Polymetis White Paper 200901


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Polymetis White Paper 200901

  1. 1. Polymetis LLC MAKING SENSE OF INSENSIBILITY JANUARY 2009 Making Sense Of Insensibility Polymetis LLC
  2. 2. “At times the world can seem an unfriendly and sinister place, but believe us when we say there is much more good in it than bad. All you have to do is look hard enough. And what might seem to be a series of unfortunate events, may in fact, be the first steps in a journey.” Violet Baudelaire Lemony Snicket's A Series of Unfortunate Events In the 1972 film The Candidate, Robert Redford plays Bill McKay, a young idealistic attorney who is recruited to run for the United States (“US”) Senate against a popular incumbent. At the climax of the movie, after securing a close and wholly unexpected victory, the confused and surprised protagonist is left to ask his campaign manager, “What do we do now?” Indeed, that is the precise question investors around the globe are pondering in the face of turbulent and uncertain economic and market conditions. Let us call it the McKay Question. This is especially relevant for investors in alternative investments like hedge funds and their derivative, fund of hedge funds (hereafter hedge funds and hedge fund of funds generically will be described as alternative investments or simply alternatives). The recent results of these investments have largely underperformed relative to investor expectations and sales and marketing pitches. So, how should investors in alternative investments approach the McKay Question? Situational awareness (“SA”) is defined as “the perception of environmental elements within a volume of time and space, the comprehension of their meaning, and the projection of their status in the near future.” In other words, SA involves being aware of what is happening around you to understand how information, events, and your own actions will impact your goals and objectives, both now and in the future. Usually thought of as it pertains to military applications (the concept of SA is embodied in Sun Tzu’s Art of War), SA is relevant across a range of fields and disciplines. Lacking SA or having inadequate SA has been identified in numerous studies as one of the primary factors in mistakes attributed to human error in such fields as medicine, sports, aviation, and power management. There is considerable value in applying SA concepts to the discipline of investing, especially for alternatives. It provides a logical and coherent path to the answer to the McKay Question. In order to select a reasonable course of action, one must appreciate the future. In order to appreciate the future, one must understand the present. In order to understand the present, one must comprehend the past. After establishing a sense of the past, prevailing, and expected environments, concerning both the global macroeconomic and the alternative investment space, the SA methodology can be employed to improve the process of investing in alternatives. A Sense of Where We Are Justifiably, there is considerable angst and uncertainty around the globe regarding the state of political, economic, and financial conditions. The world is in the midst of a recession that, to this point, is not especially dire relative to historical antecedents, but which is nonetheless painful, and which does carry the potential to attain a level of profundity. The Making Sense Of Insensibility Polymetis LLC
  3. 3. global economy is suffering through a normal cyclical recession compounded by the withdrawal effects of decades of fiscal and monetary excesses. Figure 1 is humorous without being funny. The weakness in the US economy, combined with the deleveraging of its overextended financial system, and the unwinding of a substantial real estate bubble, has had a profound effect on the global situation. Figure 1 It would be quite wrong, however, to view the global situation as simply a derivative of the problems in the US. The problems afflicting the US are, in fact, quite commonplace. Indeed, similar economic problems elsewhere in the world typically are of a greater magnitude relative to scale. Italy, Spain, Ireland, India, and China, for example, all have real estate bubbles at least as substantial as those in the US. The fiscal problems afflicting the US federal and state governments are perhaps more pronounced in the regimes of Western Europe. Last year Iceland became the first Western European country to receive aid from the IMF since Britain’s humiliating rescue in 1976. China has a banking problem that dwarfs that of the US, but it is impossible to know by how much given the opacity and unreliability of its official statistics. Other countries like Russia and Venezuela are feeling the downside of economies built on the presumption of triple digit oil prices, now trading at less than $40 per barrel. The state of the alternative investment industry is similarly distressed, although it remains in better condition than the overall global economy, even with the full effects of the Madoff scandal still to be determined. After growing at a nearly 30% per annum rate from 1990 to 2007, the assets under management (“AUM”) in alternatives declined significantly in 2008 Making Sense Of Insensibility Polymetis LLC
