Thursday, November 29, 2007

Two Up Days in a Row!

With the Dow on pace to trade in positive territory for the second day in a row, the index will break its streak of 20 trading days without two consecutive up days. In the table below, we calculated each period since 1970 where the Dow had a similar streak of at least twenty days. For each period, we calculated how the index did during the month before the streak was broken (includes the performance during the two up days) as well as how it did following the second up day.


A ‘bloody awful time’ for event-driven hedge funds

Hedge funds aiming to profit from activism and corporate events have been hit hard this month as a raft of deals fell through and markets plummeted, writes the FT’s hedge fund correspondent, James Mackintosh.

The so-called event-driven sector, which includes many of the best-known activist hedge funds, is bearing the brunt of a downturn in hedge fund performance during November, the worst for the industry since the credit squeeze hit home in August.

According to investors, several funds turned in double-digit drops in the first three weeks of this month, hurt by losses as private equity groups walked away from agreed takeovers and by the renewed impact of concern over credit.

Chicago-based Hedge Fund Research’s daily HFRX index calculates the event-driven sector is down 4.3 per cent so far this month, with only long-short equity traders – who tend to be highly exposed to the market – producing a worse performance. By September the main stock markets had turned in their worst performances since the bear market of 2001-2002.

“It is bloody awful,” said one prime broker. “The dispersion between the best and the worst this month is something we have never seen before.”

Among prominent fallers, according to investors, are JPMorgan-owned Highbridge’s $750m Event Driven fund, down 12.7 per cent in the first two weeks of this month; two funds from New York-based Atticus; London’s Tisbury Capital; and New York’s Kinetic Partners.

However, some of the managers, such as Atticus, remain strongly ahead for the year, notes Mackintosh. Highbridge’s $1bn long-short equity fund has risen 4 per cent this month and is up 34 per cent for the year.

“Even the best event-driven managers can’t do well in these conditions,” said an executive at one big fund of hedge funds.

François Barthelemy, manager of F&C Partners’ listed fund of event-driven hedge funds, said the sector had suffered as falling markets hurt the value stocks that are their favourites. But he noted that the outlook for the sector was strong as managers would switch from looking for potential private equity bid targets to finding value in troubled companies.

According to one US hedge fund manager, 15 US deals have fallen through or been subject to renegotiation this month, hurting the traditional merger-arbitrage side of the business. Still, the drop this month is far less serious than the problems in August, when deal spreads – reflecting the risk taken by merger arbitrage – ballooned, notes Mackintosh.

Wednesday, November 28, 2007

Global Equity Market Declines

Below we highlight global equity market declines from recent peaks. As shown, China is currently off the most from its highs -- down nearly 21%. Sweden, Japan and Italy are also down more than 15%. Spain, Australia, Russia and Germany have held up the best, while the Nasdaq and the S&P 500 are just about in the middle of the global spectrum. With US subprime woes widely regarded as the cause of these global equity market declines, it's clear that the US still matters -- a lot.



Subprime Near a Bottom?

Interesting that Markit's ABX index of the value of BBB-rated subprime has slowed its descent in recent week. Are we near a bottom? Unless you think it's all going to zero, at 20-ish cents on the dollar you have to imagine it's close.

Tuesday, November 27, 2007

The stealthy rise of the sovereign wealth fund

Wall Street might be forgiven for thinking that this whole Middle East, sovereign wealth fund business has rather crept up on them. One minute American financial institutions reign supreme. The next they’re flogging off stakes at eye-watering prices to little-known investors.

But wait! Citigroup on Monday night hailed the Abu Dhabi Investment Authority as “one of the world’s leading and most sophisticated equity investors.”

Let’s look at the evidence. In 2006, the ADIA merited a mention in how many stories in the pages of the business and financial press?

Wall Street Journal - 0
New York Times - 0
Financial Times - 6

So this leading light of the world’s equity investors was operating very much on the hush-hush last year. As a point of comparison, Warren Buffett got 184 mentions in the WSJ in the same period; Citigroup themselves got a massive 1,480.

But then outgoing investment from the Middle East into the world’s financial heavyweights has really been a story of 2007. So how has ADIA fared so far this year?

Wall Street Journal - 10
New York Times - 2
Financial Times - 30

Still not exactly saturation coverage, so confusion may yet reign. After all, Fox Business’ travails with the geography of the Middle East have been well, and humorously, chewed over. Then there was that Cutter Associates business that rather threw some observers earlier this month.

We sense a gap to be filled here. And we’re getting right onto it.

In the meantime - here’s a brief reminder of where and how the Middle East has been making financial waves in 2007.

  • April - Saudi billionaire buys 3.1 per cent stake in HSBC
  • May - Dubai International Capital makes substantial investment in HSBC with a holding that did not surpass the 3 per cent level
  • May - DIFC revealed to have built a 2.2 per cent stake in Deutsche Bank
  • July - Apollo Management sells a stake of less than 10 per cent to the Abu Dhabi Investment Authority
  • September - Carlyle Group sells a 7.5 per cent stake to Mubadala Development Company, owned by the Abu Dhabi government
  • September - Rivals Qatar and Borse Dubai take 48 per cent of the LSE between them, while also competing for influence in OMX, the Stockholm-based group
  • October - Och-Ziff sells a 9.9 per cent stake to Dubai International Capital
  • November - Colony Capital reported to be considering the sale of a stake to a Middle Eastern SWF

Monday, November 26, 2007

Hedge fund ipos and permanent capital

Veryan Allen

Hedge funds "work" because of monetary incentives and checks and balances on managers that closely align their interests with clients. The often cited "heads I win, tails you lose" compensation scheme is a myth. The possibility of investors redeeming for poor performance, high water marks, no lockups and the principals' wealth at risk assures clients of shared downside exposure and incentivizes managers to try to minimize drawdowns. Fees for failure have impacted shareholders of corporations where senior management were neither competent nor motivated to prepare for difficult times. While PROPER hedge funds are structured in ways that provide upside AND downside alignment, this is NOW not always the case with some funds.

Investing in a hedge fund should be about replacing market risk with manager risk. If, like me, you believe in alpha not beta that makes sense as "the market" is unhedged and notoriously volatile. Hiring a TRUE hedge fund manager means you are paying 2 and 20 to someone who is incentivized to make money while hedging risk. Managers provide the skill and some capital and limited partners then provide more capital to leverage that skill. It is a business model that has proven a win-win for BOTH parties for over 50 years despite much criticism from commentators who have never invested in a hedge fund themselves.

A NEW source of return and keeping 80% of gross alpha is a great deal for investors provided the manager is motivated to keep on performing, managing risk, restricting AUM to the size they can perform well with and continue working 100 hour weeks. Redemption fears, high water marks, personal wealth in harm's way and non-permanent capital if you don't do your job well are protective covenants for investors though, of course, nothing is guaranteed. We have seen the dangers of covenant-lite loans and there are possibly similar issues with covenant-lite fund capital.

Necessity is NOT the mother of invention. Motivation is the REAL mother of invention. Lots of things weren't considered necessary until long AFTER they were invented. Life went on before wheels, electricity, cars, computers, internet or mobile phones and few said beforehand that we needed any of them. Hedge funds got invented because some were motivated to find safer, better ways of growing capital than simply owning assets. Incentive fees ensure managers keep working hard and figuring out even more ways to make money for investors. If, and only if, clients make money then you make money. "Cheaper" management fees mostly result in index hugging and asset gathering often at the cost of performance.

Actively managed mutual fund and other relative return products have fees that are often HIGHER than hedge fund fees. Most mutual fund returns are at least 90% driven by the beta of whatever asset class they are investing in. Since beta fees are effectively zero (the holdings can be lent out to cover the indexation cost), that means a mutual fund charging 1% could be considered to be charging 10%(!) since it is actively managing only a small part of the portfolio and indexing the rest. Mutual funds get paid that fee whether they make or LOSE money. In contrast good hedge funds that can make money whether the market is up OR down are a bargain.

