Friedberg Mercantile Confirms Collapse In Traditional Market Neutral Strategies, Laments Death Of Efficient Markets

We have long warned about the collapse in traditional market neutral trading strategies which for the past decade provided a major portion of the moderate market liquidity, and whose participants offset at least to an extent the disastrous influence of the HFT self-fulfilling prophecy that drives fractal momentum to ridiculous levels and whips the market into an irrational, lemming-like frenzy based on microvolatility, until everything snaps. Furthermore, our observations of the deplorable performance of various MN indices and funds, confirms that between liquidations and capital losses, this investment category may be doomed. The second quarter report by the Friedberg Mercantile group confirms this observation: "We continue to experience problems with our equity hedge program, a market-neutral strategy applied to U.S. stocks. For many years a successful program, earning above-average returns that were totally uncorrelated to S&P 500 returns, the program has repeatedly disappointed us in the most recent past, losing money in each of the past five quarters. This persistence of unfavourable outcomes is a totally unique event in the 19-year history of the program... Structural changes such as the proliferation of exchange-traded funds and super-rapid computer-based bloc trading, activities that are totally unconcerned with valuation metrics and/or long-term trends, are still taking place and there is little or no prospect of this development coming to an early end." There is a massive shift going on behind the scenes in market structure, and it is now far too late for the SEC or really anyone to do anything about it now. We anticipate implied correlation to approach 1 quite soon as every trading day becomes a manic-depressive bout in which the last few remaining traders and algorithms push the market up and down by a thousand points as the market becomes nothing than a sleaazy, unregulated, second rate, back-door Atlantic City illegal gambling parlor with a few stripper poles on the side for the CNBC cheerleaders. The point being anyone who tells you they can predict any movement in stocks now that valuations play no role in asset prices, is a charlatan, an idiot, is selling a subscription to a newsletter, or all three. Full must read Friedberg observations below.

We continue to experience problems with our equity hedge program, a market-neutral strategy applied to U.S. stocks. For many years a successful program, earning above-average returns that were totally uncorrelated to S&P 500 returns, the program has repeatedly disappointed us in the most recent past, losing money in each ofjavascript:void(0); the past five quarters.
 
This persistence of unfavourable outcomes is a totally unique event in the 19-year history of the program. To boot, the cumulative loss for this five-quarter period, at 18.45%, has materially affected the fund’s performance. A rough estimate, taking into account the average allocation given to this program, puts this effect at approximately 500 basis points. What is noteworthy is that this has occurred despite the fact that we have not changed any of our procedures, neither the selection process nor the hedging formulas. For some time we have speculated that the results have been affected by the lack of, and perhaps growing lack of, dispersion among stocks. A recent article in The Wall Street Journal, entitled “The Herd Instinct Takes Over” (July 12), fully confirms this suspicion. The sub-title of the article is: “Component stocks’ correlation to S&P 500 at highest level since ’87 crash,” and the article goes on to say that the correlation has recently hit 83%, a remarkable number when one considers that it has averaged 44% since 1980. The growing popularity of exchange-traded funds, among other things, has leveled the returns of individual stocks and sectors. By maintaining (or freezing) over- and undervaluations, this phenomenon has become a nightmare for stock and sector pickers. And, while it is true that this phenomenon raises hopes that, at some point in the future, large profits will be able to be made by exploiting these inefficiencies, such may not be the case for quite some time. In fact, structural changes such as the proliferation of exchange-traded funds and super-rapid computer-based bloc trading, activities that are totally unconcerned with valuation metrics and/or long-term trends, are still taking place and there is little or no prospect of this development coming to an early end.

As a result, we have temporarily decided to downscale the program, reducing the allocation by 10 percentage points. Simultaneously, we have decided to reduce the number of stocks in the program to approximately 25 from 45 to 50. With the greater concentration, we hope to ensure a more robust selection, one perhaps capable of overcoming the leveling effect of indexing. The future of this program will be decided towards the end of this quarter, after we have had a chance to assess results.

Full presentation:

 

FMGL 2ndQ 2010 F