Two step economy:
Its quite clear anecdotally at least that the bifurcation of the world economy into rich and poor has accelerated in recent years. Wealth creation has accelerated among the rich while the rest of the population has failed to catch up. This has occurred both between countries as well as within countries. Globalisation has played an interesting role. Whereas before, labor prices were a function of local productivity, they are today a function of global productivity. As a result we see wage deflation in manufacturing where capacity has been exported to countries like China and India, while wages accelerate in services which are less portable.
Evidence of a two speed economy can be found across the globe. Aggregate inflation numbers show a fairly benign picture, and it is indeed a benign picture. However, while aggregate numbers cannot represent the extremes of consumers, they fail badly where the distribution tends towards being bimodal. Inflation numbers for the developed world range between 1% - 3% at the aggregate level. Over the last 30 years HNW inflation has risen an average of 5.5% while CPI has risen 2.3%. In the last 10 years HNW inflation has risen by 6.3% while average CPI has risen 2.6%.
Inflation risk:
The key inflation risk is not in rising commodity prices. Fuels and utilities and motor fuel account for only 5.4% and 4.1% of CPI respectively. The key inflation risk arises from the unequal distribution of intellectual capital. The long term growth potential of an economy is heavily influenced by its intellectual capital or technology for a given stock of land, labour and capital. Where inflation comes from commodity prices, human ingenuity is deployed to solve the problem. Where inflation comes from wages, human ingenuity is deployed to exacerbate the problem. And the problem lies in the relatively short supply of high value labour, particularly where the value is derived from intellectual capacity. High income and high wealth individuals are incentivised to protect their industries through high barriers to entry. It is also in their interests for their offspring to inherit their positions on the economic ladder. The high cost of education is a primary barrier in perpetuating the unequal distribution of intellectual capital. I will not discuss welfare economic further except to say that there is good argument for central planning from a general welfare perspective. The unequal distribution of wealth leads, through the education system, to unequal distribution of intellectual capital and on to unequal distribution of income which manifests in inflation data.
Central bank policy:
One suspects that interest rate policy goes beyond fighting inflation. Rates were raised aggressively in the late eighties to tackle inflation. As the economy sank into recession the Fed quickly reacted to create liquidity. In 1994 where there was little sign of inflation rates were put back up. In 2001 when recession struck again rates were aggressively cut. In 2004 rates were put back up again in a fairly benign inflationary environment. It seems that interest rate policy is driven as much by crisis as by inflation. A cynical assessment would be that rates are put back up in times of calm so as to reset the reflationary tool.
Today, as it was 12 years ago, interest rate policy is once again in the spotlight. One could argue that a ‘good’ level for rates would be in the region 6.5%. In the absence of turbulence it affords ample room for rate cuts. One could also argue that this is an acceptable hurdle rate for investment. One of the consequences of too low an interest rate is that it encourages over investment.
From an inflation point of view it looks as if rates are perfectly poised. If there is inflation it is coming from services and housing with some volatility from commodities. Since there are two inflation rates for two segments, rich and poor, each has to be looked at separately. Unfortunately there is but one interest rate that has to be set to a compromise solution.
In the US, a full 42% of CPI is due to housing of which rent is 5.8% and owners’ equivalent rent is 23%. Across the globe today we see rising housing costs, particularly in the metropolitan areas. Residential real estate prices are bifurcated along the very lines of rich and poor. Within countries and within cities, price differentials are evident and in many cases are growing. Much of this element of inflation therefore impacts the higher income segment. As prices are being driven up by income and not the other way around, this may be an acceptable situation to a central bank. At lower incomes, house price inflation is less robust and in step with wage growth so there is not an immediate problem.
We can try to generalize this. Rich sector inflation is higher. However, as incomes are higher and wealth creation derives from investments as much as wages, the marginal propensity to consume out of incremental wealth is lower. A central planner may find this acceptable. At lower levels of wealth, inflation is not just lower, its low. Looking at the aggregate economy, there doesn’t appear to be any need to raise interest rates.
