Lessons from Switzerland – A Call for Transparency
Full transparency is a heavy risk, but transparency should not mean handicapping oneself through a loss of flexibility.
There is perhaps no moment more gut wrenching for the CIO of an endowment than reading the apologetic email from one of her alternative investments which just blew up. Hedge funds are already being scrutinized for their outlandish fees and dubious claims for superior performance. A blowup? However schaudenfreude it may be to rubberneck at, it brings critics to the forefront and often derails the clearheaded approach a permanent capital structure requires to navigate a complex investment process.
In the aftermath of the Swiss National Bank’s unexpected unpegging of its currency, several high profile funds have been vaporized from asymmetric, leveraged bets on the Swiss Franc. Others will undoubtedly report heavy losses in the coming weeks. These are the types of trades coined as “picking up pennies in front of a steamroller”. Think of it as seeing a wallet on a subway track, and mischeviously looking at the next expected train time which says 25 minutes. You assume that even though there is some fatal risk, it’s safe enough to jump down to get. We all know what happens next. You may cry, “The chances were so small! The sign said 25 minutes! I should have had plenty of time!” The truth is you should have never jumped down there in the first place.
It has been reported that Goldman Sachs’ CFO mentioned on an investor call that the currency’s move was akin to a 20 sigma event; something so astronomically uncommon that it dumbfounds any notion of probabilistic risk. These mea culpas may ring hollow given how often we are getting these once an eon events. The ongoing confluence of many sigma events only solidifies this fallacy, whether it is LTCM, subprime debt, or a flash crash algo loss.
This post is not meant to be an attack piece on quantitative or analytical risk; Novus calculates VaR, eVol, sensitivities, and scenario analyses for our clients. I am a firm believer that there is value to be had from that type of analysis, especially when stitched together with common sense risk such as balance sheet exposure and leverage. This post is a retort to a VaR figure as a true testament of risk, given how correlations and assumptions can change the very notion of risk on its head. Just ask AIG Financial Products quants.
This is meant to question the practice of a glossy VaR and scenario chart as a communication tool to investors, rather than detailing true fundamental risk exposures. This is a dialogue on pedantically talking down to investors because the modeling and principles of one’s approach are too complex for them to ever appreciate. This a reminder of the fallacy of derivative computation as a standard currency for transparency.
If investors choose to invest in complex strategies that cannot be explained to a board member (a good bellwether of reality), the true antidote to exposing themselves to the sinewy left tail of permanent capital loss is full portfolio position-level transparency. Without it, investors will continue to wade into the dark hoping not to fall into a trap. Sadly, some managers will continue to obfuscate outlandish risks, and the reality is those risks will be taken given the convex payoff of prevalent heads I win tails you lose compensation structures.
Full transparency is a heavy ask. I fully empathize with the need for a GP to protect the intellectual property of her positions. I get it that superstar managers need time and stealth to incubate ideas before they hit the blogosphere. I agree that quantitative strategies that unearth true arbitrage opportunities cannot simply be leaked only for the mispricing to evaporate. But at the end of the day, acquiescing to transparency should be a requisite for those recouping 2/20 from their LPs, if that relationship is one of trust and long term mutual objectives.
Transparency should not mean handicapping oneself through a loss of flexibility. I think that is the unfortunate consequence of liquid alternative mandates which convolute transparency/risk control with rigid constraints that can hinder alpha generating tools. A manager may want to size a position aggressively. They may want to capture an illiquidity premium on an obscure instrument. There is no reason she shouldn’t as long as it is not a fatal risk. If fatality is an integral component of the fund (e.g., many arb strategies), it must be explicitly communicated to the LP. Transparency means accountability for straying from investment mandates and institutionally tolerable risk limits. Fundamental focused funds should not be trading futures and speculating on macro bets. Macro funds should be open about how they model risk and what the true downside is when employing leverage.
If the modus operandi is trading rates mid-month with nary a whisper of it on a month-end exposure report, it must be changed. If it is beefing up a Sharpe ratio through convex 40x levered trades like EUR:CHF and communicating that risk through a vague VaR number, it must be stopped. Until then, it is tough to harbor any sympathy for a reckoning. Allocators simply must demand more accountability and true transparency.
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