Global Macro Trading Journal

[Martinghoul]

So let me speak very generally about some of the issues that Daal raised... Especially, since I am being accused of being non-constructive. My goal here was to avoid getting into a discussion that would be more about our biases than about the substance of the issues.

So there are a few points and I'll try to be as specific as I can. I am happy to expand on any of the particular statements made.

1) The main and the biggest issue with the idea that risk concentration (and, more broadly, Ackman's risk management strategy) is fine is very simple. Specifically, it ignores the simple fact that any hedge fund is a highly leveraged institution. In fact, the conclusions in the article about the stock portfolio diversification in the presence of leverage are very telling.

2) In a setting where leverage is present and, especially where a "value" strategy is used, it's contradictory and nonsensical to use Optimal F or Kelly (full or half or whatever) as one's benchmarks. There is ample literature on this. This is also the reason why direct comparisons with Buffett are inappropriate.

3) This is a very useful guide to the particular issues that apply to hedge funds (straight from the horse's mouth, so to speak):
http://www.hkimr.org/uploads/seminars/133/sem_paper_0_343_capula_risk_framework_v11.pdf
The chart on page 26 in that document is instructive.

4) The argument that PS is somehow special and typical hedge fund constraints and leverage logic don't apply to Bill Ackman is not credible. I see no evidence whatsoever that Ackman's arrangements with his investors, prime brokers and administrators/custodians are magically less onerous than for other funds. Furthermore, it's silly to argue that it's not the manager's fault that their investors are more risk-averse than expected. Managing and satisfying investors is part of the job description for any hedge fund manager.

5) Finally, one needs to also be realistic about the negative externalities associated with getting a highly concentrated bet wrong. For instance, Bill Ackman has had to join VRX board. This means that his VRX investment is completely illiquid for an indeterminate amount of time going forward (especially, in light of the Quebec MCTO). There are several other concerns along similar, but unrelated lines.

6) IMHO, given the compensation that hedge fund managers receive, they do not deserve the right to make mistakes. As far as I am concerned, Ackman's conduct demonstrates multiple errors of judgement and he has already struck out once before. I am not referring here so much to the initial size of the VRX bet, but rather everything that followed (especially, the options trade).

 

[Daal]

I was sick saturday so I had plenty of time to ramble and discuss. Markets will open in a few minutes today so I can't reply but I will read that paper and answer when I have the time

 

[Daal]

Here is a quick trade idea. Short Jan 2017 Fed funds futures. If the Fed doesn't hike this year, you lose 23bps or so, if they hike once you are more or less flat. If they hike twice you make ~25bps, if they do it three times, you make 50bps. I think they will go 1 or 2, maybe 3. I see little chance of no hikes barring a recession or a stock market plunge (but even if they plunge, if it comes back, then hikes are back on the table). The Rosengreen statement this morning makes me think this can be a good trade

 

[Daal]

Its not a nobrainer because this is a bit like being long stocks and stocks seem overbought but its a interesting trade that is likely to work or at least not lose anything

 

[Daal]

Since you like throwing ideas and you talked about numbers lets see something imaginary. An uncle gave you $2 Billion (with a B). You decided to invest $1B in real estate (not REITs but directly to properties yourself eg an apartment in New York and so on) and left the other $1B for the markets. Now we assume that because of the fact that you are renting all your properties you have an absurd monthly income that can support your life forever. So you decide to be as aggressive as you want. You are investing as a family office so you can invest and have access to whatever you want like a normal hedge fund but you invest only for yourself not investors.

How would you invest your money both in bulls and bears?