Hedge funds mostly charge that infamous 2% to cover much higher fixed costs on a generally smaller AUM; usually they ONLY get paid if they produce NEW profits. But in some cases now the 2% is also becoming a profit center and some hedge funds are sadly morphing from hunter gatherers into asset gatherers. Permanent capital reduces the fear of redemptions, falling too far below your high water mark and the many alignment benefits of ALL senior managers having most of the wealth at risk in the fund.

Recently I was asked by an investor whether they should automatically redeem from an alternative asset manager that tries to IPO. Good question. After all, the IPO process, before and after, is a major management distraction away from focussing on portfolio and risk management while the monetization of what are effectively future management fees may reduce motivation in subsequent years and also the interests of public shareholders and fund investors are not necessarily the same. Worse it tends to transfer the emphasis to the 2 rather than the 20 leading to more marketing and less performance driven fee dependence.

Why buy an investment banking stock when the CEO can still parachute out no matter how poor a job they do? Why buy an AAA rated CPDO when the ratings agency won't be financially damaged if it drops to a C rating? Why purchase a "Strong Buy" equity pushed by an analyst who won't be financially punished for being wrong? Why buy into hedge fund or private equity IPOs when the founders are selling? Why provide permanent capital and allow net present value monetization of fee cash flows far into the future when the possibility of having that capital taken away is such a powerful incentive to keep performing? Permanent returns guarantee permanent capital.

Hedge fund managers have always been able to monetize their skills through the performance fee. The more money investors make the more the manager gets paid. Jim Simons, George Soros, Michael Steinhardt, Julian Robertson or Bruce Kovner among others never went or have never expressed an intention to go public yet seem to have monetized their businesses fairly well and attracted talented employees. For a quality hedge fund there is no need to IPO. Selling a stake to a strategic investor might make sense, listing a FUND might make sense but the manager itself going public is a clear short sale signal.

There are a few funds now more motivated by the 2 than the 20. Shareholders like the 2 while obviously limited partners should like the 20 since the more fees they pay the higher the returns. Asset size is usually the enemy of performance. Surely the best motivator is that if you don't perform then the money will desert you. Lockups and redemption penalties reduce this fear but are only appropriate for some strategies. With permanent capital the fear of losing the assets is taken away. As we have seen with subprime mortgages, SIVs or executive compensation, take fear out of the equation and greed alone MUST lead to problems. There is nothing wrong with greed per se provided it is not a free call option with no downside. Greed is GOOD but fear is FABULOUS.

Almost every quality hedge fund operating today BEGAN with less than $100 million under management. Every one of those funds was motivated primarily by the performance fee. So the argument that the biggest funds will win ignores factors that have underscored the success of the industry since inception. There is strong empirical evidence that newer and smaller hedge funds perform better. Yet currently more money is flowing to the biggest funds by besotted investors operating under the delusion that large AUM equals large FUTURE returns. There seems a strange dichotomy here. Isn't money supposed to go the funds likeliest to perform better? Whether a firm has $500 billion or $500,000 under management gives little indication of its abilities. People should have learnt that expensive lesson from the traditional financial world by now.

It is true a large proportion of new assets into hedge funds have recently gone to more established funds. With most investors it made sense to enter the space through funds of funds but as their familiarity has grown direct investment into larger funds is the stage we are in now. But with the superiority of early performance and higher returns on smaller asset sizes there is always going to be capital for niche managers with new ideas and strategies. With the industry still so tiny compared to future demand there will be plenty of space for large AND small hedge funds. Core-satellite is how the traditional world evolved and is how the hedge fund space will evolve. A core of fund of funds and multistrategy behemoths enhanced with specialist managers filling a specific portfolio gap. Lots of room for good hedge funds of ALL sizes as long as the people in charge are incentivized AND feel fear.

Motivation and incentives are the fuel of any functioning economic model. Fees for failure threaten that system. There is surprisingly little correlation between how hard someone works and their net worth. There are plenty of billionaires working just as hard as when they started out. But there is a danger that some managers might lose their motivation if the worst case scenario isn't that bad and when shareholders prefer AUM more than performance fees. Will the Och-Ziff partners burn the midnight oil in 2008 as much as when starting out in 1994 even if the IPO proceeds have been reinvested in the fund? Hopefully they will but it is yet another question investors will have to ask themselves.

Nomura and the China and Dubai sovereign wealth funds can't be very impressed with the post IPO performance of Fortress FIG, Blackstone BX and now Och-Ziff OZM. It is not often such obvious short sells come along but when someone stands on a streetcorner throwing out $100 bills you try to grab all you can. Some shorts this year like credit or the dollar weren't completely obvious unless you did your homework but shorting those IPOs WAS blindingly obvious. If the principals are selling it makes sense to sell alongside. Since there was previously no easy way to short hedge funds it makes sense to short OZM even if you think Och-Ziff is a good firm. OZM now serves as hedging instrument in the same way the FIG and BX IPOs enabled a way to short private equity.

When a hedge fund manager "takes home" a billion it is great news for their clients since it is fair compensation for strong performance. Any management team should be incentived to do a good job. But if you IPO then you become similar to a CEO of Merrill Lynch or Citigroup as it does not align shareholder or client interests with management. Those properly incentived to work don't play bridge or golf when their firms are taking massive losses either. Any hedge fund manager worthy of the name was available 24/7 during the recent problems. Non-permanent capital and easy redemption forces managers to work hard especially if their net worth is at risk.

As in any industry if you want cheap you can get cheap. "Cheap" hedge fund clones and replicators are out there as are so-called "hedge fund" style mutual funds. As usual you get what you pay for. While proper hedge fund fees remain stable there has been some fee reduction in the funds of funds arena. An investor may be proud of getting "lower" fees instead of the former 1% and 10% second layer but the chances are they are being penny-wise, dollar-foolish. There are costs to due diligence, infrastructure, monitoring and attracting the quality of staff able to identify good hedge funds. It is easy enough to just pick names that had a good recent performance and charge 70 bp and skimp on the massive due diligence you claimed in your powerpoint. It is much harder and expensive to do a good job picking quality hedge funds that WILL perform.

Someone asked me what I expected to be the best performing strategy over the next 10 years. I answered that considering financial incentives and innovation that the chances are the top returning strategy over 2008-2018 probably hasn't been invented yet and that the managing firm is likely to be not YET be established. They responded that they figured "China short only" would be the best performer which was interesting. They might be right, they might be wrong but if they do find such a manager they need to make sure anyone they provide non-permanent capital to is properly incentived to 1) make money 2) not lose most of it.

Citadel Said to Be Up 27% for the Year

Despite market volatility, the Citadel Investment Group, a hedge fund based in Chicago, has gained 27 percent year to date in what’s shaping up to be its second straight showing of double-digit returns, The Chicago Tribune reported.

Citadel, run by Kenneth C. Griffin, topped 30 percent in 2006, helped by energy bets after it took over some assets from Amaranth Advisors, which imploded in September 2006.

That deal has continued to pay off in 2007, along with Citadel’s opportunistic purchase of distressed hedge-fund assets during last summer’s credit turmoil, according to The Tribune.

The average hedge fund is up 11.8 percent this year, down only slightly from the 12 percent in 2006, according to

News of Citadel’s strong performance comes amid chatter that the hedge fund may be plotting an initial public offering. In September, Citadel hired John Andrews, the head of investor relations at Goldman Sachs, who was brought on at the bank shortly before its initial public offering.