Friday, 16 February 2007
Saturday, 10 February 2007
Trader's Mentality. Let's Play a Game
You play Solitaire. The card game. Its not important what game is being played. This is just an example and Solitaire is convenient. It has an element of skill and luck. The luck bit is how the pack has been shuffled and the initial set of cards dealt.
Let's say that you have a strategy that seems to work pretty well and the strategy involves playing from right to left, dealing with the longest piles of cards first.
You start playing. You win 7 times in a row. You lose once. You win 5 times in a row. You lose once. You win 10 times in a row. You are doing well. Then you start to lose. 4 losses in a row. You get annoyed. The cards are not in your favour. A fifth loss. You have had a good record of winning. Why are you now losing? There is some disbelief. Its just bad luck. You'll get over it. But nobody has such bad luck, you are angry. Maybe the strategy isn't working. You try something new. You no longer work the longest piles first but any pile that has an immediate solution. You lose again. You try again. A win! So the strategy was at fault. You continue the myopic strategy. A loss. A win. Two losses. Its pretty patchy now. You are frustrated. You should stop playing. No, wait. One more. One more win and you'll stop. A win! You need to convince yourself that it was more than luck. You deal another hand. A win. One more you tell yourself. A loss. The disappointment is unbearable. One more. You refuse to stop when you are behind. You'll stop when you're ahead. You need to play until you are ahead. Then you'll stop.
Strange thing psychology. You had a good strategy. You were winning 80% of the time. You hit a bad patch. Bad patches happen to everyone at some point. You changed your strategy to a sub-optimal one. You began to win 50% of the time. It was pure luck now. You should have stopped playing and packed up for the day. Had a rest. Thought things through and come back the next day. Instead you persisted and your track record became pure luck.
Here is how it works in a trader's head:
- Damn I'm good.
- Its just a couple of losses.
- I cannot believe anyone can be so unlucky.
- Let's try this other method.
- I cannot believe that nothing I do works.
- I refuse to stop until I win.
Let's say that you have a strategy that seems to work pretty well and the strategy involves playing from right to left, dealing with the longest piles of cards first.
You start playing. You win 7 times in a row. You lose once. You win 5 times in a row. You lose once. You win 10 times in a row. You are doing well. Then you start to lose. 4 losses in a row. You get annoyed. The cards are not in your favour. A fifth loss. You have had a good record of winning. Why are you now losing? There is some disbelief. Its just bad luck. You'll get over it. But nobody has such bad luck, you are angry. Maybe the strategy isn't working. You try something new. You no longer work the longest piles first but any pile that has an immediate solution. You lose again. You try again. A win! So the strategy was at fault. You continue the myopic strategy. A loss. A win. Two losses. Its pretty patchy now. You are frustrated. You should stop playing. No, wait. One more. One more win and you'll stop. A win! You need to convince yourself that it was more than luck. You deal another hand. A win. One more you tell yourself. A loss. The disappointment is unbearable. One more. You refuse to stop when you are behind. You'll stop when you're ahead. You need to play until you are ahead. Then you'll stop.
Strange thing psychology. You had a good strategy. You were winning 80% of the time. You hit a bad patch. Bad patches happen to everyone at some point. You changed your strategy to a sub-optimal one. You began to win 50% of the time. It was pure luck now. You should have stopped playing and packed up for the day. Had a rest. Thought things through and come back the next day. Instead you persisted and your track record became pure luck.
Here is how it works in a trader's head:
- Damn I'm good.
- Its just a couple of losses.
- I cannot believe anyone can be so unlucky.
- Let's try this other method.
- I cannot believe that nothing I do works.
- I refuse to stop until I win.
