Timing and your investment decisions revised

Take timing out of your investments with a well-managed Fund of Funds

By Gary Busel, Manager of Karasel LP

There is an old cliché people use when they are discussing real estate:
“Location, location, location!” This is certainly good advice for anyone considering a real-estate purchase, but better advice would be: “Location, location, timing.”

I have first hand experience that will make this abundantly clear. Several years ago my family and some other investors were involved in the purchase of about 100 prime acres of residentially zoned property on the north shore of Long Island. Before any homes were built, the real-estate market started to decline, and the decision was made to sell the property at a loss. The location was great, but our timing was not. The group that purchased the property purchased it at the perfect time. The real-estate market took off, and they eventually went on to develop the property and make a tremendous profit. Unfortunately we didn’t have a crystal ball or the fortitude to wait out the bad times. Timing was the difference between making and losing money on the exact same investment.

This is why I advise people to “take timing out” of their investment decisions.
Many big name pundits are often seen on national television espousing the credo, “Invest for the long term.” As if that is going to make anyone who has suffered huge losses in the past three years feel any better. These investors are sitting on positions that are more than 50% lower than when they purchased them. There are many others that needed to sell their positions and are now, basically out of luck.

Maybe over the next 20 years these investments will turn around and make money, but who wants to wait, hoping and praying for your positions to come back, all the while suffering financial and emotional stress? I certainly do not. That is why when I hear anybody tell me that “The stock market has historically returned 10% annually, and if held for the long term very tax efficient,” I disagree. My response is the same when I hear so-called “experts” on television say “we think 65% of your portfolio should be in stocks and 35% in bonds.” I don’t want to be involved in any investment that can take forever to work, or have the possibility of significant losses. My first priority is capital preservation, the next is making as much as possible with almost no volatility.

Having your money in a money market account is a perfect example of how to preserve capital and take timing out of your investment decision, but it is certainly not maximizing your return. Your investment will always be slightly profitable and completely liquid, and you need some of your assets completely liquid for everyday living expenses. Of course you return is miniscule but it is safe. Bonds are another good way to preserve capital but other than government issued bonds with very low returns; all others have a measure of risk and liquidity issues. Don’t listen to a broker’s advice; they are in the business of selling you product after product. Do your homework before you invest in bonds. While most investors realize there is risk associated with distressed bonds, they are not aware that there is risk and liquidity issues associated with triple tax free Municipals. There is a place for both investments in ones portfolio, but its best to leave it to a professional who makes it his business to understand the risks, and knows how to effectively HEDGE those risks. Someone who is paid for his performance, not on the amount of product they sell. Where can I find these professionals? How do I diversify properly? How can I make a solid return that is safe, steady and liquid? Somebody please help me! Where do I put my hard earned money?

Diversifying is a good start. Every investor has different needs, and different tolerance for risk. Therefore everyone’s investment decisions will vary. The one common thread between all investors is: NO ONE WANTS TO LOSE MONEY. A portion of your investments should be in extremely safe, liquid investments such as money markets, while other portions of your portfolio should be in riskier strategies that may yield a much higher return. But make sure you fully understand those investments, or you might end up with some hefty losses, wondering: What happened to my money? For a professional stock trader or investor, the stock market might be good place to put part of your portfolio. But for the average person this is probably a bad decision. Many people don’t understand the risk associated with a margined account, and end up wiped out before any long term profits come to fruition. My suggestion for investing in the stock market is simple: Never use leverage, and only invest an amount of money you will NEVER need. What about mutual funds you say? I say mutual funds although more diversified than most individuals portfolio, are just as dangerous. They are typically all long, and although they may be in different sectors of the market, they will suffer the same swings as the individual sectors do. That is not to say a small portion of your investments shouldn’t be in mutual funds, just follow the same advice I have given you about investing in stocks. For those wealthy enough, some of their money should be put into the opportunities hedge funds have to offer. They are not as liquid as money markets but many offer quarterly and monthly redemptions. I believe in liquidity so I don’t recommend investing that much into hedge funds that have 1 or more than 1year lock-ups. A lock-up is the duration of time you MUST leave your capital invested in a particular strategy.

