A New Alternative Investment: Infrastructure

Institutional Investors are planning to invest directly in infrastructure projects such as fixing roads, bridges, water lines, sewage plants and dams.  Returns on these investments are above their benchmarks.  Ontario Teachers' Pension Plan was up 13% in 2010 versus 4% for their benchmark and Ontario Municipal Employees Retirement Systems was up 10.1% versus 8.5% for their benchmark.  Other investors looking at the $50 trillion market (over the next 25 years) include California Public Employees' Retirement Systems, California State Teachers' Retirement Systems, Abu Dhabi Investment Authority, China Investment Corporation and Government Investment Corporation of Singapore.

The source for this article can be accessed here.

Mutual Fund of Hedge Funds

Hatteras Funds manages $2.1 billion in the alternative investment space.  One of its products is mutual fund of hedge funds.  FINalternatives posted a recent interview with the President of Hatteras Funds, Bob Worthington. Their funds invests in five strategies:  long/short equity, equity market neutral, relative value long/short debt, event driven and managed futures.  The hedge funds have between $25 to $500 million in assets under management.  The mutual fund is diversified with 23 managers in a portfolio of $550 million.  Hatteras thinks that they can manage $5 billion in assets with 35 managers.  The managers have to meet compliance/risk control standards as well as being a good fit in the overall portfolio.

The mutual fund has daily liquidity.  This allows great flexibility in determining a tactical asset allocation.  Hatteras usually does not make adjustments on a daily or weekly basis but they can adjust if market conditions change dramatically.  The fund increases liquidity and transparency when compared to more illiquid fund of fund or hedge fund vehicles but has less risks and returns.  However, the fund gives the investor access to hedge fund strategies.

The article can be accessed here.

Regulated Hedge Funds: UCITS and Mutual Funds

SEI published a white paper on the growth of alternative investments called Regulated Alternative Funds: The New Conventional.  Because of the credit crisis of 2008 and the current Eurozone crisis, more and more investors have clamoring to be able to invest in alternative investments to lower downside volatility and offer returns uncorrelated with long-only mutual funds. In the first 8 months of 2011, $61 billion flowed into these investments. $22 billion (39% of all investment capital) were invested UCITS funds. There are now more than 1,500 UCITS funds managing $254 billion. $39 billion were invested through US mutual funds and ETFs. They now compose 4.4% of mutual fund assets and are growing at a 17% rate since 2007 when they were 2.2% of mutual fund assets. There are approximately 730 of them with 118 launched in 2011. Mutual fund families such as Ategris, BlackRock, PIMCO, Nuveen and First Eagle have funds that invest in traditional hedge fund strategies such as managed futures, long/short, credit, commodities, arbitrage and absolute return fixed income.

Internationally, they are constructed in an evolving vehicle known as Undertaking for Collective Investment in Transferable Securities (UCITS). Success has brought on investors. There are established funds with good returns, transparent investment and risk management strategies, and strong brands. The largest fund is the Standard Life Investments Global Absolute Return Strategies with $13.6 billion in assets under management. Other large funds include Julius Baer BF Absolute Return, Newton Real Return, JP Morgan Income Opportunity and PIMCO GIS Unconstrained Bond.

Within the US, they are launched within mutual fund families and ETFs. The largest are, in order of size, the SPR Gold Shares ETF, PIMCO Commodity Real Return Strategy, Ivy Asset Strategy, and iShares Silver and Gold Trusts. For investors, both structures offer more transparent risk management, liquidity, counter party diversification and limits on leverage. Investors are seeking better returns, lower volatility and to protect capital. Mutual fund families are aggressively marketing to and educating investors and registered investment advisors through white papers, instructional videos, fact sheets, regulatory filings and road shows.

Mutual funds are seeking to increase their fee structure. Alternative asset managers are seeking to have a more varied investor base.

When new products are launched, rules are reviewed. They are on the third iteration for UCITS. In the US, the SEC has stopped approving new funds and ETFs to review the effects of derivatives on portfolios. Within Europe, Luxembourg and Ireland are expecting to conform with UCITS regulations with the bonus of having additional flexibility. This may make them preferable to certain investment strategies and investors.

Demand is growing from sovereign wealth and national pension funds in Asia, Latin America and the Middle East and US institutional, high net worth and retail investors.

SEI's 2011 Private Equity Survey: Investor Demands Since 2008

411 private equity fund managers, investors and consultants participated in SEI's 2011 Private Equity Survey.  Due to underperformance in the years since the credit crisis, fund managers have been providing more transparency and liquidity.  Management and incentive fees have been lowered.  22% of investors are paying lower management fees and 38% are paying lower incentive fees.  37% of fund managers lowered management fees and 11% lowered incentive fees.  Size also matters.  The larger institutional investors were more likely to have their fees lowered while the larger private equity funds were more likely to lower them.  Managers were also trying to make their investors comfortable with their infrastructure, giving them solid performance data and educating them on the portfolio.

Factors to consider when raising capital:

• Have a clear investment philosophy
• More transparency
• Turn client service into asset growth

The source for this article can be accessed here.

Private Equity Firms During the Credit Crisis

Through Global Finance magazine, I was directed to a white paper on Merrill DataSite called Riding Out the Storm:  How Private Equity Firms Survive and Thrive During Tough Economic Times.  The global recession that began in 2007 change private equity investment conditions drastically.  Financing deals grew more expensive as banks tightened their loan procedures.  Company valuations declined as the equity markets tanked.  Deals fell apart.

The private equity firms that did well during the recession followed these basic practices:

• Apply sound business discipline to their investment practices
• Good personnel
• Portfolio diversification
• Have proprietary deals
• Overseas investments
• Stellar professional reputations

The firms that did not do well made these mistakes:

• Difficulties fund-raising
• Lack of due diligence on portfolio companies
• Pay too much for debt
• Did not add value to portfolio companies
• Disorderly change of management at portfolio companies

In the future, the paper concludes that private equity firms should concentrate on their core strengths, reduce their debt and practice honesty and fairness to weather the next economic crisis.

When Will Asset Correlation Break in 2012?

According to Ned Davis Research, the monthly returns of eight diverse asset classes has become correlated almost 50% of the time when compare against the Standard & Poor's 500 Index.  In the 1990's, they never had the same returns.  The assets are MSCI indices for international and emerging markets stocks, spot gold prices, copper futures, three and ten year US Treasuries, the Euro and the Reuters-Jefferies CRB commodities index.  The correlation of large cap US stocks to the S&P 500 is at 85%.

According to Jane Buchan, chief executive of Pacific Alternative Asset Management, at the 2012 Reuters Investment Outlook summit the correlation will break at some point.  The key question is when.  She thinks that healthcare and technology sector stocks should diverge. Investors should position their long/short investments to take advantage of this.

According to FX Concepts LLC, a foreign currency hedge fund, the high correlation in 2011 was caused by low interest rates globally, the increase in the money supply by the Federal Reserve Bank and central bank support for the Japanese Yen and Swiss Franc.  For the Group of 10 nations (Belgium, Canada, France, Italy, Japan, the Netherlands, United Kingdom, United States, Germany and Sweden), the trading range for their currencies is within 6%.  Historically, it has been 20%.

The source for this article can be accessed here.

Institutional Investors Favor Long/Short Equity, Macro and Special Situations in 2012

The following chart was published on Pensions & Investments Online website from Deutsche Bank's 2011 Institutional Survey.  1 in 4 institutional investors will be adding to its hedge fund investments in 2012.  Long/short equity, macro and special situations seem to be the most popular.  Distressed and long/short credit are the least.

The source for the article can be accessed here

Success Factors for a Buy-side Analyst

As a member of the New York Society of Security Analysts, I was invited last week to listen to a panel talk about the buy-side and how to succeed in it.  There were four speakers:  Subrata Ghose, CFA, Lauren Lambert, CFA, Stanley Lee, CFA and Thierry Wizman.  Their points can be boiled down as follows.

Ghose is an equity research analyst at Lord, Abbet & Co.  To be successful, he must:

• Simplify his research for the portfolio manager to make decisions
• Be objective
• Have conviction in his opinions
• Be quantitative
• Talk to the entire supply chain of the company (vendors and clients)
• Not hide when wrong

Lambert is a portfolio manager at AllianceBernstein and former Director of Research for Non-US equities at Bessemer Trust.  She added the following points:

• Be excellent with clients
• Do not be too narrow i.e. do not just follow your stocks
• Learn about other asset classes

Lee is a portfolio manager for Neuberger Berman and runs the (David) Greene Group All Cap Intrinsic Value strategy.  His items were:

• Have conviction in your stocks
• Understand the industry and economic environment
• Have good ideas that make money
• Sell ideas in a simple manner

Wizman is the Director of Research at Artha Capital.    His notes were not targeted towards success factors but more of the difference between buy-side and sell-side.  They were:

• Buy-side is exposed to many opinions from the sell-side.  The sell-side analyst is by himself.
• Buy-side can have conditional opinions or change opinions easily
• Buy-side has continuous exposure to a small audience.  Sell-side has a large audience.
• Buy-side becomes portfolio managers.  Sell-side becomes Directors of Research.

