Asian Hedge Fund News

I received an alert from Albourne Village about small hedge funds in Asia.  They were having trouble competing with large hedge funds, as measured by assets under management (AUM), for investors.  Institutional investors want a fund to have at least $100 million USD AUM.  Most funds (67%) in Asia have less than $50 USD AUM.  There are increasing operational, compliance and risk management costs for the small funds.  Finally, there is doubt that the manager can continue the fund's performance if AUM increase.  The article can be accessed here.

US Insider Trading Investigation - Latest Events

The fifth consultant working for Primary Global Research, an expert network firm, was arrested yesterday.  Winifred Jiau was accused of leaking insider information about two technology companies:  Marvell Technology and Nvidia Corporation to two unnamed hedge funds.  As noted before, expert network firms are much like corporate access departments at investment banks.  They match experts in a company, sector or industry with investors whereas corporate access matches company officers with investors.  Unfortunately, the experts are not as well-trained as the company officers in what they are allowed to say.  Most companies have investor relations departments that coach the officers.  There is nothing like that for experts.  The latest articles are from
Bloomberg and Reuters.

Mutual Fund Categories

We have spent a lot of time on hedge funds.  Let's spend a little time on mutual funds.  Mutual funds, through their investment policy, define their investment universe.  This may be the type of security:  equities or fixed income.  Equities are divided by the size of the companies such as micro, small, mid or large capitalization stocks.  It can be the type of stock:  growth or value.  Fixed income can include different classes of bonds:  high yield, corporate, convertibles, US Treasuries or municipal.  Both equities and fixed income can be split into sector/industry and country/region of the company.

The basic sectors are:

• Basic Materials
• Conglomerates
• Consumer Goods
• Financial
• Healthcare
• Industrial Goods
• Technology
• Utilities

Regions can be classified as:

• US/Canada
• Latin America
• Western Europe
• Emerging Europe, Middle East and Africa
• Japan
• Australia/New Zealand
• Asia ex-Japan

Based on the investment universe, most mutual funds limit themselves to an asset box such as small cap growth stocks or high yield bonds of US companies.  An exception would be Ken Heebner at Capital Growth Management.  Mutual funds are usually constrained by what they can invest in.  Hedge funds are defined by how they trade.

Where Are the Investment Ideas?

Most of the investment strategies that have been described have a common theme:  the manager is seeking to profit by finding undervalued or overvalued securities.  Where do they find them?  Is it in widely followed large capitalization companies in the US?  Not likely.  It's hard to see mispriced stocks when there are twenty sell-side analysts ferreting out information on the same investment.  It's better to go where there is little research coverage.  In the US, Western Europe and Japan, this would be in micro, small and mid-sized companies.  It may be an industry or company in the developing (such as China, India or Brazil) or frontier countries (such as Nigeria).  A manager may decide to invest in esoteric securities such as Credit Default Swaps and OTC (Over the Counter) Derivatives.

Of course, there are exceptions:  David Einhorn and his very public bet against Lehman in 2008.  For those interested, his detailed analysis has been posted here (starting on page 4) by Whitney Tilson at seekingalpha.com.  George Soros and the British Pound;  Jim Chanos and Enron.

Investing Across Many Funds

The last strategy that we will talk about is investing across multiple strategies.  There are two methods:  through a third party called a fund of funds or within a multi-strategy hedge fund.  Both are similar investments that create market forecasts.  They are used to allocate capital to the funds and strategies that will outperform.  If there is a lot of merger and acquisition activity, they may invest in a merger arbitrage fund.

For the fund of fund strategy, the advantages are:

• Diversification among hedge fund strategies
• Ability to invest in different hedge fund managers
• Another layer of monitoring and due diligence

The disadvantage is that the fund of fund manager charges an additional layer of fees.  This is known in the hedge fund world as the "2 and 20" (2% of assets under management and 20% of profits).  Because of this additional layer, the fund of funds would need to have a higher return than the multi-strategy fund to give the investor the same return.

The advantages of a multi-strategy manager are longer lockup periods and flexibility to invest in different strategies.  Investors cannot withdraw their capital during the lockup period.  This allows managers to expand their investing universe to less liquid assets.

The disadvantages of a multi-strategy fund manager are:

• Manager may not have the expertise to manage different strategies
• The investor is not diversified in manager selection

Global Macro: Go Anywhere, Do Anything

Many investors view global macro as the Wild West of strategies.  Managers following this strategy can invest in any country, market or security.  Macro is short for macroeconomics.  By studying these statistics such as interest and foreign exchange rates, commodity demand and political conditions, managers identify price movements and invest to exploit them.