Friday, 9 February 2007
Asset Liability Management of a Hedge Fund
Yesterday we looked at how hedge funds resembled banks. In fact they look pretty much like the result of the dismemberment of banks. Now lets look in a bit closer, at the capital structure of a hedge fund. To a corporate treasurer, a hedge fund would look like a very strange animal. The hedge fund manager looks at NAV (net asset value) of his portfolio on the one hand, and investors providing capital on the other. If you don’t believe me, ask any hedge fund manager about his assets and liabilities. We rule out credit managers since this would be familiar to them, or should be familiar to them. Even the odd credit hedge fund manager does a double take from time to time. If we ask what the assets and liabilities of a hedge fund are, it should look something like this.
Assets
Current Assets – Assets that can be liquidated quickly
Cash – that’s easy
Marketable Securities – the liquid long positions
Accounts receivable – proceeds of sale of assets, premia from written options and CDS
Interest receivable – from fixed income
Non Current Assets – Assets that can’t be liquidated quickly
Illiquid investments – private equity, small caps, large positions,
Cash from shorting held with Prime Broker
Liabilities
Current Liabilities – Short term liabilities
Securities borrowed for shorting – and which may need to be covered or recalled
Short term loans – for leverage
Long Term Liabilities – self explanatory
Equity
Share Capital
The typical hedge fund is open ended, i.e. has a variable equity structure. This means that balance sheet leverage can be affected by changes in equity, as much as by the mark to market of the fund’s assets and liabilities. The fund manager has some degree of control over the assets and liabilities, hopefully. It is their job to grow the equity in a stable way. But instability can come from the equity base as well, often when the manager is not performing well. Investors can redeem out of a fund causing the equity to shrink and requiring the fund manager to reduce the size of the balance sheet. This is not always easy to do. Even if balance sheet leverage is allowed to change to handle changes in equity, providers of credit to the fund will be watching the stability of capital as well and are likely to similarly restrict funding precisely when a fund needs it. The Share Capital of a hedge fund therefore needs to be appropriately structured taking into account the strategy that the fund manager pursues and the nature of the fund’s assets and liabilities. This is the argument for lock ups and long notice periods.
Today there are funds which offer high liquidity and there are those with restricted liquidity. Mostly the liquidity terms are driven by what the fund manager can achieve. Terms that are too restrictive can hamper the growth of the fund. Terms that are too relaxed result in an unstable capital base. More often the terms are driven by the reputation of a manager. The better the reputation, the greater the demand, the better the terms in favour of the manager. Unknown quantities have to live with providing good liquidity whether their strategy warrants it or not. It is clear, however, that sometimes, restrictive liquidity terms are there for the protection of the investor as much as the business interests of the hedge fund manager.
Assets
Current Assets – Assets that can be liquidated quickly
Cash – that’s easy
Marketable Securities – the liquid long positions
Accounts receivable – proceeds of sale of assets, premia from written options and CDS
Interest receivable – from fixed income
Non Current Assets – Assets that can’t be liquidated quickly
Illiquid investments – private equity, small caps, large positions,
Cash from shorting held with Prime Broker
Liabilities
Current Liabilities – Short term liabilities
Securities borrowed for shorting – and which may need to be covered or recalled
Short term loans – for leverage
Long Term Liabilities – self explanatory
Equity
Share Capital
The typical hedge fund is open ended, i.e. has a variable equity structure. This means that balance sheet leverage can be affected by changes in equity, as much as by the mark to market of the fund’s assets and liabilities. The fund manager has some degree of control over the assets and liabilities, hopefully. It is their job to grow the equity in a stable way. But instability can come from the equity base as well, often when the manager is not performing well. Investors can redeem out of a fund causing the equity to shrink and requiring the fund manager to reduce the size of the balance sheet. This is not always easy to do. Even if balance sheet leverage is allowed to change to handle changes in equity, providers of credit to the fund will be watching the stability of capital as well and are likely to similarly restrict funding precisely when a fund needs it. The Share Capital of a hedge fund therefore needs to be appropriately structured taking into account the strategy that the fund manager pursues and the nature of the fund’s assets and liabilities. This is the argument for lock ups and long notice periods.
