Lessons from the Best-Ever Hedge Fund Manager

by: Veryan Allen April 14, 2008    

Veryan Allen

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Best hedge fund? Recently I visited the home of the world's best-ever hedge fund manager and I often re-read his writing on investment topics. On my way to his house I saw some black swans on a lake which seemed appropriate and later ate at a restaurant that had run out of rice which appeared even more significant. It is sometimes the minor data points that lead to major opportunities.

How does one define "best" in the fund manager universe? I have looked at lots of funds, both traditional and alternative. Here is the performance chart of one I analyzed a while back:

Seems pretty good. It is a real fund and you could, if you want, invest in it. No lemon apparent with this product; the fund exists and that chart and performance numbers have been audited many times. A 20% compound annual return with ten consecutive winning years. Heavily regulated and open to investors everywhere. Zero management and incentive fees - 0 and 0 is better than 2 and 20. No leverage, no lockup and no valuation risk. The manager can accept $100 or $100 billion without damaging performance or capacity and offers full position transparency. The fund only invests in listed common equities on the world's largest stock exchange by market capitalization.

Sounds like an ideal fund but after thorough research I concluded this fund was not a suitable candidate for investment. I decided to try to figure out who is the best fund manager ever. The criteria for an investable fund are complex but necessary to identify the "best". If we were to define the top hedge fund as that which extracted the highest percent amount of absolute alpha over several decades, the wealth accumulated by the portfolio manager from his trading acumen, the consistency and repeatability of that performance, the existence of clearly defined protectable edges in fundamental and quantitative analysis and a legacy of investment theory, then the best ever hedge fund manager is pretty clear.

That person was of the great Munehisa Honma who managed a long/short commodities hedge fund during the 18th century. His house is well designed and much larger than most hedge fund managers, but his book "Fountain of Gold" is brilliant. Probably the best investment book ever written. His trading ability enabled the Honma family to go on to become the largest land owner in Japan for over a century. In today's money, his likely net worth was much more than $100 billion. Some years he would have "taken home" the equivalent of $10 billion so it is curious that there are those excited about John Paulson's "record" pay of $3 billion; fair compensation for the $12 billion absolute alpha he generated for investors that they would not otherwise have.

But Honma's returns were higher. Back in 1755 he knew that it was psychology and the irrational actions of market participants, not economic logic that drove markets. The study of behavioral finance isn't new, it's over 253 years old. Also he didn't buy and hold rice and wait to be compensated for its high risk. He did not "expect" a commodity risk premium. And even though rice futures were heavily traded and analyzed back then, the liquidity did not produce an efficient market. Like good traders today, he worked out that if he worked hard to develop competitive informational and analytical advantages, he could extract absolute alpha out of other rice traders, regardless of whether rice prices themselves were rising or falling.

Munehisa Homna had many insights that paved the way for the absolute return managers of today. Translated adages from his main book: - "Market action is more important than news." "Prices do not reflect actual value." "Buys and sells are decided on emotion not logic." He discovered the truth all that time ago and without the computers and communication systems we have. His fund's results speak for themselves. The Swedish Central Bank should retrospectively give him one of those "Nobel" prizes that the efficient, equilibrium economists still have as they continue their fruitless search for a rational, random market.

Honma wrote of the returns to be made buying when all others are selling and shorting when everyone is buying. Consult the market about the market. Even today so many spend time on Fed, ECB and BoJ-watching when they could be watching what the market is saying. The market told us we were entering a recession several months ago. It also clearly implied the credit crisis was not "contained". Mr. Market informed us that rice, oil, gold and sulphuric acid were going up while the pundits claimed inflation was under control.

However Honma did spend a lot of time on fundamental analysis, what moved rice prices, who was buying or selling and why. He also had detailed historical weather data and analyzed it to predict a key factor driving rice crop yields. His trading required good execution latency so, despite the pre-electricity era, he established a signaling system all the way from Sakata to the Dojima Exchange in Osaka to get orders in and prices back as quickly as possible. He developed many quantitative techniques to maintain his competitive advantage; some simple ones, like candlesticks, have entered the public domain but many others he kept to himself. Honma was the original black box algorithmic trader and system developer. As his impact on the markets grew, he evolved from market-taker to market-maker. He leveraged his informational advantages and adapted to the situation as needed.

