With economic pessimism becoming a growth industry, it’s interesting to note that the glummest of the glum work in a field with the most potential to influence how everyone else is feeling: the media.

Pollsters Ipsos MORI recently asked the British to cite the most pressing issue facing their country. Out front by a country mile was ‘the economy’, with two thirds citing it as the most important challenge (1).

And in terms of occupations, Ipsos found journalists were the most negative, with 96 per cent of that grouping believing the economy would get worse. There may be many reasons why journalists are so gloomy. Perhaps, things really are that bad.

But if that were the case, why are investors expressing greater optimism, as reflected in the large bounce in risk assets recently? As of early May, the US S&P-500 was 34 per cent above the lows struck two months before. Other major world indices were up by between 20 and 40 per cent.

Of course, no-one knows whether the bottom really has been reached. But it seems for now that there are enough seeds (I’ve grown tired of the phrase “green shoots”) of recovery to encourage those risking their capital to move back into the market.

(1) Economy Still the Most Important Issue Facing Britain, Ipsos MORI, May 1, 2009

Although we can only guess at the direction of the upcoming market, we can all be pretty certain that Wall Street’s pitch from their army of brokers will be safety. Investors will be presented with a plethora of structured investment products that will theoretically provide profits and limit losses. Where do I sign up?

An article in this week’s Wall Street Journal, Twice Shy on Structured Products, states as much. Still ringing from the 2008 stock market, selling safety to potential investors is easy. The problem is that what is easy is not necessarily appropriate. Investment advice should not be “sold.” It should be based on need. And if the recent events have any learning experiences, it is that incentives need to be aligned with outcomes and not with short-term compensatory opportunities.

Structured products if misused can easily cash in on investors’ short memories by pushing these high-fee products with safety as the big selling point.

As the article points out:

“Brokers are eager to sell these structured products because commissions are high, but they face explaining why many of these products didn’t perform as advertised. They also must convince clients that the firms behind these products are solid. Investors who bought products backed for firms that failed, such as Lehman Brothers, have big losses.”

“When Lehman Brothers Holdings Inc., which floated at least $900 million in structured products last year, filed for bankruptcy in September, investors sustained big losses. Many are hoping to recover just 20% of their investment, says John Barry, chief executive of fixed-income trading platform Bonds.com.”

I guess another lesson from this past market is that in times of extreme stress and when safety is needed the most, the words “principal” and “protection” should go together only if it is followed by the safety of U.S. Gov’t. short-term treasuries.

Many times we are guilty of writing about why we invest a certain way, while not reporting on research that fails to support the inclusion of certain investment strategies. Hedge Fund investing is one of these. Although we have written extensively on this topic in the formal literature, An Alternative Look at Hedge Funds, we have not made a point to consistently convey our views on hedge funds to our clients.

Due to the recent flood of news about hedge funds that are closing and in the spirit of this blog, it seems now is as good a time as any to give a brief eight point list of what we feel are the most significant issues with hedge funds as a viable investment alternative for investors.

1. Hedge funds are not an asset class but a compensation structure.
2. Hedge fund fees have option-like qualities that create an incentive for volatility.
3. The available data on hedge funds are far from perfect.
4. Analyzing the performance of hedge funds is difficult at best.
5. Hidden risks can lurk behind a veil of secrecy.
6. Hedge fund manager selection is no easy task.
7. The scarce resource captures the rents.
8. Hedge fund diversification is not a free lunch.

While I frequently report on the investment underperformance of active mutual fund managers, I have largely left hedge fund managers unscathed. Although hedge funds represent to many the equivalent of an investment status symbol, one should also ask himself if the emperor has any clothing. Hedge funds can be argued are the ultimate in active management because they are free from the constraints of traditional manager guidelines, hedge funds can short securities (they are after all hedge funds!), employ leverage, and trade derivatives.

In 2008, the average Hedge Fund return as measured by the Hedge Fund Research Institute’s Hedge Fund of Fund Composite index fell 21%. Although better than a 100% equity portfolio, this almost matched the 22% loss of a traditional 60/40 (1) stock/bond “balanced portfolio.” Because hedge funds are notoriously tax inefficient, on an after tax basis hedge funds would have faired significantly worse.

Robert Arnott notes: “This invites the question: Where was manager skill, the ability to side step the worst of the equity markets?

