Wednesday, September 6, 2006
As we conclude August 2006 our Diversified Option Strategy program returned a positive 1.51% resulting in a year-to-date return of 7.10%. The S&P 500 Index (GSPC) returned 2.13% finally overcoming the negative sentiment leftover from May and is up 4.45% year-to-date. For comparison, the Barclay CTA Index is positive 0.32% as of this writing and up 1.20% for the year. Please refer to our website at www.cervinocapital.com for the most recent performance statistics on our investment programs.
It seemed appropriate at this time to take a step back and analyze the state of the “hedge fund” industry, the changes that have taken place over the past fifty years and opportunities that are still available to us, participants in the alternative investment arena.
We were recently invited to be guest speakers at an international business class at UCLA. The topic of our presentation was “Cultural Crosscurrents within the Financial Services Industry.” Our thesis, applied across various economic case studies, was that norms within society have been progressively influenced by the rapid pace of globalization, resulting in macro-level transformation of the financial industry’s values and its institutions. Which ever way resulting cultural values and norms shift, astute players seek to arbitrage anomalies between local business practices versus innovations in global products/services, regulatory jurisdictions and price parity.
Such arbitrage is fast taking place in the alternative investments segment of the financial services industry as an increasingly competitive environment has subjected practitioners and their respective strategies to the unrelenting march of market efficiency. Over the past fifteen years hedge funds have become widely accepted by investors and institutionalized. By doing so, many sophisticated and previously successful investment strategies have effectively become victims to the hedge funds industry’s success.
The raison d′etre of our industry should be to provide superior money management to clients. Unfortunately this altruistic objective has in varying degrees been complicated by well-meaning regulators, sales practices distorted by conflicts of interest, but most importantly human nature itself where the intrinsic need for social acceptance and validation undermines essential qualities that are prevalent with successful investors – that of nonconformity and unorthodox thinking. Yet as soon as the mainstream assimilates maverick strategies into their portfolios, the seeds of demise are laid for such investment approaches due to a concept George Soros calls reflexivity.
The term “hedge fund” as it is now commonly used is a misnomer. It is loosely defined to be either synonymous with any type of non-regulated fund regardless of investment strategy, or jargon meant to represent all alternative investments strategies in general. Even the Department of Treasury, Board of Governors of the Federal Reserve System, Securities Exchange Commission and Commodity Futures Trading Commission in their 1999 report on “Hedge Funds, Leverage and the Lessons of Long-Term Capital Management” admit that the term is “not statutorily defined.”
Hedge funds first came into existence in 1949 when Alfred Winslow Jones opened an equity fund that was organized as a private partnership to provide maximum latitude and flexibility in constructing a portfolio. He took both long and short positions in securities (thus the name) to increase returns while reducing net market exposure and used leverage to further enhance the performance. To those investors who regarded short selling with suspicion, Jones would simply say that he was using ‘speculative techniques for conservative ends.’ Not only did Jones’ fund outperform the best mutual funds, he kept all of his own money in the fund and employed a performance-based fee structure.
It is interesting to note that Jones operated in near obscurity for seventeen years. Nevertheless, by 1968 approximately 200 hedge funds were recognized to exist, most notably those managed by George Soros and Michael Steinhardt.
During the 1960s bull market, many new hedge fund managers found that selling short impaired absolute performance while leveraging created exceptional returns. Such leveraged exposure turned out to be dangerous as many of these new funds perished after the market downturn of 1969. In 1984 only 68 hedge funds were identified, but this trough marked the beginning of an upsurge with $39 billion under management and 550 funds documented in 1990 growing into $1.2 trillion in assets and over 8,800 hedge funds in existence today.
