New Rules for Swap Dealers

The Securities and Exchange Commission (SEC) is proposing new rules for swap dealers and their clients.  The SEC, which was asleep during the credit crisis of 2008, is trying to oversee a swap business of $600 trillion in notional trades.  The transactions that will apply the new rules are security-based swaps and some credit default swaps.  The former are swaps that are derived from the performance of a stock, bond or index.  The latter are insurance against a default for a corporation or government's bonds.  Some of the rules are:

• The security-based swap dealers would have to act in the best interests of the state or local government or pension fund, recommending suitable swaps.  
• They would have to disclose information about the trade's risks and any conflicts of interest.
• They would have to verify that their customer is financially sound.  
• The dealers would also have to know that a qualified independent adviser was representing the fund for a transaction.  
• They would have to build a compliance department for oversight.

Swap execution facilities are being set up by thirty to forty dealers such as Bloomberg and Tradeweb.  Banks, hedge funds, insurance companies and other institutional investors are prepared to trade on these facilities.  They are waiting for the SEC rules to be approved and finalized.

Here are the sources for this article:

• New York Time Dealbook
• Washington Post
• Bondbuyer.com
• Wall Street Journal

Small Hedge Funds Are Thriving

A survey by Citi Prime Finance found that hedge funds with $1 to $5 billion in assets under management grew the largest in 2010.  This can be traced back to performance.  Smaller funds outperform the giants by 1.88% on an annual basis.  Large institutional investors such as pension and sovereign wealth funds still allocate to the larger hedge funds because they do not want to be the largest investor in a smaller fund.

Funds of funds allocations from hedge fund investors have fallen to 33% from 45% since 2006.  Meanwhile, direct investments in hedge funds have risen to 66% from 55%.  Funds of funds are invested in too many funds and have an extra layer of fees.

The source for the article can be accessed here.

Trends in Funds of Hedge Funds

Charles Gubert of www.cooconnect.com opined funds of hedge funds (FoHFs) need to respond to investors requests for managed accounts, liquidity and transparency.  Last month, Preqin, a hedge fund industry research firm, said that 40% of institutions would invest directly into hedge funds instead of using the FoHF vehicle.  Another trend seen in the FoHF universe is the offering of specialty strategies to accommodate a new investment thesis.

So far in 2011 FoHFs have underperformed hedge funds - 0.66% versus 1.92% according to HFRI indices.

The source for this article can be found here.

ETFs for the Emerging Markets

I subscribe to several other financial blogs.  Money magazine recommended one authored by a portfolio manager named Roger Nusbaum that I have been following recently.  His post on Friday is about Exchange Traded Funds (ETFs) sponsored by EG Shares.  ETFs are securities that represent a basket of securities.  Unlike mutual funds which are priced daily, ETFs are priced continuously.  Most ETFs are based on an index such as the Standard & Poor's 500 or NASDAQ 100.  These are called passive ETFs.  There are active ETFs that mimic the portfolio of a fund manager.  These are rare.  EG Shares has created 10 sector specific funds for the emerging markets.  The emphasis is on Brazil, Russia, India, China and South Africa.  Nusbaum finds the materials, telecom and industrial ETFs the most interesting.  Less so with the technology ETF which has 88% of holdings in China and India.  He also gives some ideas on how to pair sector specific ETFs and country funds for proper diversification of holdings.

The source for this post is here.

Return Components of Commodities

At times, I have referred to terms before defining them in this blog.  This happened in an earlier post about commodities.  Returns for commodities are composed of the spot return, the roll return and collateral interest.  The spot return is the percentage change in spot prices of the commodity.  As commodity futures approach their expiration date, investors sell them and buy futures contracts that have a later expiration date.  This is called rolling their positions.  The gain or loss is the change in the prices of the contracts.  If the commodity forward curve is sloping downward i.e. contracts with a later expiration date are less expensive, then the market is in backwardation.  If the contracts with a later expiration date are more expensive, then the market is in contango.  To establish a futures position, the investor has to put a small amount of margin - usually 5% to 15%.  This varies depending on the commodity contract.  The remaining cash is invested in Treasury bills, TIPS, money markets and other, safe, liquid assets and used for collateral for the remainder of the position.  The interest earned on these assets is the collateral interest.  Commodity futures have a implicit leverage due to the structure of the markets.  In addition, an investor can apply another layer of leverage by borrowing money to establish the position.

Trading Revenues Falling for Banks

For the second quarter of 2011, trading revenues are predicted to fall for investment banks.  Fixed income will fall 30% and equities will fall 15%.  The European debt crisis and slowing US economy are contributing factors to the downturn.  Investors are spooked by both and have ratcheted down their trading volumes.

