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.