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.