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This note was originally published at 8am this morning. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK in real-time, published by 8am every trading day.

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“The best investors in the world do not target returns; they focus first on risk.”
-Seth Klarman

EARLY LOOK: Focus on Risk - Screen shot 2010 08 25 at 9.13.37 AM

 
Seth Klarman founded Baupost in 1982. He’s one of the best players who are left playing this game. He’s not your huckleberry if you are looking for someone to get levered up long. He’s conservative. He likes cash and he has no problem moving to a cash position greater than 50% of his assets.
 
I’m not Seth Klarman, but I like cash too. I currently hold plenty of cash in our asset allocation model. I get that some investors have (or think they have) leverage figured out. I have yet to see a levered long equity or commodity fund perform in a bear market, but that certainly doesn’t mean one may not exist. Please forward details if you know of one that’s generated absolute returns in both 2008 and 2010.
 
Yesterday we invested 6% of the Cash position in the Hedgeye Asset Allocation model, taking our recommended Cash position down from 61% to 55% (buying DJP and IHE). When we started getting bearish in April/May, our allocation to cash peaked at 79%. In bear markets like these, I fundamentally believe in managing a large cash position dynamically.
 
I’m not ready to say “buy-and-hold” is dead. I don’t think it will ever be. Whether it’s investing in Hedgeye in 2008 or buying Starbucks (SBUX) in early 2009, I doubt I’ll ever sell these positions. However, I will say that buy-and-hope is dead. Buying on valuation alone in a slowing growth environment is rarely a catalyst and hope is not an investment process.
 
Managing risk in an interconnected global ecosystem of colliding macro factors is a repeatable risk management process that we can all apply. If we are accountable to our investors in focusing “first on risk”, that is…
 
Every day the score is re-calibrated. I’m pretty sure that the triumvirate of Google, Wikipedia, and YouTube will be holding us all accountable to how we managed risk on both the downturns of 2008 and 2010. History will decide whether Hedgeye was useful to your investment process long after I am dead.
 
We’ve been bearish on US Equities and now we are accountable to our clients in recommending where they book gains in these bearish positions. Making calls on US GDP or housing slowing is only one part of the risk management process. The most critical part of the investment process is getting the timing right.
 
We had the timing right on the way down. The question now is can we get the timing right on the way out? Here’s how I thought this through yesterday as I was covering 5 of the 14 short positions in the Hedgeye Virtual Portfolio (SPY, XLI, HOT, IWM and XLY):


 
1.      Math: Immediate term TRADE support (our most immediate term risk management duration – 3 weeks or less) in my macro model for all of the aforementioned short positions was 2.5 standard deviations oversold. This is not to say that 3 and 4 standard deviation moves couldn’t occur this morning, but looking at the macro calendar of events today, I made a conscious decision to bet against those low probability events.

 

2.      Risk/Reward: For the sake of this illustration I’ll use the SP500 (SPY) short position – moving to a 3 standard deviation level of downside support I was coming up with 1040 (the 2.5 standard deviation level = 1053), and in terms of immediate term TRADE upside I was registering 1077 on a 2 standard deviation move. Net net, I saw 2.5:1 upside versus downside in getting longer and I thought that was worth taking.

 
3.      Volatility: The inverse relationship between the VIX and the SP500 continues to be a heavily weighted risk management signal in our 27-factor baseline model. It hasn’t always been – it just is now because the inverse correlation between the two remain very high on an intermediate term basis. At the same time as I’d call the SP500 immediate term oversold anywhere south of 1053, I was registering the VIX immediate term overbought anywhere north of 27.57. Since the VIX closed at 27.46, that was close enough for me to stick with my cover/buy signal.

 

Now all this starts and ends with risk management. I wasn’t trying to decide whether or not we should drop our net long exposure from 140% to 107% yesterday. I was risk managing how to A) get out of 1/3 of my short positions and B) get into some long exposure to US Equities. There is no rule saying I can’t re-short any of these positions at anytime today. This doesn’t make me bullish either.
 
Again, it’s a lot easier to think this through from a position of strength. I’m certainly not always in a position of strength either. Yesterday I was, and my risk management task was to focus on risk first. Don’t get squeezed on the short side and focus on investing cash when markets are oversold.
 
I realize that this is unconventional. I realize that sometimes it’s hard to read about my team’s wins. I am very aware of the confidence interval I have in this team’s risk management process, and I can assure you that the hardest part about all of this is how hard I am on both my team and myself. Showing you what we do, when, and why isn’t easy. Neither is modern day risk management.
 
As of last night’s close, our Hedgeye Asset Allocation portfolio had the following positions and weightings:
 
1.      Cash 55%

2.      International FX 21% (Chinese Yuan (CYB) = 15%, British Pound (FXB) 6%)

3.      Commodities 9% (DJUBS Commodity Index (DJP) = 6%, Gold (GLD) = 3%)

4.      Bonds 6% (all TIP)

5.      US Equities 6% (Utilities (XLU) = 3%, US Pharma (IHE) = 3%)

6.      International Equities 3% (Brazil (EWZ) = 3%)

 
Best of luck out there today,
KM