Additionally, fixed income, currencies and commodities trading are down because of de-leveraging by hedge funds, the shutdown of proprietary trading desks by banks, widening credit spreads and lower volatility.  Commodities trading revenue is contributing a larger portion to the revenue mix while debt trading is shrinking.  Quarter over quarter comparison for equity is down 32%.

Trading accounted for 56% of Goldman Sachs' revenue compared to only 16% for Bank of America.

The source can be accessed here.

Hedge Fund Redemptions Increase in June

GlobeOp, a hedge fund services firm, reported that more investors are asking to redeem their investments.  The Forward Redemption Indicator had increased to 4.01% on June 15th.  This continued the trend since April when the figure was 2.45% and May when the figure was 3.92%.  There were two theories about the increase.  July 1st is when most funds re-allocate their portfolio and the withdrawals are part of the normal business cycle.  The other theory is that the surprising fall in commodity prices in May destroyed the returns of many funds.  Investors were taking money out due to the poor performance.

The source for the article can be accessed here.

Coller Capital's Survey of Private Equity Investors

There was a recent article in Pensions & Investments that commented on the correlation of returns between the markets and private equity during the financial meltdown in 2008.  In a survey, 54% of investors were surprised that both assets moved down in tandem.  Other results from the survey were that 87% were not planning to re-invest with their managers due to poor performance.  There were also negative attitudes towards follow-on funds.  19% of investors believe 33% of the funds will not be able to raise capital for new funds.  24% believe 21%-30% will fail and 38% believe 10%-20% will fail.

Protecting a Portfolio Against Inflation

I was directed to a research report written by AllianceBernstein about how an investor can prevent inflation from eating into real returns for a target date fund.  Target date funds are a relatively new asset allocation product that adjusts the percentages of each asset during the length of the investment.  This is called the glide path.  The asset mix is higher for riskier assets (i.e. equities) early.  As time goes by, the asset mix becomes more conservative with a heavier weighting in bonds as the fund approaches its target date.  Although the paper was written for target date funds specifically, it can be applied to any traditional portfolio.

Spikes in inflation can be considered a rare tail risk event (three times since World War I).  When it happens, they reduce the value of investment portfolios considerably.  Once the spike is identified as such, buying any protection skyrockets.  The addition of real assets can serve as a hedge against this event.

AllianceBernstein considers three factors when analyzing hedges:  sensitivity to inflation, reliability and cost-effectiveness.  The sensitivity is how an asset reacts to inflation.  Equities has a -2.4 sensitivity.  When inflation is up 1%, equities fall 2.4%.  20 Year Treasury bonds have a -3.1 sensitivity.  Treasury Inflation Protected Securities (TIPS) have a sensitivity of 0.3 to 0.8, depending on the duration of the bond.  Commodity futures have a sensitivity of 6.5.  The second factor, reliability, tells how often the sensitivity factor is correct.  For example, commodity futures have a reliability factor of 54%.  When inflation rises, then the futures may rise but it only does so half the time.  The chart shows that TIPS are the most reliable, then commodity stocks, REITS and commodity futures.  Buying these assets have an opportunity cost.  The investor is giving up returns to buy this insurance against inflation.

Here is a list of hedging assets:

• Equities - natural resource and real estate sectors
• Commodity futures
• Currency forwards
• Real Estate
• Gold
• Short term bonds
• TIPS

The report recommends a portfolio of commodity futures, equities and currency forwards.  The weight depends on the lifecycle of the investor.  Of the investor is still working, it should be about 5%-15%.  At retirement, 15%-35%.  After 10 years of retirement, 30%-50%.

Hedge Fund Assets Reach $2 Trillion Mark

Hedge fund assets passed the $2 trillion mark in the first quarter of 2011.  In the past 12 months, there was a net  increase of 295 funds.  684 funds were liquidated.  The range of returns decreased to 55.3%.  The best funds gained 41.3% and the worst funds lost 14%.  Management fees are holding steady but incentive fees are decreasing.  Funds opened in the last 12 months charged an average of 17.2%.

The source for this post is here.

Commodities: Futures vs. Equities of Natural Resource Companies

In an earlier post, one of methods of investing in commodities is to buy stocks in companies that buy, sell or produce them.  A research paper written by RS Investments of San Francisco, California suggests that having an equity position in these companies is better for portfolio diversification, a better hedge against inflation and will have a higher return than commodities.

