Daily Dose of Optimism

On "market neutral" and other misnomers

“John Shad, a free market fundamentalist, was Regan’s choice to run the SEC [1981]. Shad’s idea was to turn the commission into a public-detective agency, ferreting out cases of individual cheating.

Meanwhile, he provided official benediction for a tidal wave of new securities – the offloaded fragments of public and private debt, stock options, and assorted other financial instruments dubbed “derivatives,” a term that neatly captured the aura of higher mathematics and pseudo-science enveloping the street.

Designed as prophylactics against risk, in the end they proved riskier than traditional forms of unprotected financial intercourse. Indeed, the Street’s new lingo was positively Orwellian: “risk arbitrage” was supposed to lower risk, but turned out to be a very high-risk business; “portfolio insurance” was designed to ward off disaster but actually helped trigger it; “hedge funds” didn’t so much hedge bets as inflate them.”

– “Every Man a Speculator: Wall Street in American Life,” Steve Fraser, 2005

I came across this passage last week, and I think it nicely sums up the sort of chaos we see in the markets today. Not to make light of what is happening, or could happen, to our collective investments, but I'd just like to point out that the S&P 500 is down just 6.5% from its recent record highs to Thursday's close.

None of this is to say that the market couldn't still fall 15% from here, in what could shape up to be a summer that rhymes with a repeat of 1998's summertime collapse during the "Asian Contagion."

However, it's worth remembering that for all the talk of the armageddon occurring "RIGHT NOW," we plebes invested in plain-vanilla S&P 500 index funds are still up 2.5% for the year through Thursday's close. The irony of "market neutral" hedge funds reporting significant declines in this environment is rich.

The way many "hedge" funds behave, it's enough to make you wonder whether the real "market neutral" position is simply owning anything ... without leverage.

Along these lines: Cramer's recent freak-out on CNBC is a must watch for anyone even remotely interested in the markets. Having watched this clip several times over the past few days, I'd sum up Cramer's performance as the personification of a market going through withdrawal from an addiction to easy money.

Although I've certainly written about brewing issues in the housing market in the past, I think the cause of today's problems was the Fed lowering rates in 2001-2002, so I'm very skeptical that the right thing for the economy at this very minute is to simply dose up the addict with more of the stuff that brought him to the hospital in the first place.

Is there an equivalent of methadone for the financial markets? I guess we'll soon see... - Ed

Some More Wisdom on "Hedge Funds" that Don't Hedge

Jeff Matthew's piece on Friday, Since When Did "Hedge Funds" Stop Hedging?, reminded me of this piece below by Carlo Cannell, from 1999. Cannell's article is more data-driven, whereas Matthews extrapolated wildly from a conversation he heard at Starbucks (as we bloggers are wont to do). My money says that Matthews is right about as early as Cannell was - which means we've got a great year ahead of us in 2007. Enjoy! - Ed

Bogus hedge funds -- those with no short positions -- will not survive the next market downturn
By J. Carlo Cannell (Red Herring - February 1999)

Phoenician sailors earned a thick slice of the profits from a successful voyage. Today a different risk-taker -- the modern-day hedge fund manager, or "hedgie" -- earns a similar benefit on land.

According to Hedge Fund Research, there are now more than 3,200 hedgies, two-thirds of whom operate in the United States. Estimates of their total capital under management vary from $150 billion to $250 billion.

Hedge funds have multiplied because in a bull market there are few better businesses. Assuming a standard 20 percent profit allocation, for example, a hedge fund general partner who started 1997 with $100 million and matched the S&P 500 would have received a paycheck of more than $6 million the next New Year's Eve -- healthy compensation for matching an index.

The rot in this picture is that most of these hedge funds have little or no short exposure. According to Edward Bowman of Hawthorne, the asset management division of PNC Bank, less than 10 percent of what are today called hedge funds have had any real hedge for the past several years.