Today there are funds which offer high liquidity and there are those with restricted liquidity. Mostly the liquidity terms are driven by what the fund manager can achieve. Terms that are too restrictive can hamper the growth of the fund. Terms that are too relaxed result in an unstable capital base. More often the terms are driven by the reputation of a manager. The better the reputation, the greater the demand, the better the terms in favour of the manager. Unknown quantities have to live with providing good liquidity whether their strategy warrants it or not. It is clear, however, that sometimes, restrictive liquidity terms are there for the protection of the investor as much as the business interests of the hedge fund manager.
Thursday, 8 February 2007
Systemic Risk in the Hedge Fund Industry: Risks arising from the liability side of hedge fund balance sheets:
Are hedge funds banks? Some people seem to think so. In particular a research report, excerpts of which are available at http://ftalphaville.ft.com/blog/2007/02/07/2365/the-great-unwind-is-coming-warn-dresdner-pair/ , draw comparisons between Citadel and Deutsche Bank’s investment banking division. The similarities are remarkable. For a long time there has been a preference for hedge funds set up by proprietary traders as opposed to asset managers. Historically asset managers tend to be seen as long only index benchmark huggers and prop traders as swashbuckling long short risk takers. Its pretty clear that one could take a bank, cut it up into little bits and end up with a collection of hedge funds. Fixed income traders trade relative value and global macro. Structured derivatives desks need to lay off their option risks in everything from fixed income to credit, equities, FX and commodities. Equity sales desks provide flow information. Equity prop desks beef up trading profits to augment fee and interest income. On the commercial lending side, asset liability management requires credit traders. In wholesale credit, asset backed and structured credit desks are active. In distressed debt, the commercial lending activities also cross over. In investment banking, mergers and acquisitions provide event driven opportunities. In trade finance and factoring we have the basis for the asset based lending hedge fund.
Many articles on hedge fund risk consider the risks that hedge funds pose to investors. Tail risk, liquidity risk, concentration risk, excessive leverage, short optionality, are oft cited criticisms of hedge funds. But there is also risk on the liability side of hedge funds’ balance sheets. We’ve made a stab at associating hedge funds with banks. Now lets look at how banks are funded. The deposit taking bank is funded by a large number of depositors each providing small amounts of capital to the bank. The fact that there are many diverse individuals, each with their own liquidity requirements, providing capital, means that a bank can quantitatively model the aggregate liquidity requirements of the collective and thus optimize its asset base to the collective and not the individuals that make it up. It allows banks to borrow short term, through current accounts and short term deposits, and lend long term through mortgages, term loans, and other forms of longer term assets.
If you ran a bank, how comfortable would you be if you had 100 depositors, each providing you with 10 million dollars in deposits? That’s 1 billion dollars of capital. Additionally, how comfortable would you be if 70 of these depositors came from the same industry and 80 of them from the same country? This is typically what many hedge funds face. Most of the capital they receive come from a small number of investors. Most of these investors are funds of funds. The representation of investors from New York, London and Geneva is disproportionately high. Most of these investors talk to each other, exchange notes and are very likely to behave as a coalition.
This is not to deny that there are systemic risks arising from the asset side of hedge funds’ balance sheets. The risks on the liability side are as great. At the heart of this strange evolution of the typical hedge fund funding base is the evolution of the industry. By their opacity and coyness, hedge funds have traditionally found that investors find them instead of the other way around. The only investors in the business of expending considerable search costs are professional investors. Funds of funds are the largest such aggregators.
Aggregators do more than reduce the granularity of assets. They create correlation. To the extent that hedge funds are influenced by the preferences of their largest clients, large aggregators decrease independence in trading behaviour and hence the returns. If regulators worry about a hedge fund blow up potentially precipitating a system wide problem they should perhaps look at the stability of the system arising from the source of capital.
More later on the asset liability management of the hedge fund.