Institutional Investors Favor Emerging Markets and Alternative Investments

In an article published by Pensions & Investments, the Deutsche Bank 2011 Institutional Survey shows that investors are planning to shift their capital into the emerging markets and alternative investments (commodities, hedge funds, private equity and real estate) over the next year.  They will be moving out of the US stock and government bond markets.  The survey was conducted for 101 investors with $1.2 trillion in assets.

The source for the article can be accessed here.

As Revenues Fall in Equities, So Does Headcount

Investment banks have been reducing headcount in their European Equities Departments as a result of decreasing profitability because of the ongoing Eurozone debt crisis.  Trading commissions are being reduced because of the rise of electronic execution firms.  The daily average capitalization of stocks being traded in European markets have fallen 58% since 2007.  Unlike US stocks, European commissions are calculated based on the capitalization multiplied by a basis point rate.  They are not based on the number of shares.  The average rate in 2009 was seven basis points.  In 2006, it was nine basis points.  Total trading commissions have gone from 10.7 billion Euros in 2008 to 8.9 billion Euros in 2011 according to the Tabb Group.

Europe's top traders were Credit Suisse, UBS, Morgan Stanley and Deutsche Bank.  They have approximately 8% to 11% of the business in 2010.  Regionally, Europe was 35% of the banks' revenues.  The US accounted for 55% and 10% was from Asia.    Banks that have laid off equities staff include Unicredit, Bank of America, Credit Suisse, UBS, Royal Bank of Scotland and Nomura.  One firm bucking the trend is Barclays.  They are not reducing their European Equities staff.

Some alternative business models include specialization and outsourcing.  Mediobanca added an eleven person team in London that covers financial stocks.  Unicredit hired Kepler Capital Markets to provide sales, trading and research for some stocks.

The source for this article can be accessed here.

Managing Counterparty Risk for Prime Brokers and Hedge Funds

Before the failures of MF Global, Bear Stearns, Lehman and Merrill Lynch, hedge funds and their investors gave no or little thought to the idea of measuring counterparty risk.  Fund managers should perform due diligence at the onset and during their relationship.  The same analysis should be done on any third party service providers such as auditors, fund administrators and lawyers.

Here is how hedge funds manage counterparty risk of their prime brokers:

• Use multiple brokers
• Add "amber" terms to the prime brokerage agreement.  If the credit default swaps spread reaches a certain figure, then the fund's assets should be moved to a separate account.
• Discover the exposures of the prime broker
• Buy credit default swaps on the prime broker

The source for this article can be accessed here.

Notes on China's Government Debt

In the November 2011 issue of Global Finance magazine, Thomas Clouse wrote an article about China's government debt.  As part of the stimulus plan enacted by Beijing, local governments must fund infrastructure and public projects.  Since they cannot issue bonds or levy property taxes, they use real estate to fund them.  Local government investment vehicles borrow money using the real estate as collateral.  Lately, the real estate market has been cooling down which will cause losses on these loans.  Who will take on the losses?  The banks, local governments or the central government.  There are $1.5 to $2.1 trillion in loans which is 70% of China's Gross Domestic Product.  Stephen Green of Standard Chartered Bank believes that the central government's balance sheet surplus and taxation authority can resolve this high level of debt without triggering a banking crisis - as long as there is strong nominal growth.

S&P Downgrade Is Sent in Error

The ratings agencies Standard & Poor's, Fitch and Moody's have had a rough time in the 2000's.  Between missing the disasters at Enron, WorldCom, Tyco International, the credit crisis of 2008 and the downgrading of US debt, they have been under fire for conflicts of interest and incompetence.  On Thursday, Standard & Poor's sent out an email message to its subscribers of its Global Credit Portal that French debt was downgraded from AAA.  Two hours later, S&P corrected it and affirmed that France was still rated AAA.

Market reaction was swift and immediate.  The Stoxx Europe 600 Index kept falling 1.5% and French bonds yields rose 28 basis points on the ten year debt.  When yields rise on bonds, prices fall.  Commodities, US Equities and the Euro fell briefly.

The source for this article can be accessed here.

Investors Ignore Smaller Hedge Fund That Have Better Returns

In earlier posts, we noted that smaller hedge funds had better returns than large ones.  PerTrac did a study named Impact of Fund Size and Age on Hedge Fund Performance.  There were six conclusions from the research report:

• From January 1996 to December 2010,  hedge funds managing less than $500 million outperformed funds above that threshold in 10 of the 15 years.
• The smallest funds had the best performance.  Funds with less than $100 million in assets under management (AUM) had a return of 13.6% for the same timeframe.  Funds with $100 million to $500 million in AUM had a return of 10.87% and those with over $500 million in AUM had a return of 10%.
• In 2008, during the credit crisis, the reverse was true.  Large funds with over $500 million in AUM had better returns.
• In the first six months of 2011, the trend continued with large funds returning 0.83%.  Funds with less than $100 million in assets under management (AUM) had a return of 1.02%.  Funds with $100 million to $500 million in AUM had a return of 1.05%.  

However, institutional investors are not heeding this data.  According to Russell Investments, 80% of hedge fund assets are managed by funds with AUM over $1 billion.  The largest 10% manage 15% of the total assets.  Funds that are larger than $5 billion in AUM manage 62.4% of the industry's AUM.

The article was written by Michael Beattie, President and Chief Investment Officer of Tradex Global Advisors, and can be accessed here.

Some Hedge Funds Benefit from October's Rally

The Standard & Poor's 500 stock index rose 11% in the month of October.  There was no real change in the economic outlook.  The rally was based on an external event;  that the European debt crisis would be resolved.  Some hedge fund managers such as Jim Simons at Renaissance Capital and Robert Gibbins at Autonomy Capital built on this year's successes.  The Renaissance Institutional Equities Fund rose 5% in October and is up 33% year to date.  The Global Macro fund of Autonomy Capital is up 2.7% in October and 13.9% for the year.    Other managers merely pushed into positive territory.  David Einhorn of Greenlight Capital rose 8.5% for the month and is up 1.87% for the year.  Bill Ackman of Pershing Square was up 14.4% and is even for the year.  John Paulson of Paulson & Company made some gains during the month but is still down substantially.  Some managers such as Daniel Loeb of Third Point Capital and John Thaler of JAT Capital had reduced their risk exposures to the markets in September.  When the rally came in October, they missed out on the gains.

The source for this article can be accessed here.

Insider Trading: SAC Capital Trades Flagged

The Financial Industry Regulatory Authority marked nineteen SAC Capital trades as suspicious and forwarded them to the SEC.  They included drug companies such as Genentech Inc., ViroPharma Inc. and United Therapeutics Corporation.  These trades were flagged because they were executed around major news announcements.  In 2003, Genentech's rose 45% after it published the positive results of a drug study for Avastin.  SAC made $158,500 by buying days before the news.  Same situation occurred in 2007 with United Therapeutics.  Just before the positive results of a drug trial were announced, SAC took a position in the stock.  SAC made $2.3 million when the stock rose 38%.  SAC shorted ViroPharma in 2009 - just before its drug trial was pronounced ineffective.

Other trades being investigated were made before merger and acquisition activity.  Two of them are Hologic Inc.'s 2008 buyout of Third Wave Technologies Inc. and Johnson & Johnson's purchase of Couger Biotechnology.

Over the last ten years, SAC Capital has made $14 million on these trades.  For enforcement purposes, only the trades in the last five years count.  There is a five year statute of limitations on insider trading.

The source for this article can be accessed here.

Private Equity Funds in India

Private equity investors have favored India as a source for their emerging markets investments.  Recently, China and Indonesia have supplanted it.  All three countries have a need to build out infrastructure, education and healthcare systems but a few trends that have tipped the scales away from India.

The Chinese government is supporting domestic, local currency private equity funds with less regulatory oversight and restrictions on ownership.  Carlyle Group, Blackstone and Texas Pacific Group have invested in joint ventures with Chinese state-owned enterprises and governments.  The Indian stock market is performing poorly and not conducive to IPOs.  Capital flows have been negative as foreign investors have been de-risking.  Meanwhile, China's markets are restricted to local investors which makes it easier to exit private equity positions.  Indian fund managers lean towards the deal-making side and not on generating high returns by adding value to the portfolio companies.

The Securities and Exchange Board of India (Sebi) has proposed some restrictive rules.  Private investments in public equity (PIPE), private equity and infrastructure funds should register with Sebi.  The general partner of a fund has to invest at least five percent of the fund assets.  This restricts large funds to be managed by the Blackstones of the world.

India has an inefficient stock market with many small and mid-cap companies that are not adequately covered by research analysts.  Unlike the standard private equity deal, some fund managers take minority stakes of 2% to 7% in these public companies and work with their managers to improve their businesses.  Meanwhile, they work with the sell-side to raise their companies' profiles to investors.  When the stock prices rise, they sell their position on the secondary market.

The source for this article can be accessed here.