From 1970 to 1999, commodities as an investment was negatively correlated versus equities, provided protection against inflation and performed the same as equities.  This caused investments in commodities to increase from $15 to $354 billion from 2001 to 2010 as investors sought after improved risk-adjusted returns.  During this timeframe, commodities became more correlated with equities and had worse returns.  The article shows a chart with the correlation statistics for the Standard & Poor's Goldman Sachs Commodity Index (GSCI) and the MSCI World Index.   In the last five years, it has risen to 0.60 and is slightly higher, 0.64, during down markets.  For example, if the market has a 10% up move, then commodities will have a 6% up move.  In the last three major downturns in the stock market (1998, 2001 and 2008-9), commodities have negative returns too.  Contrast that with the bear markets from 1970 to 1990, commodities actually had positive returns.

From 2001 to 2010, equity indices in natural resources companies outperformed commodity indices.  The paper believes that this will continue because one of the return components of commodities has been affected negatively by the commodity futures curve.  The return is generated by the changes in the spot (current) price of the commodity, the roll yield and interest on collateral posted when buying futures contracts.  (These terms will be more fully defined in a later post.)

Both asset classes had high correlation with inflation.

A study on portfolio performance was done based on an 85%/15% equities to commodities/natural resource equities allocation.  Every portfolio with the 15% natural resource equities position had higher returns and lower volatility compared to the equity/commodities portfolio.

The author of the study is RS Investments and the paper can be found here or here.

Asset Allocation for an Individual Investor

This post is slightly off topic.  As part of the CAIA program, I was exposed to a paper - Beyond Markowitz: A Comprehensive Wealth Allocation Framework for Individual Investors by Ashvin Chhabra.  This article takes the traditional asset allocation format and adds a person's other assets such as real estate and pensions into the calculation.  People are not only exposed to market risk.  They have personal and aspirational risks.  Some examples of personal risk are employment, health issues, age and how money is spent.  Capital allocated to protect against personal risk is defensive in nature - being used to protect people's lifestyles.  Market risk under Markowitz gives people risk-adjusted market returns and allows people to maintain their lifestyle.  Aspirational risk is for people who want to enhance their lifestyle.  Assets are categorized under each risk and allocations are made depending on the profile of the investor.  Below are samples of each category:

• Personal - cash, Treasuries, annuities, homes, insurance and salary
• Market - equities, bonds, funds of funds and commodities
• Aspirational - employee stocks and options, hedge funds, private equity, mortgaged real estate and business ownership

Chhabra goes through an example of a portfolio with the traditional asset allocation and transforms it using the new rules.

Alternative Investments: Changes in Portfolio Allocation

A survey of 55 investment consultants handling $10.4 trillion of assets under management was conducted by Casey Quirk and eVestment Alliance.  One of the conclusions was that alternative assets would become part of the mainstream of a portfolio - an idea recently presented by Mark Yusko of Morgan Creek Capital Management.  Instead of being in a separate alternatives bucket, they would part of an asset class.  The investor allocation asset classes will be:  illiquid investments, liquid alpha, real assets, equity, fixed income and cash.

According to the survey, the buyside will have to adapt.  The firms that bring the most value to their clients would have non-correlated investments, both traditional and alternative funds and a robust innovation/product development pipeline.  Looking at Quirk's chart, hedge funds, fund of funds, emerging markets equity and real estate are poised to grow in 2011.  Direct investment in hedge funds is favored by large institutions.  Smaller investors use fund of funds.

The source for this article is Simon Kerr's Hedge Fund blog, a blog that I have referred to in past articles.

Don't Fight the Fed: Maiden Lane II

During the credit crisis of 2008, the Federal Reserve Bank created a vehicle named Maiden Lane II to buy residential mortgages from AIG.  The valuation at par of the portfolio was $39.3 billion, as set by Blackrock.  Maiden Lane II paid $20.5 billion with $19.5 billion financed by the Fed.  The face value is now $30 billion.  The portfolio has mostly subprime, Alternate-A Adjusted Rate Mortgages (ARMs) and option ARMs.  In March, AIG bid $15.7 billion to buy back the mortgages.  At the time, there were other investors such as Barclays, Credit Suisse, Morgan Stanley, Goldman Sachs, Blackrock PIMCO and some large hedge funds interested in the assets and AIG's bid was rejected.

Fast forward three months and AIG's bid now looks attractive.  As Maiden Lane II assets have been sold, the banks buying them have hedged their positions by using the Markit ABX and CMBX indices.  The bonds that compose those indices are dropping in price, forcing other bonds such as junk or corporate bonds to follow suit.  Other side effects include bank default swaps and various Markit CDX indices going higher. 