This growth was not in a vacuum. In response to Congress’ actions with respect to the Small Business Investment Incentive Act of 1980, the SEC proposed Regulation D to replace existing private and limited offering exemptions contained in Rules 146, 240 and 242. Regulation D recognized that there are situations in which there may be no need for the registration provision of the Securities Act, and it also further clarified the definition of “accredited investor.” Shortly after adoption of Regulation D, in a series of no-action letters, the SEC confirmed that hedge funds that made offerings of securities under Rule 506 could rely on Section 3(c)(1) under the Investment Company Act, assuming they had no more than 100 investors. Ultimately, hedge funds came to rely heavily on Section 203(b)(3) of the 1940 Investment Advisers Act which exempts from registration an adviser with fewer than 15 clients during the prior 12 months and who does not hold himself out to the public as an investment adviser, and does not act as an adviser to a registered investment company.
The “retailization” of hedge funds is based on Section 203(b)(3), and the fact that historically the SEC has interpreted a "client" to be someone who is given financial advice by the investment adviser. Since investors in a hedge fund do not receive advice—they are simply investing their money—the recipient of the advice is the fund itself as administered by the investment adviser. What evolved in practice is a non-regulated structure in which a hedge fund manager could advise15 funds (ie, 15 clients), each with 100 investors or 1,500 ultimate investors. This is an example of regulatory arbitrage.
In 2004 the SEC concluded that the “retailization” of hedge funds merited regulatory action and proposed a rule requiring registration. In its push to expand its regulatory oversight to hedge funds, the SEC contended that the meaning of “client” should include the ultimate investors and under this new definition regulators would ‘look through’ the fund to the actual number of investors in the fund.
This rule was put into effect in February 2006. Hedge funds with at least $30 million in assets and investment lockups of less than two years were required to register with the Commission. But to the surprise of many, the U.S. Court of Appeals for the District of Columbia Circuit recently ruled in favor of a lawsuit brought by a hedge fund manager named Phillip Goldstein. In their unanimous ruling the Court stated that the SEC’s argument for imposing hedge fund registration was unconvincing and its rule “arbitrary.”
But this is only one half of the story…
As suggested previously, hedge funds have evolved to represent the vehicle of choice for most alternative investment strategies. These investment strategies as tracked by The Barclay Group include: convertible arbitrage, distressed securities, emerging markets, equity long bias, equity long/short, equity market neutral, equity short bias, event driven, fixed income arbitrage, global macro, merger arbitrage and multi strategy.
Such strategies use to be niche plays disregarded by the mainstream financial services industry as recently as the late 1980s. But in the aftermath of the great bull market of the 1990s they are now being marketed vis-à-vis name-brand wirehouses as institutionalized financial products. Give such acceptance, what does the future hold for this segment of the industry when “fund-of-hedge funds” have successfully exploited the Section 203(b)(3) loophole to become multi-billion dollar “retail” products?
What we do know is that at this size hedge funds need to operate differently than they have in the past.
Already we have seen one hedge fund purchase a controlling interest in K-Mart for the land underneath, while others have been engaged in private investments in public equity (PIPEs) or involved with leverage buy-outs reminiscent of the Michael Milken days. At the same time certain investment companies have redirected their efforts into offering alternative investments within the mutual fund product structure. There is no explicit rule against derivatives in mutual funds, but rather usage of such instruments is constrained by various rules such as “cover requirements,” “illiquid assets" 15 percent rule, and Subchapter M “diversification test,” and “90 percent” and “30 percent gross income” tests.
Many respected opinion makers including James Altucher in his Financial Times article “A thriving juggernaut that is getting too greedy” and Bradley Rotter in his MARHedge guest commentary “Why I’m Getting Out of Hedge Funds” have pointed out that returns have diminished significantly and many opportunities have dissipated as the “anomalies and arbitrage situations these funds earned their keep on don’t really exist any more.” Further, they argue that given recent performance, most of these hedge funds do not deserve the management and incentive fees they’re charging, much less all the other administration fees “fund-of-hedge funds” tack on.
Yet there is still very much a need for superior risk adjusted performance notwithstanding the effort by the industry to commoditize performance with absurd ideas such as hedge fund indices. So what are savvy investors to do?