An Interview with KStone Partners

Finalternatives.com held a recent interview with Joseph Marren, President and CEO of KStone Partners, a fund of fund manager that has three funds with $125 million in assets under management (AUM).  Their returns are +20% for 2009, +8% in 2010 and in positive territory in 2011.  KStone offers access to diversified alternative investments to institutional and high net worth investors.  They use 25 to 33 managers in their funds that have a low correlation to the equity and debt markets.  They find their managers through their networks mainly.

He believes that there will also be a role for a fund of funds manager.  Small and medium institutional investors need them to provide access to a diversified hedge fund portfolio.  They do not have the scale (in AUM).  As for large institutions, the current trend is self-management of portfolios.  Marren thinks that investors will discover that they do not have the personnel to create an alternative investments portfolio and will return to the fund of funds model.

Securities Lending: Considerations for Investors

Everyone knows that hedge funds may short securities to enhance their returns.  This is the simple act of borrowing them and selling them at a higher price.  Then buying them back at a lower price (hopefully).  Where do the prime brokers get the securities to lend to the funds?  They have securities lending desks; can lend out securities in custody from other funds or even retail accounts.  Let's look at the desk.  It negotiates with investors to have access to its holdings.  Why would an institutional investor do this?  They can generate extra revenue for better returns or to offset expenses with their bank.  The investor should consider the following:

There are five program structures:  agency discretionary, client directed, auctions, exclusives and principal.  Agency discretionary is where the investor uses a third party (like a prime broker) to handle the details such as sourcing transactions and record-keeping.  Client directed is when the investor handle transactions on its own and using its custodian to facilitate loans and/of cash collateral transactions.  The last three are agreements with a borrower to give access to their portfolio for a fee, price or period of time.

The investor has to decide on the loan type.  The most common loan is open where the loan can be closed at any time and the fee renegotiated.  The term loan is for a specific period of time with a fixed fee.  A general collateral loan is used for securities that are not popular with the borrowing funds and a specials loans is used for securities with a high demand i.e. those with a high short interest.

The investor has to set parameters for is lending program.  An example would be setting a limit on the amount of securities on loan to borrower(s) as a percentage of the portfolio or market value.  Restrictions can be made on the security or client level.

The investor decides what types of collateral to take from the borrower.  They may take other securities or cash.  The decision should take into account the size of the lending program, liquidity, ownership/control, transparency and risk levels.  They can place the collateral in a separate managed account, commingled account with other lenders, external investment account with another fund manager or "self-invest" where the investor controls the assets.

The source for this article can be accessed here.

Views on China: This Is What Makes Investing Interesting

China.  There is so much news about the country in the financial news.  We will pursue a couple of viewpoints in this post.  First is the article in the New York Times about China participating in the bailout of the Eurozone.  I hope China is smarter about it than the US Government in bailing out the banks in 2008.

In a post written by Burnham Banks at hedged.biz, China's GDP growth was 9.1% for the third quarter of 2011, well ahead of the 8% needed to keep stability in the county.  It is down from a previous figure of 9.5%.  However, inflation is rearing its ugly head.  In September, it was 6.1%.  If you look at its components, you see some worrisome numbers.  The price of food is up 13.4% with meat being up 28.4%.  The government has to walk a fine line between growth and inflation.

Managers of commodities funds are more positive since the September sell-off but are cautious about China's economic growth.  They believe that the government will loosen monetary policy later this year to keep growth at the 9.3% target.  Also, the drop in commodity prices is causing certain fund managers to see value in them, such as industrial metals and crude oil.  The source for this part of the article can be accessed here.

China perma-bear, Jim Chanos, says that the hard landing for China's economy has begun with troubles in its banks and real estate.  In a nationwide survey, home prices rose in less than 50% of seventy cities.  The number of home transactions has fallen 40% to 60% in the past two months when compared to last year.  But the performance of China's banks do not support his investment thesis.  Agricultural Bank of China, Industrial & Commercial Bank of China and Bank of Communications Co. reported huge gains in the third quarter.  Chanos' replied, "Western banks reported record profits in 2007 before collapsing."  Hard to argue with someone who shorted Enron in 2001, the homebuilders in 2007 and credit-related stocks in 2007.  However, we hear a lot about his successes.  What about his failures?  The source for this part of the article can be accessed here.

The Return of Prime Broker Counterparty Risk for Hedge Funds

The Greek debt crisis in Europe is causing hedge funds to re-visit their prime brokerage relationships.  In the last debt crisis, Lehman's bankruptcy exposed funds to billions of dollars of frozen trades in London.  The Federal Reserve Bank backstopped the trades in the US to prevent a similar situation.  Hedge fund managers are using credit default swaps (CDS) to measure their brokers' risk of default.  Some sample costs of five year CDS contracts are:

• Morgan Stanley - 320 bps
• Bank of America Merrill Lynch - 300 bps
• Societe Generale - 270 bps
• JP Morgan - 150 bps
• Credit Suisse - 150 bps

Another risk to hedge funds is that prime brokers may also have to pull their financing to protect their parent companies' balance sheet.

In the second quarter of 2011, JP Morgan was the biggest prime broker, as measured by assets under management, with 28% market share.  It was followed by Goldman Sachs (20%) and Morgan Stanley (14%) according to Hedge Fund Research.  Other banks that are taking on more prime broking business are HSBC and SEB Enskilda.

The source for this article can be accessed here.

Funds of Hedge Funds: 1 in 20 Deliver Alpha

In a research report by Benoit Dewaele and Hugues Pirotte of the Brussels Free University in Belgium and Nils Tuchschmid and Erik Wallerstein of the Geneva School of Business Administration, fees associated with fund of funds wipe out almost all alpha for investors.  Alpha is defined as risk-adjusted investment gains.  Only 22% of fund of funds create any alpha.  Of these funds, one in twenty delivered alpha by picking the best performing funds.  The remainder was delivered through hedge fund indices.

50% of fund of fund managers underperformed the indices.  Hedge funds are not adding value over the past thirty years.  The average fund has a lower return than a stock market index fund.  The analysis was done on 1,300 fund of funds from 1994 to 2009.

The report's title is Assessing the Performance of Funds of Hedge Funds.

The source for this article can be accessed here.

Being Bullish on Commodities

Hedge fund managers are optimistic about the commodity markets.  They accumulated more long positions by October 18th in 18 futures and options contacts.  The commodities with the biggest jump in contracts were heating oil, gasoline, coffee and soybeans.  The Standard & Poor's GSCI has been extremely volatile the last two months.  It is up 9.2% this month and was down 12% last month.  Managers are predicting that the emerging markets countries and the US will continue to grow.

Crude oil is up 15% in October.  Corn is up 9.9%.  Coffee has been up 22% for the year.

Nelson Louie, Global Head of Commodities at Credit Suisse Asset Management, said that the recent fluctuations in the markets were a result of traders deciding to increase or decrease their exposure to commodities based on the macroeconomic concerns.  Once they are resolved, then supply and demand should drive commodity prices.

The source for this article can be accessed here.

50% Chance of a Recession According to Dr. Doom

Nouriel Roubini, Dr. Doom and founder of Roubini Global Economics LLC, says that there is a 50% chance of recession in the United States, United Kingdom and the countries in the Eurozone within the next year.  A re-structuring plan for Greek debt will be published on October 26.  If the plan is not successful, Greece may default on its sovereign debt and put Spain and Italy as the next dominoes to fall.  Uncertainty as to which European banks are exposed to a Greek default are making their counterparties nervous and unwilling to extend them credit.

On the other hand, emerging markets have been aggressively fighting a recession with various stimulative measures.  Indonesia and Brazil's central bank cut their interest rates and the Philippines are embarking on a stimulus package of $1.7 billion.

The source for this article can be accessed here.

Another Firm To Start Trading Shares of Private Companies

Liquidnet has started trading shares of private companies such as Facebook that do not want to do an IPO.  Staying private allows companies better control of their shares as they can dictate how to allocate shares and how they are traded.  This is predicted to be a $7 billion market in 2011.  The dominant firm in this type of trading is SecondMarket.

Liquidnet is widely known for 'dark pool' trading.  Institutions can anonymously trade public stocks to minimize their effect on the price.

The source for this article can be accessed here.

Defensive Investment Ideas from a Bearish Fund Manager

Nandu Narayanan, Chief Investment Officer of Trident Investment Management, believes that we are in a global recession and should be investing in defensive stocks like Johnson & Johnson and Procter & Gamble.  Why should we listen to him?  His fund was up 44% in 2008, during the credit crisis, while the average fund was down 18%.  His ten year performance is 11.2% per year.  The MSCI World Index is about even for the same period.  In addition to consumer staples, he likes:

• Drug companies
• Water utilities
• Oil companies 
• Gold (both companies and the commodity)
• Canadian, Norwegian and Australian bonds
• Corporate bonds from emerging markets
• Canadian equities

The source for this article can be accessed here.

