Tuesday, July 31, 2007

Sowood Is So Sowwy

The letter a hedge fund manager sends to his/her investors in the event of bad news like, say, a meltdown, etc., is an exercise in trying to jam a huge ego and an “I’m sorry, but I’m not really sorry, but I’m saying I’m sorry” onto one page. We’ve been calling him out a lot lately for what he’s done wrong, but one thing James Cayne did right was his memo to investors. As you well know, Cayne informed them that, contrary to what he and his colleagues had been pretending in the weeks previous, Bear Stearns’ two hedge funds were worth jack. As this charade was getting exhausting, and not because it’s wrong to lie, the big guy took it upon himself to come clean with the sad sacks (his words) who were silly enough to give Bear their money only to watch it be lit on fire. This would have all been rather unfortunate, Cayne went on, if it were going to hurt employee compensation at year end, which it won’t, thank god, so that’s pretty much it. Shipshape.

Sadly, Sowood Capital Management founder Jeff Larson has apparently not mastered the art of this particular love letter, and comes off as actually rather regretful and apologetic in the one he sent to his investors yesterday, re: selling “substantially all the funds’ [Sowood Alpha Fund LP and Sowood Alpha Fund Ltd] portfolio to Citadel,” which was more than happy to take them on. Larson even says “We are very sorry this has happened.” It’s actually all rather off-putting. Full letter (which seems to imply Sowood will be shutting down) after the jump.

July 30, 2007

To Our Investors in Sowood Alpha Fund LP and Sowood Alpha Fund Ltd.:

Sale of Assets
Today we made the painful and difficult decision to sell substantially all the funds' portfolio to Citadel Investment Group. We took this step to protect your investment. Our actions over the weekend followed severe declines in the value of our credit positions and non-performance of offsetting hedges. Given what we were facing and our uncertain ability to meet margin calls, we sought other buyers for some or all of the positions. Citadel offered the only immediate and comprehensive solution. The transaction enabled us to avoid anticipated forced sales at extreme prices that would have been made in order to satisfy obligations under our counterparty agreements.

Performance Update
After the transaction with Citadel, the Net Asset Value (NAV) of Sowood Alpha Fund Ltd. and Sowood Alpha Fund LP will have declined approximately 57% and 53% month to date respectively, and approximately 56% and 51% calendar year to date respectively. As a result, our NAV as of July 30 is approximately $1.5 billion.

Current Plans
We will be advising you of plans to distribute assets as soon as we can, subject to reserves and holdbacks for completion of the audit, contingencies and potential liabilities. Proceeds will be distributed in accordance with the governing documents of the funds. We will seek to retain key staff to manage the distribution process going forward. We understand this is a very difficult moment for you and are committed to keeping all lines of communications open. Since we are still working through positions and details of the transaction, it will take us a few days to organize everything in a manner that will satisfy your questions. That said, we are planning to hold one-on-one meetings starting next week with investors. In addition, we are planning a listen-only conference call later this week at which time I will discuss the actions we took over this past weekend and next steps.

During the month of June, our portfolio experienced losses mostly as a result of sharply wider corporate credit spreads unaccompanied by any concomitant move in equities and exacerbated by a marked decline in liquidity. This occurred over a broad range of credit related instruments. In the first two weeks of July, spreads continued to widen, and we experienced a loss similar to June. The weakness in corporate credit - particularly focused on loans and loan credit default swaps - accelerated sharply during the week of July 23. Until the end of last week these developments, while reducing the value of our portfolio, were manageable. Our counterparties had not severely marked down the value of the collateral that the funds had posted nor changed our margin terms, and immediate liquidity needs could be met. However, towards the end of last week, given the extreme market volatility, our counterparties began to severely mark down the value of the collateral that had been posted by the funds. In addition, liquidity became extremely limited for the credit portion of our portfolio making it difficult to exit positions. We, therefore, reached the conclusion over the weekend that, in the interest of preserving our investors' capital, the appropriate course of action was to sell the funds’ portfolio. We believe that the arrangement with Citadel provided our best option under the circumstances, since we were unable to find other sources of liquidity.

We are very sorry this has happened. We have always attempted to do the very best for our investors. A loss of this magnitude in such a short period is as devastating to us as it is to you. We are committed to acting in the best interests of the funds' investors and to keeping investors informed of decisions made in furtherance of this objective. We sincerely appreciate your patience and understanding during this challenging period.

Jeff Larson

Monday, July 30, 2007

PE Week - Random Ramblings

Goldman Sachs was feeling its pop lit oats on Friday, when it sent out client research titled "Hung Bridges and The Deathly Hallows." It included such gems as:

But like J.K. Rowling’s protagonists, the battle between investor sentiment and company fundamental will continue until the demise of one of the participants.


It is impossible even for a wizard like Harry Potter to reconcile two facts: Stocks cannot BOTH melt down because the market fears financial institutions will have to fund and hold levered loan commitments while at the same time shares of target companies sell off on the belief the same transactions will not close.

That last line led to Goldman’s primary recommendation: That folks should buy stock in the 22 listed companies that already have agreed to go public -- many of which are currently trading below their buyout price. For example, Alliance Data closed Friday at $75.33 per share, even though Blackstone has agreed to buy it for $81.75 per share. And I tend to agree, but for a different reason than Goldman.

My reason is simple: I don't believe the banks will bail, due to the pending breakup fees, legal fees and reputational fees. A few deals might fall apart, so consider the 22 as a bucket best kept whole.

Goldman, however, sets up a false choice: Investors cannot simultaneously believe that:
(1) Banks will make bad loans to fund LBO deals, which is why the overall market is tanking.
(2) Banks won't make bad loans, which is why target company prices are sliding.

But that’s assuming that it’s the same investors making both bets. What if average investors have lost faith that future take-privates will get done, thus lowering the artificial markups based on the dream of future LBO premiums – while investors in the 22 stocks are simply hedging their bets after having gotten substantial gains? In fact, I think that's exactly what's happening.

*** Even if the Golden Age of Buyouts is over -- or at least on vacation until Labor Day -- it's not as if the market will disappear. Remember, deals got done back when lenders were stingier -- and there is exponentially more dry fund powder today. Returns may go down, but the market will survive just fine. (that's right, I'm not bearish, just a contrarian)

Sunday, July 29, 2007

Hedge Funds Pounce on Debt Amid Turmoil

Unfazed, Some Take
Advantage of Reluctance
To Buy Loans, Bonds
July 28, 2007; Page B1

The turmoil in the credit markets is beginning to wound some high-profile hedge-fund managers -- but it's prompting others to swoop in and snap up some beaten-down assets.

Sowood Capital Management, a hedge-fund firm founded by a manager who had helped run Harvard University's endowment, has sustained significant bond losses lately. The firm is down about 10% so far this year.

[ ]
Scorecard: How credit-market tremors have affected junk bonds, LBOs and hedge funds

The firm, which trades both stocks and bonds, has sold various positions, including merger-related shares, to raise cash to deal with continuing difficulties in the credit markets and to raise money for potential margin calls from its lenders.

A number of hedge funds have profited by anticipating the difficulties in the housing market. But others made money in recent years through holdings of riskier debt, and now these managers are seeing their securities drop in value. At the same time, their investors want to get out of the funds and lenders are demanding more collateral, forcing additional sales.

Some financial pros sitting on cash are looking to take advantage of the situation. Wall Street's Goldman Sachs Group Inc. is launching a $20 billion fund to invest in corporate debt. The fund was expected to amount to $12 billion but has been expanded to take advantage of the turmoil in the market, according to people familiar with the matter.

"It may be fortuitous, but the timing is superb as it relates to the markets," says John Danhakl, a partner with Los Angeles-based private equity firm Leonard Green & Co. LP.

A Goldman spokesman declined to comment.

Hedge funds such as TPG Axon and GSO Capital Partners, which had kept some of their powder dry, were among those pouncing on debt of companies whose bonds have traded down amid a massive supply of debt, according to people close to the matter. They also are offering to help private-equity firms finance deals that the banks are unwilling to underwrite, these people add.

These funds are taking advantage of a sudden unwillingness on the part of investors to continue to buy loans and other products that have financed buyout deals.

