Wednesday, August 02, 2017

Efficiently Inefficient #3 : Alpha shenanigans from Investor Exchange 2017

In today's segment, I'm going to talk about how to incorporate some concepts from hedge fund investing into the talk we just had last week, but first you need to remember what I reported on REIT returns last Saturday.

If you buy all the REITS in the stock market and rebalance your purchases annually for the past 10 years, you would expect to earn about 8.3%. Generous returns by any standard as the STI could barely stretch 5% during that same period of time.

Suppose you then buy 50% of the REIT universe which gives higher yields, you would do 1.15% better or earn a return of 9.45%. It does not take much mathematics to figure out that the lower yielding REITS would return 1.15% less than the average at 7.15%.

A hedge fund manager with a prime broker might be able to structure a bet that allows buying of the top 50% yielding REITs and shorting 50% of the lowest yielding REITs.

This method of investing would yield a really nice 2.3% that does not correlate with the general REIT index. So you can have a market neutral fund that returns 2.3%. This is realistic because Singapore Savers Bonds return about 2.3% risk free.

The industry calls this alpha, which in this example, would be 2.3%.

But the book also mentions this ratio called the Alpha-to-margin ratio.

Some hedge fund managers are given a lot of flexibility from their prime brokers. Suppose the prime broker allows a margin of 20% which allows the hedge fund manager to obtain a leverage ratio of 500%.

The alpha to margin ratio in this case is 2.3% / 20% or 11.5%. This is a 5x magnification of returns.

I bet this is how accredited investors can be told about market neutral returns at such ridiculous.

While it would be fun to create small portfolios like this for individuals, investing in such hedge funds was probably what led to market nightmares like what happened to LTCM. You are using a vacuum cleaner to suck up pennies on the railway while there is an incoming train.

It starts with a simple backtest suggested by an engineering geek which is then followed up generous offers of market leverage from brokers. Sometimes, a market anomaly occurs and low yielding REITs might outperform high yielding REITs for a period of time and KABOOM !

You got a disaster in your hands.

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