Many articles on hedge fund risk consider the risks that hedge funds pose to investors. Tail risk, liquidity risk, concentration risk, excessive leverage, short optionality, are oft cited criticisms of hedge funds. But there is also risk on the liability side of hedge funds’ balance sheets. We’ve made a stab at associating hedge funds with banks. Now lets look at how banks are funded. The deposit taking bank is funded by a large number of depositors each providing small amounts of capital to the bank. The fact that there are many diverse individuals, each with their own liquidity requirements, providing capital, means that a bank can quantitatively model the aggregate liquidity requirements of the collective and thus optimize its asset base to the collective and not the individuals that make it up. It allows banks to borrow short term, through current accounts and short term deposits, and lend long term through mortgages, term loans, and other forms of longer term assets.
If you ran a bank, how comfortable would you be if you had 100 depositors, each providing you with 10 million dollars in deposits? That’s 1 billion dollars of capital. Additionally, how comfortable would you be if 70 of these depositors came from the same industry and 80 of them from the same country? This is typically what many hedge funds face. Most of the capital they receive come from a small number of investors. Most of these investors are funds of funds. The representation of investors from New York, London and Geneva is disproportionately high. Most of these investors talk to each other, exchange notes and are very likely to behave as a coalition.
This is not to deny that there are systemic risks arising from the asset side of hedge funds’ balance sheets. The risks on the liability side are as great. At the heart of this strange evolution of the typical hedge fund funding base is the evolution of the industry. By their opacity and coyness, hedge funds have traditionally found that investors find them instead of the other way around. The only investors in the business of expending considerable search costs are professional investors. Funds of funds are the largest such aggregators.
Aggregators do more than reduce the granularity of assets. They create correlation. To the extent that hedge funds are influenced by the preferences of their largest clients, large aggregators decrease independence in trading behaviour and hence the returns. If regulators worry about a hedge fund blow up potentially precipitating a system wide problem they should perhaps look at the stability of the system arising from the source of capital.
More later on the asset liability management of the hedge fund.
Monday, 5 February 2007
Hedge Fund Strategies: The Outlook for 2007
We are no better off letting the weatherman predict the economy and the economist predict the weather... having said that, let us press on.
Stock selection:
Stock selection strategies and strategies that profit from an increase in specific risk will find more opportunities this year. The withdrawal of liquidity by central banks of US, UK, the Eurozone and the Japan over the past three years is beginning to take effect. Liquidity will diminish as a driver of financial market returns relative to fundamentals, increasing the share of idiosyncratic risk as a proportion of total risk in asset prices. This favours equity long short, event driven, credit long short strategies which are based on fundamental security selection.
Macro:
Global macro has always profited from trending markets. Trending equity markets, surging ones in some areas did not help macro in 2006. The changing face of macro is responsible. Discretionary and directional macro is out of fashion and in some cases out of businesses. Whereas in the mid 1990s discretionary macro was able to profit despite considerable uncertainty over policy by punting equity markets, today’s macro is more fixed income driven, more systematic, less discretionary. Fixed income markets have behaved erratically and counter intuitively. Whether they settle into a pattern this year is crucial to macro. As always, macro is difficult to call. Macro managers who can and do actively participate across all asset classes will find ample opportunity. Macro managers trading in fixed income land will likely continue to generate sub par results.
Event Driven:
Over the years the event driven space has grown in variety and richness. Once dominated by merger arbitrage and distressed investing there is now a growing supply of multi strategy event driven funds. Activists are a resurgent breed within the space. Merger deal flow will continue until corporate balance sheets are once again stretched. For the moment they are still relatively fat. When equity swap deals begin to proliferate will mark the time for caution. Until then, bet long on this strategy. At the distressed end, value is slowly being squeezed out of the market as default rates struggle to keep up with demand from ever sprouting hedge funds. In the convertible space, distressed investing has all but dried up from the dearth of low delta issues. The hostile activist which was in the limelight in 2005 and 2006 has lost some of its shine. High profile retractions show chinks in the armour. In emerging markets, a friendly activist still finds ample opportunities as corporates look to them for assistance.