Sources for this post are at:

• Bloomberg.com
• Seekingalpha.com
• Federal Reserve website

Trading Swaps on US Treasuries

In recent months, there have been many articles about Congress and raising the debt ceiling.  There were a couple of articles of how institutional investors were approaching this news by taking up positions in derivative securities based on US Treasuries.  Hedge funds are trading positions in credit default swaps, trying to predict how and when the debt ceiling situation will be resolved.  There are $26.1 billion in gross notional outstanding on May 31st.  Most investors do not believe that there will be a default.  Trades have been structured where the fund is buying swaps against the shorter term bond and selling swaps against the longer term bond.

The article can be accessed by clicking here.

On the other hand, Bill Gross of PIMCO, has bet against the US Treasury in his Total Return fund by being short interest rate swaps.  This means that PIMCO is paying a fixed rate of interest and receiving a floating rate of interest.

Allocations to CTAs by Institutional Investors

According to Don Steinbrugge of Agecroft Partners, managed futures funds run by commodity trading advisers (CTAs) are becoming more attractive investments for institutional investors.  Hedge funds using this strategy hold of 15% of assets under management for all hedge fund strategies.  During the internet and credit bubble of 2000-2002 and 2008, CTAs generated positive returns while stocks were down significantly.  In 2008, returns for various asset classes were:

• Barclays CTA Index +14%
• Dow Jones - UBS Commodity Index -35%
• US equity -40%
• Emerging market equity -50%
• High yield bonds -30%

The advantages of CTAs are liquidity on a monthly basis, transparency, risk management and good infrastructure (research, technology, operations and legal/compliance).  Some CTAs have weekly or daily liquidity.  More information about managed futures can be found here.

The source for this post can be found here.

Real Returns

The website www.finalternatives.com has an interesting article by Charles Gradante, Managing Principal of the Hennessee Group.  He writes that most people evaluate investments based on nominal returns and not real returns.  Real returns are equal to nominal returns less inflation.  He refers to two Standard & Poor's charts.  The first one displayed the annualized performance of the equity markets in 10 year period beginning with 1970.  The 70s had a negative real return of 1.48% as inflation was higher than the return of the equity markets.  The 1980s and 1990s returns above inflation were 12.48% and 15.29%.  The last decade, 2000s, lost 3.48% annually.  The loss in the 2000s was hit hard in 2008 with a negative real return of 37.10%.

Internet IPOs 2.0

Morgan Stanley has been an underwriter of many large technology IPOs this year.  The companies include LinkedIn, Yandex - a Russian search engine and Renren - a Chinese Facebook.  They popped over 100%, 55% and 30% on the first day of trading respectively.  The target percentage gain is usually 15%.  The high returns are reminiscent of the internet bubble of the late 1990s.  Internet companies are hard to value.  There are almost no peer companies to use for comparison purposes.  The private markets, where Facebook is traded, does not serve as a useful benchmark for the public markets.  Transactions are infrequent and for the privileged few.

For more information, the source for this post is here.

Gaia Capital: A Lesson in Tail Risk Management

Gaia Capital, one of the larger hedge funds with $150 million in assets under management invested in Japan, has lost 75% of its assets after the earthquake, tsunami and nuclear power plant crisis.  At the end of March, the fund had $92 million in assets.  There was $32 million at the end of April due to losses and investor redemptions.  Gaia had been successful in prior years, returning 36.1% in 2009 and 21.7% in 2010 but it all unraveled after the natural disaster.  The losses were in derivative strategies such as swaps and put options.  The fund had placed a bet that the Japanese market would remain in a trading range i.e. they were short volatility.  As a result of the earthquake, the Japanese index, Nikkei 225, fell to 8,234.6.  The expected trading range was between 9,500 to 11,000.  Investors fled.  When the fund tried to exit its positions, there was no liquidity.  Gaia had to liquidate its positions at the bottom of the market.

Shorting volatility is exposed to event and/or tail risk.  A large downward move in the market causes large losses for the fund.

For more details, the source for the post can be accessed here.

A Different Way of Looking at the Current Investing Environment

Members of CAIA were invited to an event sponsored by the New York Hedge Fund Roundtable last week.  Mark Yusko, CEO and Chief Investment Officer of Morgan Creek Capital Management (with $10 billion in assets under management), presented on how to invest in the current low return environment that he called the 0-3-5 problem.  Cash is at 0%.  Bond yields are at 3% and stocks are expected to return 5%.  In order to attain returns in the high single digits that investors such as pension funds and university endowments need, he proposes that investors move to a skill based portfolio.  There were a multitude of themes presented.  They centered around the lack of returns in the developed world and the rise of the emerging markets.

