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Mailbag: By Our Own Petard

Date: Sunday, December 8, 2019 3:19 AM EDT

I don’t think it’s every worth getting caught up in trying to create a hurdle from anything that starts to look like risk model beta, whether that’s holdings-based (e.g. Barra, etc.) or multi-factor regression based on historical returns. It is a recipe for an irreconcilable argument with your manager. Every time.

If you are dealing with a delta-1 long/short equity or credit manager, by which I mean one which almost always expresses exposure through vanilla long and short positions and only rarely options, I think you are best served by suggesting a hurdle based on 3-to-5 year average net exposure. Once you start getting into documentation of more complicated calculations or beta adjustments to that net exposure, the execution/completion risk becomes overwhelming. Don’t get cute and include an ongoing update to the calculation. Find the number. Hard code it in the document. Monitor it and re-open the issue if it’s no longer appropriate. I’ve been successful getting this kind of hurdle.

Once you start getting into more complicated strategies that have long effective net exposure but incorporate asymmetric securities to get it, you can either get in the game of incorporating delta measures into your hurdle (woof!) or basing the hurdle on a single factor returns-based beta/slope calculation against the major beta benchmark (also woof, but less so). I’ve successfully negotiated the latter. Never the former.

If you’re dealing with managers who maintain that they have no beta bias – especially in global macro, managed futures, and market neutral strategies – good luck. I’ve had zero luck getting any of these funds to agree to any kind of hurdle like this. T-Bills or LIBOR-Plus hurdles, sure, but not any net exposure-based, returns-based, or other approach to calculating long-term beta biases.

No, not even when you show that their macro fund’s returns are just a steaming pile of negative alpha wrapped around mostly static rates beta and random rotation through different carry trades.

This a really important post. My experience as a manager has been that even the best efforts never get us to complete alignment and, as Rusty suggests, we need to accept this. I used to think the gold standard in alignment was for managers to have a large % of their net wealth invested in their own funds. I still think this helps, but following Rusty’s logic, it’s no more than that. What I came to realize as a manager with something like 80%+ of my wealth in my own fund was that my risk preference at certain times was likely to very different from my clients where our fund was one piece of a much larger portfolio. This really hit home in 2009/2010 after we had navigated the GFC with only a modest single digit drawdown which we recovered over the next 18 months. We could have recovered more but remained in somewhat of a defensive crouch with lower levels of leverage than pre-GFC. A client said he was disappointed in our results – we should have more aggressively re-levered post the crisis. At the time I honestly felt he was a bit crazy – wasn’t the crisis driven by excess leverage? But with time I’ve realized that part of it was a difference in our risk preferences. As managers with the vast majority of our wealth in the fund we were nervous about re-levering, even if we didn’t explicitly recognize this. As an outside investor, with distance and other investments they felt this was time to be greedy when everyone was else was scared. We ended up not being aligned at that moment and I think a big part of it was that having so much invested in the made if very difficult to asses the risk-taking environment objectively.

Pack Member Kevin Coldiron
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