  4. 4. due to the combination of losses and withdrawals. Precise figures are not yet available, but it is reasonable to conclude the decline in AUM in 2008 will exceed 30%, easily the biggest decline ever in both absolute and relative terms. Interest in alternatives, which had reached a fevered pitch in the past few years, remains, appropriately, at a reduced but still high level relative to prevailing conditions. Although both existing and prospective investors are disappointed that alternatives have failed to live up to expectations during the current turmoil, this is due more to faulty expectations than a failure of alternatives. An early guesstimate is that the performance of alternatives in 2008 was a decline somewhere in the high teens. This performance, if true, still is greatly superior to that of most traditional investments, which suffered precipitous declines far in excess of most alternatives. A Sense of Where We Were The causes of the current economic situation are, of course, varied and complex. There are, however, a few broad generalizations that may be drawn from a dispassionate assessment of the current environment and the events leading up to it. Although it is said that success has many fathers while failure is an orphan, the existing problems are not the result of any single event, person, or policy. The current economic turmoil actually is an understandable, although painful, response to a montage of political, economic, fiscal, and monetary causes over the past 25 years and more. Since the mid-1980s, even as the global economy has generally prospered, central bankers have injected ever increasing amounts of liquidity into the financial system. One of the results of this constant priming has been a series of asset bubbles over time: real estate in Japan, emerging market equities, internet and technology stocks, and, most recently, real estate in the US and elsewhere. In effect, the excess liquidity created an asset inflation rather than traditional price inflation. Along with this lack of monetary discipline has been a distinct lack of political courage and complacency on the part of government authorities. These factors combined have created a structure of increasing direct and indirect costs for the private sector, while allowing public sector fiscal discipline to decline dramatically, particularly with regard to the costs of entitlements and other social welfare programs. Regulators have been both tardy and lax in providing judicious oversight of markets, accounting standards, and financial systems. Corporations have resorted to using escalating amounts of financial and accounting gimmickry to maintain unsustainable growth and profit targets. The cumulative effect of all these corrosive elements eventually reached a critical mass that the global economic and financial systems could no longer tolerate painlessly. The alternative industry prospered greatly during this time frame, growing from a cottage industry into a highly glamorous global business. Alternatives provided considerable advantage to its investors by offering attractive risk-adjusted returns on a consistent basis. To be sure, the industry weathered some adversity, including, but not limited to, the merger arbitrage debacle at the end of the 1980s, the struggles of the “3 Davids” in 1994, the demise of Long Term Capital Management in 1998, and the fraud of Michael Berger’s Manhattan Capital in 2000. Each time, however, the industry recovered and became stronger as a result. In some respects, however, the alternative investments industry became a victim of its own success. The industry’s resilience and strong performance led to a tremendous growth in assets under management, competition from traditional firms and spin-offs, and, perhaps most importantly, an unrealistic sense of its infallibility. Making Sense Of Insensibility Polymetis LLC
  5. 5. A Sense of Where We Are Going There are a wide variety of opinions regarding the paths that the world economy and the alternatives industry will follow, covering all points from doom-and-gloom to relative Pollyannaism. Professors Kenneth Rogofff and Carmen Reinhhart have suggested in a recent paper that the aftereffects of the financial crisis in the US, and we may conclude by extension the rest of the world, will be severe, long-lived, and pervasive. Economists Brian Wesbury and Robert Stein recently argued in Forbes magazine that the worst of the economic crisis may be past. As this point, either forecast may be true and the outcome will depend greatly on policy responses moving forward. As Herbert Stein famously pointed out, if something cannot go on forever, it will stop. The fiscal and monetary excesses that have built up over decades cannot go on indefinitely, but it will not be for a lack of trying. The incoming Obama administration, for example, is proposing an initial budget with a deficit in excess of $1 trillion. Most other developed countries are contemplating similar fiscal irresponsibility