Afterword
I read Maneet Ahuja’s book, The Alpha Masters, less interested in understanding the wonderful personalities in the book and more interested in culling out lessons on investing. For those, however, who want to become familiar with larger-than-life personalities, the Alpha Masters, Bill Ackman, Ray Dalio, Jim Chanos, Pierre Lagrange and Tim Wong, Marc Lasry and Sonia Gardner, Daniel Loeb, John Paulson, David Tepper, and Boaz Weinstein provide great material for the investor’s People magazine.
The stories are fun to read and provide insights into those who perform in such a competitive “dog-eat-dog” atmosphere. Moreover, the stories provide us with the managers’ versions of their trading successes and failures. I was impressed that they all learned from their experiences. One common lesson is that they were persistent in achieving their goals, realizing that both bad and good outcomes provide learning that would make them better future investors. Many willingly impart their learning to the next generation of investors, students at their own firms or in universities, and to Ms. Ahuja in this book.
What did I gleam about these investors? As personalities, they stressed that their own road to success involved a tremendous amount of learning how to invest in their trading strategies; that is, what skills they needed to acquire to embrace and understand uncertainty how to handle risks and the factors that affect their returns. To build an investment business, they all had to become “experts” in their discipline, which involves a combination of evolving theory and experience. Many disciplined themselves to approach investment as a business without emotion.
Learning here included: (1) trust your own intuition and be willing to make and learn from mistakes; (2) take a longer-term perspective, realizing that the best strategies might take many years to come to fruition; (3) handle risk aversion unemotionally (meaning don’t be afraid to lose money), and make sure that all money is not invested in one single strategy so it is easier to remain calm and analytical; (4) take aggressive postures in combination with protecting the downside; (5) invest with those who have their own money on the line and assign backup information gathering (the homework of investing) to the team, and test investment ideas by listening to others across a broad cross-section; and (6) work with the numbers (accounting statements, time series, previous shocks, systematization of previous learning, etc.) to calculate value and test ideas.
As an academic, I wouldn’t be doing my part if I didn’t take issue with the title, however.
Although these Masters make excess returns for their investors (including themselves), in my reading of their strategies, I would not call these excess returns “alpha.” In a global sense, alpha might be returns that are not explained by systematic factors (e.g., the stock market), so-called “beta” returns. But, in my view, the classic definition of generating alphas are returns that are earned by those who can forecast future cash flows or the beta factor returns (macro factors) more accurately than other market participants, which, as alluded to in the book, is a zero-sum game. Not all can outperform—those that do are paid by those who don’t—and it is extremely difficult for those that do to replicate their successes over many periods. This is not at all the story I read in this book. There is a systematic bias that favors them. They don’t believe that they are investing in a zero-sum game; they are paid for their expertise.
I have defined the true earning power of these hedge fund managers as not alpha but “omega” after Ohm’s law, where omega is the varying amounts of resistance in the market. As resistance increases (decreases), they are willing to step in (step out by short-selling or exiting positions) and reduce (increase) the resistance and earn a profit by so doing as other market participants change their holdings of securities over time. I have called these reasons constraints (e.g., although investors know that they are selling at too low a price they are forced to sell to reduce their balance sheet risk); money is made by understanding constraints and reacting to them. Omega is not zero sums because investors are willing to pay others to take risks from them. Risk transfer is a crucial component of the investment process wherein speculators, those willing to carry inventory forward until others realize the value (or provide inventory to the market when investors willing overpay for it, for example, dividend paying stocks because of low bond yields), are compensated by hedgers, those wanting to transfer inventory risk to others. Speculators are paid by hedgers who don’t have the skills to understand the risks (or are in different businesses) and willingly pay the more skilled speculators to carry the risks forward until others can understand the value.
Graham and Dodd’s value investing starts with the question of whether an investment is cheap and then why is it cheap. These questions involve forecasting the future and not knowing which among thousands of investments to analyze or even to start looking at to ask their questions. For example, out of thousands of stocks I could pick Microsoft and project its cash flows, future investment prospects, financing policies, and so on and determine whether it is undervalued according to my model and then ask, if it is undervalued, why so. (I remember that they do have rules that truncate the analysis process and with computing power and databases, filters can generate a much smaller list into which to make the deep dive.)
All of the Masters start with the question that great speculators ask: Why does someone want to pay me to carry the risks forward in my domain of expertise? Or why should I not sell inventory because investors no longer want to pay me to carry risks forward? This is a business; it is the risk transfer business and, like any business, the proprietor is required to understand the uncertainty of running that business. As the business makes money, markets function more efficiently.1 They make money because they understand the activities they are involved in and that there is a demand for their services of transferring risk in their chosen areas of expertise.
William Ackman, for example, developed an expertise in the restructuring of companies to make them more efficient, not as a consultant, but as an active participant. Understanding the business, in particular consumer companies and related businesses, gives his fund the opportunity to take a significant position in a company without paying a control premium, while also capturing its share of the gains on improving the operations of the company. And, if companies are in difficulty, his business’s understanding of the underlying potential of the company’s assets and whether their claims have downside protection allows the business to carry the risks forward while others who have little understanding or the skills to analyze the situation give up returns. Time is needed to carry the risks forward, and, as a result, he seeks ways to raise permanent capital that protects his activities if the horizon of the funds’ investors is shorter than the risk transfer needs of the deals.
