by John Mauldin
In theory there is no difference between theory and practice. In practice there is” – Yogi Berra, as cited by Ben Hunt in today’s Outside the Box. Or, to put it in macroeconomic terms, “Why is global growth so disappointing?” In the aftermath of the Great Recession, fearing a deflationary equilibrium (which, as Ben notes, is macroeconomic-speak for falling into a well, breaking your leg, at night, alone), the Fed bought trillions of dollars in assets … and saved the world. Sort of. If you don’t count the reckoning yet to come. The theory was that with all that monetary-policy injections, global growth would spring back to “normal.”
But what did practice show? The global economic engine never fired back up. The central banks’ answer? Do more. So the Fed gave us QE 2 and QE 3, and then we got Abenomics, and now it’s Draghinomics.
Still no real growth. What’s missing? asks Ben. He has a surprising answer. Read on.
Ben works for Salient Partners and writes the fascinating letter called Epsilon Theory. You can subscribe to it for free here, or by emailing bhunt@salientpartners.com.
I had dinner last night with my good friend Richard Howard, who, besides being a charming young Australian lad, is also the wickedly brilliant chief economist of Hayman Advisors, the hedge fund outfit run by my friend Kyle Bass. We try to get together every few months at one of the local eateries and hash out the world. And yes, for those interested, the recent action in Japan has both of us smiling a “we told you so” sort of smile. But also thinking that the magic will last for Abe-sama a little while longer. Actually, we talked about why this trade could take a lot longer than most yen bears expect.
(Side note: As longtime readers know, I had just hedged a good portion of my newly acquired mortgage this year by shorting the yen using 10-year put options. Just for grins, I called my broker [a.k.a. The Plumber – Eric Keubler of JPMorgan] and asked how much my position was up. I know, I bought 10-year options and shouldn’t check more than once a year at most, but I was just curious – so sue me. Anyway, with a 5-yen move in my favor I expected to see a rather nice profit. It turned out the profit was about 3% of what I was expecting [not a typo]. That seems odd, I said. No, he told me, all the volatility in the option price has collapsed. The complacency in the currency market and especially in the yen-dollar market is simply massive. This made me glad that I bought 10-year options, as I fully expect that the volatility will have to reappear in the future – unless human nature has somehow changed without sending me a memo. But it goes to show you, gentle reader, that you can be right on the trade and lose money, perhaps a lot of it, if your timing sucks. Ironically, I can get roughly the same trade today for only a few dollars more than I paid five or six months ago, with the 5-yen advantage to the home team. Go figure. I plan to add to this trade, so if you are watching and know when I’m going to do it, you will know that volatility is exceedingly high when my personal situation allows me to execute.)
Richard and I then went on to talk about the interesting decision by CalPERS to completely exit hedge funds. I think the consensus as we left the table was that it is both an odd decision and a perfectly reasonable one, depending on your perspective. Please note that in their press release CalPERS used 5 years and 20 years as their retrospective time horizons. The intervals between 1994 and 2009 and the present just happen to be very convenient time periods to compare overall portfolio returns for CalPERS and for equity markets in general versus hedge funds. If you used 2000 or 2006, your internal rate of return would suck, and your portfolio performance would be less than flattering. Still, hedge funds in general have not performed as well for the last five years as they did in the past, and in general they didn’t offer the downside protection in 2008 that they did in the prior correction of 2000-2001.
In my opinion, CalPERS was not very good at choosing hedge funds, and their timing in entering and exiting a number of their funds wasn’t any better. You can go to any number of pension funds and find far better results than CalPERS achieved. To be fair, I would suggest that the majority of hedge funds are not worth the fees they charge, as they simply provide leveraged beta. Choosing hedge funds is as much an art form as it is a science. Kind of like choosing stocks.
I mean, every asset class has its own particular rhythm. As we all know, over the very long run stocks generally do well. But there are some periods of time when the performance numbers don’t live up to the promise. Those are called secular bear markets, and we had one beginning in 2000. I don’t think we have come to the end of it, and so we still live in a world where we have to look for absolute returns. That’s just the way I see the data.
All that said, I can totally understand CalPERS’ decision to exit the hedge fund world. First, their entire hedge fund investment portfolio was less than 2% of their total portfolio. Even if their hedge fund portfolio was crushing it, that wouldn’t move their overall needle. They were paying $135 million in fees for the privilege of being continually second-guessed by their critics. Frankly, if they had asked me, I would have said, either go large or go home.
And there’s the problem. They really can’t go large. Let’s say they put 10% of their fund into hedge funds. That means at least $30 billion. I don’t think you can allocate $30 billion appropriately from the standpoint of public pension fund responsibility. I wouldn’t even begin to know how to do it. Two or three billion? Absolutely. It would be difficult, but it could be done.
The problem is, you don’t want to become too big a portion of any one fund. Seriously, there are not that many good large funds. Most hedge funds are way too small to be considered as potential investments by CalPERS. So if you are CalPERS you are size-constrained and limited to a small universe of very large hedge funds. Which is not typically where you find hedge fund alpha. And you don’t want to have 100 different funds, as the complexity of tracking all that is enormous.
So you either end up with a portfolio that is ridiculously spread out and is going to regress to the mean, that is, to general market performance; or you going to be over-allocated to some fund that will prove to be a time bomb just when your public relations team is being overwhelmed with something else. I’m not sure who in the universe is in charge of the rules on timing, but it does seem that things are structured so as to cause the greatest possible embarrassment.
So I can certainly understand extremely large public funds leaving hedge funds. I do think that they should consider what other forms of alternative investing might make sense. Pension funds have one commodity that very few other investors have: they have time and lots of it. Most of them sell their time for ridiculously cheap premiums in the fixed-income market. Perhaps figuring out how to increase the return on your patient cash would be the way to go. And that’s not a bad strategy for individual investors as well. Just saying…
That’s the news from beautiful, sunny Dallas. It is time to go ahead and hit the send button as The Beast is lurking in the gym, waiting for me. Have a great week, and enjoy Ben Hunt’s essay.
Your ready to get on a plane again analyst,
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