JAT Capital: Fund Tries to Keep a Low Profile

Hedge fund JAT Capital did not report its performance through mid-October to HSBC Private Bank.  You may ask what is interesting about that.  An earlier article mentioned some reasons that a fund may not continue to report its returns.  It's interesting because JAT Capital, through September, was up 31% for the year and had the best returns in HSBC's rankings.  The average hedge fund has lost 5% in the same period.  John Thaler, manager of the fund, may be trying to keep a lower profile or may not need any more capital raised.  The long/short equity fund has $2 billion in assets under management.  That may be the limit at which his investing strategy is successful.

The source for this article can be accessed here.

Galleon Group Founder Sentenced to 11 Years

Raj Rajaratnam, Founder of the hedge fund Galleon Group, was sentenced to 11 years in a federal pension after being convicted of insider trading, securities fraud and conspiracy.  He was also fined $10 million and to give back $54 million from profitable trades.  Fifty out of fifty-four people have been found guilty in the last two years.  One is a fugitive.  Three cases are pending.  The main people caught up are portfolio managers, expert network analysts and executives of well regarded companies such as Intel, McKinsey and IBM.

The source for this article can be accessed here.

China's Banks Are Downgraded

Yesterday, Sanjay Jain, research analyst covering Chinese banks for Credit Suisse, wrote a negative report on that sector.  Bad loans to real estate companies, manufacturers, local governments and small/medium entreprises would cause losses of 40% to 60% of equity capital in the coming years.  I am surmising that many were made during the credit crisis of 2008 when the central government ordered banks to loan money to stimulate the economy.  The MSCI China Financials Index is down by as much as 43% in 2011.  To support the sector, Central Huijin Investment Ltd, part of China's sovereign wealth fund, is buying shares of the four largest banks.  The China Banking Regulatory Commission is watching the banks closely in case real estate prices start to fall as part of their effort to cool that market.

The source for this article can be accessed here.

Negative Outlook on Fund Management Firms

Publicly traded fund managers in Europe are seeing more of their shares shorted by investors.  The average ratio for stock out on loan is 1.32% of outstanding shares.  Several managers have seen their short interest skyrocket during the last month as their stock underperformed the general market.  They include Ashmore Group (2.24%), Man Group (1.85%), Hargreaves Landsdown (2.4%) and Schroders (2.21%).  Man Group is down 25% since September.  Ashmore Group has fallen 20%, Schroders has fallen 13% and Hargreaves Landsdown is down 6%.

The Greek crisis has caused investors to withdraw assets from different fund managers which directly affect their management fees.  Aberdeen Asset Management had $1.25 million in outflows in July and August.  Man Group said that withdrawals were at the same rate as early 2009, immediately after the credit crisis.

The source for this article can be accessed here.

Talent Introduction: Another Service for Hedge Funds

Hedge funds pay about 35% of the trading commissions on the exchanges.  To attract more of this business, prime brokers are adding recruiting to the normal suite of services (such as trade settlement, financing and consolidated reporting) that they provide.  Positions are mainly in the back office and accounting.  The advantage for hedge funds is that they do not have to pay the recruiter's fee.  This has been done for many years but has been formalized only in the last few years.

As with any resource, there are some obvious conflicts.  Banks could hire staff away from one of their clients.  They are privy to inside information on the fund if an important person, say a portfolio manager, wants to leave his firm.  Other departments at the prime broker may act on this information by reducing the fund's financing.

The source for this article can be accessed here.

Gold: September Weakness Is Only Temporary

In early September, Gold hit a high of $1,920 per ounce.  It has since dropped to $1,655 per ounce as of October 7th.  Reuters asked the best performing commodities funds, as ranked by Lipper, about their forecasts for the metal for the rest of the year.

The fourth ranked manager, Paula Bujia of the Schroders Gold and Precious Metals Funds, bought only gold and midcap gold mining companies.  She is waiting for more selling of gold ETFs before adding to her positions.  Her choices for stocks are Randgold Resources, Yamana Gold and Eldorado.  They are predicted to have record earnings, increasing dividends and cash levels for their balance sheet.  However, until the markets return to a more normal state, their stocks will continue to be under pressure.

The third ranked fund manager, Kurt Hug of the Antares Precious Metals Funds, thought that gold and other commodities would rebound in the near future.  There are few other investments that investors can buy in a difficult market.

The top ranked fund is the LGT Dynamic Gold Fund.  Peter Sigg of LGT Capital Management said that they were slightly leveraged in gold's run-up to $1,920 and slightly invested in cash during the retreat.  He noted that in September 2008, gold prices fell in tandem with stocks and commodities and may do so in 2011.

The article can be accessed here.

Hedge Funds Are Down in the Third Quarter

Hedge funds lost 5.02% for the third quarter of 2011 according to research by Bank of America Merrill Lynch.  This is the largest decline since the third quarter of 2008 when they fell 9.48%.  Much of the losses were caused by the sell-off in August after US debt was downgraded and by the European debt crisis and commodity price collapse in September.  The stock markets have continued to fall in October.  Commodity Trading Advisors were even for September and they were the best performing hedge fund strategy. Equity long/short was down 4.76%.

On the other hand, Red Kite Capital Management's commodity fund is up 47% year to date benefiting from a large short position in copper.  It was up 19% in August and 17% in September.  The short position was established based on a contrarian idea that Chinese demand for copper would slow down.

Sources for this article can be accessed at Reuters and www.hedgeworld.com.

Alternative Hedge Fund Structures

Speaking at FINforums Annual Hedge Fund Summit in New York, several senior executives - Ludiger Hentschel, Principal and Head of Quantitative Research and Asset Allocation at Investcorp and Meredith Waterman, Co-head of Managed Accounts Strategy at Man Investments -  favored managed accounts as the best hedge fund investment structure.  Investors get transparency, liquidity and control.  They receive daily position information and liquidity is not controlled by the fund manager but by the investor.  As for the returns under a managed accounts structure, they outperform others according to Hentschel.

A different hedge fund structure promoted by Adam Patti, CEO of IndexIQ, is investible indexes.  He stated that investors can replicate hedge fund returns by using derivatives and ETFs.  Investors receive liquidity, transparency, low fees and tax efficiency.

These two structures are better than the popular UCITS (Undertakings for Collective Investment in Transferable Securities) funds.  This European structure allows funds to market themselves to a wider audience than a standard structure.  UCITS funds generally have easy liquidity (14 days notice), leverage is limited to two times assets and does not allow the manager to have most of the assets in a single position.  Waterman stated that UCITS funds underperform regular funds.

The source for this article can be accessed here.

Private Stock Exchanges for Start-up Companies

SecondMarket and Shares Post are private exchanges where start-up companies' stocks can be traded by investors and employees without having to go through the rigorous IPO process.  Unlike the public exchanges, companies selling shares on the private exchanges can choose which investors are allowed to buy their stock and limit the frequency of transactions.  For example, they may restrict the investor to trade their shares four times in a year.  Companies are able to retain their employees until they are ready for an IPO.  For these emerging companies, there is a market value.  In the traditional process, the investors are reliant on valuations from the venture capital and private equity firms that own them.

Barry Silbert, CEO of SecondMarket, believes the IPO market is dying.  In the last ten years, there have been between 100 to 150 IPOs per year.  There were 400 to 500 per year in the 1980s and 1990s.  It takes ten years for a company to go public since its founding.  It was five years in the 1980s and 1990s.  The growth of online brokers and the end of research from the banks are also factors in this trend.

The source for this article can be accessed here.

John Paulson Is Having a Bad Year: What Will Investors Do?

John Paulson positioned his hedge fund to benefit from an economic recovery in 2011.  For example, his Advantage fund was 80% long at the beginning of 2011.  It was the wrong decision.  Through August, his two largest funds are down 20%.  September results are not in.

Even with his current underperformance, Morgan Stanley has raised $12 million for its Morgan Stanley HedgePremier/Paulson Advantage Fund II LP.  The first fund was created in 2009.  A client can invest only $150,000 to get access to Paulson's funds.  A direct investment requires $10 million.

However, several investors are being advised to stay in the funds despite the poor performance.  His return history is one reason.  They believe he can rebound in the months ahead as in late 2010.  Paulson's net asset value is deep under the watermark and cannot charge performance fees for a while.  In a prior post, the Journal of Alternative Investments analyzed fund managers' behavior when their funds were more than 10% underwater.  They decreased their portfolio's risk to preserve their capital base.  Maybe the worst is behind Paulson & Company.

The source for this article can be accessed here.

Investment Trends since the Credit Crisis

In the IMF's Global Financial Stability report for 2011, they find investment trends since the credit crisis in 2007-2009.  They are:

• 50% of assets under management (AUM) are in the US;  this is trending down
• 14% of AUM are in Japan (as of 2009); down from 23% in 1995
• More AUM are in investment funds (from 29% in 1995 to 40% in 2009); less are in pension funds and insurance companies
• US investors equity allocation is down 10% to 44%
• Asset allocations differ by country
• Generally, investors have pulled out of equity and debt investments
• Markets such as emerging markets with good long term growth predictions are receiving capital flows
• The equity allocation is being replaced by long duration debt securities
• Investors are analyzing the risk profile of their portfolio instead of the individual components

The source for this article is here.

China's Banks: A Crash Waiting to Happen?