Convertible Arbitrage:
Convertible arbitrage managers have returned to profit despite volatility remaining low. While implied vols have fallen back from the elevated levels of last summer realized volatility has risen. This has created opportunities particularly outside the US. In the US, the VIX continues to track realized volatility closely. Convertible arbitrage is more than being short implied and long realized vols. With the protracted shakeout of 2004, convertibles are showing good value. Rising deltas on the back of strong equity markets have improved the returns of synthetic puts. The trading of convertibles from a credit or equity directional view has also gained ground during gamma’s troubled years. Increasingly capital structure arbitrage, directional views on a particular stock, are expressed in the convertible market. These strategies are more exposed to event and execution risk than global trends in implied or realized volatilities.
As credit spreads have compressed across ratings, convertible bond issuance has slowed. This has implications on the competitive environment in the convertible arbitrage space. As corporate balance sheets re-lever and equity valuations become stretched, convertible bonds become a more attractive source of funding for corporate treasurers.
Credit:
In the tranched credit markets, correlations have been rising. This has provided the long equity versus senior trade some tailwind. The liquidity scenario painted above, of rising inflation and more hawkish central banks threaten this scenario as it encourages dispersion.
Credit spreads continue to decline, particular in HY where spreads are near historical lows. IG spreads remain barely wide to 10 year lows. Private equity investors continue to be active creating LBO risk and higher volatility in spreads. This is expected to continue into 2007 providing the event driven credit strategy healthy deal flow. For fundamental long shorts, LBO activity is a risk they have to manage carefully as private equity investors become less demanding and hence more unpredictable.
Asia:
Asia represents considerable threats and opportunities. Just as 2005 witnessed hedge fund assets growing in Japan on the back of high returns generated by levered long bets on the direction of the Japanese equity market, so too Asian hedge funds have printed remarkable results, also on the back of levered long bets on Hong Kong, China and India. In early 2006, the Japanese equity market wobbled and Japanese hedge funds recorded large losses. A similar risk plagues Asia ex-Japan.
Just as Japanese managers who have weathered the storm are now emerging with more reasonable and stable returns, well risk managed hedge funds in Asia will find the region a rich and rewarding space. Activists will find particularly interesting situations if they are happy to be constructive critics. Credit funds are finding improved market depth and range. Stock borrow improves daily in Asian markets while derivative technology opens up shorting opportunities in India and China.
The attraction of Asia is clear: India and China as the new engines of world growth. The complex relationships within Asia mean that obvious trends often result in counter intuitive outcomes. For the astute investor, the less efficient markets of Asia present rich pickings.
Commodities:
A four year bull market in commodities, following nearly 20 years of dead money, has led to strong interest in the asset class. This despite a very volatile and negative 2006. Interest has rotated first from precious metals in 2002 as a store of value, USD short, to industrial commodities such as base metals and energy on the China growth story, to softs and ags almost by default. A secular growth story supporting a long only exposure based investment strategy no longer works. Investors seek more intelligent trade expression which they hope to find in hedge funds. Whether they will find it is another matter. Commodities are factors of production with very peculiar supply dynamics. Too many financial traders participate in a market which should be driven by marginal cost. The result is ample alpha for the skilled trader and a high attrition rate among managers.
Stock selection:
Stock selection strategies and strategies that profit from an increase in specific risk will find more opportunities this year. The withdrawal of liquidity by central banks of US, UK, the Eurozone and the Japan over the past three years is beginning to take effect. Liquidity will diminish as a driver of financial market returns relative to fundamentals, increasing the share of idiosyncratic risk as a proportion of total risk in asset prices. This favours equity long short, event driven, credit long short strategies which are based on fundamental security selection.
Macro:
Global macro has always profited from trending markets. Trending equity markets, surging ones in some areas did not help macro in 2006. The changing face of macro is responsible. Discretionary and directional macro is out of fashion and in some cases out of businesses. Whereas in the mid 1990s discretionary macro was able to profit despite considerable uncertainty over policy by punting equity markets, today’s macro is more fixed income driven, more systematic, less discretionary. Fixed income markets have behaved erratically and counter intuitively. Whether they settle into a pattern this year is crucial to macro. As always, macro is difficult to call. Macro managers who can and do actively participate across all asset classes will find ample opportunity. Macro managers trading in fixed income land will likely continue to generate sub par results.