Friday, November 23, 2007

Private equity underperforms market

By Martin Arnold, Private Equity Correspondent

Published: November 22 2007 16:48 | Last updated: November 22 2007 16:48

Private equity has on average underperformed the stock market in the last decade, according to a detailed survey of the buy-out industry submitted to the European Parliament on Thursday.

Oliver Gottschlag, assistant professor of strategy at the HEC business school in Paris, compiled the research, which undermined the stereotype of private equity cutting costs at companies and making colossal profits from selling them soon afterwards.

The research – based on data from 6,000 private equity deals and about 1,000 buy-out funds – shows that average private equity returns have underperformed the benchmark S&P 500 share index by 3 per cent, after fees charged to investors.

“This does not correspond with the stereotype of the industry making its investors extremely rich,” Mr Gottschlag told the Financial Times. “Investors have not had much fun in this asset class, even though they have all been obsessed with gaining access to the best-performing funds.”

Excluding fees and carried interest (a widely used profit sharing scheme), returns from private equity outperformed the S&P 500 by 3 per cent.

“So private equity is generating value somewhere, but its fee structure means the general partners capture double the out-performance they generate,” said Mr Gottschlag, who is also head of research at Peracs, an advisor to buy-out investors.

The research was based on data collected from investors in 852 private equity funds raised before 1993, to be sure they had sold all their assets. But Mr Gottschlag said analysis of more recent funds showed their performance had been similar.

Big buy-out firms have come under attack in Europe for cutting jobs at companies, such as the AA, the UK motor repair services group, and Gröhe, the German bathroom fittings maker.

Buy-out titans, such as Permira’s Damon Buffini, have defended their industry by arguing that occasional job cuts are necessary to achieve superior returns for their investors, many of which are big pension funds.

Mr Gottschlag admitted that some private equity firms were consistently outperforming the stock market. But he was sceptical about the number of buy-out funds that say they are “top-quartile” in performance rankings.

“I have never met a general partner who was not top-quartile. So I wonder where three-quarters of the industry is hiding,” he said.

On a more positive note for the buy-out industry, Mr Gottschlag said his research showed private equity firms were longer-term investors than many listed company shareholders. He also found they were more focused on growth than restructuring.

A comparison of buy-outs completed in 1996 and big minority shareholders in a broad selection of public companies found that after five years, 55 per cent of private equity investors had sold out, against 88 per cent of minority shareholders.

Mr Gottschlag said a survey of 1,000 buy-out case studies found that 91 per cent of private equity groups had growth initiatives at the companies they bought, against only 54 per cent with restructuring initiatives.

“This suggests that buy-outs really fulfil a very important role of triggering a revitalisation of mature companies,” he said.

The report also found that private equity-owned firms outperformed their listed peers and continued to do so after a buy-out firm had exited. “So I see no evidence that private equity harms the companies it invests in,” he said.

Watch Out: A Correction in Oil is Coming

The nature of business is cyclical. No matter what.

Take the oil sector for example.

Tuesday, November 20, 2007

The Outdated Index that Won't Give Up

By Gregg Wolper | 11-20-07 | 06:00 AM

An index should closely approximate the universe that investors are choosing from. It's no surprise that the NYSE Composite Index, which tracks the performance of the common stocks listed on the New York Stock Exchange, isn't all that well-known these days. Relatively few investors are limited to the stocks listed on a single exchange, so an index that excludes Microsoft (MSFT), Apple (AAPL), Oracle (ORCL), and every other company listed on Nasdaq doesn't provide a relevant benchmark by which to judge the performance of a manager who can, and does, buy those stocks.

With that in mind, it's odd that the MSCI EAFE Index remains by far the most common benchmark chosen by foreign-focused mutual funds. (MSCI is Morgan Stanley Capital International, and EAFE stands for Europe, Australasia, Far East.) The EAFE index excludes all stocks from emerging markets, as defined by MSCI. That means South Korea, Taiwan, and Israel are out, along with most every other country you'd expect. And because North America is missing from that moniker, Canada joins the United States on the sidelines.

This arrangement made sense years ago. Most mainstream mutual funds were extremely cautious about investing in emerging markets. Those markets were considered much, much riskier than Western Europe, Japan, and Australia, because the political structures in so many of them were unstable, currency crises were fairly common, and their stock markets far behind in terms of automation, trading volume, and regulation. And emerging markets often fell prey to extreme swings in performance.

The index doesn't exclude Canada on those grounds, but at one time many institutional investors did consider that country's economy and stock market to be so closely tied to those of the United States that lumping the two together seemed reasonable. Moreover, Canada had very few stocks that showed up on the radar screens of major international investors.

A New Era Arrives

Much has changed. These days, most portfolio managers running foreign-stock funds invest in emerging markets. The typical manager running a broad international fund has roughly 10% in the markets designated as emerging by MSCI. A manager doesn't have to be aggressive or "have a positive outlook for emerging markets" to reach that level in his or her portfolio.

While the trend toward greater acceptance of emerging-markets investing has been under way for a long time, it really got rolling in the past five to 10 years. There are several reasons. First, the numerous emerging-markets financial and currency crises of the mid- and late 1990s receded from memory. Second, most emerging-markets countries have made vast improvements in their financial structures and government management, with hefty natural-resource revenues helping ease the task. Third, many more companies that previously were smaller or almost unheard of, such as Infosys of India, became global leaders in their fields and could no longer be so easily ignored. Last but not least, the amazingly strong stock market performance in those areas attracted attention.

Meanwhile, the growing prominence of Canadian energy companies and other noteworthy firms such as the maker of the BlackBerry ( Research in Motion (RIMM), plus a very strong currency, all made Canada harder to dismiss as well.

It's Not Gone Yet

With that in mind, a more appropriate index for most broad foreign funds would be one that includes emerging markets and Canada. The MSCI All-Country World ex-US Index is one that fits the bill. Thus, it made sense for Julius Baer International Equity (BJBIX), which has long owned significant emerging-markets stakes, to change its benchmark recently to that index from MSCI EAFE.

Few other funds have followed suit, though. One reason seems to be that funds, and fund boards, simply are reluctant to make changes to fundamental policies. Changing benchmarks isn't something funds have typically done unless they drastically alter their strategy. Moreover, certain well-known benchmarks have become standard. You're a U.S. stock fund, your benchmark is the S&P 500--end of story.

A second reason, less likely to be stated, could be that with the strength of emerging markets, it's easier for an international fund to beat an index that excludes those hot markets. Over the five-year period through Nov. 16, 2007, the MSCI EAFE Index has gained an annualized 21.4%, while the MSCI All-Country World ex-US has posted a 23.8% gain.

In any case, it's worthwhile for investors to recognize that most broad foreign funds still compare themselves with the MSCI EAFE Index. When your fund boasts that it beat its benchmark, see if that benchmark is EAFE. If your fund topped it by owning stocks in emerging markets, most rival funds were doing the same thing. How did it rank against them?

Another realm in which EAFE has maintained its relevance is by serving as the benchmark for index-tracking funds. In fact, its prominence in that arena has been growing. The second-biggest exchange-traded fund, and one of the biggest international funds in mutual fund, ETF, or closed-end format, is iShares MSCI EAFE Index). That fund has $48 billion in its coffers. Does investing in that ETF, or another EAFE-tracker, still make sense? We'll explore that issue in a future Fund Spy column.

Hedge Funds Pounce On CDOs

I've been hearing over the last several days of CDOs being snatched up by a number of hedge funds for approximately 40 cents on the dollar. Meanwhile the Treasuries and other high-quality bonds continue to decline in yield.

Monday, November 19, 2007

Sub-Prime In Its Context

Gillian Tett :

…the main point that emerges from the map is a simple one: namely that although sectors such as subprime or leveraged loans have grabbed headlines this summer - and inspired panic due to the potential of these assets to generate losses - the assets represent a tiny part of the financial system as a whole. On sheer size, subprime securities are dwarfed by other asset classes, such as equities.