under the guise of economic stimulus. Policies such as these have been, of course, a substantial contributing factor to the current economic weakness. Politicians around the world never seem able to follow the sage advice of “Don’t just do something, stand there.” Nevertheless, as the political capital seems to be available to implement these policies in the US and elsewhere, additional political intervention in markets and economic activity seems likely for the foreseeable future. Such measures will include increased regulatory burden, subsidy and support mechanisms, possibly protectionist measures, and, almost certainly in the near future, higher taxes. Ultimately, however, Mr. Stein’s maxim will hold true and there will be political backlash of some kind. The nature and timing of such a change remains to be determined. A myriad of other dark clouds loom on the financial horizon. China’s economic rise has been dramatic over the past 30 years. Currently the third largest economy in the world, China is poised to surpass Japan for the number two slot within a few years. Yet, the Chinese miracle is of questionable quality. Economic statistics are unreliable and the opacity of their banking system precludes an accurate assessment of the extent of financial problems there. Anecdotal evidence as well as reasonable analysis suggests it is profound. It remains to be seen how energy producing countries like Russia and Venezuela can weather the collapse of oil prices over the past year. It is eerie how many parallels currently exist between the current situation and that of the 1930s. There exists a not insignificant possibility that the world will follow a similarly disastrous arc. History may not repeat, but it often does rhyme. Similarities and parallels do not mandate a comparable outcome, however. There are some positive factors to consider. The severe drop in oil prices has acted as a massive tax cut for the developed nations, helping to offset decreased consumer purchasing power caused by job losses, while simultaneously dampening inflation. Productivity remains robust. To this point, by almost any measure, the current global economic turmoil is no worse in intensity or longevity than previous instances of economic weakness. The alternatives industry has shown a remarkable ability to adapt and transform itself to prevailing conditions. This will continue, albeit not without some pain. The industry will undergo its largest rationalization yet. The number of hedge funds and hedge fund of funds will almost certainly decline dramatically. A number of observers have forecasted that up to 20% of the existing hedge funds will close within the next 12-18 months. Some have Making Sense Of Insensibility Polymetis LLC
  6. 6. suggested the number may be as high as 40%. The hedge fund of funds business will also decline dramatically as too many of these entities (such as any that had assets with Mr. Madoff) have proven that they add little value in return for an extra layer of fees. While painful for those directly affected, this overall winnowing process is healthy for the industry as a whole. Other changes will occur or continue to occur. Traditional asset management firms will continue to blur the line between alternatives and long-only strategies. Fees will face greater scrutiny and require greater justification. The relative attractiveness of strategies and approaches also will change. Those strategies that depend on large amounts of leverage to generate returns will suffer until underlying spreads widen to accommodate the new, less liquid environment. The dynamic between investor and manager also will shift. Before, managers and their gatekeepers held the upper hand in the allocation process. The pendulum will swing back so that managers will need to prove themselves to investors instead of the reverse. SA: A Sensible Alternative Although SA derives its modern roots from the study of military aviation during World War I, particularly in the last two decades, a number of prominent researchers, including Drs. Mica Endsley and Cheryl Bolstad amongst others, have demonstrated the utility of applying an SA framework in other areas of human activity and organization. It seems reasonable, therefore, to determine the benefits an SA framework can yield when applied to investing in alternatives. SA comprises both the process and outcome of acquiring knowledge. The terminology in the available literature to describe these concepts varies according to timeframe and industry application. In military and aviation applications, where the focus generally is on short-term or tactical objectives, situation assessment refers to the process of acquiring knowledge while situation awareness is the actual state of knowledge. In most academic and business applications, where the timeframe is long-term or strategic, sensemaking is used in lieu of situation assessment, while understanding is used in place of situation awareness. Although investing is a long-term activity, this paper will use the terms situation assessment and situation awareness. The prevailing theoretical framework of SA is largely the work of Dr. Mica Endsley. As Figure 2 illustrates, SA is a continuously-operating feedback mechanism comprising three main parts or levels. Level 1 comprises the acquisition and monitoring of relevant input (data). Level 2 involves the evaluation and synthesis of the Level 1 data to create a comprehensive picture or schematic (information). Level 3 covers the extrapolation and projection of Level 1 and Level 2 inputs to form a projection of future states (outlook). Making Sense Of Insensibility Polymetis LLC