Several institutional investors - including Kynikos Associates, Grantham Mayo van Otterloo and  Vontobel Asset Management - are predicting that Chinese bank stocks will fall off the cliff.  The MSCI China Financials index fell 24% in September.  They believe the banks have too many bad loans to local provincial governments, a slowing real estate market and a slowing economy.  In Liaoning province, 85% of the government financing vehicles are struggling to repay their debt obligations.  Real estate developers are also seeing higher borrowing costs as banks cut their lending.

Since 2008, the banks have loaned $3.8 trillion.  A major portion went into infrastructure and real estate.  In five years, real estate prices have risen 60%.  Jim Chanos of Kynikos has short positions on almost all the banks.  He believes that they will fall below the value of their net assets.  Currently, the banks trade at a 20% premium to their assets.  They still have bad loans from prior banking crises and the local government debt has grown to 200% of the gross domestic product.  As in the US, they may have to raise capital to reserve against bad loans and expanded lending.

A sellside analyst, Mike Werner of Sanford Bernstein, says that the growing Chinese economy will limit the amount of bad loans.  If these loans do increase greatly, the banks will be less profitable but will not collapse. The Beijing government would prop them up.

Some of the bank stocks include Agricultural Bank of China, Bank of China, China Construction Bank, China Merchants Bank and Industrial & Commercial bank of China.

The source article can be accessed here.

An Inflection Point for Gold?

Over the last two trading days, gold and silver futures have dropped by 9% and 25% respectively.  Up until recently, gold had been regarded as a safe haven investment.  As investors sold riskier securities, they bought US Treasuries and gold.  Now, gold is being treated as any other commodity.  In the last two weeks, gold has fallen in tandem with stock markets while the US dollar has risen.  There are a number of reasons for the change in investor psychology:  fear of a global recession, the Euro debt crisis, contents of the Federal Reserve's speech on Wednesday and hedge fund selling.  Funds were rumored to be taking profits from their gold positions, using them to raise cash for margin calls on other positions or raise money for possible investor redemptions.  In a replay of the credit crisis of 2008, funds sometimes have to sell what they can, not what they want.

Sources for this article can be found at www.hedgeworld.com and the New York Times.

S&P 500's Correlation Rises to Same Level as in 2008

Last month, there was a post on another blog that I found interesting but did not get the time to re-post.  In a chart after the Standard & Poor's downgrade of US credit rating, it shows that the correlation of the stocks in the S&P 500 had spiked to 0.85.  This is higher than during the credit crisis of 2008.  There were large declines of stock prices while volatility, cost of interbank borrowing and gold were high.  These conditions increase the difficulty of managing an equity long/short hedge fund.

The measurement, Value-at-Risk (VaR), should be higher as the volatility increases.  When correlation increases, then stock pickers find it very difficult to outperform the markets.

The source for the article can be accessed here.

A Look at High Frequency Trading

High frequency trading has been in the news over the past couple of years.  It has been maligned as market manipulating and blamed for crashes.  It accounts for 70% of equity trades in the US.  There was a recent interview with Arzhang Kamarei, Partner at Tradeworx, published at allaboutalpha.com.  Tradeworx is a quantitative investment management firm that uses high frequency trading to run equity market neutral hedge funds.

Most high frequency trading firms are market makers and provide liquidity for securities.  They make money by "rebate capture" and on the bid-ask spread while acting as a principal.  The rebate is offered by the exchanges $0.0025 per trade.  There is a distinct advantage in being faster and having your trade orders in the exchange before others.  When your trade is in the front, there is a better chance of having it executed at the bid price.

These firms like markets that allow them to end the day with no net exposure, have trading venues with low latency, have securities with lot sizes small enough for risk control and where automated market making have an advantage.  They like volatile markets because there is high trade volume.  The more trades - the more money they make.

High frequency traders have to watch their inventory.  They need to diversify across securities and keep their net balances low - same as with portfolio managers.

Rogue Trader Strikes UBS for $2.3 Billion Trading Loss

Another rogue trader struck the investment banking world last week.  This time the firm is UBS;  the loss is more than $2 billion;  and the trader is Kweku Adoboli.  This is the biggest loss since Societe Generale lost $7 billion in 2008 with Jerome Kerviel.  The accused trader worked as a director trading ETFs on a desk named Delta One.  The details are not clear but the trades seem to be in index futures on the Standard & Poor's 500, the DAX in Germany and the Euro Stoxx 50.  As in the Kerviel case, false trades were entered into the system to evade the bank's risk management levels.

UBS has had a history of one-off losses.  There was their $1 billion investment in Long Term Capital Management in 1998.  Dillon Read Capital Management, one of their hedge funds, lost 150 million francs in 2007 before it was shuttered.  In 2008, $50 billion in losses on subprime mortgage securities caused the resignations of CEO Marcel Ospel, Finance chief Clive Standish and Investment Banking Head Huw Jenkins.  There are people pressing for the resignation of the current CEO Oswald Grubel.  He had become CEO in 2009 and was reforming the bank's risk management.

The sources for this article can be accessed at Bloomberg.com, the Telegraph, Reuters, the New York Times Dealbook and Business sections.

Tail Risk Strategy Profiting from European Debt Crisis

Hedge funds with investment strategies designed to generate positive returns during market shocks, tail risk or black swan funds, have been very successful in August and September.  Other funds have lost 4.8% since July 30th due to the European credit crisis.  The tail risk fund of Saba Capital Management has risen 15% in August and 11.5% in September.  Pine River Capital Management has risen 14.5% in August.  Other hedge funds that run this strategy are Capula Investment Management and Gramercy.

The VIX Index, a measure of market volatility, has doubled in the last two months.  Junk bonds have lost 4% in August according to a Bank of America Merrill Lynch index and the Standard & Poor's 500 lost 5.4% for the month.

The source for this article can be accessed here.

Notes from a Private Wealth Management Panel Presentation

Last night, I had the pleasure of attending an event sponsored by the New York Society of Security Analysts (NYSSA) on the State of Private Wealth Management.  The speakers were Hinton Crawford of TD Wealth Management; Chip Packard, Managing Director and Head of the Eastern Region for Deutsche Bank Private Wealth Management and Mason Salit, Head of the International Private Bank for HSBC.

They noted several trends in the private banking business.  Clients were interested currently in investment products that protect principal, are liquid, reduce risk, reduce tax burdens through Master Limited Partnerships and senior level tranches of structured products.  However, investors tend to have short term memories and the preferred products were different a couple of months ago.  Investors want simplicity, control, consolidated reporting, help with generational wealth transfer and philanthropy.  Returns were ranked seventh.  Private bankers are spending a lot of their time with legal, compliance and risk in the current environment.

Frontier Markets

I recently came across a research report from Northern Trust Global Investments that was written by Greg Behar and Stefanie Hest, Senior Investment Strategists.  Due to the growth of non-US markets, they are advocating a higher allocation to frontier markets.  A frontier market is in a developing country that has a high economic growth rate and a small, illiquid stock market.  The country is not part of an index such as MSCI Emerging Markets.  Examples of countries classified as frontier would be Bulgaria, Croatia, Lithuania, Romania, Ukraine, Ghana, Kenya, Nigeria, Jordan, Kuwait, Qatar, Bangladesh, Pakistan, Vietnam, Argentina, Colombia and Panama.

Frontier markets had a real GDP growth figure of 4.79%, about equal to emerging markets and two times developed markets.  This trend should be continuing in the future.  From a valuation perspective, they are more attractive than emerging markets.  The trailing P/E (price to earnings ratio) is hovering at 10 (as of 2010) compared to 15 for emerging markets.

Frontier markets have a low correlation (0.54) to the Standard & Poor's 500 Index which improves a portfolio's diversification.  Compare this to emerging markets and small cap indices' correlation of 0.8.  The historical risk/return profile (standard deviation of returns) is attractive.  However, this may be the smoothing effect of having illiquid markets.

Some additional risks of frontier markets are operational (trade settlement), regulatory/market (capital flow restrictions and limits on foreign ownership), political and transaction costs (commissions, high spreads, taxes and less liquidity).

The report can be accessed here.

Hedge Funds Are Combing Through Illiquid Debt Assets for Bargains

Hedge fund managers live for inefficient markets.  They are finding them in fixed income securities such as asset-backed securities, European sovereign debt (on the short side) and structured finance vehicles of European banks.  These securities are very complex, opaque and illiquid.  Hedge funds are looking to capitalize on sellers trying to unload them and buy them at a discount.

To handle these assets, managers are extending their lockup period to 2 to 5 years.  Fortress Investment Group is looking through busted structured finance securities.  It is where the best opportunities are but, since they are very illiquid, managers have to be include this risk in their pricing.  Blue Mountain Capital Management is researching subprime auto loans, non-agency option arms of residential mortgage-backed securities, relative value trades in dividend swaps and structured finance assets being unloaded by banks to meet regulatory requirements.

Other hedge funds in this space are Prosiris Capital Management (with Investcorp International), Bayview Asset Management (with Blackstone Alternative Asset Management) and Corbin Capital.