Funds such as TPG Axon and GSO are approaching the banks and offering to take both loans and bonds off their hands -- at a sizeable discount, attracted both by the discount and the generous yield. Several hedge funds, for example, bought huge chunks of junior slices of the debt of Dollar General at 87 cents on the dollar, which amounts to a 17.5% yield.

Kohlberg Kravis Roberts & Co. won the retailer in an auction which saw Bain Capital, Blackstone Group and TPG all drop out as the price rose. Investors are especially nervous about Dollar General because of the debt load and because there is general concern about retailers vulnerable to a slowdown in consumer spending.

Hedge funds are discovering that their ability to borrow money to bet on the markets is drying up because the banks themselves are under pressure, left with commitments to fund deals as investors retreat. In many cases, brokers are calling hedge funds and asking them to post more collateral as the value of their holdings plummets.

At least one hedge fund is unfazed by the new environment. AQR Capital Management LLC, based in Greenwich, Conn., plans to file registration documents for an initial public offering of shares on Monday intended to raise $500 million, according to a person familiar with the matter. The deal is being handled by Goldman, Lehman Brothers Holdings Inc. and Credit Suisse Group's investment banking unit, this person said.

Run by a group of former executives from Goldman's asset-management division's quantitative-research team, including Clifford Asness, AQR, with roughly $35 billion under management, is one of the world's largest hedge funds. The firm was founded in 1998 and has had top-notch returns.

Fund managers on Friday were eagerly trying to determine which of their colleagues were feeling the pain from the market's drop. So far, Sowood seemed to be one of the only prominent names affected. Sowood has met the margin calls and isn't closing down, according to a person familiar with the matter. Sowood doesn't face any potential redemptions from its investors until the end of 2008.

At Sowood, the person close to the matter says the hedge fund is down about 10% this year, with most of those losses coming in the past two months.

Sowood was launched with fanfare by Jeffrey Larson, who has one of the most-impressive pedigrees in the hedge-fund world. Mr. Larson was among a group of managers who picked investments for Harvard Management Co., which remains an investor in the firm.

--Kate Kelly, Anousha Sakoui and Kate Haywood contributed to this article.

Write to Gregory Zuckerman at gregory.zuckerman@wsj.com, Henny Sender at henny.sender@wsj.com and Alistair MacDonald at alistair.macdonald@wsj.com

Managed Futures: Changing Course

Barron's Online
Monday, July 30, 2007

Becalmed No More

Managed Futures: Changing Course


Disrespected for their allegedly exorbitant costs, their perceived riskiness, their widespread reliance on inscrutable black-box trading systems and all manner of other things, these funds bear a heavy burden: almost five consecutive years of underperformance against just about every equity benchmark.

But a funny thing has happened on the way to hell. The assets invested in managed futures, now widely regarded as a subset of the hedge-fund universe, have more than tripled since 2002, the last year they beat the S&P 500. As of March 31, investors had an estimated $172 billion in this sector, according to Barclay Trading Group, a data provider based in Fairfield, Iowa. One reason: The markets appear to be becoming more volatile, and managed futures thrive on volatility.

Just look at what's happened to the John W. Henry & Co. Financial and Metals Portfolio. On March 31, it was down almost 20% for 2007 and in the midst of a three-year, 40% slump that was the longest and one of the deepest in its 22-year history. The decline and resulting investor redemptions, cost the firm -- controlled by John W. Henry, principal owner of the Boston Red Sox -- more than 80% of its assets, which now stand at little more than $500 million.

In the second quarter, however, the portfolio surged 25%. Ironically, Merrill Lynch (MER) ended a long-term relationship with Henry in April and pulled its mostly retail investors' assets out of his fund -- almost exactly at the portfolio's nadir.

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Henry declined to comment for this article. But his managed-futures operation certainly wasn't alone in performing poorly over most of the three past years. Barclay Trading Group founder Sol Waksman, who has followed managed futures since 1985, says this span was the most unusual he's seen. Other than funds that invested heavily in energy, none seemed to have a trading strategy that worked well, regardless of whether their focus was long-term (which in this world means several months) or short-term (a week or a day).

"PERFORMANCE HASN'T been good, and once upon a time, that would have meant big redemptions and people going out of business. Instead, we've seen this huge growth in assets, and those new investors being willing to stay committed," Waksman observes. "Perhaps they've got the message about the strategy's diversification benefits" for investors in stocks and bonds.


And perhaps some of it is a perception disconnect. Managed futures are widely viewed as a proxy for commodities. Its managers are regulated as "commodity-trading advisers" and "commodity-pool operators" ultimately by the Commodity Futures Trading Commission. Yet it's been a long time since commodities dominated the holdings of advisers specializing in managed futures.

The long-running Campbell & Co. FME Large strategy -- the acronym stands for financials, metals and energy -- currently has about a third of its $10 billion-plus assets in currencies, and much of the rest in roughly equal chunks of stock indexes and interest-rate instruments. Commodities rarely account for more than 20% of its positions.

Many commodity markets are simply too small to accommodate the positions that large managers need to move the needle. In fact, few managers overseeing more than $1 billion trade as much as half their assets in commodities, including the more liquid energy and precious metals. Most of those with $2 billion or more are heavily weighted toward the deeper, more liquid, financial-instrument market.

Although the going has been challenging for managed-futures managers over the past few years, some have excellent long-term records. Among them: Renaissance Technologies, a New York-based quantitative shop founded by James Simons. Its Renaissance Medallion Fund, long closed to new investors and essentially a managed-futures vehicle, has returned more than 35% annually for almost 20 years, after subtracting a very hefty 5% management fee and a 44% incentive fee on any profits.

RENAISSANCE IS gearing up to open a new managed-futures fund in the fall. (Simons declined to comment for this article, citing regulatory concerns.) In early July, the industry newsletter Hedge Fund Alert reported that the new vehicle is designed to manage up to $25 billion, and would take a longer-term approach than famously frenetic Medallion. It's reportedly modeled on the Renaissance Institutional Equities Fund, which has amassed about $30 billion in assets in barely two years. The projected size of the fund implies that it will trade only the most liquid futures markets around the world.

The new fund probably offers a range of fee structures less startling than Medallion's, and even the sector's standard 2/20 structure -- 2% management, 20% incentive. Renaissance Institutional Equities Fund's fees range from a fixed 2%, with no incentive fee, up -- or down -- to an option of a fixed fee of 0.5%, along with an incentive fee of 35% for any gains over the Standard & Poor's 500 index's (dividends included).

To invest in the new fund, investors will have to shell out a very sizable minimum sum -- Renaissance Institutional Equities demands $25 million. Some financial institutions provide access to that product through pooled vehicles with lower, although still substantial, minimums, but it's unclear whether Renaissance will allow that for the new fund.


In less rarified air, long-standing efforts to make managed futures more accessible, and less expensive, for retail and "mass-affluent" investors are finally putting products on the investment shelves. Historically, those investors got in through retail-brokerage offerings that larded rich layers of additional cost, including sales charges and management fees, onto the strategy's already high fee structure.

FUTURES OBLIGATE participants to sell or buy commodities or financial instruments at a specific time, and they allow them to make big leveraged bets, which can be dangerous if they backfire. Relatively few individuals trade futures on their own, viewing them as too risky.

Asset Alliance, a New York-based boutique, has announced plans for a hybrid closed-end fund aiming to replicate the Barclay Group's BTOP50, an index reflecting the net trading performance of 23 large trading advisers. The fund will require only a $10,000 minimum, and even allow monthly redemptions, at net asset value. Designed to be sold through a network of wealth managers and brokerages, the fund is expected to be launched in October.

In March, the Rydex Managed Futures1 Fund (RYMFX) became the first conventional mutual fund to use a managed-futures strategy. With a $2,500 minimum investment, daily liquidity, a 1% redemption fee on shares owned for less than 90 days and a 1.65% expense ratio, it's already attracted $150 million in assets.

Instead of investing in managed-futures advisers, it aims to replicate the performance of the S&P Diversified Trends Indicator, a long-short futures investment benchmark based on 24 U.S. exchange-traded contracts in 14 sectors, divided evenly among commodity and financial futures.

The DTI is based on technical indicators and is "positioned each month...based on price behavior, relative to its moving average" -- allowing it to capture profits in both up and down markets, according to an S&P white paper.