  7. 7. Figure 2 Adapted from the following source: Endsley, M. R. (1995b). “Toward a theory of situation awareness in dynamic systems” Human Factors 37(1), 32-64. Applying SA: Sense and Accountability Historically, investors in alternatives have engaged the services of investment professionals, selected based on several primary criteria, including pedigree, experience, expertise, size, reputation, and fee arrangements. These factors, of course, can be important, but certainly are not definitive. The alternative space is well-populated with experienced and capable individuals and firms. The Madoff scandal is only latest proof that even high-profile, long- run entities staffed with distinguished individuals are not immune to catastrophic error. The application of SA can be used to differentiate among the myriad of choices available. Accurate mental models are a necessity for achieving SA. According to Professor Robert Glaser, a mental model is a set of well-defined, highly organized dynamic learning structures developed from expertise and experience over time. Existing alternative investors and advisers have established procedures which may emphasize quantitative or Making Sense Of Insensibility Polymetis LLC
  8. 8. qualitative aspects, both which usually encompass elements of both. They tend to cover the 6 Ps: people, philosophy, process, procedures, performance, and portfolio. These different manners and styles all can be effective as there is no one right answer. An approach that does not at least implicitly embody the use of accurate mental models using Endsley’s 3 levels likely will be unable to provide value over time. Over time professional investors in hedge funds (such as hedge fund of funds, wealth managers, investment advisers, and consultants) have made a number of claims in support of their sales and marketing efforts. These include: Bigger is better – our size gives us better terms, better access, and more resources to devote to the investment process, Smaller is better – our size allows us to be more nimble and take advantage of niche managers or those with limited capacity, Since we invest in only the best managers we can be agnostic as to future market conditions, Our fees are justified by the extensive due diligence and research we conduct, Our proprietary quantitative tools provide a defined edge in evaluating managers and constructing portfolios, and Our long track record proves our ability to prosper in all market conditions. The evidence suggests that these claims have been proven to be completely false, only conditionally true, or ultimately irrelevant. Applying Endsley’s and Glaser’s work, rather, would indicate the following characteristics or traits are the relevant factors in determining the long-run success of professional alternative investors: A defined investment process covering research, due diligence, portfolio management, and risk management, that seeks relevant information while excluding extraneous noise, The necessary resources, experience, and expertise to design, apply, and refine the investment process over time, The continual use of feedback to adjust not just the state of knowledge but the actual process of gaining that knowledge, and The ability and willingness to act in anticipation of projected future conditions. Beyond SA: Sense and Acumen Applying SA certainly is no magic bullet for alternative investors looking for capable professionals with which to partner. It does, however, represent a useful paradigm in which to make those evaluations and decisions. There are a number of other factors that are critical in differentiating among the myriad of choices available to investors seeking assistance, including: Loyalty – the freedom from actual or potential conflicts of interest with other clients or business arrangements, Courage – the willingness to offer opinions and make decisions independent of, or even contrary to, prevailing thought, Transparency – the willingness to share knowledge through education and communication above and beyond that of regular data distribution, Making Sense Of Insensibility Polymetis LLC