The answer is to identify emerging niche money managers who operate transparently with agility in markets where anomalies still exist, but also where larger hedge funds cannot trade profitably without incurring undue risk for miniscule returns relative to their size. This is known as the “investor’s edge,” an explainable source for returns and an advantage with respect to trading skills and performance. Institutions call this “alpha.”
For us at Cervino Capital Management, we understand that our clients' returns and by extension our success depends on how we approach the following issues:
Problem #1: Structure—hedge fund structure has certain advantages, but disadvantages include lack of transparency, greater potential for conflicts of interest, lockup periods that restrict redemptions to timeframes inconvenient for investors, and with respect to “fund-of-funds” the layering of fees resulting in much higher costs.
Solution #1: Separate Managed Accounts—clients assets are held by a third party custodian resulting in full transparency and the ability to monitor trading activities on a daily basis; increased flexibility with respect to account additions and withdrawals; ability to revoke trading authorization at any time; competitive fee schedule when compared to the “fund-of-funds” structure due to fee layering.
Problem #2: Regulations—hedge funds are not free from all regulation, but a substantial change in regulations regarding hedge funds poses a major threat to the industry as it is an important factor when assessing the sustainability of certain strategies.
Solution #2: CFTC Oversight—managed futures is unique within the alternative investment universe in that it has operated in a highly regulated environment for the last 30 years under the purview of the Commodity Futures Trading Commission and self-regulatory organization National Futures Association.
Problem #3: Performance—the new paradigm of “portable alpha” proposes that market return (ie, beta) can acquired cheaply and excess returns (ie, alpha) can be “ported” onto beta through exposure to hedge funds; problem is that in recent years hedge funds have reflected performance that is highly correlated to the market as witnessed this May 2006.
Solution #3: Absolute Returns— diversification across a variety of relative value trading strategies with high probability for positive outcomes is the best way to achieve “absolute returns” on a consistent basis; recognition that capacity limitations are a material hindrance to large funds, but the upside is that market anomalies remain in existence with money managers who operate at a smaller size; repeatable strategies utilizing speculative techniques for conservative ends is best way to achieve “alpha.”
Cervino Capital Management has incorporated all the above solutions into its Diversified Options Strategy program. Our vision is to remain a niche money manager utilizing sustainable and lucrative trading techniques in which we can explain where our returns are derived from. We believe that fundamentally the outlook to the global economy present situations that cannot remain in equilibrium. The eventual dislocation of major trends is wonderful for nimble players, where volatility is the friend. For funds whose size prohibit agility, this is a minefield. For the best trading talent, it is a gold mine.
- Davide Accomazzo, Managing Director
- Mack Frankfurter, Managing Director
Sunday, September 3, 2006
can affirm, which he will not believe.
— Dr. John Gordon, 'The Doctrines of Gall and Spurzheim', 1815
I recently attended a brilliantly marketed event held at a certain hotel. The costly mailer advertised that several Genuine MILLIONAIRE Experts including a certain celebrity would share the “secrets and strategies” to creating wealth. One of their testimonials touted:
“I’ve almost tripled my portfolio in the last 11 months from just under $1M to over $2.7M. Thanks!”
While archetypal of claims made on late night infomercials, financial professionals are well aware that the Investment Advisers Act of 1940 prohibits advisers from making misleading statements or omitting material facts. In particular, "false advertising or mis- representation includes the use of testimonials or endorsements which is prohibited." This bears repeating... THE USE OF TESTIMONIALS OR ENDORSEMENTS IS PROHIBITIED.
My curiosity piqued, and so I decided to investigate this "once in a lifetime" celebrity symposium. Who were these guys, what were they promoting, and how were they able to skate by industry regulations?
The definition of a charlatan is a person practicing quackery or some similar confidence trick in order to obtain money or advantage by false pretenses. Unlike a conman, he does not try to create a personal relationship with his marks, or set up an elaborate hoax using roleplay. Rather, charlatans resort to quackery, pseudoscience, or some knowingly employed bogus means of impressing people in order to swindle victims by selling them worthless nostrums, goods or services that will not deliver on the promises made for them. The word calls forth the image of an old-time medicine show operator, who has long left town by the time the people who bought his snake oil tonic realize that it does not perform as advertised.
