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INVESTMENT PHILOSOPHY
Excerpt from Oct 2005 Investor letter
Dmitry Balyasny, Managing Member
"... The point of having many different strategies and income streams within a
portfolio, or a diversified fund, is to achieve consistently high returns with
lower volatility as different strategies outperform at various times. So the
theory goes. However, in my opinion there are two main problems that creep up:
First, psychology and the quest for immediate returns causes investors to add
to areas that are currently doing well. Thus many investors overweight
strategies like event driven, activist long/short, and energy. We saw this in
the go-go mutual fund days when funds with good performance would gather most of
the new asset flows and add to existing positions. This caused further stock
run-ups and reinforced the perilous cycle until we ran out of incremental buyers
and the whole thing came apart quickly. Today's difficult market environment
causes the same problem as neither hedge funds nor fund of funds can afford to
miss the next hot thing. Thus there is a real herd mentality with everyone
chasing the latest trend.
Second is the lack of distinction between beta strategies with an alpha
component and alpha strategies with a beta component. Typical long biased
strategies like energy, healthcare, Asia long/short, event, distressed, emerging
markets, activist, and deep value long/short to name a few, are all beta
strategies with a manager adding alpha through their timing and stock selection.
By virtue of running the portfolios significantly net long, there is an
inherent beta bet on the strategy when the allocation is made. In my view, this
bet is compounded as many investors and fund managers are involved in correlated
areas and seek to reduce risk during times of stress, causing the portfolio
correlations to increase to the downside.
There are as many ways to make money in the markets as there are hedge funds,
and I would certainly invest with many of the outstanding managers who had tough
short periods but have solid long term records.
Let me share how we address the
inherent challenges:
1. Don't chase.
This was one of the first lessons I learned when I
started trading. If you miss it, you miss it. There is always another trade,
strategy, or business opportunity around the corner. By the time a beta
strategy has had 12-18 months of outsize returns, the trade is probably over.
Even if the thesis makes sense for a longer time, markets do a very good job of
discounting and a lot of it gets priced in. The difficulty of identifying a
trend, finding a manager with edge in that strategy, making the allocation and
then timing the exit within these fast cycles is very hard as an outside
investor. The advantage a multi-strategy manager brings should be one of
consistent alpha generation combined with opportunistic trading and allocations.
2. Focus on alpha and leave beta strategies to relative performance
funds.
In my view, this is where both fund managers and investors, especially
in long/short, may cloud the picture because they want to have it both ways. As
a manager, I love to show how much we outperform when the market is down. As an
investor, many tend to compare equity funds to the S&P 500. So an investor who
is thrilled in 2002 when his long/short fund is flat, is disappointed in 2003
when the same fund is +12% in a bullish market. You can't have it both ways. I
think managers have to decide if they are in the absolute or relative
performance business and present the funds accordingly. If a manager has an
alpha strategy he should have nothing to do with the S&P.
At BAM, we have always been in the absolute performance business through a combination of trading strategies that are run on a low market exposure basis. If we make a market or
sector bet it is for a defined period with a tight stop loss. The majority of
the capital is allocated to alpha strategies that should generate positive
returns regardless of market directionality. The additional benefit of this
sort of capital allocation is the expected lower correlation among strategies.
For example, at BAM we have bottoms-up, low net exposure portfolios in
financials, energy and healthcare that don't have much in common (other than
good managers!). However, if you allocate to a long biased energy fund, a
typical macro fund, an event fund, and a long biased global long/short they
might all be long the same energy stocks.
3. Watch the common factors.
When we interview portfolio managers, we
like to ask where they have made money. We like it when a manager with good
performance has a hard time answering this question. That means that they make
money on lots of little bets as opposed to getting a theme right for a period.
You can make a lot of money hitting base hits consistently. We spend a lot of
time looking at where our guys are making money and making sure it's not due to
common factors like market cap exposures, directionality, momentum, interest
rates, etc. We have very little overlap between strategies and work hard to
make sure we have no "hidden bets."
4. Constantly look to bring in and develop alpha generators.
Although
we can always do a better job of this, we feel that identifying trading and
analytical talent, bringing them in, and developing the teams is one of our core
strengths. This is key to maintaining a diversified portfolio. Otherwise, you
wind up turning a balanced multi-strategy fund into a single strategy in
disguise as more and more capital is allocated to the best performing strategy
or to correlated beta strategies. We treat consistent alpha strategies as
businesses for the long run and treat beta strategies as trades..."
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