I havent had the time to read Martin's paper so let me answer your question which I believe its more clear cut. So you gave three pieces of info, you already have 50% of the assets in US real estate, you want to be "as aggressive as you want" and you have no investors

Since capital growth is what matters and you already own a a fair amount of fully paid US real estate (which I assume has a lot of properties and consider a low risk investment) having the other 50% be focused on equities I believe is what makes sense. But I wouldn't want to have it all in the US because it would leave the investor overly exposed to just that country. I believe a 1/3 US 1/3 Emerging markets and 1/3 other developed markets makes sense. The FX risk can be significant but that can be debated (from what I have read, hedging EM exposure as a USD based investor costs money over the long-term but maybe the data is not sufficient)

Maybe I wouldn't want to deploy it all at once, I believe that in this enviroment (with risk assets likely to be trading in a range), you want to be buying on weakness, VIX spikes, etc. Keeping a decent cash reserve to deploy into those panics

I would also want to have a good amount of that money in different countries for further judicial/confiscation protection

 

[Daal]

So I read your paper. I got to say, its excellent, it should be required reading to anyone running/planning to run a hedge funds I agree with pretty much all of it

The thing is, it looks to me that you don’t seem to know the Ackman funds structure deeply enough and that is leading to think he is in some major violation of the principles you outlined in the paper.

Here are some main points from the paper:

“The funding (Prime Broker) option is especially potent, given the fact that most hedge funds (unlike banks) do not have access to equity or other capital markets for financing”

And that’s why the Ackman funds are unique (or at the very least, rare). He does have access to equity and capital markets financing. Approx 50% of his AUM is from equity, bond (with long maturities) and management capital (with the majority of that being from Ackman himself, which is very permanent)

But there is more, a lot of the other 50% are from long-term investors who have been with him a long-term, have significant profits off their investment and are unlikely to redeem. He wrote in the letter to shareholders “The balance of our funds is also quite stable as the substantial majority of our private funds has one eighth per quarter liquidity and is held by investors (other than several new investors who joined in the last year), who have made large profits over many years of investment in Pershing Square.”

The evidence of the stickiness of that is the fact that in Q1 2016 redemptions were still very low even though Ackman had its worst year ever last year and was bashed in pretty much very newspaper/financial TV.

Therefore, to use your own risk management principles, the amount of risk capital that he can employ at any given time is higher than you seem to be realizing because the short option (coming from investors redemptions) is further out of the money than it looks.

“One of the main points that we wish to get across (to be elaborated in much greater detail later) is the fact that the expected return of a hedge fund, as well as the associated risk, depends not only on the ex ante evaluation of the hedge fund portfolio strategies per se, but also on how effectively the hedge fund manages the funding and redemption options. “

Judging how he structured his funds after Gotham Partners I’d say that he has restructured his investment approach to be very much in line with your risk management principles. He priorized having that stable capital base. Also, because he regularly communicates with investors, that also helps people from freaking out and panicking

“The ‘redemption option’ held by the investors is usually dealt with through carefully articulated and investor-approved contractual provisions such as a reasonably long redemption cycle (say quarterly) and with a reasonable notification period (say 45 to 90 days), lock-up periods (can be hard or soft), early redemption penalties, investor-level or fund-level gates, etc”

“The presence of lockups and gates will serve to lower the value of redemption options, cetaris paribus. Aragon (2004) uses monthly data to document a positive, concave relationship between a fund’s excess returns and its redemption notice period and minimum investment size.


“Hombert and Thesmar (2009) show empirically that funds with lockups outperform funds with no lockups, conditional on past bad performance. “

“It should be clear that the triggers depend on contractual terms: for example, we may expect that R will tend to be higher with gates than without.“

Good stuff. This is why his approach now seems to be the poster child for your method. I understand you have some issues with the options trade, and I will address that, but from the client funding perspective he has followed your method in a significant way.

 

[Daal]

“Second, if the hedge fund has multiple PBs, its positions are likely to be distributed across different PBs and therefore there is a loss of margin efficiency in that risk across PBs can not be netted. The aggregate risk perceived by each of the PBs will therefore be higher than the portfolio risk (namely ) 1 ( * ' Lt  t ). As a result, t will typically be much higher than the credit multiplier that each PB assigns to the hedge fund.”