Many techniques can be traced back to Honma. It is interesting how sometimes Western investors get caught out trying to trade Japan. I've seen more than a few "star" bond or treasury traders get blown away by JGB futures. Some fixed-income hedge funds got hurt by Japanese bonds recently. The yen carry trade has damaged some that didn't realize that a low interest rate doesn't mean a weakening currency. And of course there are equity strategists and some beta dependent Japan "hedge funds" who have been saying "Japan is cheap" since the Nikkei was at 16,000 but now it is down in the 12,000s. As Honma said, the cheap can get much cheaper.

Some investors might be skeptical of technical analysis and know nothing about Japanese technical analysis. Fair enough. There are plenty of fundamental ways to make money. But if another bigger investor with lots of yen to put to work does believe in Dojis, Harumis, Ichimoku, Kagi or Rengo, that may impact the markets and lose money for those who do not keep up with such methods. As Honma knew and John Maynard Keynes succinctly implied, the key is working out what others will do and how they value securities, not your own estimate of its value. The market may never value it "correctly" as some activist investors in Japan have found out to their cost. Equity analysts visiting companies is useful in many countries but I have seen little evidence of its utility in Japan.

Honma was probably the first successful quant in finance. Isaac Newton's earlier market forays weren't very good but then gravitation modeling is easier than financial modeling. The sun will rise tomorrow but the motion of the markets is less predictable. It is interesting how today more scientific method and new math is being applied to the markets. But then the old math and old economic theory have not coped well with reality. Assets classes affect each other and the ways they interact change over time. The equity market neutral crowd will be keeping a close eye on credit traders from now on and vice versa but they should have been doing that all along. Honma kept an eye on many things even if they had no apparent connection to rice prices. Everything is related and nothing is independent.

Japanese electronics, washing machines and subway systems make use of fuzzy logic. Fuzzy logic was a trend in Japan for quite a while though it was first developed in the US. It is disdained by those who think we live in an orderly bivalent world of right and wrong and 0s and 1s. Many years ago I developed a fuzzy model to measure the bullishness or bearishness of the market. It used to give nice projections for the daily ranges for the JGB, Nikkei and yen fx markets. Given the inappropriateness of Ito's stochastic integral for pricing derivatives, I also tried adapting Sugeno's fuzzy integral to derive a more accurate option trading model. Isn't the world itself fuzzy, so fuzzy logic could be of use? Subways run on time in Japan.

That some hedge fund strategies are short volatility - and can be modeled as effectively short sellers of options and hoping a black swan won't show up to transform the fund into a lemon - is old news. Fortunately there are many other hedge funds run by managers who are fully aware of potential "rare" event tail risks, carefully hedge and maintain a long volatility profile. Some hedge funds are indeed lemons but there is lots of other quality "produce" in the investment grocery aisle.

So Japan had the world's best ever hedge fund - Honma's long short rice trading hedge fund managed from the 1740s to the 1790s - but also surprisingly the world's best performing index fund over the long term of 50 years - still the Japanese TOPIX. The fund chart above is the fund performance from 1980-1989. Below is the full performance chart from 1980-2008. Past performance was not very indicative for future performance.

Things haven't been too good since the high water mark of December 1989. Interestingly the 1980s weren't the best period; the 1950s compounded at a 25% CAGR and returned 10X investors' money plus even more in high dividends. Even now, 18 years into the bear market, the TOPIX remains the best index performer in the post war period. Would I therefore invest in it? Absolutely not.

I prefer the manager risk, security analysis and trading skills of today's Munehisa Honmas, not the market risk of every stock that happens to be listed on the Tokyo Stock Exchange. Ditto for other countries and asset classes. Honma would have thrived in current market conditions and with three billion people eating rice as a staple, the recent rice price rises are potentially very important. Possible recession and inflation are going to make the absolute alpha generated by the best fund managers important to portfolios and they have Honma, among other great traders, for inspiration.