It claims, accurately, both low volatility and a low correlation with stocks and bonds. But it does include some rules that few, if any, managed-futures advisers would implement. For example, it doesn't invest in stock-index futures (thus reducing its correlation to the equities market), and it doesn't short energy issues, which can jump quickly on any inkling of tight supply.

Rydex says that that the pro forma risk-return profile of the DTI is more conservative than that of actively managed futures funds. Its annual compound return of 11%, with a 6% standard deviation (a measure of riskiness), compares with the BTOP50's yearly 9.44% return and 13.5% standard deviation over the past two decades.

SINCE THE DTI went live in January 2004, it has outperformed the BTOP50, and its correlation with the S&P 500's total return remains extremely low, at just 2%. In contrast, the BTOP50's correlation with the stock-market benchmark has been almost 60% since 2004, undermining one of the most important selling points for managed futures -- diversification. (Over 10 years, the correlation is a negative 17%.)

Managed futures probably will never be a mainstream investment, but the availability of new ways to play them, combined with the return of market volatility, is bringing them more respect.

GREG NEWTON is a free-lance writer, based in Stratford, Conn.

Saturday, July 28, 2007

Mauldin excerpt

When the Facts Change

John Keynes, upon being confronted by someone that he had made a different prediction than what he held a his current view, is famously quoted as having said, "When the facts change, I change my mind. What do you do, sir?"

And I think that everyone in the group would agree. While we take the "game" of investments very seriously, if you do this long enough, you will get humbled quite often. That is why you constantly evaluate your analysis, and change them when the facts change.

And the credit markets are changing their opinion in a very rapid manner. Earlier this spring, the credit markets started to get concerned about subprime mortgages. But "everyone" said it would not spread to the rest of the credit markets, so there was no cause for concern. I was not so sanguine. I have consistently thought that the entire credit markets would be affected, through a tightening of credit standards. And now the markets are starting to agree. Let's look at a few charts, and then think through the opportunities, especially in the high yield space.

Let's first look at the BBB paper in the mortgage markets. It is now trading at less than $.38 cents to par (100), and that chart is still pointing down. Catch a falling knife, anyone?

The Subprime Virus

But that is just the subprime stuff, John. A few weeks ago, no one thought it would spread. But spread it has. And spread is the correct word. Spreads on high yield bonds have widened. By spreads I mean the difference, or spread, between the yield on a bond and its corresponding yield on a government bond (of the same time frame). If a high yield bond had a spread of 300 basis points, or 3%, then it would be yielding 3% over the government bond.

Let's look at this next chart, which is the spread on credit default swaps on high yield bonds. Note that the spread has risen from below 250 basis points as recently as early June to almost 500 basis points this morning. That also means that high yield bonds have dropped in value by almost 9% from the high, which was slightly over par less than two months ago!

In other words, less than two months ago, the average trader and manager did not think there was any risk in the high yield space, or at least there was historically less risk than at any other time in history.

So, let's look at the next chart to put this into perspective. Let's look at this chart from Bear Stearns (courtesy of good friend, business associate and high yield maven Steve Blumenthal of CMG) which shows high yield spreads for the last almost 20 years. Now, this is a different index than the Markit CDX high yield, with different underlying bonds, but the point is to show that even though yields have almost doubled, they are still not all that high by historical standards.

Now, even if you take out the ugly periods in 2001-2 which were caused by Enron, WorldCom, etc. it would still take another sharp rise just to get back to the average yield spread.

Now, Steve tracks yet another high yield index. It reached a low in late February of this year of a spread over treasuries of only 209 basis points. Today it is at 504! That is a significant move! And the spreads are widening. They could easily (and probably should) go higher.

So, what stops them from going back to the 2001 yield spreads? Just as CDOs and subprime derivatives have made the markets more volatile and risky, Credit Default Swaps on high yield bonds will soon have traders licking their chops in anticipation.

First, let's point out that defaults are at an all-time low. Corporations are generally in better shape than they have been in a long time in terms of being able to manage their debt. Even in a slowing economy, there is not reason to think that defaults are going to rise back to 2001 levels.

Let's start with a very simplistic analysis. Say you're a high yield trader sitting at a fund or a prop (proprietary trading) desk at a major investment bank. You can buy $40 million of high yield bonds yielding almost 5% over cost by putting up just $10 million in collateral. You get 5% on you margin capital and a total of 20% ($40 million x 5%) on your invested capital from the excess yields on your bonds (which you probably bought as a credit default swap, avoiding the time consuming hassle of buying the actual bonds). You are making a total of 25% on your money.

So far so good. If the bonds drop 2.5% in value, you are down 10% on your margin money but still making a net 15% over a one year period. However, if they drop 10%, you are down 40% and it will take two years of those high yields just to recover your initial capital, if you and your investors can stand the pain and the margin calls.

But what if you were leveraging a few months back when yield spreads were just 200 basis points? You were getting a total of 13% returns (4 x 200 basis points on the spreads plus your 5%). Not very juicy, but respectable in a low return world. But then the market falls outs, and drops by 9%. You are now down almost 36% of your original capital, and it will take a long time to get back to even, assuming you can hold on that long, and of course assuming you meet your margin calls. Otherwise you take the losses.

And that will be the game over the coming months. The underlying debt that creates the credit default swaps in the high yield space is well defined and transparent. You can bet that there is a lot of work being done on the credit quality of each of those bonds that comprises the index. At some point, traders step in and decide the risk is worth the reward, and the market stops falling.

By the way, this whole market is a fairly recent development. You couldn't do this even five years ago in any size and with any liquidity. Now any Tom, Dick and Harry fund or prop desk can do it. But if trader's think the market is going lower, they will wait.

Credit? What Credit?

Over 40 Leveraged Buy Out (LBO) deals have been pulled in the past few weeks. The biggest investment banks are having to "eat" the paper on the Chrysler and Boots LBOs, as they cannot find buyers for the paper. In essence, they committed to lend the money and planned to sell the bonds into the market, keeping fat fees and commissions. Now, they have to put the loans onto their books.

This is not all bad. It simply means they have to use their own capital, and at yields lower than they could get today, to fund the deals. It is not that the paper is bad. It is just that the market wants a higher yield, and the banks would have to lose money to sell at the higher yields.

But what it does mean is that now the banks have less capital to fund new deals, and that private equity funds will have to pay more interest and put more equity into a deal to get it done. That makes a lot of deals less attractive than they were a few weeks ago.

Part of the sell-off in the stock market is from stocks which were thought to be "in play" but are now no longer take over candidates. The wind in the sails that has been private equity and buybacks is dropping, as funding is drying up rapidly.

Issuance of collateralized loan obligations (CLOs) soared to a record $57 billion in the first half of 2007. That has since slowed to a trickle. So far this month, just $1.9 billion of CLOs have been sold, according to Standard & Poor's Leveraged Commentary & Data. "Leveraged finance's cash engine -- the CLO market -- has ground to a halt," S&P noted in a written commentary on July 19. (WSJ Online)

CLOs prices, like high yield bond prices, have dropped in the past month. Just last month they were priced over par. Now the index is down about 6%, as yields have risen from a spread of a little over 100 basis points to almost 350. That is a major change. And this is on loans, gentle reader, which are generally senior to bonds and usually have some type of collateral baking them.

This simply illustrates that all the credit markets are acting in tandem. Part of the reason is that the margin clerks are demanding increased collateral on the riskiest loans, and when there is a crunch you sell what you can and not necessarily what you want. That is why nearly every asset is going down in tandem - stocks, bonds (except for government debt), commodities, gold, etc.

This is acerbated substantially by the unwinding yet again of the yen carry trade, as the yen is rising rather rapidly against a host of currencies and those who borrowed long yen are rushing to the exits only to find everyone else trying to get out the same small door.

The yen was almost 124 to the dollar almost a few weeks ago. Now it is below 119, a drop of over 4% in a few weeks, which is huge in the world of currency trading.

If you are leveraged long the yen to invest in the Australian or New Zealand dollar (or whatever your poison of choice is), you are now down 3-4% times the amount of your leverage in just a few weeks. That is also putting pressure on the markets.