  9. 9. Skepticism – the readiness to inquire beyond and behind “established” facts and opinions, Curiosity – the desire and initiative to look beyond what happened in order to understand why things happened, Conviction – the confidence to establish and implement a plan based on a thoughtful outlook, and Humility – an appreciation for the inevitability of mistakes and their associated costs. What To Do Now Returning to the McKay Question, the long-term answer is to apply SA. SA provides a useful conceptual framework for investing in alternatives, with a wide range of practical applications beyond the ones noted above. Implementing SA also suggests a number of sensible steps and specific actions that can be applied immediately: Don’t act emotionally as decisions made in highly emotional or agitated states are not usually optimal ones. SA represents a detached and objective process that avoids the downside of temperamental decision-making. Engage in honest introspection as to whether you have the resources, time, experience, expertise etc to invest successfully in alternatives, especially using SA as the overarching framework. Keep perspective by using even negative experiences as inputs to adjust both your knowledge base and your investment approach. Develop a plan about what to do in the new global environment as gaining information is useless unless it is to gain perspective about future states. For those already invested in alternatives, hold your professionals accountable for their decisions as part of your continual feedback loop. Don’t trade strictly on performance as that means a small amount of data dominates the majority of other, perhaps more relevant, information. It has been said cynically that experience is what one gets when one doesn’t get what one wants. In that case, there are many experienced investors around the globe. As Abraham Lincoln famously wrote, in part, in his Bixby Letter in November 1864, “I feel how weak and fruitless must be any words of mine which should attempt to beguile you from the grief of a loss so overwhelming.” For investors licking their wounds from losses, whether from alternatives or from traditional investment opportunities, the use of SA will provide little emotional solace. It can provide, however, a useful framework for successfully navigating the uncharted waters that lie ahead. As Kipling noted, the best course of action is to keep your head while others around you are losing theirs. Using SA can help to do just that. Making Sense Of Insensibility Polymetis LLC
  10. 10. Additional Information Polymetis LLC is an investment boutique founded in 2009 by Thomas Kuntz, CFA to provide premier due diligence, research, and investment advisory services in the alternative marketplace. For more information please contact: Thomas Kuntz, CFA 5 Lyons Mall, #153 Basking Ridge, NJ 07920 908-350-7087 tk@polymetisllc.com Copyright ©2009 Polymetis LLC. This Publication is protected by U.S. and International Copyright laws. All rights reserved. No license is granted to the user except for the user's personal use. No part of this publication or its contents may be copied, downloaded, stored in a retrieval system, further transmitted, or otherwise reproduced, stored, disseminated, transferred, or used, in any form or by any means, except as permitted with prior written permission. This publication is proprietary and limited to the sole use of specified clients of Polymetis LLC. Each reproduction of any part of this publication or its contents must contain notice of Polymetis LLC’s copyright. Pursuant to US Copyright law, damages may include lost profits from the infringing activity, or statutory damages ranging from $250 to $150,000 for each infringing copy or higher for willful infringement, in addition to the recovery of costs and attorneys' fees The information contained herein is presented as is, is not necessarily complete or accurate, is subject to change without notice, and no representation or warranty, either express or implied, concerning its accuracy, completeness, or reliability is made by Polymetis LLC or its principals. Any comments contained herein do not constitute investment advice or a recommendation the basis of which is sufficient to make an investment decision. This information does not constitute investment, legal, tax or accounting advice. Recipients are encouraged to consult with their tax, legal, accounting or other advisors prior to making an investment decision. Neither the information, nor any opinion expressed constitutes a solicitation or recommendation for the purchase of any security referred to herein. Any prices or quotations contained herein are indicative only and do not constitute an offer to buy or sell any security at any given price. Any further disclosure or use, distribution, dissemination or copying of this message or any attachment is strictly prohibited. Information, whether derived from this report or from any oral or written communication by way of opinion, advice, or otherwise with a principal of Polymetis LLC, is not warranted in any manner whatsoever, is for the use of our customers only, and has been obtained from internal and external sources considered to be reliable. Polymetis LLC or any of its affiliates, its directors, officers and employees, or clients may have or have had interests or long or short positions in the securities or related financial instruments referred to herein, and may, at any time, make purchases and/or sales in them. If you have received this communication in error, please notify us immediately by electronic mail or telephone. Making Sense Of Insensibility Polymetis LLC