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This article has 17 comments:

  •  
    Apr 14 09:27 AM
    Really nice article, its great to see when truisms developed hundreds of years ago are applicable to today. Fundamentals alone don't always reflect the true price of a security. Sentiment, expectations and other factors play heavily into short-term pricing, and as the old saying goes, "The Tape Tells The Tale".
    Reply | Link to Comment
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    Apr 14 10:38 AM
    Interesting article - I've always been a big fan of market psychology. How does a stock increase 20% one day and drop 50% the next? Majority of it driven by the crowd.

    Look at all the boom and bust we've witnessed over the years, a majority of these trends have been driven by the overly enthusiastic or the overly pessimistic views of the general investment community.

    The fact that ideas generated hundreds of years ago can be applied in today's markets is testament to how the human nature rarely changes. After all, there is no market without the crowd.
    Reply | Link to Comment
  •  
    Apr 14 10:53 AM
    Excellent article, thanks.
    Reply | Link to Comment
  •  
    Apr 14 11:01 AM
    This is one of the best articles I've read on seekingalpha in a very long time. Great job!
    Reply | Link to Comment
  •  
    Apr 14 02:04 PM
    does anyone know where i could find this book ?
    Reply | Link to Comment
  •  
    Apr 14 02:48 PM
    Its not just one of the best articles on seekingalpha its one of the best investment historical examples period. Bravo!
    Reply | Link to Comment
  •  
    Apr 14 03:32 PM
    My biggest problem with Veryan is that he does not post enough.

    Kick the preening peacocks off this site, and bring on some new blood.

    Well done as always, Veryan.
    Reply | Link to Comment
  •  
    Apr 14 03:43 PM
    killer article bravo.

    Now how do we get the book?
    Reply | Link to Comment
  •  
    Apr 14 04:21 PM
    This is why I check SeekingAlpha everyday. Great article!!
    Reply | Link to Comment
  •  
    Apr 14 04:23 PM
    The book please? Where can we get it?
    Reply | Link to Comment
  •  
    Apr 14 06:44 PM
    I'm with MysteriousForce - the only books I've been able to find on Amazon have been Candlestick Charting Books that only mention Homna. A book just on Homna would be an interesting read.
    Reply | Link to Comment
  •  
    Apr 14 08:16 PM
    SA readers, good luck finding the book in English; there's an edited/revised version and a manga version of "Fountain of Gold" in Japanese. There may be a translated version floating around that someone did their self... If I understand correctly, Steve Nison may have been one of the first to come across the scriptures and openly discuss them in the Western world.
    Reply | Link to Comment
  •  
    Apr 15 01:34 AM
    I just accidentally sat on a black swan. It was already dead.
    Reply | Link to Comment
  •  
    Apr 15 01:51 PM
    Reminds me of the old saying..."Stocks move based on 20% fundamentals, 20% technicals and 60% Market Psychology!
    Reply | Link to Comment
  •  
    Apr 16 04:56 AM
    Well written story. This statement is facile: "The market told us we were entering a recession several months ago. It also clearly implied the credit crisis was not "contained". Several months ago, the market was at an all-time high. How does that "clearly imply" an uncontained crisis? Everybody's a genius at predicting the past.
    Reply | Link to Comment
  •  
    Apr 16 01:32 PM
    Doing businenss the right way has always payed off. Unfortunatly so has cheating and greed. Doing business right makes friends. Profiting through greed frequently winds up with somebody getting even or simply with the house of cards collapsing. This was a wonderful article and reminder that some principals never change.
    Reply | Link to Comment
  •  
    May 12 04:08 PM
    Great article. I completely agree that you can make money just using fundamentals or just technicals. However, if you want to be the best you must understand supply and demand and to know that there are hedge funds out there that use technicals means you have to know them.
    Reply | Link to Comment
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