See picture :

Find the subprime market…click to enlarge

Map from BofE Financial Stability Report [p 22]

Sunday, November 18, 2007

Bond Funds Are Victims of Timing

Thinking Worst Was Over,
Top Performers Now Lag Behind
November 17, 2007; Page B1

After successfully dodging the bond-market storm earlier this year, several big mutual funds thought the worst was over. It was a bad call, and now they're feeling the pain.

The result: Some funds with great long-term track records -- including funds from Capital Research & Management's American Funds, and Legg Mason Inc.'s Western Asset Management group -- have taken significant hits in just the past month or so. Some that have long been top performers are now posting below-average returns and lagging behind the broad bond market by anywhere from one to nearly five percentage points, a huge gap for bond funds.

[William Gross]

Some of these funds used a "bull-market strategy" of buying on a dip, says Jeffrey Gundlach, manager of one bond fund that has largely avoided the recent damage. That strategy "doesn't work in a bear market," he says.

Mr. Gundlach's TCW Total Return Bond Fund, which focuses on mortgage-backed securities, continues to shy away from investments tied to lower-quality mortgage securities. That's help lead to a 6.9% gain so far this year, beating 97% of the competition.

Similarly, Pacific Investment Management's Pimco Total Return Fund, managed by Bill Gross, has steered clear of investments like these and has maintained its track record.

The funds doing the buying took small positions in battered bonds backed by subprime mortgages, or in debt issued by beaten-down mortgage lenders such as Countrywide Financial Corp. In general, mutual funds have steered clear of the risky mortgage-backed-securities market, which has inflicted tens of billions of dollars of losses on Wall Street giants including Merrill Lynch & Co., Bear Stearns Cos. and Citigroup Inc.

Indeed, bond-fund managers in general take credit for being better than these giant Wall Street firms at spotting the early-warning signals a year or two ago of housing-market trouble. They say it was clear to them, for instance, that lenders were making it too easy for borrowers to get mortgages by offering, no-down-payment loans to buyers with poor credit.

There were warning signs in other parts of the bond market, too, suggesting that the prices on riskier securities were vulnerable to big declines, says Tad Rivelle, a portfolio manager on the Metropolitan West Total Return Bond Fund. "We recognized that the corporate-bond market, the high-yield market, as well as the subprime market" were all making borrowing too easy.

Perhaps the most vocal warning was issued by Mr. Gross of Pimco, a unit of Allianz SE. In 2006, Mr. Gross began worrying about the impact that a collapse in the housing market would have in 2006 and repositioned his portfolio toward lower-risk investments. It turned out that he was early in his prediction, and as a result his fund's performance fell far behind through the first half of this year. Now, however, his Total Return Fund is beating 97% of rival funds so far this year with a 7.1% gain, 1.3 percentage points ahead of the benchmark Lehman Brothers Aggregate Index.

"When the tide goes out, you get to see who's swimming naked," Mr. Gross says.

"Pimco has had its bathing suit on for a long time," Mr. Gross says, expecting a housing downturn and a deterioration in mortgages and derivatives related to that.

In late summer, the bond markets were roiled by the credit crunch and prices fell sharply for mortgage-backed securities, as well as bonds issued by mortgage lenders and high-yielding corporate debt.

It was around that time when some bond-fund managers felt the declines were starting to look overdone. American Funds' $35 billion Bond Fund of America, which is ranked among the top 5% of its Morningstar Inc. category for the past five years, was among them.


For example, five-year debt from Countrywide had fallen significantly in price so that its yield went from about 0.50 percentage point above comparable maturity Treasurys to as high as 5.5 points above Treasurys.

It was much the same story for debt issued by Residential Capital LLC, or ResCap, a unit of GMAC Financial Service. Bond Fund of America also added some ResCap holdings.

Making similar moves was Western Asset Management, the country's biggest bond manager. The firm's Core Bond fund had already been lagging behind, in part owing to the firm's typical strategy of holding more corporate and market-backed bonds and less of lower-yielding Treasurys, which were rallying. Western added subprime debt, as well as bonds from Countrywide and ResCap.

For a while, it looked smart: Countrywide's bonds rallied so that the yield hovered around two percentage points above Treasurys, and there was a slight rebound in subprime prices. Then, in late October, the mortgage market imploded a second time. The ABX index tracking triple-A mortgages -- the highest-rated kind -- collapsed from around 95 to the high 70s. Countrywide fell back to about five percentage points over Treasurys, where it remains.

"We thought we had a pretty conservative position," says James Hirschmann, chief executive of Western.

Compounding the woes related to the mortgage market, Western also suffered as corporate bonds were hit to a similar degree. The two markets don't generally move in lockstep, in the recent downturn they did, says Mr. Hirschmann.

Meanwhile, Bond Fund of America is lagging behind 74% of its rival funds, and is returning 2.3 percentage points less than the Lehman Aggregate index in 2007.

Some managers who stayed clear of subprime, such as Mr. Rivelle, as well as those at BlackRock Inc., are now dipping their toes in the water.

Hedge Fund Masters

Will looking under the hedge fund hood reveal investment gems - or are you driving by looking in the rear view mirror?

The 13Fs are arriving and it is that time again - time to look under the hood and see what all the top hedge funds are up to. This post is particularly timely as my truck just blew a gasket and I am now carless.

(For background on this approach, check out the following links - Show Me Your Hand - Betting on the Smart Money & How to Really Trade Like Warren Buffett.

Also, a new study coming out by Gerald Martin of American University in Washington and John Puthenpurackal of UNLV further validates this approach. The paper on SSRN is "Imitation is the Sincerest Form of Flattery".)

Below is a table of updated performance figures for the two strategies we track, followed by individual fund holdings and commentary. In our previous backtests, we found that the strategies outperformed the stock indexes by 6-12% per year since 2000 with similar volatility. Is the outperformence a statistical artifact based on survivor bias, or will the strategies hold up out-of-sample?

As you can see, both strategies are outperforming the indexes by quite a wide margin.

Hedge Fund Consensus - Top holdings owned by 15 value hedge funds, ranked by # of funds with the same position. The biggest winners last quarter were Schwab (SCHW) and Google (GOOG) at 33% and 24%, respectively. The biggest losers were Crocs (CROX) and Comcast (CMCSK) at approximately -23%.

Hedge Fund Best Ideas - Top two holdings from each of 10 value hedge funds listed below. The biggest winners were Mastercard (MA) at 38% Apple (AAPL) at 32%. The biggest losers were Level 3 (LVLT) at -44% and SLM at -16%.


AMX (5)
ORCL (5)
WMT (4)
AXP (3)

At the end of the post is a list of double repeats.

Best Ideas:
(Since GOOG is the top holding at Lone Pine and Tiger, I am going to take the next holding at Lone Pine, QCOM. CA also replaces AT since it is going private.)



Baupost Group

News Corp takes over the top spot, representing ~ 13% of Klarman's portfolio. Exterran Holdings, Inc. (EXH), a $5 billion market cap nat gas service company, is the second largest holding. Domtar (UFS), SLM, and Broadridge (BR) round out the top five. Klarman tripled his positions in News Corp and Domtar, while reducing his SLM holding by 70%.

Top sectors in the portfolio include:

Financials 30%
Services 27%
Basic Materials 11%
Energy 9%

Top 10 holdings are:


Blue Ridge Capital

Griffin has a fairly similar portfolio as last quarter, with increased positions in the top five holdings. Every position in the portfolio is less than a 7% holding, but then again, it is hard to move around >$3B in just a few names. He nearly doubled his positions in Level 3 and Broadridge.

Top sectors in the portfolio include:

Services 40%
Financials 18%
Technology 18%
Basic Materials 8%

Top 10 holdings are:


Warren Buffett

If it is hard to move around a couple billion, its is REALLY hard to move around over $60 billion. He seems to manage, however.