This fall provided some vindication for the classic hedge. By early October the Russell 2000 was down more than 20 percent for the year; classic hedge funds were up more than 20 percent, but hedge funds as a whole were down more than 40 percent. During the last "trough" for hedge funds, in the early 1970s, there were fewer than 300 funds managing only a few billion dollars. Going forward, will we see an attrition to this level? Yes.

HEDGE HOGS

When things are good for hedgies, they're really good. Hedgies are the ultimate purchase managers, meeting, playing, and dining with scores of interesting entrepreneurs. Travel and computers are often their biggest expense items.

The hedgie mortality rate, however, is high. A shocking survey published in 1998 by Montgomery Asset Management indicates that the average U.S. investor expects the market to return 34 percent annually over the next ten years. The historical reality is somewhere closer to a 7 percent annual return. Fueled by these inflated expectations, some of the long-only managers masquerading as genuine hedgies will fall into a chasm of margin calls and redemptions like oblivious motorists plummeting off a cliff.

THE LONG AND SHORT OF IT

The Harvard-educated sociologist Alfred Winslow Jones is the father of the true hedge fund. In 1949 he structured a portfolio consisting of common stocks that held both long and short positions at all times -- even in a rising market. Mr. Jones's theory was that one can analyze a particular business even though the stock markets can't be reliably forecast. Buying good, well-respected but neglected companies long while shorting wildly overvalued companies should yield above-average results, he reasoned. By 1966 his fund had nearly doubled the results of the Dreyfus Fund, one of the better-reporting funds of the day. "Hedging," Mr. Jones often said, "is a speculative tool used to conservative ends."

KEEPING THE FAITH

A couple of years ago, as I broiled under the sizzle of short squeezes, a colleague told me that "a hedge fund doesn't have to hedge." What does it mean, then, to manage a hedge fund? Why do I deserve these high fees without undertaking the difficult process of researching short candidates -- a specialized and painstaking task that is usually more than twice as time-consuming as researching long candidates?

It hasn't been easy to be faithful. The longest-running bull market in history has toughened and twisted those true hedge fund managers who have survived it. I know one traditional hedgie who regularly vomited from anxiety during trading. Another has become so skeptical of financial statements that he retains private detectives to verify all information.

Windsurfers on the San Francisco Bay are an apt metaphor for today's proliferating hedgies. Both love to perform acrobatic feats in steady, high summer winds. Those winds, like the last 25 years in the equity market, can seem remarkably predictable. But eventually fluke winds do arrive, and the equipment's lack of keel and buoyancy makes the cold water and strong tides treacherous. The windsurfer's sailboard, like the fake hedge fund, is not an all-season craft.

Thoughts like these make cranks like me feel a little better.

J. Carlo Cannell is the president of Cannell Capital Management, an alternative asset adviser.

Deja Vu - Superfund!

I recently drew your attention to the rise and fall of a somewhat hyped hedge fund. Today, I'd like to refer you back to a fund that hasn't done anything wrong, but sure seems like it might:

New York Times: Hedge funds are not meant to be for everyone. But that has not stopped Christian Baha from using the mass media to promote his fund.

A new commercial for his fund, Superfund, which is technically not a hedge fund but a managed futures fund, is expected to make its debut in a number of large markets.

But there is just one problem, Mr. Baha concedes halfway through the 30-second spot. As a pitchman for a product that is really not supposed to be publicly pitched, he is severely limited in what he can say. "I would love to tell you more about Superfund, but regulations prevent me from describing it on television," Mr. Baha, 36, explains in an Austrian accent that makes him sound like Arnold Schwarzenegger channeling Peter Lynch of Fidelity Investments. Instead, he flashes a Web site address and a wink.

His fund company, based in Monte Carlo and recently renamed Superfund Group, offers hedge funds in more than a half-dozen countries in Europe and Asia. But here they are carefully referred to by their technical name - managed futures funds that are publicly registered partnerships - to appease regulators in the United States. Hedge funds, after all, are private capital placements, and are forbidden by federal regulators from advertising their offerings to the general public.

His grand visions of giving the little investor a piece of the action is at the very least tempered by Superfund's extraordinarily high fees. Superfund is guaranteed at least 8.75 percent in brokerage and management fees, and can take up to a 25 percent cut of any profits after expenses in any month when a fund reaches a new high.