In short, it is going to be a while before credit markets stabilize. They will, of course. But it means businesses are going to be paying higher rates for loans, mortgages are going to be harder to get (and now cost 50 basis points more than they did a month ago), and fewer deals are going to get done.

The subprime virus has spread. The markets are getting a fever, and like most viruses, it will simply have to run its course.

Next week, we will look at what all this means for the economy, but the short version is that it will mean slower growth in the last half of the year.

Thursday, July 26, 2007

Risk management and high conviction investing

Investing is hard. We have referenced this post any number of times. Not because it is particularly revolutionary, but because it rings true in any number of contexts. Undoubtedly recent volatility and market stresses have put any number of investors on edge. However, a recent piece by a prominent investor, Mohamed El-Erian of Harvard Management Company, may mean a more difficult time for investors in the future.

His entire comments are found at FT.com but this (extended) excerpt from a Helen Thomas recap at FT Alphaville gives you the gist of the argument.

Trouble is, suggests El-Erian, that the past few years, when virtually any risk asset has outperformed, has not been a good environment in which to test the appropriateness of portfolio construction, and whether by diversifying across risky asset classes, portfolios will continue to mitigate risk sufficiently.

we may well be in the middle of a regime shift: exiting a world in which the difference among individual investors’ performance was essentially a function of the degree of their exposure to the most illiquid and leveraged asset classes, and entering a world where more sophisticated risk management capabilities will increasingly be the main differentiator.

Recent market performance, including the unwinding of the subprime mortgage mess, is going to put into clearer focus those investors who have been taking on risk in a measured and prudent way, and those that have been doing so in a more cavalier fashion.

Risk management, as mentioned, is an often neglected topic. One respect in which it is underplayed is the way in which investors apply their findings of “market anomalies” to portfolio construction. A recent paper by Ryan McKeon at SSRN.com investigates the degree to which a portfolio could tilt towards known market anomalies within the constraints of institutional-type risk parameters.

Unfortunately the answer is not all that well. The author finds “…that long-only constraints and tracking error are significant real-world impediments to successfully implementing profitable strategies from the academic literature.” That would seem to argue for loosened constraints like those found in either a hedge fund or in the newly popular 130/30 fund structure.

Again the evidence is not crystal clear on this point. The fact of the matter is that the term ‘hedge fund’ has strayed markedly from its original use to describe a truly ‘hedged’ fund that includes both long and short positions. Today hedge funds, as an asset class, have become subject to “cloners” who seek to replicate their returns in a mechanical fashion omitting the possibility of generating alpha, while capturing so-called ‘hedge fund betas.’

130/30-type funds have become popular in that they are designed to allow institutional investors to have greater latitude to implement security selection while maintaining a (relatively) constrained risk profile. This is in contrast with many hedge funds where risk parameters are entirely less rigid. The always excellent All About Alpha blog has a post up on the question of whether 130/30 or 1X0/X0 funds are really and truly “high conviction” investment vehicles. As they write:

Therefore, if you’re looking for a concentrated fund, don’t assume that 130/30 fund necessarily fits the bill. In the end, a particular 1X0/X0 strategy might not actually be ”high conviction” at all. The irony is that 1X0/X0 strategies actually represent a way for managers to express more of their beliefs, not to necessarily express those same beliefs with a “higher conviction”.

What is the upshot of all of this? If we are entering an era in which the benefits of cheap leverage and now-mainstream alternative asset classes no longer provide easy alpha, then risk management and portfolio construction will become ever more important differentiators of performance.

Investors need to realize that while risk constraints may prevent portfolio accidents they will also prevent truly outstanding performance. The irony is that in order to generate truly unique returns investors will now have to take on meaningful idiosyncratic risk. Hey, wasn’t that the way it was supposed to work all along?

Wednesday, July 25, 2007

The Great Credit Contraction of 2007

Wednesday, July 25, 2007 | 07:31 AM

What is the inter-relationship between Housing, LBOs & Stock Buybacks?

Last month, I noted 6 reasons why rising yields were a threat to equity prices:

The M&A/LBO Put
Share buybacks
Consumer spending

As of late, we have seen the threat of two of these issues increase dramatically: The M&A/LBO Put and Share buybacks are being pressured by the increasingly expensive credit.

Much of this is derived from the mess in Housing: As many of the ARM/liar loans in the Sub-prime and Alt-A mortgage group increase their default rates, the residential mortgae backed securities (RMBS) that were packaged into CDOs have begun to unravel (See WTF is going on in the ABX Markets?). All told, the many variations of these were a prime source of cheap financing. This was what has been driving private equity buying frenzy and many share buybacks. That financing source is rapidly fading.

How much is the credit drying up? According Merrill's Richard Bernstein:

"Bloomberg Radio reported this morning that the monthly issuance of Collateralized Debt Obligations (CDOs), or packages of debt instruments bundled together to form a "portfolio" of debt, dropped from $42 billion to $3 billion in the latest month. That 93% drop represents a significant tightening of liquidity that is starting to ripple throughout the credit markets. The fixed-income markets appear to be starting to understand that the days of free-flowing liquidity are likely to be behind us. Most credit spreads are widening."

See Bill Gross latest for further discussion of the great credit contraction of 2007.

Lastly, for those hoping this marks the bottom of the Housing derived credit crunch, according to the UK Telegraph, "some $2 trillion of subprime and 'Alt A' mortgage debt is falsely priced on the books of banks and funds worldwide.”

And to imagine: Some tv pundits -- cretins of the lowest order -- actually have been insisting that the Housing market would have absolutely zero impact on credit, the economy, markets and retail. What a bunch of tools . . .


UPDATE July 25, 2007 10:47am

Both CNN/Money and Reuters are confirming what the WSJ reported this morning, that Chrysler's bankers could not sell the $12B in loans for the auto business and they are getting stuck with $10B of it with Daimler and Cerberus likely responsible for the balance.

The expectation is that the finance unit will eventually get done -- but at terms that are considerably more attractive to investors. Bloomie is reporting that KKR was forced to accept much higher loan costs on the Alliance Boots deal.

Expect more term deals to falter like this in the near future . . .

Naive Investors: Illusions of Personal Past Performance

Do individuals understand their actual aggregate investing/trading performance? In their July 2007 paper entitled "Why Inexperienced Investors Do Not Learn: They Don't Know Their Past Portfolio Performance", Markus Glaser and Martin Weber measure whether individual investors can correctly estimate personal absolute and relative stock portfolio performance. Using the responses of 215 online investors to a 2001 internet survey and actual portfolio returns for these investors during 1997-2000 as calculated from their holdings during that period, they find that:
  • Actual gross returns for respondents range from -16% to +24% per month. On average, they underperform appropriate benchmarks, with a mean monthly return during 1/97-3/01 of 0.54% compared to 2.02% for the DAX.
  • Individual investors cannot accurately estimate actual personal stock portfolio performance over the past four years. The correlation between their self-estimated and actual returns is close to zero.
  • Individual investors estimate on average that 47% of other investors earn higher returns than they do. About 30% of respondents rate their returns as average.
  • Individual investors with more investing experience and higher actual past portfolio returns make better estimates of past personal returns. The improvement is significant for those with more than five years of investing experience.
  • Conversely, individual investors with lower actual returns make worse estimates of personal returns. Fewer than 5% of respondents think they had negative returns, but more than 25% actually had negative returns.
  • Individual investors who think that they had above average past performance actually did not. Also, high actual returns do not tend to make individual investors overconfident in assessing personal past performance relative to other investors.

The following chart, taken from the paper, relates actual (realized) past returns to the returns estimated by survey participants based on responses to: "Please try to estimate the past performance of your stock portfolio at your online broker. Please estimate the return of your stock portfolio from January 1997 to December 2000: [Answer] percent per year on average." The correlation between these two series is a very weak -0.07. The difference between the mean estimated return and the mean actual return is +11.5% per year, a significant overstatement of past performance. However, more than 50% of respondents correctly estimate the sign of their past actual returns.

The next chart, also from the paper, relates the actual relative investing performance of respondents to their estimated relative performance based on responses to: "What percentage of customers of your discount brokerage house had higher returns than you in the four-year period from January 1997 to December 2000? (Please give a number between 0% and 100%): [Answer] percent of other customers had higher returns than I did." The correlation between these two series is -0.01, indicating no relationship. The average difference between the actual return percentiles and the self-assessed percentiles is positive, implying that investors typically overestimate personal relative performance.