But before you make your first investment into a hedge fund, first you need to understand what those opportunities are and more importantly, what are the risks? Most people think of hedge funds as a way to enjoy the upside of bull markets while limiting their exposure on the down side. This is a very simplistic way of viewing hedge funds and possibly very far from the truth. “Hedge funds” have come to mean almost anything nowadays, that is why the entire universe that hedge funds encompass is now called “Alternative Investments.” In fact there are more and more complicated strategies that few people understand, popping up all the time. It’s no longer just Long/Short Equity, its Capital Structure Arbitrage, Convertible Arbitrage, Fixed income trading, Mortgage backed security trading, Distressed security trading, Stat Arbitrage…you get the idea. Some hedge funds are much RISKIER than traditional investments due to more and more complicated derivatives and use of leverage.

That is why it is important to understand exactly what the hedge fund you invest in really does. How else can you make a determination of what your risks really are? Once again timing can be vital. As with most investments, there are times and cycles that certain hedge funds thrive in, while other managers employing different strategies have difficulty. If you had the money to diversify into 100 different hedge funds, all not correlated to either the market or to each other, you still couldn’t guarantee success. In fact I know a professional stock trader that has done just that, and is down on his investments over the last several years. He has beaten the stock averages, but is that what you’re really trying to do? I personally don’t want to lose money in any year. I don’t even want to lose money in any month. That is why I like to invest only with hedge fund managers that have taken TIMING out of their equation for success. Where can you find and identify these types of hedge fund managers? Professional investors like me know how to use statistical and quantitative data to help in making our decisions on where to invest, but how many investors really know what Alpha, Beta, Sharpe Ration, Sortino Ratio, Standard Deviation etc. really mean or how to use the data effectively? And for those of you reading this, that are sophisticated investors, and know exactly what all this information means and how to use it, do you have time, effort and money to spend trying to pick the right managers? It really is a job for professionals that spend all of their time doing ONLY this, and has the experience and contacts necessary to do it well. That is why a FUND OF FUNDS is truly the cheapest and most efficient way to invest in hedge funds. A good fund of funds manager will do all of the work required in setting up and maintaining a safe effective portfolio of hedge fund managers for you.

They will spend the time and money in doing the proper due diligence, they will constantly monitor all the funds they have invested in, and they will be forever seeking out new opportunities. There are many different kinds of fund of funds, each with different risk reward profiles, and it is probably wise to consider diversifying even amongst fund of funds. But use the same logic, and you will come to realize that the bulk of your investment into fund of funds should be in low risk, low volatility, and somewhat liquid fund of funds that manage to take timing out of the equation. A fund of funds that is diversified in different sectors of the market whose managers use high leverage and little hedging can be extremely risky. Most likely the fund of fund manager has done much more due diligence on the underlying managers than you could possibly do on your own, and the fund may perform extremely well in certain time periods.

Therefore this might be a place to invest a small portion of your portfolio, but you must realize that timing might be the difference between profit and loss in this kind of fund. The largest portion of your investment should be in fund of funds that have returns that are consistently positive, with little volatility, that have taken timing out of the equation. Many fund of fund managers, try to choose funds that are not correlated to the market, and try to pick underlying managers that are not correlated to each other. This isn’t bad advice, but it isn’t necessarily the best way to choose the underlying hedge fund managers. Most fund of funds managers use all the analytical data to pick mangers with different styles that statistically aren’t correlated with each other. That means while one manager is finding the market difficult for his strategy another manager is doing well. Yes that is a hedged bet, but it’s a weak one at best. It’s like the wrong footed Long/Short Equity manager, which at times will lose on both his long and his short positions at the same time, or is mostly long on the way down or mostly short on the way up.