They can be split into two types:  discretionary and systematic.  Discretionary managers invest by forming a thesis and creating trades to profit from their thesis.  They may understand the emotional intelligence of investors and identify irrational and/or inefficient market conditions.  They can analyze data at the microeconomic level that has not percolated up to the macroeconomic level.  Systematic managers use trading rules to follow trends as their thesis.  Oftentimes, these trades are triggered by quantitative models monitored by computer software.  This is sometimes be called the "black box" as the rules are proprietary to the manager.  These rules may exploit differences in interest rates (carry and yield curve trades), currencies (purchasing power parity), stocks and volatility (option pricing models).  Some funds use a combination of both types.

Global macro funds' flexibility allows them to invest in any category but may produce funds that do not have an investment specialty.  Since many institutions invest using an asset allocation model, it is difficult to monitor them.  They can invest in anything and may break the allocation rules of the investor.

The most famous manager using this strategy is probably George Soros and his most famous trade "broke the Bank of England" in 1992.  A recent manager, who emerged from the housing crisis, is John Paulson.  You can read more about him in Greg Zuckerman's The Greatest Trade Ever.  For additional information about the crisis, Michael Lewis' The Big Short is great reading.  For more information - including references to other books and white papers, please go to this article.

Equity Market Neutral Strategy

Like many other hedge fund strategies, equity market neutral (EMN) managers establish long and short positions in undervalued and overvalued securities.  Unlike long/short managers, EMN positions are balanced along  sector, currency and country lines.  For example, the manager may go long Intel by buying $1 million and go short by selling $1 million of Advanced Micro Devices.  Since both companies are in the same sector, the fund has a neutral position.  This is a simple example.  The manager may choose to create a neutral position by using derivative securities.  For example, a long position in British stocks would be hedged by a futures position in the British Pound.  Any fluctuation in the US Dollar to British Pound exchange rate would not affect the portfolio.  The goal is to have no net exposure to market, industry or foreign exchange risk.  The only source of return is picking the right securities.  This is called the rule of one alpha (Bruce Jacobs and Kenneth Levy, "The Law of One Alpha", The Journal of Portfolio Management, Summer 1995).

To create these portfolios, the manager usually follows these steps:

1. Establish a universe of stocks
2. Generate a forecast
3. Build the portfolio

For more details on these steps, consult with this AIMA Canada paper or Mark Anson's Handbook of Alternative Assets.

Since the portfolio is constantly being hedged due to changing market conditions, it is important to own securities that are liquid.  A position in a stock that is thinly traded will not give the manager the flexibility to dynamically hedge against market events.

Non-Mainstream Hedge Fund Strategies

A couple of not so well-known strategies in the relative value universe are stub trading and volatility arbitrage.  In stub trading, the fund manager is identifying price discrepancies among stocks that own a large stake in another company.  This is based on the principle that the market does not recognize the additional value of the secondary company to the owning company's business.  When the market eventually sees this and prices the security accordingly, the manager can sell out the position.

Volatility arbitrage uses the same philosophy as other strategies - buy the undervalued and sell short the overvalued securities and profit when they converge.  Here the securities are options and warrants on an asset.  Using various mathematical models, the manager calculates the implied volatility of an asset.  The undervalued option can be identified using the Mean Reversion (compares implied and historical volatility of a security) or Generalized Autoregressive Conditional Heteroskedasticity (compares implied and forecasted volatility of a security) model.

Convertible Bond Arbitrage Strategy

The convertible bond arbitrage manager can create a portfolio that acts like a normal bond.  They establish a long position in convertible bonds and a short position in the equity of the bond issuer.  A convertible bond is a bond that has an option for the owner to exchange the bond for stock from the issuer.  The short equity position should be equal to the long convertible position.  The long position is equal to the amount of stock converted multiplied by a factor - called delta or hedge ratio.  This factor changes constantly and causes the fund manager to adjust their equity position frequently.

The fund has several sources of return:

• Change in convertible bond price - If the bond's price rises, then the return increases
• Change in stock price - If the stock's price falls, then the return increases
• Convertible bond's coupon - Interest paid from the bond increases the return
• Short rebate - Interest earned on capital from short stock position increases the return
• Interest paid on borrowed capital - Fund manager pays interest on borrowed funds, reducing the return

Additional Developments on Insider Trading Probe

I came across two articles from yesterday regarding the FBI's insider trading probe.

The first article, by Bloomberg News, recites the recent history of Taiwan and its place in the information chain for technology companies.  Taiwanese chipmaking foundries such as Taiwan Semiconductor and United Microelectronics manufacture chips for Apple, Dell, etc. and have proprietary insights in their businesses.  Since 2004, there have been cases of analysts (sell side and expert network)  disseminating insider information according to US standards.  However, in Taiwan, this is tolerated since information swapping is expected.