In summary, individual investors/traders should be diligent and honest in assessing personal past performance if they want to learn from experience.

For related research, see Blog Synthesis: Individual Investing.

Tuesday, July 24, 2007

Veryan Allen: Hedge fund crisis


Hedge fund crisis

Hedge funds should love a crisis. It is when market inefficiencies and mispricings are at their greatest. The current structured credit problems are nicely demonstrating the differences between good managers and non-skilled funds that simply exploited an unstable and temporary risk premium. Skill based, long volatility strategies are really the only fund management products likely to profit from market turbulence except perhaps government bonds.

Most public domain arbitrage strategies with a short volatility profile run into problems over time especially if leverage and illiquidity are involved. Two years ago we had a CB arb "crisis" and currently we have a fixed-income arb "crisis" hurting the beta bandits and helping the alpha dogs. Both offered money making opportunities to those managers with the capability to exploit them. Alpha is zero sum so the ONLY way to produce alpha is for other market participants to lose money.

It is important when picking investment styles to differentiate between skill-based and risk premium based strategies. I don't think funds dependent on simply exploiting a risk premium can be considered hedge funds. Many forms of credit and fixed-income arbitrage rely on such phenomena. The yen carry or positive yield curve trades are examples. Similarly with equities only a fraction of micro-cap or emerging market "hedge funds" actually are hedge funds; many are just playing the risk premium often exhibited by such assets during strong bull markets.

The core strengths of the alternative investment industry are strategy diversification and performance dispersion. With traditional funds if their benchmark is down, it is likely they are also down. It is unfortunate some investor capital has been lost through unjustified confidence in sub-prime linked credit products. This just confirms the need to identify proper hedge funds and even then put in only a small proportion of capital. For many investors that means quality funds of funds will probably be the best entry point. The 80/20 rule tends to apply here; only 20% of hedge funds are good and only 20% of funds of hedge funds are good at picking those funds.

In optimizing portfolio construction for alternative investments, I have usually found the maximum an investor should have in any one fund is 5% and therefore 95% in unrelated, independent strategies. Even if one accepts naive credit carry as a legitimate "hedge fund" strategy (which I do not), the most any investor would have lost from these CDO-linked meltdowns would be 5% of their TOTAL alternatives portfolio. If they have spread their bets properly they will also have money with other funds that benefit from the dislocation. That is the reason EVERY investor should allocate to short-biased equity and credit funds; even if the returns have been poor (so far!) the critical importance of negatively correlated strategies to managing portfolio risk should not be underestimated.

Most good hedge funds use quite low leverage, if at all. It is true weaker alternative investment products employing high leverage may blow up which is why due diligence is so important in determining that expertise and risk management are present. Rare event risk and massive losses are hardly confined to incompetent hedge funds. United Airlines, Worldcom and Enron and thousands of other equities lost all their shareholders' capital but that does not mean people should avoid ALL stocks just because some dropped 100%. Hundreds of dotcoms imploded a few years back losing several hundred billion for investors but Ebay, Amazon and Google and many others have performed well. Good hedge funds aren't going away any more than good technology stocks. The bear market of 1973/74 blew away dozens of long biased beta dependent "hedge funds" while George Soros, Michael Steinhardt and others thrived.

As a value investor I value strategies able to achieve consistent absolute returns at low risk. I think investors should be compensated for risk. When I look at a hedge fund I am looking for a margin of safety - performance should be much higher than the risk. Volatility is NOT risk but it is a useful first cut. Over time the S&P 500 has generated about 8% a year at 15% standard deviation so its returns have been derisory compensation for its risk. Most other equity indices and long only funds offer an even worse value proposition. Investors need products that give DOUBLE digit returns at SINGLE digit risk. 10%-14% a year at 5%-7% sigma is AVAILABLE if you do your homework. 30% a year at 15% vol is also fine but definitely NOT the other way around. Which is common sense - low risk, high return or high risk, low return?

Ideally performance is generated from securities that are liquid and frequently valued. Funds straying into illiquidity need to provide compensation for taking on that much less manageable exposure. Often it is weaker funds that wander into the minefield of things that hardly ever trade. The analysis get more complicated when a strategy is taking rare event or assumption risk. Several of the recent blow ups gave the appearance of low volatility due to investing in rarely traded, mark to model instruments. If there is a lot of leverage involved you have to look at whether the returns compensate for that gearing.

It is not in the nature of proper hedge funds to blow up, it is the nature of those who have useless trading models, baseless assumptions, don't understand complex strategies or proprietary risk management to blow up. It all comes down to experience in actually trading the strategies and due diligence in identifying whether the targeted returns are sufficiently high from the risks being taken. For illiquid, mark to model funds, 1% a month was woefully below the required return for any margin of safety in obviously hazardous long biased credit strategies.

Lending to the US government at 5% is not a bad bet but a higher yield from slicing and dicing sub-prime mortgages into allegedly bankruptcy-remote vehicles was not. Some neophyte investors place far too much reliance on "independent" agency opinions. Debt ratings are paid for by the issuer and most equity "ratings" are purchased by promises of investment banking business. Proper fund managers pay NO attention to what analysts think of a security and ignore ratings agencies. Just because Moody's or Standard and Poor's say something is AAA does not mean it is. There was nothing "High Grade" about those sub-prime mortgage concoctions.

It was absurd to assign a measure originally designed for rock solid government and corporate debt to the untested (till now!) financial alchemy of CDOs, CLOs and CPDOs. It is applying a fundamental metric to model-based credit structuring using wildly optimistic assumptions of default and recovery rates and correlations of different borrowers. Collateral is "sound" only if someone else will buy it at prices you "assume". If product structurers want to rate shop for a sellable classification that is their freedom but investors should ignore them. The only things "investment grade" are those assets whose rewards outweigh the risks. How shortsighted to gain a few hundred basis points for a while but end up losing 100%.

Just because MSCI, FTSE or Nikkei place a stock in their index does not mean it is any good. If a broker's cheerleader team (aka stock analysts and strategists) say something is a "strong buy" does not mean you should not short it. Morningstar putting 5 Stars on a mutual fund provides no information on whether to buy it. The "ratings" put out by various firms on hedge funds and hedge fund index construction are even worse. I have seen industry awards given to "top" hedge funds that weren't even hedge funds and some that imploded soon afterwards.

I am typing this watching the British Open golf championship. The Carnoustie effect is defined as "that degree of mental and psychic shock experienced on collision with reality by those whose expectations are founded on false assumptions." Sounds familiar with the current sub-prime CDO crisis demonstrating a classic reality check. A question to ask investment managers claiming to run a hedge fund, "What exposure does your strategy have to the Car-Nasty effect?". If the strategy assumes sunny market weather and normal distribution fairways, walk away.

There are other parallels between finance and golf. While everyone recognizes there are skilled golfers able to negotiate "random" Scottish weather some deluded souls continue to doubt the existence of skilled funds able to negotiate "efficiently" priced markets. Such skill MUST be in limited supply. Of all the people who have ever swung a sand wedge, few would be justified in calling themselves "golfers". Much fewer deserve to be considered "world class golfers". Similarly only a small proportion of "hedge funds" actually are hedge funds and fewer still are world class hedge funds.

The media sports pages focus on the stars while the financial pages focus on the losers. When academics study hedge funds they try to study EVERY product that says it is a hedge fund and bothers to report to a database. Hedge fund indices and "investable" hedge fund index funds are an even dumber idea than stock or bond index funds. The indexers would have you believe every large open hedge fund is worth owning! Even most legitimate hedge funds are avoids, let alone all the impostors and risk premium players. Can you imagine the average score at the Open if every "golfer" played?

It all comes down to doing your homework backed up by due diligence and advice from those who truly understand alternative investment strategies. And diversifying sufficiently so that possible negative performance of any one fund or strategy does not have a debilitating effect on your portfolio. Twenty hedge funds managing different strategies that have little correlation to each other is probably the MINIMUM number necessary.

