May 23, 2016

Quants are making money while Hedge Funds are facing more redemptions

As I've previously written, Mr. Market has more moves these days than a shortstop who's batting .110. Stocks have lost their predictability and reliability as economic variables seem to have the opposite effect from day to day in the market that's without memory from session to session. Wall Street seems to have more twists and turns than Donald Trump has former girlfriends and wives.

Let's look at some of the problems:

As I've previously written, the market mechanism is broken -- influenced in part by the dominance of quant strategies that are agnostic to private-market values, balance sheets and income statements. Machines and algorithms have replaced traditional financial analysis and active money management.

The inability of everyone from small investors to large hedge funds to react to this has doomed many people's investment performance, which has important market and fund-flow implications.

A market with little natural price discovery and lots of central-bank largesse disenfranchises both individual and institutional investors. Monthly net redemptions are continuous as retail investors leave the markets in droves.

And for those small investors who do remain, ETF's are becoming the investment vehicle of choice. Single-stock stories that have historically served as the market's foundation are becoming endangered species as individual investors focus on diversification and liquidity given today's extreme volatility.

Institutional investing's profile is changing as well. Hedge funds, which until recently had been the market's dominant players, are being dis-intermediated amid under-performance and high fees. American International Group, MetLife, Lincoln National and other life insurers are reducing their hedge-fund exposure, exacerbating the industry's woes.
Future of Human Evolution ?

As a result, hedge funds are scrambling to deal with never-ending redemption's, making it tough to hold the longer-term investments that had previously boosted the industry's results.

And the "funds of funds" that serve as feeders to the hedge hoggers are suffering even more than the hedge funds themselves are. After all, these funds' second layer of fees has become unacceptable to many investors in the wake of today's subpar aggregate returns.

Declining fund flows, investor-class exodus, slower global growth and more-competitive business landscape are all combining to create numerous industry- and company-specific potholes.

They've also contributed to the decline and fall of some of the greatest investors of all time. Several legendary hedge hoggers are electing to close up shop in recognition of the aforementioned threats and headwinds. They're too smart not to recognize how unplayable and unbeatable the markets have become.

Even Berkshire Hathaway and Warren Buffett have failed to meaningfully beat the S&P 500 in seven of the last right years. Berkshire's portfolio is looking more and more "Old Economy" these days, and the recent addition of Apple is just another example of how The Times They Are a Changing' for the Oracle of Omaha. Berkshire's huge stake in IBM (IBM) hasn't played out particularly well, nor have big bets on Coca-Cola (KO) and many other holdings.

Deteriorating fund flows aren't the only headwind that markets face. Disruption is taking place in retail, lodging, banking, entertainment and many other industries. Company efforts to reinvent and respond amid subpar top-line growth and today's sluggish global economic environment are, to state the obvious, more than challenging.

I'd like to continue my analysis by looking at how the Federal Reserve is contributing to this:

The Fed Tries the Ol' Razzle Dazzle

Central bankers continue to depend on their old tricks, using dated policies and ever-cheaper money to try to respond to new headwinds.

But this has only helped the bond and stock markets push aside natural price discovery. Quant strategies have been disruptive to the markets, rendering both fundamental and technical analysis less useful.

April Consumer Price Index shows that the Fed is achieving its inflation target. But the central bank should be careful what it wishes for. Higher costs of living can threaten the average Joe and Jane's disposable incomes as wages continue to stagnate. The Fed's trickle-down policies have been a failure over the past decade, as the benefits have only trickled up.

Central Banks Can't Save Us

The markets are trying to grapple with a complex confluence of events and disintermediation of investor and asset classes. For instance, we're seeing:

- Sub-par global economic growth.

- The rising occurrence of "black swans" and growing political and geopolitical uncertainties.

- The disruptions of many companies and industries.

- The lost influence of retail and especially institutional investors (i.e., "Peak Hedge Funds"). This poses a profound threat to the market.

- The rising role of machines and algos that tend to exaggerate short-term price momentum.

- Artificial stock prices in a world of monetary-policy largesse and fiscal-policy inertia. This will eventually fade, but if it does so in an absence of self-sustaining growth and "escape velocity," it'll be "Katie, bar the doors!" for stocks.

Add it all up and we're likely to see more volatility, less predictability and a market that could continue to chop up most investors and many traders. Unfortunately, I see no change for the better in sight on any of this. In fact, I see more possible adverse and market-unfriendly outcomes than at any time in my investment career.

The Bottom Line

Those with the right fortitude and risk profile should consider shorting the markets as a hedge against a fuzzy future, but shorting isn't for everyone. Given today's unpredictable markets (where the only certainty is the lack of certainty), most players might want to simply sit on the sidelines with larger-than-normal amounts of cash.

Personally, I plan to be a seller on any strength. I have three longs on my "Best Ideas" list right now, but 21 shorts. Many stocks look shortable to me, but few meet my standards to buy.

via realclearmarkets