Could it be that these guys are the modern day equivalent of financial snake oil operators?
Before conveying what transpired, let me emphasize that the majority of the professionals I know, from insurance agents and financial advisors to professionals in related fields of accounting and estate planning, behave honorably and in the best interests of their clients. Additionally, there are ample regulations in place as well as industry watchdogs and administrative bodies imposing strict guidelines pertaining to its members’ conduct and ethics.
All the same... “Caveat emptor”
Unfortunately this age-old piece of wisdom raises the pragmatic question of how such advice should be put into practice. The answer is twofold: first, educate yourself; second, follow the money.
Most (but not all) financial products are commission-based, that is why the economic foundation and core culture of many brand name commercial banks and brokerage houses rests in their sales force. Yet all because financial products are packaged and sold, it does not automatically make such investments “bad” for the consumer. The question is whether the traditional product-driven, commission-based sales culture that permeates the financial services industry best serves the interests of investors?
As investors have become more educated and less inclined to be “sold” financial products, there has been a transformation in the financial services industry. Have you noticed that there are no more “stockbrokers” or “insurance agents”? Financial product salespeople have evolved into “Vice Presidents,” “Private Bankers,” “Estate Planning Specialists,” Financial Planners,” and all manner of intriguing and captivating titles denoting trustworthiness, wisdom, experience and financial acumen. These titles—they may be well earned and deserved—are meant to boost professional credibility, and to provide consumers with confidence that they are being advised rather than sold, which may or may not be reality.
Fact is that the majority of stock and bond market “advisors” are commission-based “registered representatives,” which is their official regulatory title and indicates that they are agents of their employers (broker-dealers), and are registered and licensed (Series 6 or 7) to receive commissions for the sale of securities (stocks, bonds, etc.). Ludicrously, the Series tests are not at all difficult to pass, and bragging rights often go to those with the lowest passing scores because they are “most likely to succeed”—I am not kidding.
In effect, registered representatives are distribution agents for broker-dealers—it is their job to sell products to the investing public, for which in turn they are paid a percentage of the commission. The percentage a registered representative receives is dependent upon the trailing level of “production” (ie, sales) that he or she generates for the firm. That’s why broker-dealers refer to their agents as “producers” and every representative’s goal is to become a “top producer”. As in any sales culture, compensation is the ultimate benchmark used to measure effectiveness—not the performance of clients’ accounts. A top producer ranking means that he or she is among the biggest generators of sales commissions for the firm and is among the highest compensated agents.
The untarnished truth is that the majority of well-known brokerage firms (also known as wirehouses) push new advisors to sell, sell, sell and only pay lip service to the building of a financial practice with the clients’ best interest in mind.
But I digress… What were these "celebrity" get-rich-quick experts selling? The answer is half truths wrapped in a ‘one size fits all’ motivational pitch designed to push all the right “greed” buttons and get you to buy their snake oil. And the crowd was gobbling it up!
Looking sharp in an expensive business suit and carrying the swagger of a just retired football quarterback, our first presenter was selling a website that provided systematic buy/sell entry/exit points for “only $8,000”. Showing charts with well known and commonly used indicators such as MACD, RSI and stochastics he illustrated on two huge screens presentations of back-fitted trades all perfectly aligned to make money at every twist and turn of the stock. He went on to claim that “these technical tools can help you [us] make a 95% annual return, which over twenty years can turn a $5,000 investment into over $3 billion dollars!! Now, wouldn’t you [us] all like to make a billion dollars?” He extolled to the whoops and applause of a roused audience. So as to nail it home, this charismatic and authoritative speaker was willing to offer us the whole package at a reduced price of just $3,000 including a two day seminar required to make attendees overnight experts on his website system.