Sunday, July 15, 2007

Major Texas Pension Makes a Big Push Into Hedge Funds

July 14, 2007; Page B1

Pension funds -- traditionally among the stodgiest investors around -- are starting to dabble in hedge funds, real estate and other "alternative" investments once considered too dicey. Now, a major fund in Texas is about to place a much bigger bet.

The Teacher Retirement System of Texas is planning to shift about one-third of its $112 billion in assets to alternative investments. It's one of the largest-ever pension-fund wagers on investments like these.


Manning the controls is T. Britton Harris IV, the new chief investment officer at the Texas Teachers fund and -- briefly -- the former chief executive officer at Bridgewater Associates, the Connecticut-based hedge-fund group with about $165 billion under management.

Mr. Harris's strategy aims to boost returns by a modest 1% annually, though that would earn his fund an additional $1 billion a year. "We'll be able to produce these higher returns with the same level of risk," Mr. Harris, 49 years old, says.

Alternative assets like these, he points out, usually don't move in lockstep with stocks and bonds, helping to diversify a portfolio. "Investment in alternative assets has not hurt returns at other pension funds," he says. "They have helped returns."

His critics, however, are wary. The recent meltdown by two Bear Stearns hedge funds that invested in subprime mortgages was the most recent reminder of the potential risks involved. And less than a year ago, the hedge fund Amaranth Advisors squandered an unknown amount of pension-fund money while losing $6 billion on natural-gas bets that went wrong.

Pension funds nationwide are buzzing about this Texas-sized overhaul and will be watching to see if the gambit by the nation's seventh-largest public fund pays off. The result could shake up the $1 trillion pension-fund industry by helping to accelerate the trend toward hedge funds and other alternative assets -- or, on the other hand, by stigmatizing these investments if Mr. Harris's fund does poorly.

"We're going to see more of these shifts to hedge funds and other alternatives," says Monica Butler, head of U.S. consulting for Russell Investment Group, which advises pension funds. "But most funds don't want to be among the first to do it."

Pension funds have invested limited amounts in real estate and private equity for at least two decades. More recently, as liabilities have ballooned and begun to exceed assets at many pension funds, the more aggressive have looked to hedge funds in hopes of closing that gap.

So while the Austin-based pension fund isn't the first to dabble in these investments, its shift is radical. Currently, the fund ranks among the more conservative in these investments: It has only about 5% of assets in hedge funds, private equity and real estate combined, less than half the level of the average pension fund.

During the next couple of months, Mr. Harris says, he will begin a two- to three-year process that will raise that amount to around 30%.

Some skeptics have thrown roadblocks in his way. The Texas state legislature recently passed a law capping the amount of money that Texas Teachers can place with hedge funds at 5% of total assets, just half of what Mr. Harris had targeted. That curtailed his plans a bit, forcing him to roll back his investment plans in hedge funds.

Texas Pension Review Board chairman Frederick "Shad" Rowe applauds these limits, arguing Texas Teachers is moving too much money too quickly into hedge funds. "It might be more prudent for them to go a little slower," he says.

Pension funds have been burned by hedge-fund blowups before. The San Diego County Employees Retirement Association is suing Amaranth for $150 million, alleging that the collapsed hedge fund failed, among other things, to properly guard against risk.

The International Trade Union Confederation, the world's biggest union with 168 million members in more than 150 countries, recently claimed that private-equity funds -- which often invest in companies, then lay off workers as part of a restructuring process -- shouldn't be rewarded with pension-fund money. Others say the nature of private equity (where investments may take five years or more until a restructured company is sold and gains are realized) is ill-suited for pension funds with more regular liabilities.

None of these reactions seem to surprise Mr. Harris, who has been involved in the pension world for more than two decades. "I haven't found anyone in the business who doesn't like [alternative assets] as a long-term strategy," he says. "All the concerns are with implementation."

Mr. Harris was born in Bryan, Texas, the son of a Mobil Oil executive who moved the family overseas to Ankara, Turkey, when Mr. Harris was a child. He returned to the Lone Star state to get a degree in finance from Texas A&M, where he now teaches a course, "Titans of Investing," about legendary money managers like Berkshire Hathaway's Warren Buffet and John Neff of Vanguard.

His own financial career began in the mid-1980s as an analyst with the Texas Utilities pension fund. He was part of a team that helped triple the fund's assets to $1 billion. In 1991, he began running the stock-investing division for GTE, a phone company that would later merge with Nynex and eventually become Verizon.

As head of the Verizon $70 billion pension fund, he acquired a taste for alternative investments, putting 17% of the fund's assets into them. After that success, Bridgewater, which managed money for Verizon, hired away Mr. Harris to be CEO.

But this merger of two heavyweights wasn't destined to last, despite Mr. Harris's enthusiasm for alternative investments. Bridgewater's nonhierarchical management style, where there's considerable arguing to come up with the right answer, didn't appeal to Mr. Harris. "After six months of reflection, Britt decided it wasn't for him," says Bridgewater chief Ray Dalio, adding that the parting was amicable.

Mr. Harris agrees: "I do not think that they needed to change what had been a winning formula for years."

In his current job, Mr. Harris believes that many of his pension-fund peers are eager to follow his pension fund's footsteps. But if he isn't able to boost the fund's returns? "Then others won't follow us," he says, "And I'll go somewhere else."

Friday, July 13, 2007

Tax Loopholes Sweeten a Deal for Blackstone

NY Times.com

July 13, 2007

Tax Loopholes Sweeten a Deal for Blackstone

The Blackstone Group, the big buyout firm, has devised a way for its partners to effectively avoid paying taxes on $3.7 billion, the bulk of what it raised last month from selling shares to the public.

Although they will initially pay $553 million in taxes, the partners will get that back, and about $200 million more, from the government over the long term.

The plan, laid out in the fine print of Blackstone’s financial documents, comes as Congress debates how much managers at private equity firms like Blackstone and hedge funds should pay in taxes on their compensation.

Lee Sheppard, a tax lawyer who critiques deals for Tax Notes magazine and has studied the Blackstone arrangement, said it was a reminder of the disconnect between the tax debate in Congress and how the tax system actually operates at the highest levels of the economy.

“These guys have figured out how to turn paying taxes into an annuity,” Ms. Sheppard said. “What people don’t realize is that the private equity managers, the investment bankers, all the financial intermediaries, are in control of their own taxation and so the debate in Washington about what tax rate to pay misses the big picture.”

The debate in Congress is about whether most of the compensation that fund managers earn should be taxed at the 35 percent rate that applies to other highly paid Americans, or at the 15 percent rate for capital gains.

Questions in Congress about possibly raising taxes on such compensation were prompted in part by publicity about the rich rewards for people who run these firms. Stephen A. Schwarzman, the co-founder of the Blackstone Group, made nearly $400 million last year, for example.

The Blackstone partners’ tax deal, however, is for the sale of part of their stake in the management firm, which is why their profits were taxed at the usual 15 percent tax rate for capital gains. Over all, the company raised $4.75 billion in the initial public offering, but the benefits of the tax structure involve just $3.7 billion of that.

Other private equity firms and hedge funds that have gone public, or plan to, make use of similar techniques, their documents show.

The Fortress Investment Group, which went public in February, uses a form of this tax structure. Two funds that plan to go public soon, Kohlberg Kravis Roberts and Och-Ziff Capital Management, describe similar tax strategies in their preliminary disclosure documents.

All three firms declined to comment. However, several tax lawyers, who could not be quoted by name because their firms had restricted them from making public comments on these issues, agreed in principle with the analysis of the tax structure’s implications.

No Blackstone official would speak for attribution. A spokesman, who insisted on not being identified, said only that such an analysis of the tax implications of Blackstone’s deal was “totally flawed.”

A report issued this week by the Congressional Joint Committee on Taxation indicated that such deals had been done at other companies.

Victor Fleischer, a law professor at the University of Illinois, came to a similar conclusion as Ms. Sheppard after studying the Blackstone deal.

Blackstone’s tax maneuver hinges on its use of good will, an accounting term for the value of the intangible assets, like a well-known brand name, that are built up by a company over time. That value is part of the reason a company is worth more than the sum of its physical parts, like buildings and equipment.

Individuals who create good will cannot deduct it. But when good will is sold the new owners can because its value is assumed to erode. The Blackstone partners sold the good will from their left pocket to their right.