The best portfolios will not have alternative investments as a separate asset class.  They will ignore these classifications and integrate them.  A traditional portfolio may be 50% US equity, 15% international equity, 30% fixed income and 15% in hedge funds.  The updated concept will ask where the hedge funds invest.  In this example, let's say the funds invest in US equity.  Then the asset allocation of the portfolio will look like this:

• US equity 65%
• International equity 15%
• Fixed income 30%

Adding assets with uncorrelated returns such as hedge funds "can boost expected returns, while reducing portfolio volatility."  Private equity returns for funds operating during a recession are higher.  Yusko encourages investors to take advantage while funds are having difficulty with fund raising.

That being said.  Investing in US markets will be difficult.  The US is in danger of mirroring Japan on government debt, low interest rates and low growth in GDP.  Investors should concentrate in Brazil, Russia, India and China (BRIC) with an overweighted allocation in Asia.  Over the last 10 years, this has returned 250% cumulatively.  The Standard & Poor's 500 and NASDAQ have negative returns.  Credit Suisse, the World Bank and PricewaterhouseCoopers have predicted that China will surpass the US as the world's largest economy by 2020.  The emerging markets have the same forces that propelled the US to become the largest economy in the 20th century:  population growth and low debt in local companies.

Commodity prices will rise as the emerging markets nations develop.  As China and India industrialize, oil demand will rise.  The best way to play this is to invest in oil services stocks or indices such as OIH (Oil Services Holders Trust Index) or OIX (CBOE Oil Index).  Gold prices will continue to reflect the rise in US government debt as a percentage of GDP.  Other commodities with rising prices are platinum, palladium, corn and wheat.

Yusko also commented on various risk factors in the current environment.  They were:

• Inflation - There will be none unless there is growth in the money supply.  The Federal Reserve Bank is putting money into the financial system but the banks are keeping it on their balance sheets.
• Valuation - Stock valuations have been above the historical average since the 1990s.  The market will be reverting to the mean.
• Monetary - The Fed's Quantitative Easing 2 Program will end on June 30th.  US equity markets will be discounting by 20% for that event before the date.
• Growth - Rise in unemployment may signal low growth in Gross Domestic Product.
• Wealth - Housing prices continue to fall in the US and developed nations (i.e. Western Europe).
• Demographic - The US is an aging nation that will spend and grow less.
• Government - Deficit levels are not sustainable.
• Default - Municipal bonds, especially in California, Illinois, New Jersey and New York are in danger of defaulting.
• Sovereign - There may be another debt crisis in Europe because banks own the bad debt of Portugal, Ireland, Greece and Spain.
• China - The renminbi was re-pegged to the US dollar in July 2008.  This caused the dollar to strengthen and commodity prices to collapse.
• Devaluation of the dollar - Largest risk for US investors

One old rule still applies - diversify your portfolio.  In addition to the ideas above, he listed other possible assets:

• International Real Estate
• Absolute Return Strategies as a substitute for bonds
• Distressed debt in US and Europe

Thanks for the roundtable for setting up the presentation and Mark Yusko for presenting their views.

How Private Equity Firms Are Changing

Private equity firms are expanding into hedge funds, fund of funds, underwriting stock and bond offerings, infrastructure and real estate due to a lack of investing opportunities and capital raising.  They are following Blackstone's example of becoming a publicly traded firm where they have to make themselves more attractive to institutional investors by diversifying their revenue streams.  The stock performance of these firms have been disappointing.  Blackstone's share price is 45% below the IPO price in 2007.  Apollo Management is down 4% since March.  Of course, private equity firms are known for buying low and selling high.  So, if they are selling...

The source for this article can be accessed here.

Commercial Mortgage Backed Securities: Is History Repeating Itself?

The rating agency Standard & Poor's released a report in late May about the overvaluation (if that is a word) of office and hotel property loans that make up the commercial mortgage backed securities (CMBS).  There are many investors buying these loans such as insurance companies, pension funds, foreign investors, REITS and CMBS issuers.  The number of investors is driving up the prices of these loans and overly optimistic appraisals are providing the backstop for them.  The appraisals are assuming that rents will increase and vacancy rates will decrease.  The normal process is to value the properties based on current rents and vacancy rates.

Other dicey situations include:  one of the hotel loans within a CMBS has an "incentive management fee" that has priority to be paid before the loan, an increasing number of loans that have one tenant, loans based on leases expiring before the loan term ends, more partial interest loans and more complex deals.

The source can be viewed here.