Subscribers have access to the EARLY LOOK note every trading morning at 8am (in real-time). This is a one-off post for this morning.
“You need to be decisive, open- minded, flexible and competitive.”
Our profession saw one of its all-time greats retire yesterday. Stan Druckenmiller, as one of his good friends told me, was one of the best at this game because “when he knew he was going to be right, he just spread his wings.”
After they get access to an interview, the manic media quickly comes to realize that hedge fund people aren’t Avatars. The most consistent hedge fund managers in this game are very matter of fact and common sense people. They have their own repeatable risk management process. They are as competitive as a professional athlete in executing it. And they are mentally flexible enough to change their positioning as the game changes.
Stan Druckenmiller likes to look at charts. I have a beauty that’s taped on the inside of my notebook that I often show clients to depict the correlation between hedge fund strategies going back to the early 1990’s. I use the early 90’s because that’s when we started to see the divergence between the real pros in this business and the monkeys in the hedge fund mafia who chase one another’s positions.
This chart demonstrates one very obvious fact: hedge funds used to have very low correlations to one another (0.3 in 1993) and now they have very high correlations to one another (averaging between 0.7-0.8 from 2007-2009). Therefore, you should invest with those hedge fund managers that can generate absolute returns in down markets. Druckenmiller was +11% in 2008.
From our skunk-works of chaos theory here in New Haven, CT, here are some deep simplicities associated with hedge funds who consistently drive absolute returns across bull and bear markets:
1. Hedge funds that consistently find alpha in their idea generation.
2. Hedge funds that maximize that alpha (spreading their wings) when they find it.
3. Hedge funds that hedge.
What not to do: run 140% net long and cut your net your exposure to 107% when you realize it’s a bear market. That’s not what I call being hedged. That’s called being levered long. The nascent history of this industry has shown plenty of real pros who end up feeling like monkeys when they go there.
Another way that a real pro can start having performance issues is when they miss a big macro move. On top of the statistical reality that there are upwards of 10,000 hedge funds trading their gross and net exposures in a highly correlated way, you also have the institutionalization of asset management driving fund flows. When the macro wind moves from bullish to bearish, you need to be flexible.
Going back to 1993, when hedge fund returns weren’t correlated, the % of the US market controlled by “institutional investors” was running just inside of 45%. Today, that number is running closer to 65-70%, and there is an intense amount of pressure for asset managers to be “fully invested.”
Being “fully invested” means having a very low position in cash as a percentage of assets under management. After all, the art of managing money is actually having money to manage, so asset managers need to feed the beast. That doesn’t make it right.
If you look at the cash positions in US Equity Mutual Funds today versus the early 1990’s, the chart may or may not shock you. Cash as a percentage of assets under management has plummeted from 13% in 1991 to less than 4% today. Which way do you think this chart goes next?
And what do you do when long only investors are chasing relative performance bogeys on a monthly basis while levered long funds (disguised as hedge funds) are chasing them daily and weekly? I think those asset managers who are “open-minded and flexible” about thinking through this question of dynamic asset allocation to cash are going to continue to deliver to their clients what they really want – not losing their money.
I wake up every day with one risk management goal in my head – don’t lose our clients money. Maybe I should have been a goalie – or maybe I should have submitted my resume to a pro like Druckenmiller who could have taught me how to spread my wings when I get the hot hand. I have much to learn.
Our cash position in the Hedgeye Asset Allocation model is currently 61% (when we were bullish in August of 2009 it was 23%). We remain a short seller of both the US Dollar (UUP) and the SP500 (SPY) on strength and our best long ideas in global equities remain Utilities (XLU), Brazil (EWZ), and Indonesia (IDX).
My immediate term TRADE levels of support and resistance for the SP500 are now 1062 and 1099, respectively.
Enjoy time with your family and friends Mr. Druckenmiller. Your world class risk management performance will be missed, but never forgotten.
Best of luck out there today,