In simplest terms, the Blackstone partners paid a 15 percent capital gains rate on the shares they sold last month in the initial stock offering to outside investors (those shares represented a stake in the Blackstone management company, not its funds).

Blackstone then arranged to get deductions for itself for the $3.7 billion worth of good will at a 35 percent rate. This is a twist on the “buy low, sell high” stock market adage; in this case it would be “tax low, deduct high.”

The deductions must be spread out over 15 years. And the original Blackstone partners are getting just 85 percent of the tax savings, leaving the other 15 percent to outside investors. The deductions on the $3.7 billion to the partners are $1.1 billion over 15 years.

If these tax savings were paid as a lump sum this year, the partners would get about $751 million, which is $198 million more than the taxes the partners will pay on the $3.7 billion of good will.

The lump-sum value was done using the rate set by the Internal Revenue Service for deals lasting 15 years.

Officials at one hedge fund suggested that a rate three times that set by the government should be used to calculate the long-term economics because many hedge funds and private equity firms earn high rates of return. Applying this interest rate, 15 percent, still results in a net tax of $175 million for the Blackstone partners, or less than 5 percent.

How can those deductions be worth almost as much, or more, than the taxes paid?

The ability to provide answers to such questions is why tax lawyers can typically charge $700 an hour or more. Just as fashion designers blend textures, colors and shapes, tax experts mix and match elements of partnerships and corporations, and bits and pieces of the tax code, securities laws, accounting rules and economics principles.

The tax maneuver starts with Blackstone partners selling to a newly created subsidiary corporation $3.7 billion worth of good will. Such entities are known within the tax trade as blocker corporations, because they help block taxes from reaching the Treasury.

Here is how the structure works: Blackstone can deduct 35 percent, based on the corporate tax rate for depreciation, of the value of $3.7 billion in good will, or $1.3 billion. Because the partners told investors they have the right to 85 percent of that amount, that means they have $1.1 billion worth of deductions.

That amount would be saved over 15 years. But for an apples-to-apples comparison with the taxes it pays on the proceeds this year, the value of $1.1 billion in today’s dollars is $751 million.

Compared with the $553 million tax paid, the Blackstone partners will get back $198 million more than they paid in taxes.

To reap those savings from the deductions, Blackstone needs to funnel income into that blocker corporation.

So Blackstone directs to the corporation the annual fees it receives from investors for managing their money, which is 2 percent of the assets they manage. Those fees totaled more than $850 million last year, far more than the amount needed to write off the good will.

What level of confidence do you need if you have to invest $4 billion dollars in just 6 stocks?

Glenn Greenberg and His Holdings: Comcast Corp, UnitedHealth Group Inc, Laboratory Corporation of America Holdings, Crosstex Energy, Inc.

What level of confidence do you need if you have to invest $4 billion dollars in just 6 stocks? Also among these 6 stocks the number one position is 40% of the total portfolio? This is exactly what Guru Glenn Greenberg is doing. It is also a key factor why he could achieve more than 22% a year since 1984.

You may not know Glenn Greenberg, it is not surprising because he does not entertain investment ideas from Wall Street analysts; he does not do marketing, and he does not even speak to his clients. He only communicates with them with two written updates per year.

The most important rule for Mr. Greenberg is that if they lacked the confidence to put five percent of their portfolio in a company's stock, they would not buy any. Therefore he has a very concentrated portfolio. Due to this excess concentration Chieftain typically has less than ten securities in their portfolio. The most number of securities Chieftain has held is twelve and the least, six, while maintaining a 30% cash position.

How does he invest? He said that a person should have an approach that over the long-term will win and will not fail. Investors should not use an approach which can provide both huge returns and huge losses. An investor must figure out an approach that will allow them to be a long-term winner because this is a long-term business. Investors need to win successively because they will be taking profits and reinvesting them continuously over their lifetime.

What does he look in a company? He likes business that is predictable, it has no or few competitors, and it has high profit margins and returns on invested capital. He tries to find two or three investment ideas each year that fit its vision of a good business and then it does enough research to feel comfortable putting 8-20% of its portfolio in each idea.

These are the review of his holdings as of March 31, 2007.

No. 1. Comcast Corp CL A Spl (CMCSK) 37.49%

Comcast, the largest cable operator, is the number one holding of Chieftain. It reprents more than 37% of the total equity holdings. Glenn Greenberg started to own Camcast since 2002, when the prices were at low teens. Today Comcast Corp. has a market cap of $87.7 billion, it was traded at around $28.1 with P/E ratio of 30.73 and P/S ratio of 3.27.

During 2006, Comcast weighted more than 30% of Glenn Greenberg’s total portfolio. Comcast stock went up more than 60%, it alone contributed more than 20% gain for the whole portfolio.

During the quarter ended 3/31/2007, Glenn Greenberg added to his holdings in Comcast by 15.8%. His purchase prices were between $25.2 and $29.25, with an estimated average price of $27.1. The impact to his portfolio due to this purchase was 15.91%. His holdings were 55,554,703 shares as of 03/31/2007.

No. 2. UnitedHealth Group Inc (UNH) 18.87%

Unitedhealth Group Inc, the health insurer, is the second largest holding of Chieftain. It entered Chieftain’s portfolio in the second quarter of 2004. Over the past 3 years Glenn Greenberg added and reduced numbers of shares as the stick prices change. During the past quarter Glenn Greenberg reduced the number of shares by about 18%. Unitedhealth Group Inc. has a market cap of $69.19 billion, it was traded at around $51.5 with P/E ratio of 17.19 and P/S ratio of 0.95.

Unitedhealth Group Inc is also owned by 10 other Gurus including Warren Buffett. It is a small position in the portfolio of Berkshire Hathaway, with a weighting of only 0.09%. Most likely it is a Lou Simpson’s purchase. Other Gurus who own Unitedhealth Group Inc. include Bill Miller, Edward Owens etc.

No. 3. Laboratory Corporation of America Holdings (LH) 14.8%

Laboratory Corporation of America Holdings, together with its subsidiaries, operates as an independent clinical laboratory company in the United States. It has a market cap of $9.32 billion, it was traded at around $79.22 with P/E ratio of 22.92 and P/S ratio of 2.51.

Laboratory Corporation of America Holdings entered Chieftain’s portfolio in the third quarter of 2002, when the stock price collapsed from $50 to $20 during the market downturn. Glenn Greenberg bought into the company. The price has since quadrupled.

During the past 5 years Glenn Greenberg adjusted the number of shares he held, although it has always been a large position of his. Glenn Greenberg owns 7,692,279 shares as of 03/31/2007, an increase of 4.07% of from the previous quarter. This position accounts for 14.8% of the $3.77 billion portfolio of Chieftain.

No. 4. Ryanair Holdings PLC (RYAAY) 11.74%

Ryanair Holdings operates a scheduled passenger airline serving short-haul, point-to-point routes between Ireland, the United Kingdom, and Continental Europe. Ryanair Holdings plc has a market cap of $11.81 billion, it was traded at around $38.28 with P/E ratio of 20.31 and P/S ratio of 3.94.

Glenn Greenberg started to buy Ryanair Holdings PLC during the four quarter of 2006, and kept this confidential until the second quarter of 2007. Glenn Greenberg owns 9,894,700 shares as of 03/31/2007, an increase of 355.6% of from the previous quarter.

Since March the stock prices sank by more than 20%. If you buy Ryanair Holdings now, you are getting a lower price than Glenn Greenberg has paid.

No. 5. Crosstex Energy, Inc. (XTXI) 6.18%

Crosstex Energy, Inc., together with its subsidiaries, engages in gathering, transmission, treating, processing, and marketing natural gas and natural gas liquids (NGLs) in the United States. Crosstex Energy Inc. has a market cap of $1.33 billion, it was traded at around $28.99 with P/E ratio of 348.19 and P/S ratio of 0.42.

Glenn Greenberg started to buy Crosstex Energy, Inc in 2006, it owns more than 17% of the company and is its largest institutional shareholder.

