The Grim Reaper Charges 2 and 20

September 24, 2007 | 1 Comment

Cliché alert!  The only certain things in life are death and taxes.  I have to disagree to some extent with the taxes part until we get a verdict on how my carried interest is getting taxed.  The death part on the other hand seems more certain these days within the hedge fund ranks.  Without naming names, it seems the mortality rate amongst hedge fund managers has been on the rise lately.  Possibly correlated with the fact that there are simply more hedge fund managers, but also certainly due to other factors. 

Now in a couple of high profile cases, death was the result of participation in recreational activities (e.g., snowmobiling, motorcycle riding, etc.).  In these instances, it’s hard to fault the deceased for having fun and living life to its fullest. 

Heart attacks, on the other hand, should make us step back and wonder if maybe our managers are too serious, too stressed, and not taking the best care of themselves.  Now don’t get me wrong, I want my managers focused, but I also want them to live long, happy, and healthy lives.  Please folks, make time for friends, family, exercise, and recreation and eat a more healthy diet.

Since we’re on the topic of death, let’s talk mortality trades.  That’s right, long and short mortality.  How is this accomplished?  Life insurance related investment strategies.  There are a number of ways to play this trade. 

Long mortality (i.e., your return is greater the shorter the life span of the insured): here investors can buy another person’s life insurance policy in the open market, pay the premiums, and collect the benefit when the insured dies.  The policy will generally trade on a discounted basis with the primary factor being the expected life of the insured.  With that said, the shorter the life span, the quicker the pay off and the greater the return. 

Another related long mortality strategy is to make a loan to an insured at a high rate (often 10%+ per annum) with the loan collateralized by the life insurance policy.  Here you have a couple of paths: 1) the borrower makes their payments and you receive the interest; 2) The borrower defaults, you now own the policy and sell it in the open market, hopefully at a premium to the outstanding loan value; or 3) the borrower defaults, you now own the policy, and you hold the policy (and pay the premiums) awaiting the insured’s death for your payoff.

Short mortality trades, on the other hand, bet on the life extension of the insured or group of insured’s.  A typical strategy here is selling extreme mortality protection.  This strategy is basically re-insurance or taking some of the risk off of the books of the life insurers.  Here, you are collecting a nice annual premium from the insurers (generally 10 %+), but are at risk if mortality in a certain pool exceeds set parameters.  A large amount of deaths from natural disasters or disease outbreaks are really your risk here.  These trades are generally private and bespoke allowing the investor to structure the pool of insured’s’ and the triggers. 

A much more feel good strategy as you’re cheering for life, right?

Seems like some pretty sick and twisted shit, eh?  Well, it’s out there and it’s a multi billion dollar segment of the investment universe where a lot of reputable hedge funds are playing and the insured are willingly selling their policies or borrowing against them (this is a far cry from the sleazy viatical game that occurred years ago).  Most related strategies are on the lower end of the liquidity spectrum, but the non-correlated nature of the trade, along with healthy (pardon the pun) returns, makes the opportunity set attractive.
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Hedge Fund Returns on the Cheap, Really?

July 6, 2007 | Leave a Comment

We have been acquainted with Dr. Harry Kat (professor of risk management at Sir John Cass Business School, which is part of City University in London) for a number of years. In fact, we use some of his research to justify why investors are well served to take a look at emerging hedge fund managers over their well established colleagues. Recently, Harry Kat was interviewed by The New Yorker about his latest endeavor, a software product designed to generate hedge fund returns mechanically and cheaply. In particular, Kat chose to try and replicate the returns of the Quantum Fund run by George Soros. To quote the article:

“It is possible to design mechanical futures-trading strategies which generate returns with the same, and often better, risk-return properties as hedge funds,” he said. “This means investors can have hedge-fund returns but without the massive fees and all the other drawbacks that come with the real thing.”

One of Kat’s main complaints about hedge funds, or maybe not necessarily a complaint but an observation, is that the 2 and 20 compensation model used by hedge fund managers negates the returns for the investors. Now Kat does not claim his FundCreator product will match Quantum before fees, but it will match or at least come close after fees. To be fair, Kat understands this and makes it clear in the article by stating …

“People say, ‘Look, you don’t generate any alpha.’ After fees, I generate a lot of alpha. I just generate it differently. Instead of trying to beat the market, I get the fees down.” He conceded that there will always be hedge funds whose returns FundCreator can’t hope to match, but he argued that even some of the most prestigious funds owe much of their success to luck. “You can be fortunate,” he said. “You can live off market trends for quite a while. As in credit spreads”—the difference in yields between different types of bonds. “Credit spreads start to come down, and you make lots of money in credit. A couple of guys from an investment bank’s credit desk jump out and start a fund. If they are lucky, the trend continues for another couple of years, and they will look like masters of the universe. But when the trend reverses, or when there is no trend left, they are in trouble. If a guy has done well for two years, what does that mean? He could be really smart, or he could be really lucky. If I had bought stocks at the end of 1997 and you had looked at me at the end of 1999, I would have looked brilliant.”

And of course it is nearly impossible to distinguish between genuine investment skill and random variation. Yet, some firms manage to generate high returns with low volatility.

But the point is whether or not hedge fund managers will be sidelined as computer programs like Fund Creator continue to be tested, developed and marketed? This may threaten some of the more “traditional” hedge fund strategies such as long/short rather than global macro. Or maybe not. In the mean time, we would not worry much about it. We are thinking of contacting Harry Kat to get more perspective on his research and FundCreator product. Stay tuned.

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