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.

The Importance of China's Currency

According to the August editions of Global Finance magazine, China is taking some baby steps in making the renminbi an international reserve currency alongside the US dollar, euro and yen.  A bilateral trade treaty with Russia was enacted to trade using rubles and renminbi without using the US dollar.  It loosened the relationship of the renminbi to the US dollar.  A new trade settlement process created by the People's Bank of China allows government approved Chinese export companies to conduct transactions with their international trade counterparties in renminbi instead of the common reserve currencies - the US dollar, euro or yen.

The new scheme was implemented to protect China from inflation caused by China's natural demand for commodities, the weakness of the dollar and the Federal Reserve Bank's policy of quantitative easing.  The currency used for international transactions is the US dollar.  Right now, 8.7% of China's imports and exports are in the local currency (according to Standard Chartered Bank in Hong Kong).  In 2015, this is expected to grow to 15% to 20%.  This will cut the cost of hedging currencies for trading counterparties.  For a non-US firm, they only have to hedge one currency in a Brazilian real to renminbi exchange.  Right now, they have to hedge two currencies in a real to dollars to renminbi trade.  Hedges against the renminbi are more available in Hong Kong.  In August 2010, a market in deliverable forward contracts was added to the nondeliverable forward contracts in renminbi.  A deliverable contract allows a company to take full delivery of the renminbi in exchange for the notional amount.  A nondeliverable contract only allows a company to take delivery of difference between the notional amount and the underlying currency.

Multinational corporations such as McDonald's, Caterpillar, Unilever and Volkswagen have taken advantage of the new trade settlement scheme to issue bonds in renminbi from Hong Kong.  The cost of funding is much lower than on mainland China.  On a two year bond, the difference is 3.7%.  These bonds issued from Hong Kong are called dim sum bonds.  The lower interest rates are a result of large bank deposits of renminbi.  The People's Bank of China has rules on foreign capital flows.  Since Hong Kong has not been integrated in the Chinese banking system, it is considered a 'foreign nation' and needs approval to move capital into the mainland.  The difference in interest rates allows companies to cherry pick their bond offerings, allowing them to issue in the cheaper market.

The renminbi should appreciate based on this plus China's growth in exports.  Investors are flocking to fixed income funds such as Barclays Capital's Renminbi  Bond Fund in Singapore.  This fund is seeing interest from investors globally.

However, I do not see the renminbi becoming a reserve currency until it becomes a true floating currency or the restrictions on capital flows are lifted.

The source for this post can be accessed here.

Risks in Credit Default Swaps

There are four types of risk in trading credit default swaps:  operational, counterparty, liquidity and pricing.  Operational risk occurs when traders use swaps to mislead investors about their balance sheet i.e. assets versus liabilities.  A counterparty may default on its payments.  Buyers of CDSs may not pay the monthly premiums.  Sellers may be unable to pay the notional amount in case of a default of the reference entity or the sellers themselves may declare bankruptcy and not have to pay the notional amount.   CDSs are traded as bespoke contracts between two counterparties.  If an investor wishes to exit the position, finding another investor to take over the contact, known as novation, may be difficult.  Pricing may be inaccurate as it may be based on the wrong mathematical models.

Hedge Funds Struggling in First Half of 2011

Hedge fund indices have underperformed the regular indices year-to-date through June 30th.  The S&P 500 is up 6%;  the MSCI World Index is up 5.62%; and the Barclays Capital Aggregate Bond Index is up 2.72%.  Meanwhile, for the same period of time, the Dow Jones Credit Suisse Hedge Fund Index is up 1.65% and the HFRI Fund of Funds Composite Index is down 0.33%.  Despite this, investors added $29.5 billion into hedge funds in the second quarter.  Of all the investment strategies, Global Macro has had the most difficult year as there have been no market trends in the current economic environment as it lurches from crisis to crisis.  However, this message is not coming across to the investors as 64% of them will seek to invest in these underperforming funds, according to a survey of 2,700 institutional investors and hedge fund managers by Prequin Research.

The source for this article can be accessed here.