But a television commercial (that can't really advertise anything) for a hedge fund (that is not technically not a hedge fund) may take the cake. Link

To recap:

• They advertise on TV to retail investors in vague terms, not because they're building a brand (like a mutual funds), but because regulations prevent them
• They invest in "futures." They might as well say they invest in "stuff." There are futures on commodities, debt, indices, equity...without discipline, it could easily become a mess
• The fees put mutual funds (and most hedge funds) to shame
• They are not based in the US

Stop me when this starts to sound fishy. - Ed

New York Magazine - Hedge Funds Get Richest Quickest (Nov 2004)

For the holidays...below is an article from November 2004 about hedge funds as seen by New York Magazine, the gossipy chronicler of otherwise serious life. An old article, but a good one if you haven't seen it. - Ed

Get Richest Quickest
In the precarious hedge-fund bubble, it’s either clean up-or flame out - Link
By Steve Fishman

November 22, 2004

Zachary R. George, 27, serious, square-shouldered, and wearing some kind of goo in his hair, sits at a long counter of a desk in Norwalk, Connecticut. He’s got a phone and a screen, like a telemarketer. Picking up the receiver, Zachary dials into the conference call.

“Harry,” begins Zachary when it’s his turn. Zachary and Harry J. Phillips Jr., the 55-year-old CEO of Cornell Companies, one of Houston’s top 100 businesses, use each other’s first names, as if they’re cordial, which they’re not.

“You work for us,” Zachary likes to let Harry know. Zachary represents a two-year-old hedge fund called Pirate Capital, a name that Zachary says gets people’s attention. (And if that doesn’t, then the 32 percent returns per year do.) For $20 million, Pirate purchased 13 percent of Harry’s company, which runs prisons. This makes Pirate Harry’s largest shareholder and, as Zachary sees it, Harry’s boss.

Two Ken Griffin Quotes

(1) "Capital markets reward you for what you learn that other people have yet to ascertain.''

(2) "Sustaining an edge in the hedge fund business is grueling. Few hedge funds have been able to capture the founding hedge fund manager's judgment into an institutionalized process.''

Link (Bloomberg News)

Thinking about the Risks in Sell-Side Prime Brokerage

The excerpt below does nicely to point at the risks involved in prime brokerage. It also highlights what seems ridiculous risk taking/credit extension by sell-side intermediaries when taken in context of margin used to purchase a high-yield new issue..

I hope for the sake of the financial markets, that the journalist took down these details incorrectly. Somehow, I don't think so. - Ed

A senior financier at a US bank told The Independent on Sunday that much of the lending to hedge funds was "reckless" because it was secured on the value of volatile investments that could easily lose value.

"Some of this business is counter-productive because we end up making less money that we would have if the hedge funds were not there," he added. The financier cited the example of recent loans made to Naguib Sawiris, the Egyptian entrepreneur, to finance his €12bn (£8.2bn) purchase of Italian mobile phone group Wind.

Much of the high-yield debt - which was priced at 3.25 per cent over Libor (the standard interbank loan rate) was bought by hedge funds. "They could borrow 90 per cent of what they paid at 70 basis points [0.7 per cent] over Libor," he said. "Nice work if you can get it."  Link

Stephen Roach on Pensions

Stephen Roach has an excellent free piece over at the Morgan Stanley website on the Delphi bankruptcy and what it means for the US.

Aside from being an excellent piece (albeit panicky) about the current status of the US, he also includes a stat about US pension obligations which provides context for the point I made last week in the post Pensions Double Down.

The Delphi bankruptcy raises two key questions -- the first about credit spreads.  Liquidity-driven markets remain more that willing to treat Delphi as largely an idiosyncratic risk that does not pose broader credit problems for Corporate America.  GM ripple effects may well draw that presumption into question -- especially for credit markets, where spreads remain historically tight. 

