Saturday, January 07, 2006

ETF/Index Membership & The Liability of Cap

Hedge Funds are reputed to have wrought many evils upon us: increased volatility; demonstrative increase in unmitigated greed; market-manipulation; massive [undeserved?] transfers of wealth; over-compensation for assymetrical risk-taking; naked short-selling; bending and flouting of market rules; as well as the high-profile Lipper-esque fraud, theft and ponzi-like schemes that directly diminished wealth of investors, to mention but a few of the more prominent charges.

As a well compensated investment manager myself who also engages in short-selling, I must say that these charges appear excessive, overblown and are probably IMHO somewhat off of the true mark. Yet, kernels of truth are present in all them. But since these truths bite so close to the bone, they are all to often dismissed, denied, then ignored probably at one's kharmic (and possibly one's financial) peril.

This is because one of the most profound impact of hedge funds' growth and proliferation (at least in global equity markets) has been more subtle: mega-capitalization underperformance. This has been for both technical and structural reasons. For over the last few years as investors have outsourced and off-shored their speculative undertaking to the hedgies, their agents, in perhaps uncoordinated, yet no less herdlike manner, have seemingly arrived at many similar if not common stategies seemingly involving many similar if not common instruments. More specifically, one would conjecture, after looking carefully at the distribution of returns across many equity markets, equity investors are placing more long bets in concentrated smaller-cap positions (where their marginal purchases can have more price impact upon existing positions with obvious benefits), while shorting their composite index or benchmark of choice (all which are market capitalization weighted). Individually, and in itself, there is nothing wrong with a trader or portfolio manager buying what "he knows" (or overconfidently thinks he knows) and selling "a little of a lot" exemplified by a broad market, sector index or ETF thereof. But what if everyone pursues such a strategy? Some, like Joesph Heller's 'Yossarian', believe that whatever the logical contortions, one would be "a fool to do any different" since being contrarian is not just a disinterested philosophical bet, but when expressed in a position, is a bet upon one's very livelihood - something Jeremy Grantham has pointed out on numerous ocassions.

But is Yossarian wrong? Why should HE be the one who flies missions, while others back in the USA are having a good time? Where is the problem in his logic? Lawyers and risk-managers, who often agree but very rarely, and even then, on very little, both might term this "pari passu". Economists call it a "fallacy of composition" (what's good for a few is not necessarily good for everyone). As result, certain risks (Taleb terms them "the black swan" risk) are elevated. I eschew this term if only because it's imagery is so tame and too far removed from earthly reality of consequence. Instead, I like to call it: "driving really really fast downhill as you near the sharp narrow hair-pin turning adjacent to the 1000' drop into the canyon below-risk". Lots of things can happen: a tire can blow; a bicyclist or large truck could be around the blind corner; brakes could fail; there could be skree or oil on the road. There are lots of plausible, but low-probability, fat-tail like outcomes.

Back to the distribution, because this is what is fascinating. Take Japan. If you look at something lke the Barra Size factor, which is a cross-sectional regression, it has been a rather poor performer, over the last few years, this year, and as late. And if you look at the top and bottom deciles of some investable universe, and you equally weight them using some monthly rebalance schema, you get a similar picture. And the picture is the same all over the world. In most markets, historically, size and liquidity commanded a discount. Returns to scale, and stability achieved through diversification were attendant benefits to larger size, not to mention the ability to recruit and train higher calibre individuals, all which conspired to command a marginal valuation premium. Yet today, the any premium has waned, and in some cases inverted. Smaller and mid sized enterprises are trading at equivalent if not premium metrics. The Russell 2000 S&P Barra MID Index are far far above their bubble peaks, while TOPIX Mid and Second Section Indicies have also vaulted to all time price highs while their valuation spreads have narrowed to unprcedented levels.

Couldn't this be just a reflection of the lethargy and inefficiency of the big, and the nimble growth oprientation and possiilities of the small? It cannot be ruled out that such a perception is driving the phenomena. But as market wise-man Jeremy Grantham points out, the "quality" one can buy today relatively is very attractive in comparison to history, and I would add thhat it's attractive primarily because of the diminished relative valuations of larger-cap issues which tend to be more stable, have higher profitability ratios (whether ROE, EVA or CFROI) and have better balance sheets per unit of P/E. Sure there are some sector effects (particularly in the USA, and particularly in energy and energy-related sectors repsen ted in small & mid indices), though I would argue that these affects are secondary to the weight and impact of the huge hedges laid out in cap-weighted indicies and ETFs. The effect, in effect is caused by myopic informationless hedging and aggregation of individuals game playing. Those with the trade on, who are now patting themselves on their respective backs, and collecting larger performance fees for this past year for their stock-picking prowess have really been the fortunate beneficiary of huge structural effect. In this respect, they should be careful of self-attribution bias and attempt to understand where the bonus that bought the Tribeca loft actually came from.

One might ask, is it permanent? How does it work itself out? I personally do not believe it's here to stay. Since much benchmark-relative net long exposure has gone into smaller-cap at the expense of larger cap, this probably unwinds into a market correction driven either by whiffs of higher rates and diminishing or levelling-off of corporate profits growth or a more general recession where growth retreats and real rates turn positive. Liquidation of smaller-cap will necessarily cause the re-purchase or closing out of the cap-weighted hedge positions in broad indices and cap-weighted sector ETFs thus restoring some off the traditional sensibilities and relative levels of market cap spreads. But I warn allocators to hedge funds, that THIS WILL NOT PAINLESS and the managers that have been riding this filly-of-a-trade will likely be thrown from their mounts.

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