Damn you, Mr. Sharpe

  1. Treat this post the same way as you would treat a fat-guy in a pub screaming at the telly when watching a football game.
  2. If I ever had a shot at working at a macro HF I am probably about to blow it completely with this post.

After those two important disclaimers let me tell you what I think. I have a bit of knowledge of how investment managers operate, be it real money or absolute return people. And by no means what I am about to write applies to everyone but it seems that things have been on a downward trajectory for a while now. Have a look at this fancy table from the Credit Suisse’s Hedge Index:


What interests me the most in such reports is the last column, i.e. the Sharpe ratio, which basically measures the volatility-adjusted returns. As a rule of thumb, anyone consistently below one should not be paid much. As you can see here, most funds are actually below one and the sample is almost 20 years. We will get to the exceptions later.

I do realise that trading since the financial crisis has been difficult and the risk-on/risk-off environment has made it very tough to apply any meaningful portfolio strategies but that doesn’t mean hedge funds should not be accountable anymore. Just remind yourself where the name “hedge fund” comes from. No, it’s not a marketing ploy aimed at fooling the audience – hedge funds are meant to make money regardless of the market direction. Instead, these days we seem to be willing to praise hedge fund managers for leveraging bets consistent with the prevailing market trend. And since with the exception of US equities, there haven’t been many trends, the macro guys are struggling.

Here’s why I believe the whole industry is failing: the fetish of market positioning. In recent years we have seen a massive increase in focus on positioning data. Things are getting so ridiculous that some investors are taking it to the next level by wondering what the market thinks positioning is. It’s a bit like a “what if he knows I know that he knows” mentality. Consequently, many moves in financial markets are being explained mostly by positioning. Take last Friday – the often-cited reason why EMFX rallied after the US labour data was that people were short rather than the fact that historically good growth in the US has traditionally been associated with good EM performance.

Or take the euro over the last year. It doesn’t matter that fundamentals have vastly improved and that the break-up risk is virtually zero. No, the euro has rallied because the market has been short. If you think of it, this is a very convenient excuse for being wrong: “If it wasn’t for people being so short, the euro would’ve surely crashed by now and I would’ve made a fortune“. You can’t argue with that “logic” unfortunately.

So we are in an environment where hedge funds are wondering what the real money are doing and vice versa. At the same time, local investors keep second guessing the foreigners while foreigners mostly care about demand and supply from the locals. No wonder that in the end the market ends up super correlated and everyone makes or loses money at the same time. The funny thing, though, is that hedge funds charge 2+20 for the privilege…

Interestingly, results for 2013 are still not terrible (although infinitely worse than most of the passive 60:40 strategies). Why? Well, one of Abe’s arrows was golden and pretty much every macro fund caught some of the move in USD/JPY at the beginning of the year. Now they are of course celebrating even though draw-downs since then have oftentimes been eye-watering.

But let’s go back to the table. Have a look at who hasn’t fallen below unity. Special situation funds and multi-strategy guys. Special situations, like distressed debt, require a lot of ground work with little regard to global trends. If a company in stress has debt that matures in the next few months, it really doesn’t matter much whether Draghi pushes the deposit rate below zero. Or at least it’s not the most important factor.

And multi-strategy? Well, that’s sort of my point. I have no idea what are the exact constituents of this group in CS’s sample but it sounds and awful lot like the diversified market portfolio. Except it costs 2% to run.

I know plenty of smart hedge fund managers and I know many of them are fuming at all the gamblers waking up every day and thinking whether to buy or sell 500m AUD/USD given the latest positioning data they’ve received from bank X or they received directly from dealers after they asked them to judge positioning on the scale from -5 to +5. This is truly pathetic and for some reason the market is getting such funds get away with this behaviour just because Abe sent USD/JPY higher and they happened to have been in front of their screens


9 thoughts on “Damn you, Mr. Sharpe

  1. “It doesn’t matter that fundamentals have vastly improved and that the break-up risk is virtually zero.”

    Excuse me? Is there a parallel Europe somewhere I’ve been missing?

    1. Southern Europe remains in depression, and France is a bug which looks to be getting perilously close to the proverbial windscreen. (With regard to the wider Eurozone, a couple of quarters of fractionally positive GDP growth – which are well within the margin of error and anyway lump together the likes of Germany and Greece and call them a single economic entity – simply don’t evidence “…fundamentals (that) have vastly improved…)

    2. The Irish ‘miracle’ doesn’t bear in-depth analysis, and owes much to EU spin (of the “see – austerity works” variety).

    3. They are no nearer debt-mutualisation or cleaning up the banking system than they were – oh, I don’t know – the crisis before the crisis before last.

    4. Whilst I’m not going to argue about specific EUR break-up probabilities, it sure ain’t “virtually zero”. Have you read any of the musings and pontifications coming out of the French establishment recently? And then there’s next May’s Euro-elections.

    5. Declines in periphery yields reflect: the market’s belief that Draghi has its back (open to debate given that OMT represents an untested and internally inconsistent piece of ’emperor’s clothing’); recycled Japanese QE; and a Chinese desire to keep a bid under the EUR (also for trade reasons). Hardly very ‘fundamental’ – although undoubtedly powerful forces for now.

    Still, complacency reigns everywhere – so why not here as well.

    • Hello Steve. Thanks for the comment. Sorry I frustrated you a bit here.
      Of course by saying “virtually zero” I exaggerated. Things rarely have zero probability. However, I am deeply convinced that the risk of a break-up is negligible – if you browse my blog you should fine the explanation.

  2. Pingback: 10 Tuesday AM Reads | The Big Picture

    • not sure if the reply came through initially. I said that you are right and sharpe is a poor predictor but I think it’s perfectly good to assess past performance.
      thanks for the comment – I’m a big fan of your blog!

  3. I think those Sharpe ratios actually look pretty good. It is extremely difficult to achieve a >1 Sharpe over long periods of time. Even Buffet (Berkshire) has a realized Sharpe ratio of “just” 0.76 and a 60/40 portfolio has a long-term historical Sharpe of around 0.6-0.7.

    In any case, keep up the good work!

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