Confessions of a Hedge Fund Manager

204 The fast roa d dow n

revealed in 2008. Finally, the whole world depends on the US markets – as

equally painfully proved during the 2008 meltdown. It is difficult enough

to accurately assess past correlations, so it’s hardly surprising that we run

into trouble when what we are looking for is not a measure of the past but

an estimate of future correlation. Then we must try to gauge how we can

get the most diversification from investing in a combination of markets.

Past correlation data may provide a good guide for estimating future cor-

relation, but counting on those numbers alone to make precise forecasts

would be unwise; the world and correlations change constantly.

Creating a diversified portfolio

What we are trying to do is to create a portfolio of well-diversified liquid

markets across the world in a way that is cheap to put together and where

we have a reasonable estimate of the risk we are undertaking. While invest-

ing assets such as real estate or private equity may be appealing, they are

less liquid and often come with high fees. Instead we should focus on

liquid debt (corporate and government) and equity markets across the

world where we have an expectation of positive returns (as we do in most

markets), an idea of how the tradeable values move relative to other mar-

kets (correlation), and a reasonable estimate of the risk of each individual

investment (volatility). In finance theory, what we are trying to do is to

create a real-life practical investment on the ‘efficient market frontier’. For

the very technical, there are two areas where we differ from traditional

finance theory: we will not be investing according to market sizes (that

would lead to disproportionate investments where capital markets make

up a large percentage of GDP (gross domestic product) and leave us with

mainly the USA and Western Europe), and we do not think the expected

returns across the world strictly follow the methodology of the Capital

Asset Pricing Model (CAPM). This would suggest that the risk premium in

smaller markets is barely above zero.

The main concern with a broadly diversified portfolio is that diversifica-

tion gives a false sense of security. When the shit hits the fan, all markets

act as one and our fancy charts go out the window, along with correlation

assumptions, especially in emerging markets. During the 2008 meltdown,

no markets were spared, just as in September 2001 when they all took a hit