James Chanos is a short-seller. His filter is accounting mismanagement at corporations because corporate officers use accounting for their own ends, maybe to smooth earnings (borrowing from the future to inflate the current with the hope that the future will provide enough bounty to cover both the past shortfall and the current earnings needs). This sets in motion a vicious cycle of needing to borrow more and more if future bounty is not realized. This cycle tightens the constraints on managerial activity, providing opportunities for Chanos’s group to focus their expertise on spotting “red flags” and unraveling these accounting tricks. Although this might seem more like alpha than omega, the friction caused by managerial actions that cause the imbalances between market value and economic value provide an opportunity for risk transfer services. Market participants use a model to value companies; corporate officers attempt to reverse-engineer that model, and some game the modelers by providing them with “bad” inputs to the models. Market participants do not have the skills or it is not their business to dig deeply into accounting statements and corporate structures to reconfigure the inputs to their models. And, perhaps more important, they are willing to give up returns to the short sellers who have discovered the “bad” inputs.2 It was interesting to discover how Chanos finds these “red flags,” a key to his business, and those that he currently sees everywhere in China and with Chinese stocks (such as real estate and bank stocks).
Marc Lasry and Sonia Gardner (Avenue Capital) are classic omega providers. For example, their expertise is in assuming trade credit risk at a discount and carrying the risks forward until they are able to settle the claims knowing that trade creditors don’t want to take bonds or stock and wait out the bankruptcy process. Avenue Capital concentrates on the capital structure of distressed or bankrupt capital not only determining which risks to carry forward but also which risks provide downside protection. They argue that Avenue profits because investors want companies without problems and are willing to transfer risks of troubled companies to Avenue. They don’t use leverage because they make money by carrying positions (risks) through crises. (I enjoyed the characterization that others focus on liquidity while they focus on value: others want liquidity and are willing to give up returns to risk-transfer specialists who are willing to provide it.
John Paulson provides omega services in mergers, bankruptcies, corporate restructurings, spin-offs and recapitalizations, and litigations. All of these are complex transactions that involve skills, which take time to learn from the perspective of both theory and experience. They are all risk-transfer activities in that other investors don’t have the time or skills to devote to these activities and transfer risks to the speculators such as Paulson. Paulson provides a road map of how to become and to think like a speculator. He knew he would need to learn from the best to hone his skills and work his way into a position to understand and to execute the business. This is why others are willing to transfer risk: they don’t have the expertise. And he concentrates on risks and how to achieve his positions to mitigate his downside risks by trading off returns and risk mitigation. Unlike other investors, who think risk is a control issue, Paulson and the others chronicled in the book, think of risk and return as two sides of the same coin.
David Tepper learned the risk-transfer business from the perspective of a trader. He understands an investor’s needs and typical responses to situations (especially the bad ones) and when and why they are willing to give up returns for long-term gains. As a result, he is willing to take large positions in intermediate short-term supply/demand imbalances in the market. He is not afraid to lose money on positions and hold them for longer periods, as “hot money” leaves positions and “cold money” wait to take over the positions from him. He is willing to step in to buy the distressed debt of companies in the largest bankruptcies as other investors wish to transfer risks to him.
Ray Dalio learned that governments and central bankers spin stories to suit what they want to report. Investors react to these spins believing that these government entities are imparting information about the future. He decided that the historical reaction of markets to shocks provides excellent information on the current market’s reaction to today’s shocks regardless of official pronouncements. Using myriad time series, Bridgewater identifies approximately 15 or so strategies that are constructed to be factor neutral (long and short securities in each strategy to be zero beta) and uncorrelated with each other because they are in different geographical regions, or exhibiting different responses to shocks. (Although Dalio identifies his returns as alphas, I am not sure whether they are omega in my definition in that investors respond to macro information or shocks, and Bridgewater intermediates supply/demand imbalances using time series to establish the value fixed points in his system.) The uncorrelated risks reduce the risk of the portfolio of strategies dramatically, and the risk level can be increased to target risk levels through leverage while dramatically enhancing lower expected returns per strategy.
Although this is the ultimate goal of all hedge funds, most don’t control risk and take significant factor exposures. Bridgewater realized that by concentrating on alpha strategies, unconstrained management (i.e., no benchmark other than LIBOR), it could enhance investor returns and provide them with lower risk than by combining both alpha and beta strategies. Or, to put it differently, it is always possible to port an alpha-producing strategy to any factor exposure and provide superior risk-adjusted returns. The unconstrained alpha strategy produces abnormal returns; the beta strategies produce systematic returns.
Ahuja is an energetic lady. That energy flows throughout the book. She has a great group of Masters who explain their craft, who they are, and how they think, through informative and stimulating interviews. I don’t know how she was able to assemble this amazing group (or even how she got me to write this afterword), but we are fortunate to have so many wonderful insights in one place.
1The classic example of efficiency gain is the farmer transferring the risk of his wheat crop to the miller who stores the crop until the bakers ask for the flour to make the bread and cakes that we consume. The miller hedges generalized market risks by selling futures contracts and giving up return to speculators who carry the inventory risk forward until the bakers buy the flour. Without this service, the miller would not be able to store as much wheat and consumers would incur higher prices for bread and cakes. This risk transfer has occurred since the 1630s.
2Everything being equal, the price of all securities is lower, or the expected return is higher because of this phenomenon. This is a “pooling equilibrium”— the good companies cannot distinguish themselves from the bad because they use the same accounting methods and the same outside accounting firms that attest to the efficacy of their statements. Chaos tries to cull out the sick companies from the pool. And, the more successful he is, the less the provision of “bad” inputs will persist.