The source for this article can be found here.

Risks to Monitor in Structured Finance

Investors of CDOs must note the risks involved in such instruments.  Many were brought to light during the credit crisis in 2008.  They are:

• Default risk of the underlying collateral - This is greater for the equity tranches.
• Financial engineering risk - In 2008, the subprime mortgages, which were the underlying assets of the CDOs, began to default.  This caused most of the CDO tranches to suffer a drawdown.
• Downgrade risk - The credit raters, Standard & Poor's, Moody's and Fitch's may reduce the rating of the CDO tranches.
• CDO default rates - In a one year period in 2008, more than 4,000 CDO securities worth $351 billion were downgraded or defaulted.
• Differences in periodicity - The frequency of interest payments from the collateral may not match the payments on the CDO securities.
• Difference in payment dates - The interest payment schedule from the collateral may not match the payment schedule on the CDO securities.
• Basis risk - The risk when interest payments are calculated on the underlying assets of the CDO based on a different index than the payments on the CDO securities.
• Spread compression - When credit spreads become lower and result in reduced interest payments from the underlying collateral.
• Yield curve risk - Any yield curve shifts or changes in steepness affect CDOs if their underlying assets have different maturity dates.

Investors Staying with Hedge Funds Despite Down Year

According to the HFRI Fund Weighted Composite, hedge funds are down 1.22% year to date.  Equity hedge funds are doing worse, down 3.42% year to date.  Despite the less than stellar performance, assets under management (AUM) for the hedge fund industry are over $2 trillion - their high water mark.  Asian hedge funds have been leading the growth over the last decade; going from $14 billion in AUM in 2000 to $134 billion in AUM in June of 2011.  Chris Greer, global head of capital introductions at Citi, says that Asia is a hot market now but investor interest is cyclical.

The source for this article can be accessed here.

Some Smaller Hedge Funds Are Closing to New Investors

The credit crisis of 2008 has taught hedge fund managers that growing assets under management too quickly can hurt their performance.  Some small and mid-sized funds are closing to new investors.  They include Lakewood Capital Management, Route One Partners, Lobos Capital, Brenner West Capital Advisors, Jericho Capital and Redmile Group.  Small funds can get in and out of positions quickly and concentrate on their best ideas.  With too much assets under management, managers have to find investments.  At times, there may not be enough great ones so managers invest in "fair" ideas.  This lowers their returns.

To attract investors, smaller funds have to use top tier firms for their prime broker, fund administrator, legal and accountant/auditor.  Institutional investors are using seeding funds to invest in the smaller hedge funds.  They exchange capital for a portion of the hedge fund's business.  Some firms that do this are Blackstone, Goldman Sachs and Reservoir Capital.

The source for this article can be accessed here.

Another Private Equity Shop Wants an IPO: Carlyle Group

Following in the footsteps of Blackstone and Apollo Management, the private equity company Carlyle Group has filed an IPO with the SEC.  It should be closed in the first half of 2012 and raise $100 million.  Carlyle had first attempted to go public before the credit crisis of 2008.  The other private equity firms' stock prices have been failures, to say the least.  Blackstone went from $31 to $12.50 and Apollo's stock is down 33% since the IPO.  John Duffy of Keefe Bruyette & Woods had predicted this outcome.  He said, "If guy like Schwarzman are selling, I don't know if you want to be on the other end of the trade."

Sources for this article can be accessed at Crains and Finalternatives.com.

Distressed Debt Funds Seeking Exit Strategies for Their Investments

Distressed debt hedge funds took control of many companies that filed for bankruptcy during the credit crisis in 2009.  They are now seeking the traditional avenues for their exit such as an IPO or selling the business.  They include Cooper Standard (Silver Point Capital and Oak Hill Advisors), Delphi Corporation (Silver Point Capital and Elliott Management), Dura Automotive (Patriarch Partners) and Lear Corporation (Goldman Sachs) in the auto sector.  In the media sector, companies include Vertis Holdings (GE and Avenue Capital), Source Interlink (JP Morgan Chase) and Charter Communications (Apollo Management).  While in bankruptcy re-organization, the companies managed to close unprofitable divisions, reduce expenses and resolve issues with unions.

The source for this post can be accessed here.

An Investment Outlook on China

I was alerted to an article by Albourne Village written last month for a blog called hedged.biz.  The topic was Asian Economies and Investment Outlook.  The writer is forecasting several trends based on Asia:

China will build its infrastructure until domestic consumption grows - In 2009, US consumption of Chinese goods fell off a cliff.  To replace this activity, China responded with a infrastructure stimulus plan with $2 trillion being in special purpose vehicles called Local Government Funding Vehicles.  Eventually, this government sponsored program will end.  At the time, the Asian consumer will replace the US consumer - hopefully.  In China, domestic consumption will grow when income inequality becomes less and when enough people move into the "middle class" and have discretionary income.

Domestic consumption is the best strategy in China - The investor should be prepared for volatility when investing in this theme in the short term.  In the long term, it should have great returns.  There are three ways to approach this:  Asia exporters to China, Chinese domestic companies and Indonesian and Australian natural resources.

Lawsuits Planned Against the Banks on Mortgage Securities

The Federal Housing Finance Agency (FHFA) will be filing lawsuits against the largest banks because they misled investors on the quality of AAA- rated mortgage securities that they sold to Fannie Mae and Freddie Mac during the credit bubble.  The suits will be against Bank of America, JP Morgan, Goldman Sachs and Deutsche Bank.  A suit was filed versus UBS in July to recover $900 million.  All in all, the suits will seek to recover the $33 billion ($14 billion for Fannie Mae and $19 billion for Freddie Mac) in losses.  Besides the FHFA, the banks are facing private investor and 50 state attorney general lawsuits. The latter are working on a $20 billion settlement with Bank of America, JP Morgan and Citigroup.  The settlement will help homeowners being foreclosed on.  Lastly, AIG is suing Bank of America for $10 billion.  To reserve against these possible charges, Bank of America has been raising capital by selling non-core businesses.

The banks believe that mortgage securities lost value because of a slow economy and downturn in the housing market.  AIG, Fannie Mae and Freddie Mac were sophisticated investors and knew the risks involved with the securities.

The source for this post can be accessed here.

Uneasiness in the Credit Markets

The credit markets are pricing in the uncertainty caused by fear of a European debt crisis which will cascade into banking failures.  Some of the market reactions are:

Spreads Up/Prices Down

• In the credit default swaps (CDS) market, the bid-ask spread has risen to 5.4% from 3.0% of the annual cost of the contracts on the 15 most traded CDSs on US investment grade companies.  The 3.0% figure is from August 1, 2011.
• The Bank of America Merrill Lynch Global Broad Market Index has reported that spreads on bonds have increased from 170 basis points at the end of July to 231 basis points.
• The Barclays Capital Global Aggregate Corporate Index has an absolute yield of 3.82%, up from 3.67% on August 19th.
• The Markit CDX North America Investment Grade Index has risen to 122 basis points from 96.3 basis points in August.  This index increases as investor confidence improves.
• The Barcap CMBS Super Duper Index has a relative yield of 3.03% compared to 2.13% on July 25th.
• The Standard & Poor's/LSTA US Leveraged Loan 100 index is down 4.7% in 2011.

Investors have de-risked their portfolios by moving out of the leveraged loans and distressed debt.  Banks are continuing to close down their proprietary trading desks and lowering their exposure to corporate debt.  They are not committing capital to facilitate trades or acting as a principal.  There is less liquidity in the market because of these factors.

The source for this article can be accessed here.

CDO: Alternative Assets Being Used as Underlying Assets

CDOs were created to use bonds, mortgages and commercial loans as the underlying collateral.  In the last ten years, they have begun to use alternative assets such as distressed debt, hedge funds, commodities and private equity as the underlying.  They have also created CDOs with one tranche.

Distressed debt is defined as securities of companies in default or that are trading below investment grade.  They have a yield of the Treasury rate plus 10%.  The portfolio of the CDO may include both distressed and not distressed debt.  By the structure of the CDO, the rating of the senior tranche is higher than the underlying portfolio.  Investors can gain access to distressed debt and limit their risk.  Banks are the main sellers of distressed debt to CDOs.  It cuts their losses on the debt, offloads their liabilities to the CDOs and frees up reserve capital by reducing their nonperforming assets ratio.

Collateralized fund obligations (CFOs) have multiple hedge funds as the underlying assets.  The institutional investors interested in this vehicle are pension funds, insurance companies, mutual funds and high net worth clients.  The hedge funds are aggregated under a fund of fund manager.  The manager has restrictions on the total number of hedge funds, number of investment strategies and percentage invested in each fund.  The restrictions are set by the rating agency.  When the payments are due to the investors of the CFOs, the fund of fund manager has to notify the hedge fund managers to redeem the investments.

Commodities can be the underlying assets for collateralized commodity obligations (CCOs).  More accurately, the assets are Commodities Trigger Swaps (CTSs).  These transactions trigger a payment when a condition is met.  An example would be when the price of the commodity hits a price target.  The CTSs would be based on a basket of commodities.  They would avoid extremely volatile assets.  The trigger events would have to be substantially spread out to avoid multiple payouts at the same time.

