Graduating To Lower Risk Through Hedge Funds
by Joseph Omansky, SkyRank System Creator, 06/06/05
I had just bit into my half-sour pickle at my favorite deli when peering over my father’s shoulder I saw a young man reading the stock pages. He was preparing his coffee, looked unhurried, and pleased at the money he was “earning” while stirring in his cream and sugar. That was it for me as a kid, I think, that which bit me and perked me up to the financial markets. I was 12 at the time, and purchased my first stock shortly thereafter.
Since then I’ve also invested and traded in futures, options, mutual funds, bonds and hedge funds. I learned slowly, and often painfully, that each has a different risk profile, the best hedge funds with the lowest risk of all. Now 24 years later, I look back, and realize my investing experiences seem to have been a series of lessons on how to find the ideal investment, that which lowers risk as much as possible in order to deliver positive returns regardless of all else. The lessons learned have pointed to hedge funds as the optimal investment opportunity as a method to reduce risk significantly while delivering positive returns.
So, at 12, I began attending the school of risk by buying that first stock, ToysRUs (TOY). My $500 investment quickly dropped to $450, a 10% loss in just two months. No sooner had I sold, did TOY rise out from the depths, with my original investment back to $500, as if the stock were yelling, “now that the kid is out, let’s make some money!” Investing in an individual stock seemed very risky indeed.
A few years later, I read about the growing popularity of an investment vehicle called mutual funds. Now it was possible to buy 50, 100, even 200 stocks instantly, all for one price called the Net Asset Value. After my experience with TOY, and before diving in to mutual funds, I read about Ralph Wanger, the manager of a high quality mutual fund, The Acorn Fund. Mr. Wanger had a rare talent for finding under-priced securities throughout the world. Instead of fluctuating wildly as with TOY, the price of The Acorn Fund moved up and down less, and in fact, I actually earned a healthy return that year, accompanied by much less volatility. From December 1985 through December 1989, The Acorn Fund experienced approximately 10% less annualized volatility than TOY, a significant reduction. As a mutual fund, Acorn achieved lower risk through a combination of Mr. Wanger’s stock-picking skill and by diversifying among many stocks.
I remember as a kid talking with relatives about government and savings bonds as low risk attractive ways to save, but they didn’t earn a very great return. They also fluctuated quite a bit relative to interest rates. I was told the rich guys had much better ways to invest; they earned a great return and risked very little. Those opportunities weren’t available to others though; the “alternative” investments were only accessible to the elite wealthy.
So, first it was the stock, all bets on one company. Then, the mutual fund, that risk spread out among many, but still with much market risk, a direct correlation to the broad market’s movement; when the market went down, chances were that the mutual fund also would record some negative returns. Although the safest bonds often had the faith and credit of the U.S. Government, when interest rates rose, the price of the bonds fell. So, if an investor had to sell prior to maturity, significant risk of capital loss still existed. With all traditional investments, that nagging market risk of losing capital when the markets fell persisted. I learned later that this market risk had been given a name, Systematic Risk, that risk which cannot be diversified. So, most investors had to accept losses, if the market deemed it so.
After graduate school, I continued my classes and became a broker, and finally my NBA ticket, a spot as a floor trader on the Chicago Board Options Exchange. I was now considered the expert, the options market maker. My job was never to speculate on the direction of the market, to instantaneously buy the bid and sell the ask, and to provide liquidity to the marketplace. So long as I stayed delta, gamma, and vega neutral, my reward would be participation in a transaction almost void of risk. By understanding the ins and outs of trading on the floor, and by understanding my risk, I could work to eliminate it. In a nutshell, I was a hedge fund.
Soon after, I moved off the floor to build a hedge fund of my own, a volatility model developed while on the floor. I went back to an office to study risk, at its most micro level, daily and intra-day volatility. I found that the direction of volatility was more predictive than the direction of stock prices. My lessons continued, and soon I was studying the most successful hedge funds throughout the world, attempting to build a system that found the best funds. It was true, securities with little to no risk were there – the best alternatives – the best hedge funds were waiting to be discovered. All I needed to do was to find them.
I don’t mean to make things sound so simple. For now, hedge funds are private. So, they require significant due diligence. A hedge fund can have the best historical monthly returns in town, and if those returns are not real, then there is a level of risk that cannot be quantified. The point here is that the traditional investments cannot achieve what hedge funds can, extremely high volatility-adjusted returns. Later in my career, I learned that the partners of a closely-held firm where I once worked had all of their investable assets in hedge funds -- all. Forget about that nice balanced mix of stocks and bonds as the primary method to diversify away market risk -- the partners simply bypassed that altogether through their access to the best alternatives -- their hundreds of millions of dollars invested in one asset class -- hedge funds. One hedge fund in particular I found, IIG Trade Opportunities Fund NV, amazingly delivered 10% returns each year for the entire six years it was in business, and never lost money over any month. This hedge fund has risk of approximately one-tenth that of treasury bonds, the lowest-risk investment available to the layman investor. Another one called EIS – Sector Neutral Fund LP delivered 14% annual returns over three years with approximately half the risk of treasury bonds. So, no matter what happened to the stock and bond markets, these hedge funds usually made money, with much less risk. It seemed that the hedge fund was the best kept secret in town, and the reason I was attending school.
So could hedge funds be the ideal investment, that which provides a high likelihood of an attractive return with significantly lower risk than bonds? Yes, if the hedge fund manager truly understands a market inefficiency, and has mastered trading that market segment, and appropriate due diligence is attended to, there is little that can be better. Such hedge funds rarely lose money, regardless of any market’s direction. That is the main difference between stocks, bonds and mutual funds when comparing them to hedge funds. While the traditional investment is normally linked to and dependent on the market’s direction, the alternative investment performs in a vacuum – completely independent and unaware of what is happening around it. That successful hedge fund is always seeking out the next market inefficiency to exploit, finding ways to reduce risk, and is always learning how to deliver positive returns, regardless of what is happening outside its world.
Joseph Omansky is a former hedge fund manager and equity options trader. He is the creator and owner of the SkyRank System of Hedge Fund Ratings, patent pending. The System is the most comprehensive hedge fund rating methodology in the industry, now rating over 4500 hedge funds and 1400 funds of hedge funds. It is largely considered to be the Standard Rating Methodology in the hedge fund industry. The System utilizes a complex algorithm to reveal a simple hedge fund rating that rewards those hedge funds that are established, credible, and able to consistently reduce risk over time at attractive returns.
For more information about the SkyRank System, visit us at www.SkyRankSystem.com, or email us at firstname.lastname@example.org.
The lessons learned have pointed to hedge funds as the optimal investment opportunity as a method to reduce risk significantly while delivering positive returns.