Top 10 holdings are:


Eminence Capital

Top sectors in the portfolio include:

Services 33%
Technology 30%
Financials 12%
Conglomerates 11%

Top 10 holdings are:


Greenlight Capital

Not much turnover in the top positions. New positions include Target (TGT), Children's Retail (PLCE), and US Bioenergy (USBE).

Top sectors in the portfolio include:

Services 23%
Technology 18%
Capital Goods 18%
Energy 18%

Top 10 holdings are:


Lone Pine Capital

Not much new here. Google is the top position at around 10% of AUM. New positions include Monsanto (MON) and Burlington Northern (BNI).

Top sectors in the portfolio include:

Services 34%
Technology 22%
Financials 9%
Basic Materials 8%

Top 10 holdings are:


Maverick Capital

Ainslie still likes Apple and CVS, and has built new positions in Macy's (M), Marvell Tech (MRVL), and Advanced Micro (AMD).

Top sectors in the portfolio include:

Technology 31%
Services 30%
Financials 14%
Healthcare 10%

Top 10 holdings are:


Okumus Capital

Ahmet's top four positions represent roughly 60% of the portfolio, and he added to each of them. He bought 8 million more shares of Office Depot (ODP), and 5 million each of Moody's (MCO) and Bed Bath and Beyond (BBBY).

Top sectors in the portfolio include:

Services 73%
Financials 21%

Top 10 holdings are:


Private Capital

Sold off a bit of the top holdings, but not much.

Top sectors in the portfolio include:

Services 35%
Technology 32%
Financials 22%

Top 10 holdings are:


Tiger Global

The top five positions stay roughly the same with Mercadolibre (MELI) breaking into the top five with a doubling of the position. The pm, Chase Coleman, sold off about half the shares of Baidu (BIDU).

Top sectors in the portfolio include:

Services 56%
Technology 23%
Basic Materials 9%

Top 10 holdings are:



Two funds owning the same stock:


Imitation is the Sincerest Form of Flattery: Warren Buffett and Berkshire Hathaway

We analyze the performance of Berkshire Hathaway's equity portfolio and explore potential explanations for its superior performance. Contrary to popular belief we show Berkshire's investment style is best characterized as a large-cap growth. We examine whether Berkshire's investment performance is due to luck and find that beating the market in 28 out of 31 years places it in the 99.99 percentile; however, incorporating the magnitude by which Berkshire beats the market makes the “luck” explanation unlikely even after taking into account ex-post selection bias. After adjusting for risk we find that Berkshire's performance cannot be explained by assuming high risk. From 1976 to 2006 Berkshire's stock portfolio beats the S&P 500 Index by 14.65%, the value-weighted index of all stocks by 10.91%, and the Fama and French characteristic portfolio by 8.56% per year. The market also appears to under-react to the news of a Berkshire stock investment since a hypothetical portfolio that mimics Berkshire's investments created the month after they are publicly disclosed earns positive abnormal returns of 14.26% per year. Overall, the Berkshire Hathaway triumvirates of Warren Buffett, Charles Munger, and Lou Simpson posses' investment skill consistent with a number of recent papers that argue investment skill is more prevalent than earlier papers suggest. Paper can be downloaded here:

Saturday, November 17, 2007

No Insurance, but Lots of Value


THE TYPICALLY SLEEPY municipal-bond market, a sector favored by Mom and Pop for its safety and usually low volatility, has become something of a nightmare lately. Now it's time to wake up and take stock of some pretty attractive investments.

The big fear right now is that muni insurers who place triple-A ratings on municipal debt might be downgraded by Moody's and Fitch for also insuring collateralized debt obligations -- those bonds, sliced and diced into new bonds, that are collapsing in value due to their heavy exposure to subprime mortgages.

About half of the $2.4 trillion muni market is insured, because higher ratings mean lower coupons. But "a double-A credit shouldn't have to get insurance," says Ken Woods, CEO of Atlanta-based Asset Preservation Advisors. High-quality uninsured munis, on average, have a 0.0001% chance of default, he says.

Case in point: The Schertz-Cibolo-University City independent school districts in Texas scrapped plans last week to sell insured munis, and instead sold $82.2 million of bonds rated a strong single-A by Moody's and Fitch, with top yields of 5.50%. All yields were repriced 0.03 of a percentage point lower because the deal was six times oversubscribed. A good price, apparently, trumps insurance.

Certain other uninsured munis are attractive. Yields on some California long-dated general-obligation bonds topped the psychologically important 5% mark recently as the high-tax state looks at a $10 billion budget deficit. Some New York State-related debt is trading at 0.10 to 0.12 of a percentage point above the consensus Municipal Market Advisers triple-A scale, more than its usual 0.05-to-0.10-point margin.

Dan Soldender, a portfolio manager at Lord Abbett, likes riskier high-yield munis, which have underperformed taxable debt. He's bargain-hunting for debt hospital and charter-school debt and tobacco bonds-those backed by payments from a national settlement with tobacco companies. "There's a lot of value in the yields and, historically, they've performed well," he says.

As for muni-bond insurers: Paging Warren Buffett!

IN THE TREASURY market, 10-year yields dropped to 4.15% from to 4.21% the week before, while two-year yields fell to 3.30 from 3.42%. Interest-rate futures markets last week gave 100% odds to a cut in the federal-funds rate on Dec. 11, to 4.25% from the current 4.50%.

But two voting members of the Federal Open Market Committee last week warned the market may be getting ahead of itself. The head of the St. Louis Fed, William Poole, told Dow Jones Newswires that only unexpectedly weak fourth-quarter economic data would prompt a cut, and Fed Gov. Randall Kroszner poured even colder water on rate-cut hopes in a speech to the Institute of International Finance in New York. He said that the Fed wouldn't be inclined to lower rates again, even if the economy hits a "rough patch," as he expects.

The Fed has cut its target rate by 0.75 of a percentage point at the past two meetings, starting with a half-point cut in September, followed by quarter-point reduction in October. But, to paraphrase Churchill, that may have been the beginning and the end.


Thursday, November 15, 2007

You have enough reading for more posts coming...

FAS 157 Could Cause Huge Write-offs

Banks may be on the hook for untold billions because the new rule makes it harder to avoid mark-to-market pricing of securities.
Stephen Taub, | US
November 07, 2007

It you think banks are writing off large amounts of assets now, wait until new accounting rules take effect this month.

The Royal Bank of Scotland Group estimates that U.S. banks and brokers, already under massive losses caused by the collapse in the subprime credit market, potentially face hundreds of billions of dollars in write-offs because of what are called Level 3 accounting rules, according to Bloomberg.

The U.S. Financial Accounting Standards Board Rule 157, which is effective for fiscal years that begin after November 15, 2007, will make it harder for companies to avoid putting market prices on securities considered hardest to value, known as Level 3 assets, the wire service reported.

''The heat is on and it is inevitable that more players will have to revalue at least a decent portion'' of assets they currently value using ''mark-to-make believe,'' Bob Janjuah, Royal Bank's chief credit strategist, reportedly wrote in a note published Wednesday.

Janjuah noted that, for example, Morgan Stanley has the equivalent of 251 percent of its equity in Level 3 assets, Goldman Sachs has 185 percent, Lehman Brothers has 159 percent and Citigroup has 105 percent, according to Bloomberg.

On the other hand, Merrill Lynch has Level 3 assets equal to 38 percent of its equity. As a result, Janjuah believes Merrill ''may well come out of all of this in the best health.''

In the fair value hierarchy, Level 1 is simple mark-to-market, whereby an asset’s value is based on an actual price. Level 2, known as mark-to-model and used when there aren't any quoted prices available, is an estimate based on observable inputs, Bloomberg explains.

