity-market neutral", was employed on a massive basis in the period leading up to the market meltdown. In a July 6, 2006 Asia Times Online piece, Hedge funds - playing dice with the universe, I wrote,
Get a lot of players all doing the same thing, putting in huge orders to buy or sell the same instrument at about the same time, and you can move the price of that instrument tremendously in a short time ... On June 1 the European Central Bank (ECB) warned of the risks to market stability from what it called the "correlation of hedge-fund returns" If all the hedge funds are doing the same thing - such as placing huge leveraged bets on the Indian stock market, a major casualty of the post-May 11 global selloff - then all their returns will be "correlated" or, in non-economist terms, similar. ECB vice president Lucas Papademos stated: "The increasingly similar positioning of individual hedge funds ... is another major risk for financial stability ... With all of them investing similarly, the risks of the market turning against their positions, resulting in a tremendous destruction of global capital liquidity, have also grown apace."
That appears to be exactly what happened in August. It's not that long/short equity-market neutral is an inherently bad, or an inherently good strategy. It's just that, with so much of the global wave of liquidity, the same force that so stoked the subprime mortgage crisis, being directed at hedge funds all taking a similar positions, things were bound to get grim if these positions suddenly turned bad and everybody had to get out fast all at once. It's not that there weren't enough exits to get out when the panic started; it's rather that these hedge funds were trampled to death just getting to the exits.
Lo and Khandani put it in more academically desiccated prose. "Likely factors contributing to the magnitude of the losses of this apparent unwind were: the enormous growth in assets devoted to long/short equity strategies over the past decade."
Why did the strategy fail? Think back to its basics, to buy stocks that had been underperforming the market. By July, many of the stocks that had been doing the worst all year had been the ones most exposed to the troubles in the US real estate sector, the banks, the mortgage companies, the homebuilders. If one loaded up on these stocks thinking you were due for a bounce you were in for an unpleasant surprise this summer. The S&P Banking stock index lost over 13% of its value from the July highs to August 7, the days that Lo and Khandani centered their analysis around; the stocks of the HBM Homebuilders ETF lost 18%. These stocks had been weak all year; rather than revert back to the mean in August, they instead packed up and raced away from it like the Road Runner being chased by Wile E Coyote.
If the laggards who got bought got clobbered, what about the leaders who had previously got shorted, got sold? They didn't do all that badly; over this period the Amex XCI technology index only declined 6.4%, and it has now surpassed its July highs. Many observers have noted that tech stocks and the NASDAQ did not fare that badly during much of the August turmoil and this is the reason: besides having minimal exposure to the subprimes, nobody had to sell this sector to bail out of a huge losing long/short equity-market neutral position.
Panic selling that arose out of these continuing and deepening losses intensified the damage; press reports at the time were stating that many of the hedge funds that were utilizing these strategies lost up to 30% of their value in a few weeks. In essence, in mid-summer you would have been much better off swimming at a shark infested beach rather than of using borrowed money to take on huge positions buying banking and real estate and then shorting high tech.
The banking stocks essentially bottomed out on August 3, but, for the general market itself there was still much hard slog to come, nine tough trading days ahead, before the general market would bottom on August 16, the day before the first Federal Reserve discount rate cut. Over that time the Dow Jones Industrials would lose another 700 points, about 5 % of value.
Lo and Khandani do not look much at this period, but, a continent away from where it was happening at Hedge Fund Cosmopolis, in Greenwich, Connecticut, I could feel what was going on as it occured.
Most hedge funds are started by, and still run by, great traders who, for the most part, have given up trading. The frenetic pace of modern trading is very much a young (overwhelmingly) man's game; besides, if you're shopping around for a hedge fund to park a few million in, whether you're a sheikh from Dubai or a pension official from California, you expect to be wined, dined and schmoozed by the big name Great Trader who started the fund, not some shiny blow dried salesman who a month ago was selling annuities to gingham-jumpered farm state widows.
So who's running the store down at the hedge fund trading desks? The Great Trader has found he must delegate this responsibility to new, up and coming great trader wannabes.
Traders are human, they're just like everybody else, only a lot more so. They hate to admit that they're wrong. Research has found that, if an investor's stock position turns against them, they'll hold it far longer than prudent, just so as to not have to sell out of the losing position and admit the finality of the loss, admit that they're wrong.
It's one thing for a small investor to hold on too long to a 100 share position in Countrywide Financial or some other recent market victim; the couple of thousand dollars of losses he takes from it might actually eventually come to be seen as a learning experience.
It's a whole other story when a hedge fund trader sits by and watches as a few billion dollars of the fund's borrowed money goes down the drain because the trader let his ego get in the way of selling out of the position. That does not come to be seen as a learning experience; it's more like an insolvency experience, a bankruptcy experience, and a threat to integrity of the financial system as a whole experience.
Over at the hunt club, and in between canapes and Pouilly fuisse with the rich and famous, the Great Trader who runs the hedge fund gets a daily marked to market profit/loss report on the firm's trading position, and it is then, when seeing what trouble the firm actually is in, he lets out a string of colorful invectives certainly not customarily heard at these fine locales.