“In our view, the use of the unencumbered cash as a risk management tool has not been sufficiently emphasized. Indeed, we would argue that unencumbered cash is probably the most important risk management tool at the disposal of a hedge fund. There are several reasons why. “

Ackman raised $800M in cash recently probably in order to get ahead of any issues arising from redemptions and/or the options trade. The redemption issue is likely to be very contained as it is limited (mostly) by the new investors from the 50% non-permanent capital base (and perhaps a much smaller percentage from the long-term investors). We are talking about maybe 20% of the total AUM. Even though Ackman suffered a big drawdown (more than what 99% of hedge funds would be able to survive) he is only raising 7% of AUM in cash to deal with that problem, that is remarkable. I’d say the fact that he followed your principle and secured a stable funding base is what enabled him to do that.

I understand you don’t like the options trade because it increases the exposure to the short options like exposure of having the prime broker demand margins or liquidate you in bad times. But to that I would say two things

-Because the investor funding short option like exposure is so out of the money (and hence, demands less unencumbered cash), he can afford to take more risks in Prime Broker side and still be well within reasonable levels of risk. One can’t look at the trade without factoring in the potential reward. It can turn out that he was wrong on that but that is hindsight, the actual decision to put the trade on when you have such strong and stable capital base was in line with your principles. The trade was small compared to total AUM

-I don’t know how PBs work at a multi billion dollar level but I’d say that there is a chance that his PB accepts securities as collateral instead of just cash. I mean, why wouldn’t a PB that will take MDLZ stock at a good (even if large) haircut level as collateral? The reason I suspect this is because the efforts that Ackman has made since the Gotham situation to prevent forced liquidations. He has very much tried to align his fund with your principles if you look carefully

“Greater the inefficiency, higher will be the parameter  and hence lower will be the unencumbered cash level


In general, b > a, as the asset sale after PB seizes control tends to be done at “fire-sale” prices, whereas de-leveraging in response to investor redemption can often be done at somewhat more orderly fashion and reasonable price levels, especially if the hedge fund is endowed with reasonable investor liquidity terms such as a reasonable notice period and a reasonable gate policy. “

Another reason to think his fund is unique compared to the avg fund out there

“On the other hand, the trigger level for funding option tends to be much lower than the redemption trigger level.”

“Equation (7) immediately implies that, in general, the expected excess return of a hedge fund is less than the alpha of the underlying strategy multiplied by the leverage ratio. If the leverage ratio is too high, the funding and redemption options will have a significant probability of being exercised and the expected excess return can be negative. Excessively levered hedge funds can have a return profile similar to shorting options directly as part of its investment strategies.”

Good stuff. I view Ackman’s leverage as not significant. Total strategy AUM as of Feb 2016 $12.2B, total long positions $12.5B plus HLF short (roughly $800m). $1B debt at PSH. His only levered entity, PSH, is loaded with permanent capital. The actual hedge funds have maybe 100-110% long exposures.


“This result has an important risk management message: hedge funds will be well advised to factor their contractual relationships with prime brokers and investors in determining their aggregate risk capital.”

I agree


“2) In a setting where leverage is present and, especially where a "value" strategy is used, it's contradictory and nonsensical to use Optimal F or Kelly (full or half or whatever) as one's benchmarks. There is ample literature on this. This is also the reason why direct comparisons with Buffett are inappropriate.”

I disagree. As I explained, his funds (due stable capital base) resemble Buffett’s a lot more than most hedge funds. Its not as stable as BRK (because of the non-PSH funds) but its pretty stable compared to most. This means that he can take more risk per position and hence, get closer to a safely calculated Optimal F. Not that one should get in that habit of doing that, but doing it occasionally is fine.


“4) The argument that PS is somehow special and typical hedge fund constraints and leverage logic don't apply to Bill Ackman is not credible. I see no evidence whatsoever that Ackman's arrangements with his investors, prime brokers and administrators/custodians are magically less onerous than for other funds. Furthermore, it's silly to argue that it's not the manager's fault that their investors are more risk-averse than expected. Managing and satisfying investors is part of the job description for any hedge fund manager.”

