A structural analysis of Warren Buffett's career has fascinated me for some time. His journey from independent investor to hedge fund manager to insurance conglomerate manager holds lessons for those who care to learn from the worlds greatest investors.
Other investment managers have followed Buffett's search for "float" most notable being David Einhorn (see an excerpt on "float" from Buffett's 2009 letter below the video).
Below is great interview with Joe Taussig of First International Capital, who participated in the creation of Greenlight Capital Re, the re-insurer founded by David Einhorn. He expands on the economics that makes the insurance industry attractive to asset managers.
I'd like to thank the team over at Opalesque.TV for this video, and all the great interviews with leaders in the hedge fund industry.
Buffet is know for opining about "float" that the insurance industry enjoys. Here is an excerpt from his 2009 annual letter:
Insurers receive premiums upfront and pay claims later. ... This collect-now, pay-later model leaves us holding large sums — money we call "float" — that will eventually go to others. Meanwhile, we get to invest this float for Berkshire's benefit. ...
If premiums exceed the total of expenses and eventual losses, we register an underwriting profit that adds to the investment income produced from the float. This combination allows us to enjoy the use of free money — and, better yet, get paid for holding it. Alas, the hope of this happy result attracts intense competition, so vigorous in most years as to cause the P/C industry as a whole to operate at a significant underwriting loss. This loss, in effect, is what the industry pays to hold its float. Usually this cost is fairly low, but in some catastrophe-ridden years the cost from underwriting losses more than eats up the income derived from use of float. ...
Our float has grown from $16 million in 1967, when we entered the business, to $62 billion at the end of 2009. Moreover, we have now operated at an underwriting profit for seven consecutive years. I believe it likely that we will continue to underwrite profitably in most — though certainly not all — future years. If we do so, our float will be cost-free, much as if someone deposited $62 billion with us that we could invest for our own benefit without the payment of interest.
Let me emphasize again that cost-free float is not a result to be expected for the P/C industry as a whole: In most years, premiums have been inadequate to cover claims plus expenses. Consequently, the industry's overall return on tangible equity has for many decades fallen far short of that achieved by the S&P 500. Outstanding economics exist at Berkshire only because we have some outstanding managers running some unusual businesses.
Several well known investors are betting on natural gas, according to Reuters in Analysis: Billionaires' bet on gas; brilliant or backfire?
Carl Icahn, T. Boone Pickens, and Wilbur Ross have all placed major bets on natural gas companies.
Reuters: Icahn in December more than doubled his stake in Chesapeake Energy Corp, the second-largest producer of natural gas in the United States behind Exxon Mobil Corp.
Pickens is backing a buyout led by EXCO Resources Inc Chief Executive Doug Miller, who is pursuing a $4 billion management-led buyout of the gas producer.
Ross has steadily raised his stake in EXCO to nearly 10 percent and is considering joining the buyout as well.
EXCO, like most other U.S. exploration and production companies, has invested in shale fields like the Marcellus and the Haynesville. Those fields contain so much gas -- some say shale holds more than 100 years' supply -- that it has tipped the supply and demand balance in North America and hurt prices.
It is interesting to note the different styles of these well known investors. While Pickens involvement is no surprise, as he made his name as a corporate raider and shareholder activist in the energy sector, the others are less known for their energy investments. When investors with different approaches like the same investments it suggests these companies are attractive for several different reasons, and other investor would do well to pay attention.
Below are excerpts from these investor's profiles on Wikipedia:
Carl Celian Icahn (born February 16, 1936) is an American financier, corporate raider, and private equity investor. Icahn began his career on Wall Street in 1961. In 2010 his net worth was US$11 billion, making him the 24th richest American, and as of March 2010 the 59th richest man in the world. In 1968, he formed Icahn & Co., a securities firm that focused on risk arbitrage and options trading. In 1978, he began taking control of positions in individual companies. He has taken substantial or controlling positions in various corporations including RJR Nabisco, TWA, Texaco, Phillips Petroleum, Western Union, Gulf & Western, Viacom, Uniroyal, Dan River, Marshall Field, E-II (Culligan and Samsonite), American Can, USX, Marvel Comics, Revlon, Imclone,Federal-Mogul, Fairmont Hotels, Blockbuster, Kerr-McGee, Time Warner and Motorola.
Full Disclosure: At the time of this writing, I am long the energy sector in my personal and client accounts.
In the fields of risk management and trading strategy development drawdown is an important metric. It's an intuitive conclusion that investors seek strategies that exhibit low drawdowns. However, those who build trading strategies know that approachs which have the lowest drawdowns (or almost none) have a way of blowing up when the times get tough. There are several examples of a "picking up nickels in front of a steam roller" strategy.
Therefore an investor's track record with no drawdowns should be considered with suspicion. AllAboutAlpha.com has profiled a recent study that backs up this intuition. The study can be accessed directly here.
The title of the paper is On the Economics of Hedge Fund Drawdown Status: Performance, Insurance Selling and Darwinian Selection by Jose M. Marin and Sevinc Cukurova.
Abstract: In this paper we study the drawdown status of hedge funds as a hedge fund characteristic related to performance. A hedge fund's drawdown status is the decile to which the fund belongs in the industry's drawdown distribution (at a given point in time). Economic reasoning suggests that both the current level and the past evolution of a fund's drawdown status are informative of key fund aspects, including the manager's talent, as well as fund investors' assessment of the fund, and, hence, are predictive of future performance. The analysis delivers four completely new insights on hedge funds. First, the presence of insurance selling (shorting deep out-of-the-money puts) in the industry is large enough to make portfolios of low drawdown funds weak performers, in general, and bad performers in times of turmoil. Second, the market operates a Darwinian selection process according to which funds running large drawdowns for a prolonged period of time (survivers) are managed by truly talented traders who deliver outstanding future performance. Third, a completely new dimension of risk arises as a distinctive feature of hedge funds: risk conditional on survival is tantamount to outstanding performance. Fourth, drawdown status analysis raises serious concerns about the role played by other hedge fund characteristics -such as total delta- on fund performance and casts doubts on the validity of some performance evaluation measures -such as the Calmar and Sterling ratios- that are widely used in practice.
I have just returned from the excellent Network 2011 conference, hosted by the Managed Funds Association (MFA). Several of the speakers created headlines; the conference itself was news-worthy due to the large gathering of fund managers, investors, and service providers.
Congratulations to Meredith F. and the whole MFA staff for planning a tremendous event!
Below are links to stories related to the conference and the MFA:
Why Dinan Worries About Fate of Small Hedge Funds
MFA Aiming Pitch at Institutional Investors
Hedge Funds Don't Pose Systemic Risk, Hedge Fund Group Asserts
How a Hedge Fund Can Land a Whale
John Paulson’s $5 Billion Profit Will Spur Anger, Says Hedge Fund Chief
This is the personal blog of Emory Redd.
This blog is not investment advice. This is not a solicitation to invest. Don't take candy from strangers.
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