I was amazed to watch a large group of the attendees flock to the back tables and happily plunk down $3K knowing that armed with this man’s “secrets” (and their remaining $5k from the $8k “actual cost”) they too will turn into multi-millionaires. Unfortunately they didn’t realize that this so-called “knowledge” about systematic trading is well documented on the business bookshelf at their local Borders Bookstore. And as far as all those charts and indicators on his website, these services can be easily obtained without charge on multiple websites not to mention that most brokerage firms now provide excellent trading portals with an abundance of similar tools.
Of personal interest was the regulatory loophole that allowed this mountebank to use unsubstantiated testimonials—technically he was only selling “investment education” and access to a website. And because he positioned himself as an “educator” and not an advisor, he did not have to be registered. At the same time, while websites providing specific buy/sell investment advice given should be a regulatory cause of concern, my suspicion is that his firm side-step this issue by having their subscribers input their own buy/sell rules based on the two-day seminar each must attend. What was most devious about the slideshow was that the so-called systematic entry/exit points shown were back-fitted and selectively presented. There is not enough room here to go into the development of robust trading systems, but I’ll relay to you what the National Futures Association (NFA) has to say about this:
HYPOTHECTICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOVLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNT FOR IN THE PREPARATION OF HYPOTEHTICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.
Next was a Juris Doctor appropriately bespectacled to substantiate his intellectual lawyerly demeanor. Just as polished and motivational as the prior speaker, his pitch began with C-Corps. According to him every single one of us was losing out on all sorts of tax deductions and needed to immediately establish our own C-Corp using his easy-to-use book of forms (for only another few thousand dollars, I might add). What about having legitimate business income? “Well aren’t you all going to make big bucks with that trading system you were just shown,” he taunted, “that’s legitimate business income!” Then without skipping a beat he was off and promoting Charitable Remainder Trusts as if this structure was appropriately suitable for each and every attendee.
Now there is no doubt that such structures in certain situations can be beneficial. But the operative words are “appropriate” and “suitable.” For some J.D. who isn’t even a practicing attorney in the State of California to be flatly suggesting that we ALL could benefit from his one-stop-shopping advice made my stomach crawl.
But wait, there’s more! The third expert was about to speak about the “safest, most lucrative, investment strategy in America”—tax liens. To learn everything I needed to know to set myself up only would cost me only another “measly” $3,000. I had enough... I could go on about tax liens as I was once responsible for winding down a portfolio of tax liens purchased from Kidder Peabody by the investment boutique I worked for, but I think my point is made.
So what is to be learned from all this?
Savvy investors know that good investment results requires the steady and persistent application of knowledge, hard work and prudence. Obtaining outsize returns can only be generated by outsized risk—sophisticated investors understand how to measure risk in relation to the returns their portfolio generates. They also ensure that their portfolio is well diversified across a variety of trading strategies as well as asset classes, and monitor the markets and make tactical adjustments as necessary. In order to do this properly institutional and sophisticated investors delegate portfolio management to money managers who have expertise in specific investment strategies.
I hear a lot of criticism about the financial services industry and us professionals in the business—some is deserved, but more often criticisms reflect a level of confusion about investments in general. Yes, it helps to be familiar with the structure of the financial services industry, the sales culture that it propagates, and how your advisor is being paid. But if your not comfortable with investing on your own, that should not prevent you from seeking help to create a personal financial plan and structure a well diversified investment portfolio.
So whether you invest on your own or work with an advisor(s), the key to successful investing is education, diversification and disciplined approach(es). When using a professional seek out advisors who take the time to communicate the costs, risks and benefits of their investment approach. Reputable advisors encourage the public and their clients to become ever more knowlegable about the investment process and risk-return concepts, as that translates into the ability to advise on sophisticated strategies.
Postscript: What about the celebrity? Who was he? Without naming names, it’s enough to say he was a participant in some reality TV show. Like I said, half-truths…
- Mack Frankfurter, Managing Director