The first part I already explained before. As far as risk aversion mismatching, I’d say that was more of an issue at Gotham, not now. Now, its more of his observers having a lower risk tolerance rather than his investors.


“5) Finally, one needs to also be realistic about the negative externalities associated with getting a highly concentrated bet wrong. For instance, Bill Ackman has had to join VRX board. This means that his VRX investment is completely illiquid for an indeterminate amount of time going forward (especially, in light of the Quebec MCTO). There are several other concerns along similar, but unrelated lines.”

Lets say you make an investment where you think there 75% of you doing well. 25% of you having problems and when you do have problems, you implement a plan B to deal with it and maximize the recovery of that investment. I’d say its pretty rational to do that. Some people might criticize you for having made the mistake but that is hindsight thinking


“6) IMHO, given the compensation that hedge fund managers receive, they do not deserve the right to make mistakes. As far as I am concerned, Ackman's conduct demonstrates multiple errors of judgement and he has already struck out once before. I am not referring here so much to the initial size of the VRX bet, but rather everything that followed (especially, the options trade).”

Well, I addressed that. I just think that because you never liked Ackman much, you haven’t done all DD on his funds so you assigned a much bigger factor to the investor funding option issue and hence looked at the options trade without that context. If he was running a typical hedge fund, I would agree, it would be dumb to avg down with a PB sensitive trade when your investors are freaking out. But because he followed your principles after Gotham (and the options trade was small), he is still well within good risk management guidelines. You might disagree with him about VRX but if you look in the context of his decision (secured investor base), putting a small options trade when you believe it will be highly profitable and still keep your risk exposure to funding limited, looks pretty rational to me

 

[Daal]

Its funny, you, the writer of the paper should be actually a fan of Ackman's strategy (even if you don't like some of his picks). Here is a fund that managed to have 50% of its capital not be subject to redemptions and the 50% have a 1/8 per quarter gate (and a lot of that being long-term holders). They are very resilient to having to liquidate a lot of their assets during market distress. Most of AUM that will have to be sold if everybody starts to reedeem is 6.25% of AUM per quarter (assuming the long-term holders sell). This negates most of the effect of liquidations on the manager's returns since it will take 2 years for the investors to get their money back

Since there is very little impact on returns coming from the redemptions side, that leaves a lot of room to take risk in the prime broker side, which Ackman did but still did in a small way

 

[Martinghoul]

Well, as to Ackman, needless to say I think you've got your rose-tinted glasses on. I don't expect you to believe me, but I will tell you regardless and we can maybe stop discussing this topic, since it's so subjective and non-factual. For a very long time, I have worked for a fund whose funding AND investor arrangements Ackman could only dream of. Based on this experience, as well as others, I have to tell you that you're being overly optimistic about how much Ackman's arrangements minimize the short optionality issues. More importantly, in the absence of specific knowledge of how EXACTLY the fund is structured which neither of us have, I believe a hedge fund investor needs to be very skeptical, especially around contingencies, in order to preserve the margin of safety. In fact, that, in my view, is the main takeaway from the Capula paper. Your commentary suggests to me that you're the opposite of skeptical. I can't know whether this is a function of you being in the trade already or not, but I would strongly advise you to take everything you hear with a large pinch of salt. Obviously, the ultimate judgement is yours and yours alone.

As to the point I have made repeatedly about the options trade, it's, again, about adding to the short optionality. Regardless of your personal estimate of how far OTM his funding/redemption options are, they are still shorts. The size of his position, as demonstrated by the ensuing events, also makes him short the liquidity option. To add another explicit short option position to the pile is, IMHO, foolhardy and extremely imprudent. As to posting securities as collateral, yes, of course, that's what funds normally do, but up to a certain point. Ultimately, PBs impose leverage constraints as expressed by the actual amount of unencumbered cash and these constraints tend to tighten as the fund experiences drawdown.

As to Kelly and Optimal F, I should remind you that those are dynamic quantities. So here's a question for you. What do you think a practitioner who applies such rules consistently should be doing during the drawdown such as PS has experienced?