Event Driven:
Over the years the event driven space has grown in variety and richness. Once dominated by merger arbitrage and distressed investing there is now a growing supply of multi strategy event driven funds. Activists are a resurgent breed within the space. Merger deal flow will continue until corporate balance sheets are once again stretched. For the moment they are still relatively fat. When equity swap deals begin to proliferate will mark the time for caution. Until then, bet long on this strategy. At the distressed end, value is slowly being squeezed out of the market as default rates struggle to keep up with demand from ever sprouting hedge funds. In the convertible space, distressed investing has all but dried up from the dearth of low delta issues. The hostile activist which was in the limelight in 2005 and 2006 has lost some of its shine. High profile retractions show chinks in the armour. In emerging markets, a friendly activist still finds ample opportunities as corporates look to them for assistance.
Convertible Arbitrage:
Convertible arbitrage managers have returned to profit despite volatility remaining low. While implied vols have fallen back from the elevated levels of last summer realized volatility has risen. This has created opportunities particularly outside the US. In the US, the VIX continues to track realized volatility closely. Convertible arbitrage is more than being short implied and long realized vols. With the protracted shakeout of 2004, convertibles are showing good value. Rising deltas on the back of strong equity markets have improved the returns of synthetic puts. The trading of convertibles from a credit or equity directional view has also gained ground during gamma’s troubled years. Increasingly capital structure arbitrage, directional views on a particular stock, are expressed in the convertible market. These strategies are more exposed to event and execution risk than global trends in implied or realized volatilities.
As credit spreads have compressed across ratings, convertible bond issuance has slowed. This has implications on the competitive environment in the convertible arbitrage space. As corporate balance sheets re-lever and equity valuations become stretched, convertible bonds become a more attractive source of funding for corporate treasurers.
Credit:
In the tranched credit markets, correlations have been rising. This has provided the long equity versus senior trade some tailwind. The liquidity scenario painted above, of rising inflation and more hawkish central banks threaten this scenario as it encourages dispersion.
Credit spreads continue to decline, particular in HY where spreads are near historical lows. IG spreads remain barely wide to 10 year lows. Private equity investors continue to be active creating LBO risk and higher volatility in spreads. This is expected to continue into 2007 providing the event driven credit strategy healthy deal flow. For fundamental long shorts, LBO activity is a risk they have to manage carefully as private equity investors become less demanding and hence more unpredictable.
Asia:
Asia represents considerable threats and opportunities. Just as 2005 witnessed hedge fund assets growing in Japan on the back of high returns generated by levered long bets on the direction of the Japanese equity market, so too Asian hedge funds have printed remarkable results, also on the back of levered long bets on Hong Kong, China and India. In early 2006, the Japanese equity market wobbled and Japanese hedge funds recorded large losses. A similar risk plagues Asia ex-Japan.
Just as Japanese managers who have weathered the storm are now emerging with more reasonable and stable returns, well risk managed hedge funds in Asia will find the region a rich and rewarding space. Activists will find particularly interesting situations if they are happy to be constructive critics. Credit funds are finding improved market depth and range. Stock borrow improves daily in Asian markets while derivative technology opens up shorting opportunities in India and China.
The attraction of Asia is clear: India and China as the new engines of world growth. The complex relationships within Asia mean that obvious trends often result in counter intuitive outcomes. For the astute investor, the less efficient markets of Asia present rich pickings.
Commodities:
A four year bull market in commodities, following nearly 20 years of dead money, has led to strong interest in the asset class. This despite a very volatile and negative 2006. Interest has rotated first from precious metals in 2002 as a store of value, USD short, to industrial commodities such as base metals and energy on the China growth story, to softs and ags almost by default. A secular growth story supporting a long only exposure based investment strategy no longer works. Investors seek more intelligent trade expression which they hope to find in hedge funds. Whether they will find it is another matter. Commodities are factors of production with very peculiar supply dynamics. Too many financial traders participate in a market which should be driven by marginal cost. The result is ample alpha for the skilled trader and a high attrition rate among managers.