There might be times when he makes on both, but do you want to be invested when he is on the losing end? I think not. That doesn’t mean you shouldn’t invest with any Long/Short Equity manager. Quite the contrary, Long/Short is still the most popular strategy among all hedge funds, and there are many who do a remarkable job in limiting volatility. The managers who employ this strategy who have very consistent track records are either the best stock pickers on both sides of the market, or they are experts in knowing how to EFFECTIVELY hedge their positions. What does an effective hedge mean? Many investors think the answer lies in being “Market Neutral.” Well don’t be fooled by the term “Market Neutral.” That usually means your investment is equal dollar weighted long and short in whatever financial instrument the fund strategy employs. But just as in the example of the wrong-footed Long/Short Equity trader, Market Neutral can be just as dangerous if you don’t know exactly how they are hedged. It’s not enough to be equally dollar weighted; the hedged positions must be HIGHLY correlated to be effectively hedged. Being long apples and short oranges, while at times may be very profitable, will have many periods where they lose significant capital. Once again timing might be critical to the success of this investment.

I feel the most effective, consistent and safest hedge funds are the ones that can identify situations where they can be long certain apples at low prices and short other apples at high prices and make the SPREAD. You might say that a true hedge fund manager is an expert in comparing apples to apples. That is why the most consistent fund of funds invests in hedge funds that while not highly correlated to the market, are extremely correlated where it counts the most. THEY MAKE MONEY ALMOST ALL THE TIME. And on the rare occasions where they lose, they lose very little. In my opinion a solid fund of funds will be invested in several funds that employ different strategies, use little or no leverage, have positive returns in at least 85% of all months, and have extremely low volatility. They will be constantly searching for new managers that fit these criteria. They probably will be averaging 8- 10% per annum. Investing in this manner truly takes timing out of the equation. It doesn’t matter when you get in or when you get out because your investment is steadily rising.

The BEST fund of funds will be doing the same, only their average returns will be higher, and most likely they will be invested in several managers that are closed to new investors. How long will it take before a hedge fund manager, who is effectively hedged, averaging 12-16% per year with nary a losing month, with low volatility and little or no leverage, closes to new investors? It depends on their capacity in their strategy, but most likely not very long. The savviest investors and best FUF managers will be invested before most individuals; endowments, family offices, and the average FUF manager know their name. What about the “double fees” I’m paying by investing in a fund of funds? An investor needs to keep one important fact in mind: What’s most important is YOUR net return. Even if you had as much money as say an Ivy League University’s endowment, and therefore individual hedge fund managers minimums were not an issue, there is so much more work to be done, that in my opinion the fee charged by a fund of funds is the best money you will ever spend. Proper due diligence, allocation percentages, constant monitoring of existing investments and searching for new opportunities are a full time job, and a difficult one at that. Many major institutions hire individuals to do this job for them and many do a pretty bad job. That is why many endowments got hurt so badly over the last several years. They forgot to take timing out of the equation. Luckily for most of them, they have the luxury of waiting forever for their investments to turn around. Most investors do not, that is why the best funds of funds manager truly deserve the fee they charge and in my opinion some are actually deserving of more.

Fortunately for most investors, fund of funds can handle tremendous capacity and some of the best ones are still open. Just do your homework and make sure that the underlying funds are truly hedged and can make money in all market conditions. If you do this, you will take timing out of the picture, and be profitable over any and all time periods. The market might drop 2000 points overnight; we might have another terrorist attack, or we might be in for a long period of peace and prosperity. It won’t matter. Your investment will most likely continue to be profitable, rising consistently with low volatility. You will sleep well at night, knowing you have one less thing to worry about: timing.

Related Reading:

What is a Hedge Fund?

Hedge Fund Managers

Why Hire a Hedge Fund Administrator?

Fund of Funds

Hedge Fund Performance