On negative externalities that I referred to, you have totally missed my point. My issue is not the "mistake" itself. Everyone makes mistakes. The problem is all sorts of unforeseen collateral damage that comes out of the woodwork to bite you in the a** when you make a mistake on a trade that large and concentrated.

Anyways, this is just my Z$2c...

 

[Daal]

Well, as to Ackman, needless to say I think you've got your rose-tinted glasses on. I don't expect you to believe me, but I will tell you regardless and we can maybe stop discussing this topic, since it's so subjective and non-factual. For a very long time, I have worked for a fund whose funding AND investor arrangements Ackman could only dream of. Based on this experience, as well as others, I have to tell you that you're being overly optimistic about how much Ackman's arrangements minimize the short optionality issues. More importantly, in the absence of specific knowledge of how EXACTLY the fund is structured which neither of us have, I believe a hedge fund investor needs to be very skeptical, especially around contingencies, in order to preserve the margin of safety. In fact, that, in my view, is the main takeaway from the Capula paper. Your commentary suggests to me that you're the opposite of skeptical. I can't know whether this is a function of you being in the trade already or not, but I would strongly advise you to take everything you hear with a large pinch of salt. Obviously, the ultimate judgement is yours and yours alone.

I just find that even if you are right, its ultimatly irrelevant for me. Of course, there is a certain drawdown percentage that anyone will redeem, so far it has not been reached and I believe there is still more protections there but even if they were to be breached, I'm not an investor to his parternship hedge fund, I'm in the stock which is not subjected to redemptions. So if anything, the funds redeeming would bring the AUM down which is likely to improve performance. My DD on Ackman tells that the likelyhood that he will walk away from PSH because of its distance to the high water market is very low so. Of couse there is risk but to avoid good investments because of fears to low probability events combined with other low probability events is just to want to have mediocre returns. I mean, by this logic, there is barely any investment that is ever worth making.

As to the point I have made repeatedly about the options trade, it's, again, about adding to the short optionality. Regardless of your personal estimate of how far OTM his funding/redemption options are, they are still shorts. The size of his position, as demonstrated by the ensuing events, also makes him short the liquidity option. To add another explicit short option position to the pile is, IMHO, foolhardy and extremely imprudent. As to posting securities as collateral, yes, of course, that's what funds normally do, but up to a certain point. Ultimately, PBs impose leverage constraints as expressed by the actual amount of unencumbered cash and these constraints tend to tighten as the fund experiences drawdown.

You talk as if it didn't matter at which scale he is behaving in this fashion. As if it was a sin to add the short optionality even though he is underexposed to the funding/redemption option not matter the size of the short. I believe that contradicts your very formulas because the extend of the short optionality exposures are a key input there. Yes we can't know exactly how his fund is structured but based on what is disclosed, it does not look like he is overrisking.
Of course, there is always a breaking point where everything falls apart but also, there is some amount of risk that is unavoidable in life (like being hit by a car), that doesn't mean we will shutdown all risk taking. If his PB will take stock as well (and I asked that question for tomorrow's call) then the options trade is even more aligned with your principles. Not only it is european style but posting stock will prevent forced liquidations

As to Kelly and Optimal F, I should remind you that those are dynamic quantities. So here's a question for you. What do you think a practitioner who applies such rules consistently should be doing during the drawdown such as PS has experienced?

I wasn't advocating of applying 'such rules consistently'. My point is, in order to find out where the limit is, those formulas provide a decent starting point. How can you avoid a precipice if you dont know where it is?

On negative externalities that I referred to, you have totally missed my point. My issue is not the "mistake" itself. Everyone makes mistakes. The problem is all sorts of unforeseen collateral damage that comes out of the woodwork to bite you in the a** when you make a mistake on a trade that large and concentrated.
Anyways, this is just my Z$2c...

Well, he made a mistake there in terms of allocation. But to walk away from the investment and not try to maximize the recovery would only cost him even more which does not appear rational to me