In sophisticated financial circles, a discussion about “risk” is often introduced by some statistical measure which attempts to quantify risk in terms of a precise calculated number.  It’s a clean and easy approach.  Asset managers can state boldly: “my Sharpe ratio is ‘x,’” or “my Correlation Coefficient is ‘y.’” Oh, if only quantifying risk were so easy.
 
                The game of quantifying risk cannot be boiled down to one number or a set of numbers as I have written numerous times in the past.  In the quest to mechanize risk by quantifying it in terms of fancy variables, most sophisticated market participants talk in terms of Beta, Alpha, R-squared, Standard Deviation, and on and on and on.  Although this lingo may make one sound intelligent to attractive members of the opposite sex when mingling at a midtown-Manhattan cocktail party, it has little practical use if you have your assets invested with the next Long-Term Capital.  What all of these backword-looking volatility measures fail to capture is what risk really is: the probability of losing money in the future.
 
                Dr. William Sharpe himself is a critique of the Sharpe Ratio he invented forty years ago  (all references to Dr. Sharpe in this article come from a Wall Street Journal article from August 31, 2005, on pages C1 and C2 of the “Money and Investing” section, entitled “Sharpe Point: Risk Gauge is Misused,” written by Ianthe Jeanne Dugan”). In fact, he never called it the Sharpe Ratio.  He called it the Reward-to-Variability Ratio.  He goes on to say: “hedge funds can manipulate the ratio to misrepresent their performance.  Anybody can game this.  I could think of a way to have an infinite Sharpe Ratio.  You can legitimately generate very attractive Sharpe Ratios and still, in time, lose money.  People should not take the Sharpe Ratio at face value.  It’s misleading to say the least.  I hate that they’re using my name.”
 
                There, he said it!  I have railed against backward-looking volatility gauges in past pieces I have written.  I am also no fan of references to “drawdowns” (how much a fund has lost in the past from peak to trough).  I could stuff my money in CD’s or under my mattress if I wanted limit “drawdowns.”  However, that would not warrant investors paying hedge fund-like fees.
 
                In order to command fees, a manager must differentiate himself from the herd and achieve above-market returns over time.  Otherwise, he should hand his investors’ money back.  Why would you pay “1 and 20” for the myriad of hedge funds that seek to limit volatility, but offer only limited upside potential?  If you want to limit volatility, go buy Treasury Bonds—it’s much easier and your returns will probably be roughly similar to many of the hedge fund products offered currently.
 
                As I state in our updated PowerPoint presentation, “IF YOU SEEK TO ELIMINATE VOLATILITY, EVENTUALLY YOU WILL ELIMINATE RETURN AS WELL.”  There are no free lunches.  This idea that a fund can “achieve equity-like returns with bond-like volatility” is a hoax. 
 
                Several years back, Convertible-arb funds touted they could achieve the holy grail—solid 1.0-1.5% returns every month with almost no volatility.  I remember several conversations I had at the time with savvy market participants who were telling me this was the case.  I questioned: “but there are only so many convertible bonds out there.  What happens when these funds, in the aggregate, raise more money than there is capacity in the marketplace?  They will not be able to achieve those kind of returns, and they certainly will have periods of volatility, don’t you think?”
 
                Fast forward to 2005.  With the downgrade of debt to junk status of companies like Ford and GM, and the simultaneous flat-lining or rise in their stock prices, Convertible Funds have been getting slammed.  Through the first six months of the year, many showed negative returns.  What happened to “riskless” profits, all the time?
 
                To make matters worse, most of the institutions that kindly wrote checks to these funds are now pulling money out.  A recent survey I read stated that fewer than 20% of institutions were going to dedicate more money to the Convertible-arb asset class in 2005.  Like dogs chasing their tails, these institutions are now looking to withdraw assets from this asset class in their ceaseless chase of the next hot thing.  In essence, they have thrown their hands up and quit because the drawdowns were too high.
 
                That leads into a brief discussion on drawdowns.  Drawdowns measure how much a fund loses from peak to trough in the past.  A higher percentage drawdown, supposedly implies higher risk.  However, no past-looking gauge of risk can ever quantify the risk of the current situation.  As Warren Buffett has stated: “if you could extrapolate the past into the future, the richest people would all be librarians.”
 