Great Trader doesn't give a damm about the little trader's ego; all he's interested in is keeping the firm solvent before he's summoned to the offices of the president of the New York Federal Reserve Bank like an errant schoolboy sent up to the principal's office. He finds a guy, gives him a fancy title such Audit Control Officer (ACO) or Compliance Affairs Manager (CAM); what mission this fellow is really being given is the same task given to Pontius Pilate by Tiberias - go and restore order in my provinces. In Pilate's case it was Judea, in this guy's case it's down at the trading desks.
What this ACO or CAM does is go down to the trading floor with his mighty gladius sword and just lays the place to waste. He tells the traders to sell everything, take the losses, just raise capital in order to keep the fund solvent, and "don't give me any of your sob stories".
Everything gets sold, no matter what the price. Thus, the heavy mid-August selling.
Lo and Khandani stress that it was not long/short equity-market neutral, a strategy that falls under a new class of mathematically back-tested stock investing strategies called "quantitative", or "quant", that failed, it was just that the existent market structure was insufficiently broad and deep to allow everybody that wanted to sell out of the strategy to do so simultaneously in an orderly fashion. On paper, the strategy could have worked well.
"The losses were more likely the result of a resale liquidation of quantitatively constructed portfolios rather than the specific shortcomings of quantitative methods."
This observation is true, but misleading. Investing is not a game like fantasy baseball, it is not meant to be done on paper, but with real money being invested by real, emotional human beings. Paper gains are just that, paper, and worth just about as much. You, or more likely your data-mining software, may think up a great investing strategy; maybe, if you load your program with enough data fields, you'll find that in the past it was a good idea to buy stocks whose CEOs put beer on their corn flakes, and sell stocks whose CEOs talk in a pirate brogue and walk around with parrots on their shoulders. That may work for a while, but if you can't sell out of it when you need to your paper gains are just that - paper. In the final analysis, at least in this life, it's not the paper that counts, it's what's in your wallet, what's in your bank account, what's in your house or garage, what's in your toybox.
If Lo and Khandani's analysis is right about this being the cause of August's market turmoil, to me, it just once again proves the point that greedy people are too busy and preoccupied to study history. Twenty years ago, as what would become the Crash of 1987 drew ever closer, canny investors thought that they had discovered their Sure Thing too. Back then it was hedging their individual stock positions with the then newly created stock index futures; this was called "program trading". Much like this August, this strategy collapsed when everybody tried to sell out of it at the same time; the worldwide stock market holocaust of October 19 of that year, was the result.
Former CNBC anchor Ron Insana identifies the most dangerous phrase in stock investing by the initials TTID - "This time it's different." Long/short equity market neutral is not that much different from program trading, which was not that much different from the bucket shop trading that precipitated the 1929 crash, which was not that different from the South Seas bubble of the early 18th century, which was not that different from Tulipmania in 1637 Holland, all the way back to the beginning of human history. The players and techniques do change, but mindless greed trumping reason and good judgment is always the same.
Once again, it is Charles Mackay's astounding 1841 book, Memoirs of Extraordinary Popular Delusions and the Madness of Crowds, that said it first, and still best.
"Money, again, has often been a cause of the delusion of multitudes. Sober nations have all at once become desperate gamblers, and risked almost their existence upon the turn of a piece of paper."
We're over a month past the gymnastics of August, and some semblance of order has returned to many of the markets. The Shanghai and Hong Kong stock exchanges, which weren't hurt all that much in August, are once again moving higher; US stock exchanges are back near their highs, even with the actual precipitant cause of the selloff, the subprime mortgage crisis, looking as bleak as ever. The US Fed has aggressively cut interest rates to support equities, and will probably cut again. Perhaps more importantly, a whole lot of people who had huge positions in quant strategies such as long/short equity market neutral have been blown right out of this market. Maybe we're safe for a while - until the next numskull comes up with an investing sure thing that subsequently blows up in everybody's face.
In the meantime, perhaps it's time for Lo's class to take a field trip. A couple of miles from his sparkling classrooms in Cambridge lies the local thoroughbred racing track, a tired, wheezing old place called Suffolk Downs.
I once visited this locale to do some investing, and was stunned to see what a depressed place it was. The smell of stale beer greatly overpowered that of fresh horse droppings, and the walls looked like the last paint applied to them came from World War II US Army surplus. The fixtures were rusted and dirty, as, of course, were the offerings at the snack bar.
My fellow investing clientele looked no better. They, much like the horses they were wagering on, appeared tired, wizened and wheezing - a few actually had taken their oxygen tanks with them. (The bettors, not the horses.) Their faded, torn working-class painters' or carpenters' attire was all they had to protect them from the New England cold in the unheated grandstand, and if it was near the end of the month they had to limit their betting until their next Social Security pensions check arrived.
Thirty or 40 years previously, when they first arrived at the track, they probably thought they had a Sure Thing as well.
Note
1. What Happened to the Quants in August 2007? September 20, 2007.
Julian Delasantellis is a management consultant, private investor and educator in international business in the US state of Washington. He can be reached at juliandelasantellis@yahoo.com.
(Copyright 2007 Asia Times Online Ltd. All rights reserved.)
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