The second article, by Reuters, reiterates previous news regarding information gathering in the hedge fund world.  It relates how a well known mutual fund firm (in this case Wellington Management) also runs hedge funds and the conflicts that may occur between the fund types.

Gold - The Next Bubble?

I was led to this Bloomberg article by Cam Simpson about gold through an alert from Albourne Village.  It details the creation of gold as a liquid security:  an exchange traded fund (ETF) called StreetTracks Gold Trust (ticker:  GLD).  This was later named to SPDR Gold Trust.  Since its inception in 2004, the ETF has expanded beyond the NYSE and is traded in Japan, Hong Kong, Singapore and Mexico.  Previously, gold was bought and sold as bullion, coins or part of jewelry.

With all the crises in the past decade (technology bubble, real estate bubble, bailout of financial firms and "Flash Crash"), confidence in stocks is low.  Fixed income yields are low due to the Federal Reserve's policies.  Investors are turning to buying gold as a refuge.

Last year, John Paulsen of Paulsen & Company launched a gold fund last November.  In 2010, it is up 33.6% according to this article at www.businessinsider.com.  For a more information about his gold fund, please go to this link.  As a side note, there is a quick article about the fund's performance in January (It was down 14%.).  This is just a quick comment on the short term attitude on Wall Street and volatility of any concentrated investment.

The author, Cam Simpson, writes that George Soros thinks gold is a bubble but still holds SPDR Gold as the largest position as of September 30, 2010, according to the SEC.  Gold may be a bubble but when do you get out of your position?

Fixed Income Arbitrage Strategy

The next group of hedge fund strategies are convergence trading or arbitrage strategies.  Fixed income arbitrage strategies is much like equity long/short.  The manager identifies cheap (undervalued) and expensive (overvalued) bonds and establishes long and short positions.  Returns are generated when they converge, the cheap position increases or the expensive position decreases.  Managers may use bonds such as US Treasuries, corporate, municipal and high yield bonds and mortgage backed securities.  Positions may be established at different maturity levels in the same bonds (yield curve arbitrage) or in different bonds that are similar.

Unlike equity long/short, the individual positions produce small returns.  Hedge funds that use this strategy use leverage to enhance returns.  This can be done by direct borrowing from their prime broker or using derivatives like swaps.

Most famous fund is Long Term Capital Management.  You can read a complete and concise account of the firm in When Genius Failed:  The Rise and Fall of Long-Term Capital Management by Roger Lowenstein.

Hedge Fund Strategy: Regulation D

Regulation D (Reg D) securities are sold by companies that are raising capital through a private offering without having to register with the SEC.  Reg D contains a list of rules allowing companies to be exempt from filing.  There are three main rules 504, 505 and 506.

As part of an investment strategy, hedge funds are mainly interested in micro and small capitalization companies.  There are two reasons for participating in the offering:

• The offering price is at a discount to the current market price
• Since there is a price discrepancy in publicly traded and Reg D stocks, the manager can establish a simple arbitrage position of shorting the public stock and going long on the Reg D stock.

The advantage to the issuer company is the ability to raise cash quickly.

Distressed Securities Investing

Hedge funds using the distressed securities strategy invest in companies that are being reorganized, going thorough bankruptcy proceedings or going through some poor performance.  These companies have the lowest credit ratings from such companies as Moody's and Standard & Poor's.  The notes below are a summary of the article "Hedge Fund Investing in Distressed Securities" by T.Casa, M. Rechsteiner and A. Lehmann that was part of CAIA's curriculum.

There are five main sub-strategies:

1. Short
2. Long/short
3. Capital structure arbitrage
4. Value
5. Rescue financing

For stocks, the first has been tackled in a prior article.  A manager can be short by buying the derivative instrument credit default swap (CDS).  To sum up, the manager is obligated to pay a counterparty a fixed amount on the bonds of the distressed company.  In return, if the company has something known as a credit event, the counterparty pays the manager a fixed amount.  The details of the fixed amounts and credit events are listed in the CDS contract.  As the company's situation worsens, the CDS appreciates in price or the hedge fund receives the payment.

Long/short using bonds instead of equities but the premise is still the same.  The manager will establish a position in undervalued bonds and be short in overvalued bonds.

Capital structure arbitrage is similar to long/short except that positions are taken within the same company's securities.  The manager takes a long position in the senior securities such as senior bonds and a short position in junior securities such as stocks.  In the bankruptcy process, senior securities are favored if any assets are recovered.  In theory, the net value of the long and short positions should be positive i.e. the short position should decrease more than the long position.