Unlike normal CDOs, single tranche CDOs (STCDOs), also known as bespoke CDOs or CDOs on demand, only create one tranche.  They are structured as synthetic CDOs, using CDSs to receive premiums to pay the interest rate on the CDOs' securities.  In this security, the investors have more control over the terms than in a CDO with multiple tranches and receive all cash flows.  The advantage for the sellers is that they are cheaper and quicker to issue.  In a normal CDO, the entire risk of the portfolio is transferred to the investors.  In a STCDOs, only a specific portion of the portfolio risk is transferred to the investors.  The seller is still exposed to the underlying assets in this case.

CDO squared invests in other CDOs.  This allows for more diversification and higher spread returns for the investor.  Losses are incurred based on where (the tranche) bond defaults occur.  In a normal CDO, losses are incurred based on the number of bond defaults.  CDO squared may be cash backed or synthetically created and may invest in different tranches or specialize in one tranche across multiple CDOs.  There is a danger that the CDO squared may invest in assets that are in multiple CDOs.  Rather than diversifying the portfolio, these overlapping assets cause the portfolio to be concentrated in them.  This would cause greater losses than expected if the underlying assets default.

Lastly, there also was a CDO created with private equity investments as the underlying assets.  As with CFOs, there were restrictions on the total number of private equity managers.

Synthetic CDO Structure: One More Wrinkle

Synthetic CDOs can be structured as funded or unfunded.  In a funded CDO, the investors buy securities from the manager who buys Treasury notes.  The manager receives swap payments from selling credit default swaps (CDS) and the interest on the notes.  These are passed on to the investors as interest on the CDO securities.  If a credit event happens on the CDS position, the CDO has to pay out based on the terms of the contract.  The notes are sold to cover this cost.  In an unfunded CDO, investors become the seller of the CDS position.  They receive payments from the CDS position and are liable for any payouts in case of a credit event.  The CDO is paid a management fee.

Introduction to Arbitrage CDOs

Arbitrage Collateralized Debt Obligations (CDOs) buy bonds, mortgages, commercial loans and other CDOs and sell securities to investors.  Their main creators are money managers that earn fees on the assets under management.  The CDOs make money on the spread in interest between the assets in the CDOs and the interest that the CDOs pay to their investors.  Like the balance sheet CDO, arbitrage CDOs may be cash-funded or synthetic.

Cash-funded arbitrage CDOs can be structured as cash flow or market value.  The cash flow CDO holds a portfolio of assets and receives interest and principal payments.  It issues securities that have the same payment schedule and maturity dates as the portfolio.  The CDO uses its receivables to pay its investors.  The cash flows of the CDO are dependent on the default and recovery rates of the assets.  Most of the time, the CDO manager can trade the assets of the portfolio to increase the return and to reduce the risk of loss due to defaults of the underlying assets.

The market value CDO also holds a portfolio of assets and issues securities to investors.  It is used when the payment schedule and maturity dates of the assets and securities are not the same.  The cash flows of the CDO are dependent on the interest payments and the selling of bonds to make principal payments.  They are also affected by the default and recovery rates of the assets.

Synthetic arbitrage CDOs use a swap (credit default or total return credit) to transfer the risk of an asset without owning it.  The CDO will receive swap payments every quarter.  It will pay the money manager LIBOR + spread and receive the total return on the CDO's assets.  From the total return, it will pay out to its investors.

US Debt is Downgraded and Investors Buy...US Debt

In one of the more ironic turn of events, the Standard & Poor's downgrade of US debt on August 5th caused the S&P 500 Index to fall 6.7% and the 10 year Treasury bill rose 2% (as of August 25th).  Some strategists such as Liz Ann Sonders of Charles Schwab and Kevin Rendino of BlackRock are saying equities are oversold.  Many people are saying that the downgrade was not based on the economic situation in the world but on the political gamesmanship in Congress.  The fall in stocks was led by financials but also encompassed aerospace & defense, technology and energy sectors.  If a recession can be avoided, then equities are looking cheap.

The source for this post is here.

Introduction to Balance Sheet CDOs

There are two types of Collateralized Debt Obligations(CDOs):  balance sheet and arbitrage.  We will go over the balance sheet CDOs here.  They are used to manage risk by offloading the loans on the bank's or insurance company's balance sheet to the CDO, freeing up regulatory capital used to reserve against the loans and get capital.  They are used primarily for Collateralized Loan Obligations (CLOs).

The balance sheet CDO can be set up as cash-funded or synthetic.  Cash-funded CDOs buy the underlying securities of the portfolio from issuing securities to the investors.  The synthetic CDO is more complicated.  This CDO does not own any securities.  It sells credit default swaps.  Then the regular premiums are used to pay the interest on the securities of the CDO.  Instead, it issues securities to the investors and the cash received is invested in US Treasuries.  The interest earned on them is used to fund any swap payments to the counterparties.

Absolute Return Funds: Shelter from the Storm?

Absolute return fixed income strategies have a goal of a positive return in all market environments.  It may be a real return over cash or a nominal return.  Since the downgrade of US debt by Standard & Poor's, all markets have suffered as investors are rushing to the safest investments such as gold and, ironically enough, US Treasuries.  There is a general de-risking across the board.

Absolute return funds do not have to be hedge funds.  They may be separately managed accounts.  Investors buy into this strategy to manage interest rate risk, increase diversification and enhance their returns.  There are many ways an absolute return fund may be run.  The manager's positions must be liquid.  The fund must follow a disciplined investment process across all its exposures (alphas).  The manager must be experienced in shorting assets.

The source for this article can be accessed here.

BRIC: Underperformance Leading to Fund Outflows

Funds investing in Brazil, Russia, India and China (BRIC) have seen net outflows since March 2010.  Assets invested in funds have retreated to $28 billion from a high of $38 billion in 2007.  Other fund investing in gold and Non-Japan Asia have added about $4 billion in assets each.  BRIC funds have become standard investments.  Investors are always looking for a new thesis.  There are 350 funds, 2,000 offshore funds, local funds, and thousands of diversified funds that are allowed to invest in the area.  Performance has lagged as well.  India and China have experienced inflation.  Russia has underperformed due to the US debt crisis.  Brazil has tax issues and foreign investor outflows leading to capital controls.

The source for this article is here.

An Interview with IndexIQ: Hedge Fund Replicator

Finalternatives.com published an interview with Adam Patti, CEO of IndexIQ.  His firm runs mutual funds, such as the five star IQ Alpha Hedge Strategy, that replicates hedge funds.  He says that most funds' returns are composed of multi-asset beta (the market return across different asset classes).

Index IQ runs six indices that replicate hedge fund strategies such as global macro, equity market neutral and long/short.  The indices are composed of ETFs that represent the asset classes in each strategy.  The goal here is to add value for the investor, improve transparency and liquidity, reduce fees and be tax efficient.

The interview may be accessed here.

Basics of Collateralized Debt Obligations

Collateralized debt obligations (CDOs) are backed by a portfolio of bonds or loans.  They can be split into collateralized bond obligations (CBOs) and collateralized loan obligations (CLOs).  A CDO deal is structured with a special purpose vehicle (SPV) that is legally domiciled in Delaware or Massachusetts.  The SPV is isolated financially from the sponsor through "bankruptcy remote".  If the sponsor goes bankrupt, the SPV is unaffected.  The SPV buys bonds and loans from banks, insurance companies, etc. and issues new securities against the collateral.  The payment flows of the original bonds and loans are used to pay the interest and dividends on the new securities.  The principal is paid at the end of the SPV's life by selling the bonds and loans.  The new securities of the CDO have different classes called tranches - senior, mezzanine and equity.  Cash flows from the collateral are used to pay of the obligations of the senior tranche first, then mezzanine and equity.  The securities are issued privately to institutional investors.

Banks receive six main benefits from CDOs:

• Reducing regulatory capital - This is based on the amount of outstanding loans of a bank.  By selling the loans to an SPV removed it from the regulatory capital calculation.
• Increasing loan capacity - If the bank sells its loans to an SPV, it may take the proceeds to make new loans
• Improving ROE/ROA - The bank can take the proceeds of loan sales to pay down its debt, reduce its capital base and increase the amount of high yield assets
• Reducing capital concentration - By selling loans to an SPV, the bank can increase its loan capacity to sell to a particular industry when it has reached its credit exposure limit.  It also can help manage their exposure to leveraged loans.
• Preserving customer relationships - A bank may own too much debt from a client.  It may be sold to a SPV.  Since the bank is running the portfolio for the SPV, the client does not know that the loan has been sold.  The client does not get upset with the bank.
• Competitive positioning - CDOs with high yields attract institutional investors

CDOs usually have credit enhancement to receive an investment grade credit rating from Standard & Poor's, Moody's or Fitch's.  However, the interest rate on these CDOs are lower and less attractive to investors.  They are:

• Subordination - When lower level tranches provide credit support to more senior tranches
• Overcollaterization - When lower level tranches proved additional collateral to a senior tranche
• Spread enhancement - Funds used to cover losses in a CDO.  If there are no losses, the funds go to the equity (lowest) tranche.
• Reserve account / cash collateral - Excess cash in US Treasuries or commercial paper used to support credit
• External credit enhancement - CDO manager may purchase credit default swaps, put options or an insurance contract to protect against defaults in the loan portfolio

We will look at the different types of CDOs in later articles.

