The Promise of Alternative Investments

The many proponents of alternative investments such as hedge funds, private equity, real estate etc. are promising higher returns, lower correlations and lower volatility of returns.At least, that's what I learned when I took the CAIA course back in 2007. Four years have passed, and I wonder whether those wonderful promises are being fulfilled.

Meanwhile I came across some rather skeptical observations by some investment professionals about hedge funds, the biggest of all alternvative asset classes.

Warren Buffet stated that hedge fund fees (2/20 fee structure) are ensuring that investor as a whole underperform with hedge funds.

Prof. Allan Roth of the University of Colorado wrote in his blog: 

• Too expensive: while mutual funds already earn 1-2% p.a. (for underperforming the market) hedge fund earn 2/20, but often investors hold fund of funds with 2 layers of 2/20!

• Encourage risk: 2/20 encourage managers to take excessive risks. If they win they earn big, if they loose they close the fund, and start a new one. 
• Risky hedge funds attract most money: advisors generally select funds with the best past performance, i.e. the risky ones who were lucky. Those are the most likely to blow up in the future (when luck runs out, and leverage kicks in on the down side).
• Inefficiencies reduced: Most hedge funds follow the strategy of pursuing market inefficiencies. Unfortunately, big capital inflows are chasing the same inefficiencies, diminishing opportunities.
• Lack of liquidity: Many hedge funds do not provide the possibility of liquidating your holdings in a few days.
  
• Lack of transparency: Hedge funds are generally intransparent regarding their holdings and details of their investment strategy claiming that they need to protect their secret of success. Unfortunately, this opens the door for fraudsters like Bernie Madoff.

Average hedge fund manager receiving fees

We can argue all day long, but without any evidence we are not really smarter.

Luckily a consulting firm analyzed statistical data of Swiss pension funds for the Swiss federal department of social insurance in a extensive study. Bottom line:

1. The bigger the hedge fund share the higher the pension funds management costs.
2. The average allocation to hedge funds of 6% of total assets are causing a third of total management costs.
3. The bigger the hedge fund share the lower the overall return on investments. 

To sum up, on average hedge funds are enriching their managers and not the investors.

At last, I want to point on the economic role of investors: Their function is to provide efficiently capital to the economy in the long term, and not chasing short term gains. In contrast, the classic value investor is fulfilling this role and he outperforms long term.

Derivatives, Speculation and Economics

There is an interesting article in today's (20.07.11) NZZ on page 29 by Marc Chesney (finance professor at University of Zürich) titled "Derivative Financial Products and their Systemic Risks". He is analyzing the arguments made by economists to justify the wide dissemination of derivatives:

1. Hedging of commercial market participants: The nominal amounts of derivative instruments are nine times bigger than world GDP. Hence, derivatives are used mainly for speculation.
2. Derivatives help to increase market efficiency by enabling speculation and arbitrage: Marc argues that the increased efficiency is accompanied by increased costs of excessive speculation which drive prices higher and creating havoc on the spot market. Examples: Speculation in soft commodities driving food prices higher.
3. Aligning management with shareholder interests: Management remuneration schemes involving stock options proved to be incapable of aligning those interests when (big) losses occur. Stock options encourage excessive risk taking. 

He closes his article by pointing at the systemic risks caused by derivatives (and securitization)which were apparent in the financial crisis 2008,  and he is appealing at the academic community to reconsider and update the current financial theories.
 Interestingly, financial sector profit which were less than 10% of total corporate profits 60 years ago, and are today almost 30% of total corporate profits (see chart below). Remember that the financial sector is not producing anything and its economic function is only to intermediate capital of investors to enterprises who actually produce something.

With the introduction of modern finance (and derivatives) the financial institution managed to increase their profit margin substantially. This profit margin of 50% is double the profit margin of productive enterprises (25-30%) according to the chart below.

UBS and CS are still two big hedge funds

Bankers betting your savings!

Today, July 7th, 2011, the Swiss news paper NZZ runs an article on page 27 about capital requirements for the two Swiss big banks UBS and Credit Suisse (CS).

•  Capital requirements today are based on risk weighted assets (rwa) according to the international Basel standards. rwa are calculated by models developed and run by the bank. 
  
• the models to calculate rwa rely heavily on Value at Risk (VaR) which takes daily risk in  to account but does not consider tail risk (risk of big negative events ). The result is an understatemetn of risk.
• Banks have an incentive to keep their capital low in order to in increase the shareholder return on equity (RoE), and the means by tweaking the risk models accourdingly

• While the capital ratio based on rwa has increased for UBS and CS, capital ratios based on total assets have not been increased for UBS and CS. They are at 1.63% (UBS) and 1.88% (CS).

• This equals to a hedge fund with a leverage of 60 times its equity. Would you put all your savings in that hedge fund?
  
• UBS total assets are CHF 1.300 billion, or 4 times the GDP of Switzerland. CS has a similar balance sheet. Switzerland could be the next Iceland! 

 The graphs below reflect the diminishing capital ratios of UBS and CS over time:

Goldbug

A Swiss financial news platform published an interview with me on their site, where I stated that:

• Gold inhibits the function of asset protection in times of crisis
• Gold bullion coins are a mean of payment in times of an extreme crisis when our financial system is not working. Because they are traded at big premium they are not attractive.
• We therefore recommend to hold 5-10% of your assets in physically backed gold etfs.
• Other commodities/precious metals are following other economic drivers (different from asset protection), and are mostly not physically backed (massive performance difference in regard to underlying).