Sleight of Hand

People use all sorts of mind-voodoo to get through the day.

Thinking about an upcoming holiday; a coffee break; religion; the pub after work etc.

We are good at tricking ourselves that things aren't too bad.

Portfolio managers do the same.

If you're responsible for billions of dollars of long only bonds and equities, every so often, despite your institution's mantra of believing in the long term, you need a silver lining.

Day to day risk management is about finding silver linings.

Everything going down the pan?

Find a feel-good money making story for the end of year board meeting.

That is exactly what diversification provides, a bunch of silver linings for every eventuality and that's the reason why large institutions pay hedge and private equity funds the big bucks.

Easier said than done of course.

With a pen and paper model let's see how we could turn an unattractive fund with a beta of 1 into a cutting edge one with a beta of -1.

In this highly artificial example, our fund replicates the returns of the index one period later.

We go from having a beta of 1 to -1.

Of course your brain 'sees' a beta of 1, but the calculation is -1.

This sleight of hand therefore has the added benefit of reporting decent market-like returns while apparently being a massive diversifier - no small feat.

If you were actually in the hedge fund selling game, the next trick would be to identify whether an economically viable spin on this sleight of hand is possible and gauge your potential investor's actual time horizon (institutional FOHF managers have end of year bonuses like anyone else).

Oh, and then package it, with a snazzy story