Seriously Negative Alpha

With the S&P 500 up nearly 9% since the beginning of the calendar year, it would be prudent to take the opportunity to understand your game theory going forward. As I’ve previously stated, I believe a consistent 5% annualized return will be satisfying on all levels looking back in 5 years. Assuming you have participated, to a significant extent, in this one-percent-per-week rally, your portfolio has captured nearly two years’ worth of expected returns; and you have plenty of options to navigate your portfolio successfully through the rest of the year. If this is the case, the rest of the year is very simple: stay flexible with excess cash, be selective with both your investment choices and timing, and avoid the temptation to chase. If you subscribe to the idea of sub-double digit annual returns, you’ve just hit your yearly target (and then some). Your only (avoidable) downfall this year will be the behavioral risk associated with relative underperformance, leading to erroneous choices.

Unfortunately, not all investors are in this position:

The average equity hedge fund returned 3 percent this year through Feb. 10, compared with 7 percent for the S&P 500, Goldman Sachs Group Inc. said in a report dated Feb. 21. A Goldman Sachs index of the 50 most-common stock investments at hedge funds gained 10 percent.

The funds lagged behind even after boosting their net long exposure, a measure of how much they’re investing in bets that stocks will rise, to 46 percent in the fourth quarter from 36 percent at the end of September. The figure was down from 50 percent in December 2010.

Hedge funds trailed the S&P 500 and mutual funds last year, losing 4 percent, according to the Goldman Sachs data. The benchmark index had a total return of 2 percent.

There is nothing good that can be said about that. Furthermore, it’s inexcusable. Additionally, with such a divergent set of returns in which the “smart” money is upside down compared with the retail investor, and will lead to a potentially explosive situation later this year. Before I explain what I mean, consider another excerpt from the Bloomberg article:

The outperformance of the Goldman Sachs Hedge Fund VIP Basket suggests “that ‘hedges’ and modest net exposure have created a drag on performance rather than poor stock selection,” wrote David Kostin, a New York-based strategist at Goldman Sachs, in the Feb. 21 note. “Despite finding success with their top picks, lack of net exposure to the cyclical rally has caused hedge funds to lag both the S&P 500 and the average large-cap core mutual fund so far in 2012.”

Year-to-date, the GS VIP Basket has returned 10%; which means that not only were equity hedge funds underexposed (on average), what little positive performance they did have was mostly beta, or participation in commonly held stocks.

Back to the dynamic that is likely to play out later this year. Superior stock selection alone will not compensate for the managed-money underperformance. The opportunity to look relatively better will come through future volatility and / or benchmark (and retail investor) decline. This is an all but certain outcome that cycles into itself: underperformance breeds a “catch-up” mentality, which leads to a fragile overextended condition. As that cycle naturally reverses due to its fragility, volatility ensues.

Thus far, this rally has been very stable. Domestic equities have not been as overbought as perceived. Climbing the wall of worry will continue through the end of the first quarter with only minor corrections. Addressing time frames further out is almost counterproductive to dynamic allocations. However, I suspect a larger correction to occur in the second quarter as complacency reaches a peak. Remaining tactically bullish on domestic equities through the first half of the year should continue to prove fruitful. At which point, it is absolutely critical to reduce risk.

Bloomberg Article

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