Level 3 consists of unobservable inputs, such as those that reflect the reporting entity’s own assumptions about what market participants would use to price the asset or liability (including risk), developed using the best information available without undue cost and effort, according to FASB. There is no verification requirement if the assumptions are in line with those of market participants.

FAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair-value measurements, FASB explains.

FASB notes that until now, there have been different definitions of fair value and limited guidance for applying those definitions in GAAP. Also, that guidance was dispersed among the many accounting pronouncements that require fair-value measurements.

Differences in that guidance created inconsistencies that added to the complexity in applying GAAP. In developing FAS 157, FASB said it considered the need for increased consistency and comparability in fair-value measurements and for expanded disclosures about such measurements.

Citi do a Whitney on UBS - “A major reversal of fortune”

According to a note sent out to clients by Citi analysts today, we can “realistically” expect a further $12bn writedown from UBS in the next quarter.

UBS shareholders should also expect to see the dividend slashed, and the value of their equity diluted by a rights issue of up to $7bn. UBS, Citi’s Jeremy Sigee say dryly, will almost certainly need to recapitalise.

In other words, Citi are giving UBS the Meredith Whitney treatment. Is it true what they say - every bully was once bullied?

The difference, of course, is that Citi cut to the chase in disclosing its subprime losses - releasing details of its exposure and a breakdown of the figures. Not that it did Chuck Prince any good.

UBS, however, have been far more circumspect. Consider this table of banks’ disclosed exposure and writedowns on ABS CDOs:

Banks' writedowns

While UBS have the second highest ABS CDO exposure, they have taken one of the lowest writedowns.

Clearly, UBS are not marking their assets at current market prices, and are still heavily relying on marked to model prices. Consider also the fact that many of the CDOs UBS arranged and sponsored have been some of the worst hit - like the appropriately named Vertical Capital, a CDO whose AAA debt was slashed 14 notches to junk in one fell swoop.

Consider this table from Citi, which neatly summarises the price declines on MBS and CDOs (measured respectively by declines in the ABX and TABX indices from Markit) It’s pretty clear that UBS’s average writedown so far is paltry:
ABS and CDO tranche values

Citi outline three possible scenarios for UBS:

First we assume markdowns similar to Merrill Lynch. Under that scenario, UBS would need to take markdowns of SFr 6.7bn in 4Q07. Translating this revenue shortfall one-to-one to PBT (thereby assuming no clawback on the cost side), the group’s PBT would be -SFr 3.2bn for a net loss of SFr2.3bn. The Tier 1 ratio would be 9.5% under Basel I and 9% under Basel II. This is below the group’s target. However, cancelling the dividend (SFr4.2bn) would bring back the ratio to 10% under Basel II.

The second scenario takes conclusions from our Fixed Income credit strategists, assuming 30% writedowns on HG ABS CDOs and 60% on mezzanine ABS CDOs. UBS would report a loss of SFr 7.9bn in 4Q07, its Tier 1 ratio would drop to 8.1% (Basel I) and 7.6% under Basel II. The Tier 1 would remain below target even if the dividend were cut, raising the possibility of a capital shortfall.

The third scenario is a worst-case scenario. Under this scenario (50% writedowns on HG ABS CDOs and 100% on mezz ABS CDOs), UBS would end up with a substantial SFr22bn writedown. The group’s Tier 1 ratio would drop to 5.8% (Basel II). Even after cutting the dividend and accounting for a lower group Tier 1 ratio of 9% (Basel II), a capital shortfall of SFr 8.5bn would remain, raising the prospects of a large capital increase/rights issue.

The Yield Curve Widens

November 14, 2007


Eighteen months ago, the long end of the yield curve was almost perfectly flat. Today, some daylight can finally be seen between the long-end yields. Even though the 30-year yield isn't to new lows, the five-year yield certainly is.

Posted by edelfenbein at November 14, 2007 12:28 PM

Mortgage Woes Damage a GE Bond Fund


A SHORT-TERM INSTITUTIONAL BOND RUN MANAGED by General Electric Asset Management apparently has suffered losses in mortgage and asset-backed securities and is offering investors the option to redeem their holdings at 96 cents on the dollar.

The setback at GE Asset Management's GEAM Trust Enhanced Cash Trust is the latest in a series of problems encountered by money-market and short-term bond funds from the turmoil in the mortgage and asset-securities markets.

Legg Mason, Wachovia and Bank of America have had to provide financial support to their money-market funds to prevent their funds from "breaking the buck," or falling below the $1 asset value that money funds seek to preserve.

The GE fund, totaling $5 billion, is an "enhanced" cash fund, meaning it seeks to provide a slightly higher yield than a money-market fund while preserving principal and maintaining an asset value of $1 per share.

The fund has been willing to take more risk than a money-market fund by purchasing floating-rate mortgage and asset securities with high credit ratings. The bulk of the money in the fund comes from GE's pension trust and other GE employee benefit plans.

In a Nov. 8 e-mail to institutional holders of the fund, GE Asset Management cited "extreme conditions in the credit markets" and told investors that "it will soon begin to sell certain securities held in the Fund which will result in realized losses and likely bring the Fund's yield to zero."

In the e-mail, GE Asset Management said the fund has "sufficient liquidity to redeem all non-GE subscribers at the current net asset value (.96) but there can be no assurance that this will continue to be the case at any point in the future as the difficulties in this market persist." Outside institutional investors therefore face a 4% loss on their holdings. GE said it plans to soon redeem $250 million from the fund and may liquidate additional holdings in the future.

Based on information on GE Asset Management's Website, the enhanced cash fund has about 27% of its assets in home-equity asset-backed securities, 23% in residential mortgage securities and the rest in a mix of securities, including credit-card securities and corporate bonds. This information is as of June 30.

The 4% loss suffered by outside investors is sizable relative to the added returns that the fund generated relative to short-term investments. The one-year return on the fund through June 30 was 5.49%, versus one-month Libor of 5.39%.

In response to the Barron's inquiry, GE Asset Management said in an e-mail statement that it has "ceased taking new investments" in the fund "based on our belief that recent extreme conditions in the credit markets, including liquidity concerns and value dislocations, will continue in the foreseeable future."

GE's pension and benefit plans could suffer additional losses in the fund as more securities are liquidated. It's unclear whether GE Asset Management plans to wind down the fund.

Wednesday, November 14, 2007

Sources of Volatility's Predictive Power for Stock Returns

November 14, 2007

Past research finds that stocks with low (high) short-term historical volatility tend to outperform (underperform). What causes this relationship? In the November 2007 update of their paper entitled "Volatility Spreads and Expected Stock Returns", Turan Bali and Armen Hovakimian examine the similarities and differences between realized (historical) volatility and implied volatility in the context of power to predict stock returns. Using stock price/fundamentals data for a broad range of stocks and volatilities implied by associated options with near-term expiration dates over the period January 1996-January 2005, they find that:

  • Confirming past research, a hedge strategy that is long (short) the 20% of stocks with the highest (lowest) one-month lagged realized volatilities generates significantly negative returns (an average alpha of -1.5% per month).
  • However, a similar trading strategy based on implied volatilities derived from the prices of options generates insignificant returns.
  • The difference between realized volatility and implied volatility reasonably represents volatility risk. A hedge strategy that is long (short) the 20% of stocks with the lowest (highest) realized-implied volatility difference produces average raw and risk-adjusted returns of 0.5% to 0.9% per month.
  • The difference between the volatility implied by call options and the volatility implied by put options reasonably reflects the expected future price change of the underlying stock. A hedge portfolio that is long (short) the 20% of stocks with the highest (lowest) call-put implied volatilities earns highly significant raw and risk-adjusted returns of 1.1% to 1.4% per month.
  • These results persist after controlling for size, book-to-market, liquidity, analyst earnings forecast dispersion, probability of informed trading and skewness.