Value managers take a long position in the company before it announces a reorganization plan to court.  They hope to profit from the rise in prices after the plan is approved by the company's creditors.  They can also take a long position after the plan is approved as other investors will not take the risk at this stage.

In rescue financing, the hedge fund lends money to distressed companies right to prevent bankruptcy filings or establishes a long stock position.

The above five substrategies differ in their approach and timing.  There are five stages in the lifecycle of a distressed company and each substrategy (in parentheses) invests during a certain stage:

1. Pre-default:  the company is restructuring  (rescue financing)
2. Early bankruptcy:  the company tries to restructure its finances;  usually by giving creditors an equity stake for debt reduction or extension  (short, long/short, capital structure arbitrage)
3. Mid-bankruptcy:  balance sheet is stabilized  (short, long/short, capital structure arbitrage)
4. Late bankruptcy:  company is almost recovered  (value)
5. Emergence:  company is recovered  (value)

In 2007, there were $105 billion in estimated assets in distressed securities; up from $30 billion in 2002.  With the market turmoil in 2008, this strategy will grow as there will be more distressed situations to invest in.

Maybe we can examine the bankruptcy process later.  There were many interesting articles in the Wall Street Journal about it during the General Motors and Chrysler crises in 2009.

The Current State of Small Introducing Prime Brokers

In an earlier post, I directed to you to an article about the bulge bracket prime brokers.  I came upon this at the site:  www.finalternatives.com.  The author, Michael DeJarnette of ConvergEx's Northpoint Trading Partners, writes about the smaller prime brokers.  Many of these firms have merged or been acquired by larger financial or technology firms.  The merged firms have become a new category called "mid prime", "integrated prime" or "independent prime".  The link to this article is here.

Beneficiaries of the FBI's Insider Trading Investigation

I have been following the investigation by the FBI about the possible use of insider information from expert networks.  As with everything else, someone's misfortunes may be another firm's gain.  I came across this article on Fortune's site.  Several types of hedge funds are positioning themselves to take advantage.  Hedge funds that use a quantitative method of picking stocks do not use fundamental research and have no need of an "edge".  Their strength lies in the accuracy of their algorithm.  Large firms and fund of funds with good compliance departments that safeguard their investors will also be less hurt by the probe.

Event Driven Strategy - Merger Arbitrage and More

The event driven strategy invests in a wider range of situations than merger arbitrage.  Merger arbitrage managers are concentrated on mergers and acquisitions.  Event driven managers may invest in firms that are:

• In the middle of a reorganization
• Spinning off a division
• In bankruptcy
• Starting a share buyback program
• Distributing a special dividend
• Specific news announcements such as earnings restatements
• Significant market events

Again, the manager is trying to exploit mispricings of the company's securities due to these one-time events.  Another term for this strategy is special situations.  Some sources state that merger arbitrage is a substrategy of event driven.  I can see the logic behind this.  However, for these articles, I am using the definition promulgated by the Chartered Alternative Investment Analyst program (at www.caia.org) and has these as separate strategies.

Merger Arbitrage Strategy - Investing in Deals

The next group of hedge fund investment strategies that we will take a brief look is corporate restructuring.  The most well known is merger arbitrage.  In this strategy, sharp-eyed managers identify mergers that are happening or that will happen to profit on a paired trade.  The stock of the target firm will be bought and the stock of the acquiring firm will be sold.  When a merger is announced, the buyout price is usually at a premium to the current price of the stock.  The normal market action is for the price to rise in reaction (or anticipation) to the announcement.  Meanwhile, the price of the buying firm declines as the market anticipates a short term correction because the firm will need to use resources, cash and time to integrate the target firm.

In a cash acquisition, the manager would buy the target firm at a price lower than the bid.  When the transaction is closed, the profit would be the spread between prices.  In a stock for stock merger, the manager takes the positions described above:  short the buying firm and long the target firm.  When the transaction is closed, the target firms' stock is converted and used to close out the short position.  The profit is the spread between both positions.  The hedge fund also receives the short interest rebate.

To identify the best trades, managers will use a variety of information sources such as the financial statements, SEC filings, company and sector knowledge.  They will be well informed in regulatory and anti-trust issues.  They will need to know when and at what price to trade into the positions.  Depending on their investment thesis, rumored deals may be included in the portfolio.  Obviously, this is much riskier as trading desk rumors are rampant.

There are several reasons the deal may not be completed.  The merger may not be approved by all of the regulatory agencies.  Another firm may try to buy the target or acquirer.  The target may try to acquire another firm as a takeover defense strategy.  The shareholders may not approve the deal.  This is the risk.

In bad markets, there may be very little merger activity.  In times like these, the fund will invest in low risk fixed income vehicles until activity increases or may shut down the fund and return money to the investors.