1) Using the S&P 500 for stocks and the BarCap Aggregate for Bonds.

There was an article in the May 2nd weekend edition of the Wall Street Journal titled, Odds-On Imperfection: Monte Carlo Simulation. The article states how the simulation technique known as Monte Carlo that is used by many advisors, ourselves included, fell flat on its face in failing to properly account for events like the past year. The article claims this is largely due to a faulty assumption that the market return distributions perfectly follow a normal distribution, i.e., bell curve.

Monte Carlo is not a panacea, but it does is provide a better option than a deterministic model (i.e., applying a constant 10% return to your portfolio year after year) for providing a litmus test of your current portfolio and wealth objectives. Monte Carlo adds a level of variability to the return sequence. There are still shortcomings in the analysis but it is still better than the former deterministic model.

The return distributions of the stock market can be properly accounted for by choosing appropriate distributions in the simulation. Even then though, it will not make much of a difference in terms of one’s investment conclusions. The fault is not in the methods, but in the interpretation of the results.

Monte Carlo should serve as a continuous guidepost for how clients are positioned. Things will always change and we need to be able to make educated judgments along the way. You can learn the most probable result, and the likelihood of deviation from that outcome. What you can’t learn is what will happen. What is most likely is not always what occurs. We have written on this topic in previous newsletters. See “The Straight and Narrow,” “A Moving Target,” and “The Personal Benchmark” for more detailed thoughts on the subject.

In light of what has happened in the financial service industry, financial modeling is a very dubious endeavor. And this has failed miserably in areas like risk management, option pricing, and types of “arbitrage” strategies. Ultimately, however, simulation analysis of portfolio returns is different. The question surrounding the distribution of stock returns was posed to Eugene Fama and Kenneth French, two giants in the field of economics. See their response below.

It would be very enlightening if you would comment on the Nassim Nicholas Taleb (”The Black Swan”) attack on the use of Gaussian (normal bell curve) mathematics as the foundation of finance. As you may know, Taleb is a fan of Mandelbrot, whose mathematics account for fat tails. He argues that the bell curve doesn’t reflect reality. He is also quite critical of academics who teach modern portfolio theory because it is based on the assumption that returns are normally distributed. Doesn’t all this imply that academics should start doing reality-based research?

Fama: Half of my 1964 Ph.D. thesis is tests of market efficiency, and the other half is a detailed examination of the distribution of stock returns. Mandelbrot is right. The distribution is fat-tailed relative to the normal distribution. In other words, extreme returns occur much more often than would be expected if returns were normal.

There was lots of interest in this issue for about ten years. Then academics lost interest. The reason is that most of what we do in terms of portfolio theory and models of risk and expected return works for Mandelbrot’s stable distribution class, as well as for the normal distribution (which is in fact a member of the stable class). For passive investors, none of this matters, beyond being aware that outlier returns are more common than would be expected if return distributions were normal.

For other applications, however, the difference can be critical. Risk management by financial institutions is a good example. For example, portfolio insurance, which was the rage in the early 1980s, bombed in the crash of October 1987, because this was an event that was inconceivable in their normality based return model. The normality assumption is also likely to be a serious problem in various kinds of derivatives, where lots of the price is due to the probability of extreme events. For example, news story accounts suggest that AIG blew up because its risk model for credit default swaps did not properly account for outlier events.

French: I agree with Gene, but want to make another point that he is appropriately reluctant to make. Taleb is generally correct about the importance of outliers, but he gets carried away in his criticism of academic research. There are lots of academics who are well aware of this issue and consider it seriously when doing empirical research. Those of us who used Gene’s textbook in our first finance course have been concerned with this fat-tail problem our whole careers. Most of the empirical studies in finance use simple and robust techniques that do not make precise distributional assumptions, and Gene can take much of the credit for this as well, whether through his feedback in seminars, suggestions on written work, comments in referee reports, or the advice he has given his many Ph.D. students over the years.

The possibility of extreme outcomes is certainly important for things like risk management, option pricing, and many complicated “arbitrage” strategies. Investors should also recognize the potential effect of outliers when assessing the distribution of future returns on their portfolios. None of this implies, however, that the existence of outliers undermines modern portfolio theory or asset pricing theory. And the central implications of modern portfolio theory and asset pricing-the benefits of diversification and the trade-off between risk and return-remain valid under any reasonable distribution of returns.