A second concern pertains to the funding of legacy costs.  This is a big deal for the US.  Dick Berner tells me that the Pension Benefit Guaranty Corporation puts the funding gap at $450 billion for single-employer plans and another $150 billion for multi-employer plans -- to say nothing of approximately $1.5 trillion for state and local government plans. Like all contingent liabilities, America and its creditors have long viewed this as a distant obligation. 

Delphi challenges that complacency, as do recent bankruptcy filings for Delta and Northwest Airlines.  That, in turn, raises the risks of added fiscal funding strains on the US government.  For saving-short America, those risks will only increase an already daunting current-account financing problem.

My argument was essentially that we should add an item 2b to this list, which would be pensions placing what assets remain in their funds into higher-risk vehicles to make up the shortfall. - Ed

Dan Loeb Profile in Bloomberg Magazine

If you read this site regularly, you already know that Dan Loeb is a wildly successful investor who also likes to write letters to management that are publicly available via SEC filings. (In case you are wondering, he also counts as an investing hero of mine.)

Bloomberg recently profiled him as part of a piece on activist investors, which I thought you might find interesting.

PDF is here: Download DanLoeb_Bloomberg.pdf  - Ed

Pensions Double Down

It's a common refrain among those seeking to raise capital these days that "the money is no problem" - the only problem is what to do with it.

A friend of mine was looking to copy a widely utilized investment structure, modifying it for a new sector. His only concern was whether it could be made to work; it was a given that one of three potential sources could fund it.

Listening to his plan, and reflecting also on the numerous high profile fund launches of late, I found myself wondering: why does it seem that for every willing and able manager (or guy with a dream), there is $1 billion in capital waiting?

Reading through the news lately, full of article after article about pensions raising their allocations to alternative investments "such as hedge funds", I think the answer as to why capital seems so easy to come by these days is the increasing allocation of institutional money to alternative assets, notably the assets of pension funds.

This in turn made me think: why is there such a flood of assets coming from pension funds?

My guess, based on conversations with friends at a business that had a number of clients who also had pension fund issues (which were unrelated to their services, fortunately), is that pension underfunding is a widespread problem right now because pensions had swapped the allocation of their funds during the 1990s in accordance with the higher expected returns to be gained from equities. In retrospect, that wasn't such a wise idea, as many of those pensions, running around with scissors at the risky end of the risk-return spectrum, bathing in the sprinkler of 15% returns, were eventually caught out by the downturn in the market at the end of the decade.

Applying my powers of inference to these pieces of information (inference, of course, being a widely practiced and misunderstood way of reading the news that I will get to in a later post), I believe what I am seeing is that pensions, fresh off their losses from the last time they listened to Wall Street on how to invest (the tech boom), are looking to Wall Street again for answers to how to fix the last time they were led astray, and the answer now is "alternative assets".

So, let's get the game plan straight:

When conservative investment policies are replaced by aggressive ones, which in turn don't work out as planned, the pension manager has a choice:

a) admit defeat, tighten the belt, and return to conservative investing ways...

b) ...or double down.

I think the flow of assets we see from pensions indicate that the people responsible for managing the retirement of American workers are engaged in the latter.

There's nothing wrong with hedge funds, but by the time they become viable options for investors who would otherwise be invested in tax-free Munis or long-dated treasuries, that's a sign things are slightly out of whack.

Unfortunately for us citizens, the failure of pensions over time will be shouldered by taxpayers, via social security and the PBGC. - Ed

Reader Comment on the Hennessee Group

A reader writes:

As an organization, The Hennessee Group doesn't have the resources or the ability to evaluate hedge funds.  I know, I worked there briefly.  They simply don't have people working there who are capable of understanding the hedge arena.  In addition, they don't have any of the necessary tools to do analysis even if they were capable (which they are not).  The owners of the company live quite lavishly, but they don't put anything back into the business.  I was horrified by the entire experience because this is an organization that makes claims that they simply can't back up.  They claim to do a thorough job, but it's all window dressing.  I thought they (actually their clients) would fall victim to fraud much sooner. 

Yowzer! - Ed