Credit Derivatives: Some Basic Information

In prior posts, we have looked at credit default swaps.  Let's take step back and look at credit derivatives as a whole.  They are financial contracts such as options, forwards, futures, swaps and credit linked notes that are used used by fixed income managers to hedge positions (credit protection) or to enhance portfolio returns (credit exposure).  Through credit derivatives, portfolio managers are able to isolate and transfer credit risk, get liquidity in the market and have transparent pricing by trading the underlying credit.  Previously, they would have to hold the underlying assets in their portfolio which is capital intensive.  To manage risk using this method, the manager would have to look at each company's financial statement and balance sheet to rate their soundness.  He would also look at the industries of the portfolio companies and diversify loans to companies in different industries or sectors.

What is credit risk?  There are three components:  default, downgrade and credit spread.  Default risk is the risk that the bond issuer or loan borrower will not pay the bond or loan in full.  A loan is in default if a scheduled payment is not made.  Downgrade risk is when a rating agency such as Standard & Poor's, Moody's or Fitch's lowers the credit rating of the debt.  Credit spread risk is when the market spread between the underlying bond or loan increases for the remaining debt.  Credit risk is usually measured by rating agencies or using the credit spread.

What are the underlying / reference assets that credit derivatives are used for?  They are high yield bonds, leveraged loans, distressed debt and emerging markets bonds.  These assets have low to medium correlation with US equities and low or negative correlation with US Treasuries.  They have a high exposure to large declines in prices.  High yield bonds a.k.a. junk bonds are rated below investment grade by the agencies (either below BBB by Standard & Poor's or Baa by Moody's).  Leveraged loans are bank loans made to companies of credit ratings below investment grade or with a spread of 150 basis points over LIBOR (London Interbank Offer Rate).  LIBOR is the interest rate at which banks borrow from other banks in London.  In addition to the three credit risks listed above, the borrower can pre-pay the loan by re-financing or pre-paying the balance.  This is call risk.  There are to types of loans - revolvers and term loans.  Revolvers are committed lines of credit that also back commercial paper loans of companies with high credit ratings.  Term loans are given to companies with lower credit ratings, are funded commitments with fixed amortization schedules and are based on floating interest rates.  In addition to credit risk, emerging markets debt is exposed to political risk.  Distressed debt is composed of bonds of companies that are in default because of a missed payment, bonds going through Chapter 11 re-organization, the company having cash flow problems or have low credit ratings.

Options, futures and forwards are known as binary options.  They are similar to equity options.  If an event occurs as dictated by the terms of the contract, then the option seller pays money to the holder.  A credit-linked note is a bond with an embedded credit option.  These notes have a higher interest rate than regular bonds but the holder of the note provides the issuer with some credit hedge.  The referenced asset is either a corporation or a basket of credit risks.

A total return credit swap allows an investor to rent a balance sheet.  The investor trades the return of an asset for a guaranteed rate of return, usually LIBOR plus a spread.    The seller of the swap retains ownership of the asset.  For example, an investor could be positive on Apple bonds.  A swap can be bought on the returns of Apple bonds.  The buyer would receive that return and pay the seller LIBOR plus a spread.  The seller has hedged his position in Apple bonds and is now receiving payments of LIBOR plus a spread.

Short Sellers of Chinese Reverse Merger Companies

Some Chinese companies have managed to become listed on American and Canadian stock exchanges by performing a reverse merger.  In this transaction, a US company is bought by the Chinese company that then uses the US company's public listing.  A number of research analysts have exposed accounting fraud at a series of these companies or accused the companies of fraud.  Either way, the result is a precipitous drop in the stock price.  These analysts have erased $21 billion of market capitalization from them.  Many of the companies have been delisted by the exchanges.  Auditors have quit.  The SEC is investigating them and class action lawsuits are being prepared.  Some people say that they have gone overboard and are accusing legitimate companies of fraud.  Others say that they are co-conspirators with hedge fund managers and are front-running with their research.  Here are some of these analysts:

The most well-known research firm is Muddy Waters.  Carson Block has published research that has brought down the prices of Sino-Forest Corp, Orient Paper, RINO International, China Media Express and Duoyuan Global Water.  He and hired experts visit China to confirm company's claims about their offices and factories.  They include legal experts, accountants and private investigators.

John Hempton of Bronte Capital is another investor that has publicized fraud in these companies.  He is formerly of Platinum Asset Management where he managed $21 billion.  Bronte Capital has around fifty short positions globally.  In China, he has exposed Universal Travel Group, China Agritech, Longtop Financial Technologies and China Media Express.  The most recent one is Hollysys Automation Technologies.  He is an accounting expert.

John Bird has about thirty short positions including China Sky One Medical, Harbin Electric Inc, China-Biotics Inc and Deer Consumer Products Inc.  He is long some oil, gas and pipeline stocks.  He advocates comparing the SEC filings of Chinese companies to their local filings with the State Administration for Industry and Commerce in China.

Andrew Left of Citron Research has published reports on China-Biotics Inc, China Media Express, Deer Consumer Products Inc, Longtop Financial Technologies and Harbin Electric.  He hires private investigators in China to help him in his research and has someone translating Chinese documents and filings.

Rick Pearson is a writer from theStreet.com that is also an investor.  His pedigree is from Deutsche Bank where he was in convertible bonds.  He does research on the ground in China by counting employees and cars in company parking lots, checking factories and factory equipment, confirming SEC filings with local Chinese employees and old-fashioned networking.  He has short positions in China-Biotics, China ShenZhou Mining, Gulf Resources, Harbin Electric and Longtop Financial Technologies.

The source for this article can be accessed here.

A Look Back at the Quantitative Equity Hedge Fund Crisis in 2007

With all the talk about the debt ceiling crisis and possible repercussions on the markets, I was reminded of another, more limited crisis in August 2007.  There was a paper written by Amir Khandani and Andrew Lo the following month.  From August 7th to the 9th, several quantitative long/short equity hedge funds experienced declines of 27%.  On the 10th, these same strategies rose 23.67%.

There are eight theories created to explain the whipsaw nature of the markets.  They are:

• A multi-strategy hedge fund or proprietary trading desk was forced to sell its most liquid assets, equities, to raise capital to meet margin calls, investor redemptions or to reduce portfolio risk
• The first round of selling caused other funds that were long/short hedge, long only or 130/30 to cut their leverage by selling off their portfolios
• After reducing their portfolios' leverage, there was a complete reversal on August 10th
• The losses were short term and suggests that hedge funds were crowded into the same trades or strategies
• Some factors that caused the magnitude of losses:  rapid growth of long/short and 130/30 funds, high levels of leverage used by funds, quantitative models did not account for crowded strategies and panic because of the subprime problems in the credit markets
• Losses incurred by quantitative funds were the result of the sudden liquidation of market neutral fund(s)
• Systemic risk in hedge funds have increased because of number of funds and assets under management, increased correlation among hedge fund indices and the growth of credit-related strategies
• Credit issues could cause new liquidity problems in long/short, global macro and managed futures

The crowded strategies of hedge funds magnified the losses.  Quantitative funds use the same factors such as January effect, reversion to the mean and price momentum for their investment models.  They use the same risk models.  The fund managers are educated in the same academic institutions and have similar thought processes.  When a large number of leveraged funds have the same holdings, there is often a race to sell at the best prices to limit losses.  The manager holding the position at the end would have the largest losses.

In The Quants:  How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It, Scott Patterson writes that the turning point was when Goldman Sachs Group decided to infuse their quantitative funds with capital.

What to Invest In During the Debt Crisis

Roger Nusbaum has a good blog at www.randomroger.blogspot.com that was highlighted in one of Money magazine's Best of issues.  On Friday, he wrote a good article on how to handle investing in regards to the debt ceiling crisis in Washington D.C.  The ideas came from David Rosenberg of Gluskin Sheff through another blogger Barry Ritholtz at http://www.ritholtz.com/blog/2011/07/rosie-7-investment-strategies-for-recession/:

1) “High-quality corporates” plus companies with “A-type” balance sheetsand “BB-like yields.”

2) Reliable dividend paying Stocks (including preferreds).

3) Low debt-to-equity ratios, high liquid asset ratios, good balance sheets, no heavy debt.

4) Hard assets: Oil and gas royalties, REITs – focus on income stream.

5) Sectors / companies with “low fixed costs, high variable costs, high barriers to entry/some sort of oligopolistic features, a relatively high level of demand inelasticity.” This includes utilities, consumer staples + health care.

6) Alternative assets that do not rely on “rising equity markets” or are independent of volatility trades.

7) Precious metals. Specifically, he puts a $3,000 target on Gold.
 
Roger's specific post can be accessed here.