Credit Default Swaps: Some Basics

A credit default swap (CDS) is a contract associated with a company where the credit buyer pays the seller a fixed rate for the duration of the contract.  In return, the seller pays the buyer if certain credit events happen and the contract is closed.  Within it is listed a number of trigger events that will result in a payout to the buyer.  The payout is delivered usually in the form of the company bond at par (i.e. full price).  It is similar to any insurance product.  The other type of settlement is cash.  This is used for swaps on indices or structured finance tranches.

CDS contracts contain the reference entity's bond, the notional amount (i.e. the amount being insured), CDS spread (i.e. annual payment in basis points) and time of maturity.  The maturity is usually on March 20, June 20, September 20 and December 20.  Some contracts are based on more than one company.  These are called basket CDSs  If the contract is based on more than ten companies, it can be called a portfolio product.

The trigger events are bankruptcy, missed payment, re-structuring, obligation acceleration, obligation default and repudiation/moratorium.  Bankruptcy and missed payment are a company's failure to pay its debt.  Re-structuring debt is any change that adversely affects the buyer.  Obligation acceleration is when a loan is re-paid early and obligation default is when the borrower violates any condition in the agreement.  Repudiation/moratorium is a refusal to pay debt.  Bankruptcy, missed payment, obligation acceleration and repudiation/moratorium are defined as hard events and trigger the entire bond to be immediately due and payable.  Soft events, such as re-structuring, are changes in the agreement between the reference entities.  Some of them are reduction of interest/principal, postpone payment of interest or principal and a change of currency or contractual subordination.

CDSs provide a way to separate risks in complex securities such as convertibles.  They allow investors to hedge credit risk by shorting credit.  Investors can customize their risk profile by buying contracts on bonds of different companies and maturity dates, buying contracts on baskets and buying contracts to bet on the price direction of the reference entity.  CDSs may link different markets and provide liquidity in the credits markets.  Transactions are confidential.

Family Offices and Hedge Funds

I read a recent post at Simon Kerr's Hedge Fund Blog about family offices.  They are not included in the institutional investor universe but have several advantages investing in hedge funds.  The firm Rothstein Kass polled 151 family offices.  85% are in hedge funds and 90% of them are planning to increase their investments.  On the other hand, only 50% are invested in private equity.

There are two types of offices:  Wealth Creators (71%) and Wealth Preservers (29%).  Creators are more likely  to add to their hedge fund investments.  Many of them lost capital during the credit crisis and are trying gain it back.  The most popular strategies were equity long/short, distressed and arbitrage.

Simon summarizes the advantages as follows:

• Family offices tend to have long-term investment horizons. 
• They tend to want to live with decisions for some time – as a source of "sticky money" they won't flip a multi-year investment proposition after a couple of bad quarters.
• The investment decision making is often quicker than either funds of hedge funds or institutional investors that use consultants to select hedge funds.
• Due diligence of family offices is less invasive and time consuming than for investing institutions.
• They typically require less client servicing resource than other investors in hedge funds.
• They tend to have less restricted selection criteria than institution al investors – family offices can invest in niche strategies, emerging managers and small funds.

The source material for Simon's article can be accessed here.

A Study of Passive Hedge Fund Replication Techniques

The prior post was about new ETFs that tracked different hedge fund strategies.  There are other techniques used to replicate hedge fund returns without the negatives associated with such funds.  Fund investments are not liquid, are opaque, have high fees and weak regulations.  There are two methodologies to hedge fund replication:  factor-based and payoff distribution replication.  The study Passive Hedge Fund Replication: A Critical Assessment of Existing Techniques by Noel Amenc, Walter Gehin, Lionel Martellini and Jean-Christophe Meyfredi of EDHEC studied both to determine their effectiveness.

The factor-based approach involves identifying the risk factors of hedge fund returns to build a portfolio that mirrors its performance.  The difficulty lies in finding the right factors to build a model.  They may be market factors such as interest rates, indices and credit risk or style factors such as futures and options.  Most of the portfolios underperformed hedge funds and were more volatile.  There were a number of causes for this.  It is hard to create the proper model of risk factors.  The factors are linear in nature.  Hedge funds hold investments such as options with non-linear returns.  Fund managers change their portfolio frequently.  The factors cannot follow their changes accurately and timely.

The payoff distribution approach tries to replicate the distribution of hedge fund returns by finding an index return that matches the hedge fund return and pricing the payoff function using a standard option pricing model such as the Black-Scholes model.  Amenc's study finds that the replication strategy works for a timeframe of six years or longer.  It does not mimic the time-series properties of hedge fund returns.

