Tuesday, July 1, 2008

Canadian Liquid Alpha Eh!

Today was another day to shut the computer early and enjoy the weather that blessed us this Canada Day. Unfortunately the sun was not shining on solar stocks today but institutions should carefully look into the renewable energy sector and use pullbacks to initiate and/or build on their positions in this hot sector.

In terms of future secular themes, I am a big believer in renewable energy. It just makes sense that countries stop going to war over oil and start investing money in a sector that holds tremendous potential and is environmentally friendly. In my opinion, solar stocks are going to experience a secular bull market but we are still at the early stages and they are extremely volatile. However, unlike the internet hype, many solar companies are growing revenues exponentially and some are already profitable. A lot of the current interest in renewable energy has to do with surging oil prices but I expect solar share prices to decouple from oil prices as this sector gains more interest and starts to compete with cheaper traditional energy sources. (Here is a partial list of some of the solar shares I currently track: FSLR, CSIQ, ESLR, SOLF, STP, SPWR and TSL).

Another hot (and volatile) sector is biotech. An ageing population requires revolutionary drugs to improve our standard of living. My research into the biotech sector intensified after I was diagnosed with Multiple Sclerosis at the age of 26. At the time I started taking Avonex, an immuno-suppressant interferon therapy that was clinically proven to slow the progression of the disease. That was eleven years ago and Avonex remains a leading therapy for most MS patients. However, lots of research has poured into newer, more promising therapies in the last decade. I expect the new oral therapies to supplant the older ones (it's not a picnic sticking a big needle in your thigh every week) and I am amazed at the significant progress that biotech firms have accomplished in treating all sorts of diseases, not just MS. If biotech is too volatile for you, focus on some big pharmaceuticals like Novartis and Pfizer that have licensing agreements, promising therapies in late clinical trials and offer handsome dividends.

Now, back to the main topic, Canadian liquid alpha (not oil!). I had lunch with a risk manager/trader today. I will not mention any names but I read his blog religiously (The Financial Ninja) to gain insights into the markets. I would rather read something from an intelligent trader who eats what he kills than from an arrogant Wall Street analyst who never traded in his life and typically practices cover-your-ass recommendations (why don't analysts stick their necks out more often?).

Our conversation centered around the oil bubble and weakness in financials. It was interesting to see Lehman Brothers' shares rally today after they were slaughtered in the last five trading days (this is all part of end of quarter window dressing where institutions dump losers and buy winners). Today we begin a new quarter and I expect a bounce in the broker dealer shares after the latest sharp selloff. Any rally should be seen as an opportunity to lighten exposure and /or short broker dealers and financials. In fact, institutions should remain underweight financials as long as housing prices continue to decline. The real estate and securitization bubble have popped and I believe this sector will experience a long term secular bear market that will last several years.

After my lunch, I met up with a senior institutional multi strategy manager. This person is someone that I respect because he is not afraid to speak his mind. He has significant buyside experience and he understands markets, alpha and risk management. We talked about how flawed most institutions are in their approach to hedge fund alpha. I have already posted my thoughts on bogus benchmarks governing private markets in pension funds. Below, I will share my thoughts with you on hedge funds and how most pension funds are paying hefty fees for disguised beta.

The most intelligent way to invest in hedge funds is to make sure you are not paying for beta. One of the best fund of hedge funds managers at a large Canadian pension fund once told me: "Beta is cheap. Anyone can swap into beta for a few basis points so you need to find pure alpha that is not correlated to the markets." Easier said than done. Most leading institutions do swap into into traditional stock and bond indexes and use the cash to invest in a diversified portfolio of hedge funds (a process known as portable alpha). Some of the better institutions have in-house teams to select individual hedge funds, others use funds of funds or consultants and some use all three methods.

Whatever method you use, you want to make sure that your benchmarks accurately reflect the risk of the underlying hedge fund strategies. In the last few years, investment banks hungry for fees have developed methods to passively invest in an index that replicates hedge fund strategies. These so-called "alternative beta" indexes have their protractors and their detractors. One of the harshest critics is professor Harry Kat of the Cass Business School in London. In a widely cited paper, Kat bluntly states the following:

"...investors buying into these products with the aim to diversify their traditional portfolios are likely to be disappointed as there is very little ‘alternative’ about these products, resulting in very high correlation with traditional asset classes and correspondingly low diversification benefits. Caveat Emptor!"

There is a rationale for developing passive hedge fund indexes that capture the risk distribution of absolute return strategies but investors need to be careful with exaggerated claims from greedy investment bankers looking to generate perpetual fees. I believe that the future of portable alpha will be investing in some sort of passive alpha index and looking for strategies that offer alpha that is not captured by most factor based or risk models.

Even though we are ahead of the curve, it is worth noting that some of the leading Canadian pension funds have benchmarks for hedge funds that do not accurately reflect the risks or beta (including alternative beta) exposures. T-bills + 500 basis points is not an appropriate benchmark when you are investing in illiquid strategies with three year lock-ups. Similarly, using an index of investable hedge fund managers to benchmark hedge funds is not an appropriate benchmark when the bulk of your hedge fund portfolio is invested in the top hedge funds that are closed to new capital. A better benchmark in this case would be the non-investable indexes.

I can't overemphasize the point that proper benchmarks are important because you do not want to compensate a pension fund manager for taking on more risk or for taking on more beta exposure. Proper governance should force all pension funds to properly document their choice of benchmarks for each and every investment activity, clearly demonstrating how their choice of benchmarks accurately reflects the risks of the underlying portfolio. Stakeholders and taxpayers deserve more transparency and less smoke and mirrors, eh!

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