                Further elaborating the point, Buffett’s partner at Berkshire Hathaway, Charlie Munger states:
 
“This great emphasis on volatility in corporate finance we regard as
nonsense…Let me put it this way: as long as the odds are in our favor and
we’re not risking the whole company on one throw of the dice or
anything close to it, we don’t mind volatility in results.  What we want
are the favorable odds.  We figure volatility over time will take care of
itself at Berkshire.”
 
In my view, quite often when the volatility numbers and the drawdown look their worst, that is often the time to buy a particular investment (remember, buy-low, sell-high).  This obsession of institutions in recent years to evaluate real-time volatility gauges has often caused them to pull out of funds or asset classes at precisely the worst time (like when the shuffled money out of “long-only” funds in 2003 in favor of Convertible-arb and other hedge funds).  Let me illustrate with an example:
 
§          What would you think of this investment?
§         Year-end Stock Price
§          1-  $40 per share
§          2-  $48
§          3-  $78
§          4-  $80
§          5-  $50
§          6-  $40
 
What if you had invested at the end of Year 4?  You would have a 50% drawdown at this point.  Would you have sold?  Why would you have sold if you had?  Was it because of a Sharpe Ratio or the R-squared?
 
The point I am making is that the only way to limit risk is to think.  Think a lot!  It can’t be boiled down to some ratio of past performance.  That is what brought down Long Term Capital and its investors. 
 
Now back to the above example.  As most institutions evaluate drawdowns and volatility in the current world, I would presume many would pull their assets from the above investment based on the presumption that there is too much risk.  However, look what they would have missed out on with this flawed methodology:
 
§          Stock example was Berkshire Hathaway
§         1975- $40 per share (was year 6)
§         1976- $94 (135% return in one year!)
§         1985- $2,480
§         1995- $32,100
§         2005- $83,000
 
A costly miss to say the least!  Perhaps those institutions would have been able to find a less-volatile investment to put their money in for the next 30 years.  However, I am aware of no investment that has produced 29% annualized returns during that period, volatile or not volatile.
 
For me, the name of the game is to produce the highest annualized returns while not taking on unlimited risk.  Here’s a checklist I follow: 
 
§          Invest in companies I can trust

§          Companies I can understand their business and explain what they do in four sentences or less

§          Companies without debt—they can’t go out of business if they don’t owe anyone any money

§          Companies that make money, preferably lots of it

§          Companies that have growth potential

§          Companies with few assets relative to their cash flows (high returns on capital)

§          Companies that have the lowest cost structure in their industry

§          Invest at a reasonable price or discounted price—buy dollar bills for fifty cents

§          Invest with a 7- to 10-year time horizon in mind

§          Invest with people who are demonstrated “winners”
 
 
If I stick to these principles throughout a 40- or 50-year business career, I will mitigate risk.   The stock prices will wiggle from day-to-day and month-to-month, but over time, the winners will take care of themselves and our results should be satisfactory.  Like most investors, I would be better off investing with this checklist in mind and then going away to an island for ten years and not monitoring the mindless, often irrational, price moves of the various investments in the interim.
 
                What else do investors get when they buy Tarrach Holdings, LLC?  I don’t use leverage, so you cannot lose more than you invest in the fund.  I don’t sell stocks short and take on unlimited risk.  I do not use derivatives—our investments are straightforward, clear, and again, without unlimited risk.
 
                I keep investors abreast of our investments to the extent I would expect from them if they were the Manager and I were the investor.  Plain and simple. 
 
                I do not profess this fund to be the holy grail of investing, nor will it offer low volatility.  In fact I embrace volatility, because I am aware of no other way to achieve above-market results over time.  Most hedge funds will underperform standard market index funds over the coming decade because of their obsession with keeping volatility low—allow me to go out on a limb and state this opinion right now. 
 
                What this fund will offer is a sound, logical thought process toward risk in the coming years.  I will not talk about returns in terms of Sharpe Ratios or R-Squared, but rather in sound, practical terms that I could explain to my two year old son.
 
 I expect that we will achieve above-market returns, but I certainly cannot guarantee that.  That is my goal.  If I didn’t feel that I could achieve that goal, I wouldn’t have my entire nest egg in the fund, nor would I continue running the fund.  If I was destined for single-digit returns because I was doing what everyone else was doing and trying to limit volatility to zero, I would never ask for “1 and 20.”  My conscience would not let me.
 

Written by: Chris Tarrach 
                 Chairman
                 Tarrach Holdings, LLC
 

 
570-585-0244
ctarrach@tholdings.net