Tuesday, July 03, 2007

Veryan Allen has something to say about Bear Stearns

Bear Stearns hedge fund?

What is a hedge fund? Absolute returns in difficult times is surely the acid test. The sub-prime meltdown has revealed several leveraged beta bundlers. Anyone with genuine skills and experience knows illiquidity can be expensive. The familiar problems of model assumption errors, stale valuation, gearing thinly traded assets and disguising beta as alpha appear yet again. Whether it is high yield debt, emerging market equities or commodities futures, if a fund can't thrive during NEGATIVE returns for the assets in which it trades then it is NOT a hedge fund. BSC is a good firm whose stock I have owned for years (and intend to keep) but investors cannot ever afford to relax the criteria defining a real hedge fund. Bear Stearns' two troubled investment products were never hedge funds.

Sub-prime mortgages still seem to be causing trouble and the effects are likely not yet fully "contained". Some real hedge funds like Paulson & Co. positioned well and some non-hedge funds like BSAM's, United Capital, Dillon Read Capital Management, Queen's Walk and Caliber demonstrated their lack of skill. Perhaps there will be further contagion; skill is rare so other incompetent "hedgies" may have been caught out. Being forced to adjust April performance numbers from -6.5% to -19% shows just how poorly BSAM's portfolio managers had stress tested for difficult conditions. Why do so many amateurs think the good times will last for ever? Hopefully those funds dumb enough to gear up investments in the equity tranches of sub-prime CDOs and think they wouldn't have to pay the piper will be wiped out. Check out an ABX chart; this is not financial armageddon but it is not over yet.

REAL hedge funds are MAKING MONEY out of these ongoing credit events. Three basic questions to detect a proper hedge fund. 1) Will it make money in a bear market for sub-prime credit or residential real estate? 2) Are the potential returns sufficient to compensate for the illiquidity risk? 3) Do senior management of the sponsoring firm have 50% of their total wealth in the particular product? A true hedge fund should be able to answer "yes" to each question but it was all "no's" for the elegantly(!) named High-Grade Structured Credit Strategies Enhanced Leverage Fund and its "safer" sister. Bonus questions 4) Will you blame funding counterparties if you blow up? 5) Is your "hedge" really a hedge? There is NO excuse for not understanding how the game is played or the behavior of your portfolio in ALL possible scenarios.

What's even worse than a closet index fund? A leveraged index fund. And that is what most of these toxic waste CDO funds were in effect running. Making money in BAD conditions is what hedge fund clients pay the 2 and 20 for; long only funds are the ONLY products you need in good times. Having criticised some of John Bogle's thinking in my previous post let's make something crystal clear; index equity and credit funds are the best investment IF (and only IF!) you think the asset class is going up. It is a waste of time and money to allocate to higher fee actively managed funds that simply fall apart when their market falls apart. BSC is in the S&P 500 so passive proponents are affected even if trying to avoid hedge funds themselves.

Credit hedge funds will receive end of June and end of quarter pricing marks very soon. Will some others join Bear Stearns, Cheyne Capital and Cambridge Place in getting rather different prices than their "mark to model" or "mark to dealer" valuations implied? Pricing to a model is fraught with issues not the least of which is assuming the model is correct. There was obvious autocorrelation and Sharpe ratio "enhancement" when I looked at those funds over a year ago. Model arbitrage is a great investment strategy since counterparties tend to think they have made money out of you, until the tide turns. Then they also discover that they are short lots of optionality and not be able to buy back that convexity, gamma and volga remotely near prices they assumed.

The biggest risk in pricing models is Assumption Risk. The trouble with bull and bear markets is that the price behavior and the width of bid-offer spreads can be quite different under the two regimes. If you are in roach motel assets loss cutting gets expensive. Bear Stearns was leveraged long CDOs of illiquid securities and "hedged" by shorting liquid ABX indices. As with similar problems in the past, BSC was long illiquid, short liquid. If a fund is leveraged and can only sell to a limited number of counterparties who KNOW it has a problem, getting out becomes difficult. Low end software like MeasuRisk doesn't help when risks are unmeasurable. And aren't you supposed to have proper risk management in place BEFORE you lose money not AFTER the fact?