In summary, volatility-based portfolio strategies derive their effectiveness from: (1) the difference between realized volatility and implied volatility ; and, (2) the difference between call-implied volatility and put-implied volatility.

Financial News: Hedge Fund Makes $3 Billion From Subprime Bet

Dow Jones

A single hedge fund has made a gain of more than $3 billion (EUR2 billion) at the expense of investment banks by betting on the subprime crisis.

U.S. hedge fund manager Paulson & Co. has turned an investment of almost $500 million at the start of the year into almost $3.6 billion by taking out a form of insurance that started paying out as soon as subprime mortgage securities lost value, investors said.

Four other hedge fund managers - Harbinger Capital Partners, Balestra Capital, Scion Funds and Peloton Partners - have also made substantial gains from subprime, with Harbinger's fund rising just under 100% for the year to date, according to an investor in the fund.

Paulson's Credit Opportunities fund has made a gross return of 690% and a net return, after fees, of 551% for the first 10 months of the year, according to a source close to the firm. The firm's Credit Opportunities II fund has made a gross return of 410% and a net 328%.

The firm began betting on subprime in the middle of last year. Banks were offering credit default swaps, a kind of insurance contract, on the BBB-rated tranches of securities backed by U.S. subprime mortgages. The buyer had to pay a premium of 1% a year to the banks, which undertook to pay out the value of any falls in the BBB tranches.

Ken Kinsey-Quick, head of multi-manager funds at UK asset manager Thames River Capital, said: "The best returns for these hedge funds are still to come." New investors have lifted Paulson's assets from $6 billion in January to $27.5 billion, taking it from the world's 69th-largest hedge fund manager to one of the top 10. Among the investment banks, Morgan Stanley said it expected to lose GBP3.7 billion on subprime, Citigroup said its losses would rise to more than $ 14 billion and Merrill Lynch admitted to losing $7.9 billion.

Hedge Fund of the Year : Our friends at Paulson

Paulson’s Credit Opportunities Fund

U.S. hedge fund manager Paulson & Co. has turned an investment of almost $500 million at the start of the year into almost $3.6 billion by taking out a form of insurance that started paying out as soon as subprime mortgage securities lost value, investors said.

The fund has made a gross return of 690% and a net return, after fees, of 551% for the first 10 months of the year, according to a source close to the firm. The firm’s Credit Opportunities II fund has made a gross return of 410% and a net 328%.

The firm began betting on subprime in the middle of last year. Banks were offering credit default swaps, a kind of insurance contract, on the BBB-rated tranches of securities backed by U.S. subprime mortgages. The buyer had to pay a premium of 1% a year to the banks, which undertook to pay out the value of any falls in the BBB tranches.

Banks prop up money market funds

Banks and mutual fund managers are being forced to prop up their money market funds to prevent ratings agencies from downgrading the funds, as the credit crisis spreads further through the financial system, the FT reports on Wednesday.
Bank of America on Tuesday said it would spend $600m on supporting its money market funds, some of which were exposed to troubled securities.

Legg Mason and SEI Corporation are among others to have provided capital support to their money market funds in order to protect the funds’ credit ratings. A drop in the credit rating would not itself cause the fund to lose money, but it would result in many investors pulling their money out, creating an immediate liquidity drain and a dent in the funds’ reputation as a safe harbour, says the report.
Money market fund assets have risen by $640bn to a record $2,340bn in the year to date, according to iMoneyNet, the market information provider. Investors are pouring record amounts of cash into the funds, which have a reputation for safety but are not insured by the Federal Deposit Insurance Corporation.

As well as protecting the ratings, money market fund managers are trying to ensure the funds do not lose money.As the credit crisis mounts, the spectre of a fund “breaking the buck” - a dollar invested falling below its value - has loomed.

Wachovia Bank in the third quarter bought $1.1bn in securities from its Evergreen money market funds, and booked a $40m loss on the securities to avoid the money funds taking the loss.

Investors have not lost money on a US money market fund since 1994 and it is unlikely any fund operator now would allow such an event to occur.

Should a fund come close to “breaking the buck”, its parent company would bail it out.

A spokeswoman for JPMorgan, a big money market fund operator with more than $200bn, said that its funds did not contain any of the downgraded securities.

Tuesday, November 13, 2007

Average Stock Faring Worse than Market

While the S&P 500 is down nearly 8.7% from its intraday high in October, the average stock investor is likely feeling far worse. The average stock in the S&P 1500 is down 24% from its 52-week high.

Insight: Forget the falling dollar but fear a rising yen

By Ken Fisher, chief executive of Fisher Investmentsand Fisher Wealth Management

Published: November 12 2007 17:42 | Last updated: November 12 2007 17:42

Forget the falling dollar. What we should fear is a rising yen. The most amazing statistic you never heard is: the year-to-date daily correlation between ups and downs in the global stock market versus spreads between the yen and the euro is 93 per cent. That is beyond eye-popping.

On days when the euro rises against the yen, stocks rise. On days when the yen rises to the euro, stocks fall. This year’s daily yen/euro changes perfectly track this summer’s stock market correction and subsequent resurrection. Make a chart of stocks, then the yen/euro spread; slip one on top of the other, and they are virtually indistinguishable.

It is driven by the yen carry trade financing the global bull market. But if anything torpedoes this bull market, it will be a rising yen, probably driven by Bank of Japan monetary tightening.

The same correlation is true, to a slightly lesser extent, for individual country stock markets and the relationship between the yen and other currencies.

The 2007 year-to-date daily correlation coefficient between changes in the yen/euro spread and the MSCI World Index – best reflecting the total developed world stock market – is 0.93. For the S&P 500, it is 0.89, for the FTSE 100, 0.86, and for Germany’s DAX, 0.87. All higher than most people can fathom.

The correlation of the MSCI World to the yen/sterling spread is lower, at 0.75, but is still sky-high. To the Australian dollar it is 0.86 and to the Canadian dollar 0.81. All breathtakingly high. Only to the U.S. dollar, which everyone fears, is it materially lower at 0.37.

What gives?

Today anyone with access to a global custodian can borrow short-term money in any major country. At Japan’s ultra-cheap interest rates, it makes sense to borrow there rather than where interest rates are higher.

People do, from all over the world, selling yen and moving the money to higher-yielding countries to invest, picking up the interest rate spread. To do so, they must also buy that new currency. The process pushes the yen down and other currencies up, and is called the yen carry trade.

That investors would do this to the extent they can is not surprising and is perfectly rational. Conventionally we think of it as people borrowing at low rates and lending into high-yielding countries like the UK to pick up the interest rate spread as free money. So if sterling does not fall materially relative to the yen, there is a free ride.

The process tends to be somewhat self-fulfilling, as people sell yen and buy high-yielding currencies like sterling, keeping the yen relatively weak.

The correlation between the yen/euro spread is high to major-nation bond prices too. What is shocking is that it is now higher still to stocks, and so very high. That started late in 2006 for the first time.

When we borrow short-term money in Japan, as elsewhere, that bank loan increases that country’s money supply, and in this case pours that money directly into capital markets all around the world, driving stocks higher.

The Bank of Japan is financing the global bull market directly without meaning to. The impact is immediate, and to the stock market, feels great. Most days when there is a big intra-day wiggle in the stock market, it is mirrored in the yen/euro spread too.

If you like rising stocks, you do not want to see a rising yen. If the Bank of Japan envisions Japan’s economy as adequately strong and suddenly changes policy, increasing interest rates materially – pushing the yen up – it would kill the carry trade.

That would scare those who have already taken carry trade money out of Japan, forcing them to reverse course, unwind their trades, sell stocks, and flood the money back into Japan. In the process, global stocks would suffer, as would the high-yielding countries’ currencies relative to the yen.