ETFs That Replicate Hedge Fund Strategies

Murray Coleman of Barron's wrote about ETFs that gave the investor exposure to hedge fund strategies without paying to 2 and 20 fee or being a qualified institutional buyer.  The ETFs named in the article were Cambria Global Tactical ETF (GTAA), Credit Suisse Long/Short Liquid ETN (CSLS), Credit Suisse Merger Arbitrage Liquid ETN (CSMA) and WisdomTree Managed Futures (WDTI).

CSLS tracks hedge funds using long/short strategies and CSMA does the same for merger arbitrage funds.  GTAA holds about 80 ETFs in its portfolio and the fund managers change its allocations among them depending on the current investing environment.  WDTI invests in 24 futures in about 12 sectors.  It invests using the seven month moving average as an indicator of which contracts to short and go long.

The source for this post can be accessed here.

Risk Management: Some Basics

Dr. Philippe Jorion of the University of California at Irvine and Managing Director of Pacific Alternative Asset Management Company (PAAMCO) wrote a main portion of the risk management overview for the CAIA Level II curriculum.  There are market, credit, liquidity, regulatory and counterparty risks.

Market risk is the risk of loss in financial market prices.  It is also called systematic risk.  To calculate market risk, all the assets in the portfolio should be used to find the possible profits and losses by using market data.  The most well-known model is value at risk (VaR).  This allows for tracking of any drift in investing style, hidden risks and of new fund managers, markets and assets.

Credit risk is the risk that a counterparty to a contract does not fulfill its obligation by not paying the amount or not delivering the asset owed.

Liquidity risk occurs when an investor cannot sell assets.  There are two types:  funding and asset.  Funding liquidity risk happens when investors redeem their capital from a fund, when loans from the prime broker are not renewed or during margin calls.  In these situations, the fund may be forced to sell assets to raise capital.  Asset liquidity risk is the risk of losses due to the price impact of forced asset sales.  These risks can be mitigated by matching the investment horizon of an investor's assets and liabilities, putting in place a lock-up period when an investor cannot redeem their capital, having a notice period before redeeming capital, creating gates to limit withdrawals to a percentage of capital and suspending redemptions altogether.

Regulatory risk is the risk that government or regulatory agencies may change the financial rules such as imposing short stock trades during the credit crisis of 2008.

Counterparty risk is almost the same as credit risk except it includes the counterparties of your counterparty.

We will be examining other topics from Dr. Jorion's writings in later posts.  The source for this article can be found here.

2011 Investment Outsourcing Round Table

Pensions & Investments published the transcript for the 2011 Investment Outsourcing Round Table that was held on June 1st.  There were six participants from different roles in the investment community.  They were:

• Christopher Delany - associate treasurer in finance and administration at Gettysburg College
• Jay Gepfert - senior consultant at New England Retirement Consultants LLC which evaluates investment outsourcers for institutional investors
• Jonathan Hirtle - CEO of Hirtle, Callaghan & Co. which manages $20 billion in portfolio outsourcing strategies
• George Mateyo II - senior director of investments at the Cleveland Clinic Foundation
• R. Bruce Myers - managing director of consultant Cambridge Associates LLC which manages $105 billion in outsourced strategies
• Kevin Quirk - founding partner and principal of Casey, Quirk & Associates LLC, a money manager consultant

Some interesting ideas discussed were:

There is a movement towards outsourcing as an investment solution because of poor performance in the equity and bond markets, increased demand for alternative investments and institutional investors spending less money and time on managing their money.  Outsourcing has traditionally been confined to the worlds of pensions, endowments and foundations.  Corporations with defined contribution plans (i.e. 401K's) are starting to look at outsourcing to protect themselves against fiduciary risks.

Delaney at Gettysburg College decided to partially outsource the university's endowment.  The college defined the responsibilities of the board, employees and the consultant based on where everyone would add the most value.  The consultant would have access to the best fund managers.  An analysis was done by Delaney to determine where each person would be comfortable and keep those responsibilities.  Any weaknesses would be outsourced.

The current investing environment needs to have disciplined portfolio management across all asset classes.  Currently, the fund industry is based on where the manager invests and the benchmark for that universe (the performance of large cap managers are compared against the Standard & Poor's 500).  This started in the easy investing decades of the 1980's and 1990's.