Sunday, 4 February 2007
Hedge Funds: Excellent Scapegoats, an example of what could have happened
Hedge funds are secretive, or private businesses who shun the limelight. Their success and sometimes spectacular implosions make them excellent news material and often a target for sensationalists. They are also excellent scapegoats. Here is an example of how this can be done:
Assume now that you are the ruler of a small emerging market economy. In South East Asia, say. The year is 1997 and things are getting a bit rough in the financial markets in the region. Your currency is trading at 3.20 to the USD. You see weakness in the currency of your neighbours to the north and further south. You read and hear daily about the turmoil that traders and hedge funds are causing with their speculative attacks on South East Asian currencies. Your currency, thankfully, has been spared. You decide to take preemptive action to head of any speculative attack.
You call your central bank governer to take action. In a matter of days your currency is at 3.50. The newspapers report of speculative attacks on your currency. You are annoyed. You call your central bank governer again demanding more action. One week later the currency is at 3.80. Interest rates are put up to deal with the run on the currency. The stock market begins to react, badly. More news about a general speculative strike against the financial markets of your country.
Night meetings over the local equivalent of pizza with the finance minister, the central bank governer, powerful local bankers and businessmen. The currency slips towards 4.20 to the USD. The equity market is falling. Some of your local corporates have been borrowing in USD and DM. Not a good move after all. Nobody can identify the source of speculative selling.
At last it dawns on someone in your crisis committee. Your currency is quoted in number of local units per USD. Someone subtly hints it to you. Realization. At 3.50 there was little interest in your currency or stock market. Your directive to the central bank for preemptive action led them somehow to take the currency to 3.80. You are furious. Embarrassed. You need a scapegoat. Hedge funds! Who is the biggest. Soros! Perfect. The personal profile is perfect. George Soros did it.
Maybe he did but not at 3.50. From 3.80 to 4.20 perhaps.
You need to stem the flow. Stop the bleeding. Stop everything. How about a currency board? A peg? Perfect. 3.50? It would never hold. 4.00? Doesn't help. 3.80.
Assume now that you are the ruler of a small emerging market economy. In South East Asia, say. The year is 1997 and things are getting a bit rough in the financial markets in the region. Your currency is trading at 3.20 to the USD. You see weakness in the currency of your neighbours to the north and further south. You read and hear daily about the turmoil that traders and hedge funds are causing with their speculative attacks on South East Asian currencies. Your currency, thankfully, has been spared. You decide to take preemptive action to head of any speculative attack.
You call your central bank governer to take action. In a matter of days your currency is at 3.50. The newspapers report of speculative attacks on your currency. You are annoyed. You call your central bank governer again demanding more action. One week later the currency is at 3.80. Interest rates are put up to deal with the run on the currency. The stock market begins to react, badly. More news about a general speculative strike against the financial markets of your country.
Night meetings over the local equivalent of pizza with the finance minister, the central bank governer, powerful local bankers and businessmen. The currency slips towards 4.20 to the USD. The equity market is falling. Some of your local corporates have been borrowing in USD and DM. Not a good move after all. Nobody can identify the source of speculative selling.
At last it dawns on someone in your crisis committee. Your currency is quoted in number of local units per USD. Someone subtly hints it to you. Realization. At 3.50 there was little interest in your currency or stock market. Your directive to the central bank for preemptive action led them somehow to take the currency to 3.80. You are furious. Embarrassed. You need a scapegoat. Hedge funds! Who is the biggest. Soros! Perfect. The personal profile is perfect. George Soros did it.
Maybe he did but not at 3.50. From 3.80 to 4.20 perhaps.
You need to stem the flow. Stop the bleeding. Stop everything. How about a currency board? A peg? Perfect. 3.50? It would never hold. 4.00? Doesn't help. 3.80.
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