Glenn Greenberg also owns other smaller positions such as Nike Inc. (NKE), American Tower (AMT) etc. He reduced to his holdings in Telecom Equipment company American Tower Corp. by 61.7%. His sale prices were between $37.52 and $40.32, with an estimated average price of $39.1. The impact to his portfolio due to this sale was 3.46%. Glenn Greenberg still held 5,416,700 shares as of 03/31/2007. He sold out a long time holding American Standard Companies (ASD).

What We Have Learned by Studying His Portfolio?

Glenn Greenberg concentrates his bet on the companies he understands the best. Once he bought into a company, he is there for long haul. He may trade in and out the company over the course as the price change, but he does not mind to buy shares back if he has been reducing and the price decreased. This is illustrated by the graph here:


# of Shares

Price ($)


























































It is not surprising because these are the companies he understands, if prices decreased to below its intrinsic value, why not buy some back?

Wednesday, July 11, 2007

When the best hedge fund on the planet decides to launch a new fund, it bears watching.


Renaissance to Launch New $25B Managed Futures Fund

When the best hedge fund on the planet decides to launch a new fund, it bears watching. Even more interesting is the area Rentech has decided to pursue. The full press release is at the end of the post, and below are my comments as there seems to be a great deal of misunderstanding in the commodities and managed futures space.

On one side there are the almost religious-like proponents of managed futures - dominated by long term trendfollowers who exclaim mantras such as, "The trend is your friend until it bends in the end". On the other side there exist skeptics that believe the returns are simply survivor bias in a random process. I fall somewhere in the middle, and in my opinion, this is a great example of trying to understand the drivers of a relatively simple strategy.

I have touched on commodities on the blog before:
Q&A with Harvard's El Erian
Q&A with Bob Greer from PIMCO

. . .and managed futures on the blog before:
Managed Futures...Finally (a review of RYMFX and good background info)
Out of Sample Results and Price Shocks
Hulbert Trendfollowing Article

Some more background reading from the academic literature:

"Commodities and Real-Return Strategies in the Investment Mix", David Burkhart,(CFA Quarterly conference proceedings)
"Facts and Fantasies about Commodity Futures", Gorton and Rouwenhorst
"The Strategic and Tactical Value of Commodity Futures", Erb and Harvey
"Evaluating a Trend-Following Commodity Index for Multi-Period Asset Allocation", Mulvey, Kaul, and Simsek

I don't want to repeat what these authors can convey much better than I can (especially the Erb Harvey paper), but below is a quick discussion of the return drivers for commodities and managed futures.

(Again, for a full treatment read the academic papers above.)

Commodity Long Only Returns

Readers of the blog are aware that I am a huge fan of commodities (and that is not just because half my family comes from farming and we are happily growing wheat currently). In my recent paper, "A Quant Approach to TAA", I had a full 20% allocation to commodities. Since commodities are real assets (i.e. wheat, gold, oil), they have different sources of return than stocks and bonds. (And I love the fact that none of the gurus have ANY allocation to commodities.) In addition, commodities have a low correlation with these asset classes and are a good hedge against unexpected inflation. Historical returns to commodities have been in-line with stocks, with similar volatility. (Although it is important to note that all of the commodity indices have some backfill bias.) Chart below from the Erb paper.

But will those returns continue in the future?

The return to commodities can be explained as the following:

Commodity Portfolio Total Return = Cash Return + Excess Return + Diversification Return

Cash return comes from only having to place 10% margin down on futures contracts, and the rest (or all) sits in T-Bills.

Excess return is the change in the price of the futures contract. This will be due mainly to roll yield. When a commodity is backwardated (i.e. current futures price is higher than further futures price), there exists a roll yield from holding the out futures contract. Historically roll yield has been ~ 2.5% for the GSCI, but has been declining. Energy markets are typically in backwardation, although the GSCI has been backwardated as often as it has been in contango. The bottom line is that roll returns are the expected price of insurance. From the Erb paper:

De Roon, Nijman and Veld (2000) analyze twenty futures markets over the period 1986 to 1994 and find that hedging pressure plays an important role in explaining futures returns. Anson (2002) distinguishes between markets that provide a hedge for producers (backwardated markets), and markets that provide a hedge for consumers (contango markets). He points out that a commodity producer such as Exxon, whose business requires it to be long oil, can reduce exposure to oil price fluctuations by being short crude oil futures. Hedging by risk averse producers causes futures prices to be below the expected spot rate in the future. Alternatively, a manufacturer such as Boeing is a consumer of aluminum, it is short aluminum, and it can reduce the impact of aluminum price fluctuations by purchasing aluminum futures. Hedging by risk averse consumers causes futures prices to be higher than the expected spot rate in the future. For example, Exxon is willing to sell oil futures at an expected loss and Boeing is willing to purchase aluminum futures at an expected loss. The losses incurred by the hedgers provide the economic incentive for the capital markets to provide price insurance to hedgers. Both of these examples highlight a view that commodity futures are a means of risk transfer and that the providers of risk capital charge an insurance premium.

Diversification and Rebalancing return (historically about 2-3%) is simply due to the reduction in variance from diversified portfolios (known as variance drain or volatility gremlins). The three main commodity indices have varying returns, and that is due the differing weightings. GSCI invests in 24 contracts (production weighted so it is heavy in energy), DJ AIG invests in 20 (based on production and liquidity), and the CRB invests in 17 (equal weighted).

Managed Futures Returns

Managed futures typically take advantage of two strategies. The vast majority employ a momentum, or trendfollowing approach. As I detailed in my paper, "A Quant Approach to TAA", applying a momentum based approach results in similar returns with a decrease in volatility. A trendfollowing approach in managed futures likely gets an additional performance boost from this characteristic, in addition to the extra diversification return of non-correlated long and short positions. Here are two charts from the Erb paper for simple mo approaches :

The minority apply a term structure approach. Below is a simple strategy of going long the GSCI when backwardated and short when contangoed (again, from Erb):

With many of the trendfollowers getting crushed lately, maybe Rentech is picking a great entry point into the field? I like to have a tactical approach to the asset class as a whole, and then supplement that with an exposure to managed futures.

Some symbols:

iShares GSCI Commodity-Indexed Trust ETF (GSG)
iPath Dow Jones-AIG Commodity Index Total Return ETN (DJP)
iPath S&P GSCI Total Return Index ETN (GSP)
PowerShares DB Commodity Index Tracking Fund ETF (DBC)
PowerShares DB Agriculture Fund ETF (DBA)

Rydex Managed Futures (RYMFX)

By the way, this quote from the press release is completely incorrect:

"Managed futures, a type of hedge fund strategy that was originally commodity trading, traditionally works best at times of high market volatility because it arbitrages tiny price differences. "


Renaissance to launch new fund
By Deborah Brewster in New York
Financial Times

Renaissance Technologies, one of the world's biggest and best performing hedge fund groups, plans to launch a managed futures fund with a capacity of $25bn, an unusual foray into an investment strategy that has been underperforming.

Renaissance was founded by former maths professor James Simons, last year the world's most highly paid hedge fund manager, earning $1.7bn.

The group's flagship $6bn Medallion fund, which trades in a lot of futures, has been quickly overtaken in growth by its newer Renaissance Institutional Equities Fund, which was launched two years ago and trades only in stocks. The Institutional fund, which was designed to hold $100bn, already manages $26bn. It charges much lower fees than Medallion's notoriously high 44 per cent performance fee, and was designed to provide lower volatility and a lower trading turnover, appealing to pension funds.

Investors in Medallion last year received returns of more than 40 per cent, and investors in the institutional fund received more than 20 per cent, after fees. The Medallion fund now contains mostly Mr Simons' own money and that of Renaissance employees.

Managed futures, a type of hedge fund strategy that was originally commodity trading, traditionally works best at times of high market volatility because it arbitrages tiny price differences. Managed futures funds have not performed as well as other strategies in the past few years because markets have had low volatility.

In the year to date, managed futures funds returned an average of 4.2 per cent, compared with 8.9 per cent for hedge funds in total, according to the Credit Suisse/Tremont hedge fund index. There have been few such new funds launched recently.

Like most of the largest hedge fund firms, Renaissance is a quantitative investor, developing complex mathematical models for its trading strategies. Mr Simons has said that his group hires no-one from Wall Street, but instead seeks out astronomers, mathematicians and physicists.
Copyright The Financial Times Ltd. All rights reserved.

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.