Outsourcing also has conflicts of interests that need to be avoided.  Consultants that are paid fees by fund managers, paid soft dollars because they are broker/dealers and paid by manager search.

The source for this article can be found here.

Commodity Funds: Best Performers for the Second Quarter

There was a sell-off in commodities in early May causing the average commodity fund to fall 5.12% for the second quarter.  The best commodity fund was up 6.8% in the same timeframe.  Obviously, it was a short fund - PIMCO's CommodityPLUS Short Strategy.  This fund bases its portfolio on the Dow Jones - UBS Commodity Index and takes the opposite side of the trade.  Other strong performers were gold and market neutral funds.  In fact, seven of the top ten best performers of the quarter were gold funds.  They invest in gold buillion, futures and miners.

The source for this post can be accessed here.

Basel III Effects on Shadow Banking

What is shadow banking?  The Financial Stability Board said there is no common definition in its Shadow Banking:  Scoping the Issues.  It tries to define it as "lending by any organisation outside the regulated banking sector that creates systemic risk or opportunities for regulatory arbitrage, particularly if long term assets are being funded by short term liabilities, and those assets are securitised and/or re-hypothecated."  This is close to the prime brokerage model for investment banks.  Here banks use the repo markets to fund themselves on a daily basis, using the assets (securities and cash) in the prime brokerage accounts of hedge funds as collateral.  During the crisis of 2008, Bear Stearns, Goldman Sachs and Morgan Stanley could not fund themselves because hedge funds moved their assets from the banks.  Because of the lack of collateral, the repo markets and daily funding, were diminished for them.

Basel III, the new global regulatory standard, will set tighter liquidity and capital ratios for banks.  Banks are also divesting their proprietary trading desks.  These changes will lead to an increased cost of funding for prime brokers and, therefore, for hedge funds as well.

The source for this article can be accessed here.

European Debt Crisis: Some Investment Approaches

Several hedge funds are predicting that the European debt crisis, currently centered in Greece, will spread to Portugal, Spain and Italy and are executing that investment thesis in different ways.  CQS UK is approaching it not by shorting government debt or buying credit default swaps but by trading corporate debt of discretionary spending such as mobile phone companies or of government subsidized enterprises such as utilities.  Marathon Asset Management is expecting the sovereign debt and financial institutions of Portugal, Ireland, Spain, the United Kingdom and Italy to run into trouble.  The banks are overleveraged and will have to be nationalized.  Groveland Capital is buying credit default swaps on Italian and Spanish government bonds because they are a better value than Portugal and Greece at this time.  It's too late to make money on them.

The source for this article is here.

Best Practices for Hedge Funds: Investor Preferences

In May 2011, the Alternative Investment Management Association (AIMA) released a paper:  A Guide to Institutional Investors' Views and Preferences Regarding Hedge Fund Operational Infrastructures.  There are five sections, each authored by an investor, and AIMA compiled their ideas.  The topics are Governance, Risk, Investments, Capital and Operations.  Below are some topics of interest that I found striking:

Good governance should handle any conflicts of interest between the fund manager, board of directors and the investors.  Investors should be allowed to buy shares and have voting rights similar to a publicly traded corporation.  The board would have increased duties:  managing service providers (including the fund manager) and valuation.  The board should be composed of three to five directors with a majority of them being independent.  The directors should meet quarterly.

Risk reports should be sent on a monthly basis.  The other sections:  portfolio, operational, counterparty and liquidity held no surprises.

In the investments section, investors should be able to redeem their investments within a year.

Capital and operations sections held no new concepts.

Managed Futures Are Predicting Stock Market Downturn

Managed futures funds are run by Commodity Trading Advisers that use predominantly use trend following trading strategies.  The charts of the Barclay and Newedge CTA indices are predicting a downturn in equities in the near term.  After the Barclay CTA Index traded in a range in 1999-2000 and 2006-2007, the Standard & Poor's 500 Index collapsed.  There was another period in 2009-2010 and the market has been trending down.  Looking at the daily Newedge CTA Index chart, there was a recent drop of 5%.  This is presaging a drop in equities.

The source for this article written by Thomas Lott, President of Potomac Portfolios, with charts, can be found here.