You really have to know what you are doing when designing models of prepayment and mortgage credit risks; nothing in the academic literature or public domain works. Credit is neither stochastic nor continuous and when it jumps it really jumps. I can count the number of good mortgage-backed securities hedge funds on one hand but I would need many more limbs for the traders who have been blown away by not having adequate quantitative abilities to manage ALL the exposures in this complex field. When a product is very thinly traded, indicative dealer prices are pretty useless. If a fund is investing in illiquid instruments the fund valuation needs to be marked to the real bid, in size. Mark to market is possible only when there is a market.

There is nothing inherently wrong with investing in "untraded" assets provided the risk-adjusted returns are sufficient to compensate. In bearish credit conditions ideally you usually want to be long the liquid and short the illiquid but weaker credit funds and less experienced managers do the opposite. Of course there have been skilled hedge funds in the areas of distressed debt and collateralised loans for a long time but their returns have justified the risks. But with some funds, even with apparently high absolute performance, often the excess RISK-ADJUSTED returns (the alpha!) was negative.

Just as with LTCM, being long the illiquid and short the liquid works well until the market reverses and then years of consistently positive months get given back in one massively negative month. Leverage, liquidity and valuation risks are ONLY worth taking if you are compensated for those risks and plainly this was not the case. This is where investors in a hedge fund need to look at whether the potential returns justify the potential risk. With the rare good hedge fund it does but NOT with the many "hedge fund" journeyman.

With public equities, liquid bonds, fx and futures valuation is immediate, transparent and generally unarguable and there is plenty of alpha available IF you have the skills to find it. While liquidity is a variable even on an exchange you have access to the widest number of potential buyers and sellers. Venturing into illiquid areas raises the risk exponentially when there are much fewer counterparties to trade with. Leverage just exacerbates the problems. Funds investing in illiquid assets should be achieving MUCH higher performance than liquid funds. Yet some investors seems to compare them side by side without considering the non-linear risks of gearing thinly traded securities.

Investors need to verify that a money management product purporting to be a hedge fund and charging hedge fund fees actually is one. Out of 10,000 funds that claim to be hedge funds, how many actually are hedge funds? The best estimate I have is maybe 25% tops. But of those how many are skilled? Perhaps 500-1000 at most. In other words probably only 10% of products that say they are hedge funds actually are GOOD hedge funds. Skill is rare by definition. While some investors might be discouraged by the bad news of 1/10 odds of picking a skilled fund, the good news is that they CAN be isolated in advance.

Identifying a good hedge fund is as rare a skill as being able to identify a good security. Some multi-manager products and weaker funds of funds have reduced their fees because they think picking hedge funds is easy! Most of them don't have the experience or analytical resources to decide what is and what is NOT a hedge fund, let alone trying to find the BEST ones. It is difficult but NOT impossible. Do "lower" fees help if an "advisor" puts you into a fund that drops 100%?

Hedged means you are able to manage your risks and STILL generate performance with such insurance in place. I can't forecast but I can certainly anticipate and prepare for any eventuality. There has been a lot of commentary on the so-called Bear Stearns "hedge fund" debacle, despite being a tiny proportion of the credit beta industry. Maybe it will indeed negatively affect the markets but it just enhances the case for quality hedge funds.

There will always be semantically-challenged products that screw up which is why due diligence and alignment of interests are so important. Investors should select real hedge funds NOT leveraged beta products that SAY they are hedge funds. The industry needs to rid itself of non hedge funds who can't measure, manage or hedge their risks and ride beta when proper managers aim for alpha. Fortunately we can rely on the market to conduct these shakeouts.

The colleagues of Ralph Cioffi may have liked the fund but how much of his own cash did James Cayne have in? A safety check for investors is to verify senior management are eating their own cooking. Another strength is that when someone else implodes good hedge funds should make excellent returns. In bull markets lots of unskilled traders make money; it is bear markets that show who is good. Just saying something is a hedge fund does not mean it is.
Copyright Veryan Allen 2007.

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Lunch is for wimps

Lunch is for wimps
It's not a question of enough, pal. It's a zero sum game, somebody wins, somebody loses. Money itself isn't lost or made, it's simply transferred from one perception to another.