With the correlation this high, do not fear a weak dollar; fear a strong yen. Any material sign of Bank of Japan tightening would be very bearish.

Sunday, November 11, 2007

Why Wall Street May Let Air Out of Oil Balloon

November 12, 2007

This is shaping up to be a hugely important week in energy markets. The hot oil balloon could rise to $100 a barrel. But don't be surprised if Wall Street -- driven by a mountain of expiring futures and options contracts -- steps up and pricks it.

The sheer speed with which oil has risen could intensify second-guessing as its price hovers near three digits. "Holding that number is going to require a lot more than just a belief in a momentum trade," says Ben Dell, energy analyst with Sanford C. Bernstein & Co. He says the market is hardly acknowledging that amid oil's climb, U.S. gasoline demand has slipped.

Some analysts believe derivatives markets could be making a "Great Unwind" in oil inevitable. Trading desks at big investment banks -- from Goldman Sachs Group and Morgan Stanley to Lehman Brothers Holdings -- have been active players this year in crude-oil options, which give buyers a right to buy or sell the commodity at a set price in the future. The banks' role, and the hedging they do to neutralize their exposure, can have a huge influence on crude prices.

In a recent report, Lehman analysts point to earlier this year as an example. Many oil producers wanted to hedge themselves against falling oil prices. The producers made bets with Wall Street market makers to protect themselves, Lehman says.

As part of the series of trades that ensued, Wall Street firms gained rights to buy oil at $70 and $80 a barrel. In their efforts to hedge their own positions, Lehman says, the investment banks became sellers of oil, acting as a weight on the market. When the options came into the money, Wall Street removed the hedges. Their selling pressure came off about two months ago and helped lift oil prices.

Another batch of options and futures expire this week. This time, rather than being a weight on the market as they had been earlier, many trading desks have been fueling it, says Lehman. That is because they have sold options to investors, including hedge funds, to buy oil at $100 a barrel. The closer it gets to that price, the more the investment banks buy oil to hedge.

Lehman warns a "free-fall" could follow when the investment banks stop their hedge-driven buying after options expire tomorrow. Futures contracts expire Friday. At the very least, says Lehman's chief energy economist Edward Morse, this week "could be one of the most volatile weeks for oil in years."

How big a deal are these machinations? As of Friday, says Lehman analyst Adam Robinson, 30% of all contracts to buy crude at $100 on the New York Mercantile Exchange were set to expire tomorrow.

Of course, other factors drive oil. The weak dollar supports oil, in part because investors buy it as an alternative to the cheapening currency. Strong demand in developing economies puts upward pressure on oil. And ministers of the Organization of Petroleum Exporting Countries gathering this weekend will shape the supply outlook for crude.

But when oil rises as far and fast as it has the past few weeks, one has to wonder about the role of Wall Street's financial engineers. By the end of the week, you will know a lot better.

Another Quant Liquidation Under Way?

Two days ago, we told you the there were widespread rumors that a large quant fund—possibly AQR Capital Management—might have run into some liquidity problems. Yesterday the post reported that the Greenwich-based hedge fund had scrapped its planned initial public offering after a dismal performance caused several large investors to pull their cash out of the fund. AQR hasn’t returned our calls. Time to move this story ahead despite the, uhm, lack of actual information.

Watching the markets move in the last few days—particularly with the heavy sell off in the NASDAQ—has many wondering if we’re witnessing yet another quant liquidation like we saw in late July and early August. It would make sense that if one or more funds was facing redemption notices from investors, we might see a sell-off of typical quant positions in order to raise cash. Last time around, stocks the quant funds tended to be long in plummeted, while their shorts rose. It is now part of the conventional wisdom that some of this was due to one or more quant funds liquidating both long and short positions.

So how are the heavily shorted stocks doing? Pretty good, as it turns out. Unless you are short them. Indymac BNCP, Nutrisystem, MGIC Investment CP, KB Home, MVRLP, Ryland Group, and CROCS Inc. are all up today despite the declines in the broader market. The Amex Broker Dealer index is up nearly 1.5%. With this many heavily shorted stocks rising together, it’s at least possible that some of the movement in the markets this week has been due to another quant liquidation.

Thursday, November 01, 2007

Paulson hedge funds cut subprime bets

Manager realizes some big gains, but says credit correction still not over
SAN FRANCISCO (MarketWatch) -- Paulson & Co., a $24 billion hedge fund firm that's generated huge returns from betting against subprime mortgage securities, has begun trimming those positions.
Still, the firm reckons turmoil in credit markets isn't over and has been taking more derivative bets against financial-services firms that it thinks are vulnerable, according to a letter Paulson sent to investors recently. MarketWatch obtained a copy of the letter on Thursday.
Paulson began betting against subprime mortgage securities last year. As delinquencies and foreclosures surged this year, some of those securities have slumped as rating agencies downgraded them.
That helped the Paulson Credit Opportunities Ltd. fund return 117%, net of fees, during the third quarter. That leaves the fund up more than five-fold for the first nine months of 2007, according to the letter.
As the subprime mortgage problem deepened into a global credit crisis in the third quarter, Paulson began closing some of its negative bets, locking in some of the gains from those positions.
"We took advantage of market conditions to selectively realize gains," the firm wrote in its letter to investors.
Paulson isn't the only hedge fund firm trimming subprime bets. Scion Capital, a $621 million firm run by Michael Burry, began unwinding similar trades recently. See full story.
It's not over yet
Still, Paulson also stressed that while the subprime correction is well underway, the housing market in general and other parts of credit markets are still set to deteriorate further.
Home prices have fallen 3% in the U.S. so far, but Paulson reckons there could be a 15% to 25% drop in prices from their peak.
Most of Paulson's remaining subprime mortgage positions will likely be written off as losses on these securities keep rising, the firm added, noting that it bet against the lowest-rated, riskiest parts.
Cumulative losses of 6.25%, on average, would wipe out these securities, but losses on such securities sold in 2006 could end up being at least twice that, which will wipe out higher-rated parts of these structures, Paulson explained.
Corporate debt bet
Other parts of credit markets remain vulnerable, Paulson said.
The firm has researched "dozens" of financial-services institutions and has been betting against these companies through credit default swaps. (CDS are a bit like insurance against a company defaulting. The buyer of protection, such as Paulson, is betting that companies' ability to repay their debts deteriorates).
"We believe the opportunity is similar, though not as great, as when we started buying protection on subprime well ahead of actual recognition of the problem," Paulson wrote. "We do not feel that the credit correction is over."
$15 million donation
Paulson also told investors that its funds are donating $15 million to provide initial funding for the Institute for Foreclosure Legal Assistance, a new non-profit formed by the Center for Responsible Lending.
The new group will be managed by the National Association of Consumer Advocates and will provide legal help to subprime homeowners facing foreclosure.
"Given the success of our funds, we feel it is important to help those who have suffered the most as a result of predatory subprime lending practices," Paulson wrote. End of Story
Alistair Barr is a reporter for MarketWatch in San Francisco.

A Comparison of Bubbles + China

On Monday we compared the rises and crashes of the Nasdaq and the Homebuilders during their respective bubbles. A Bespoke reader asked if we could overlay the current rise in China's Shanghai Composite on the chart to see where its bull run currently stands in comparison. The Nasdaq and Homebuilders rallied for around 2,000 calendar days, while the Shanghai has currently only been in rally mode for 560 days. However, the gains in China of 488% are fast approaching the max gains that the Nasdaq saw of 639% at its peak.

The most interesting data points here are the starting dates of the bubbles. The Homebuilders began their enormous rise on March 14, 2000, just four days after the Nasdaq peaked. Interestingly, the Shanghai started its meteoric rise on July 11, 2005 -- just nine days before the Homebuilders peaked. Investors have seemingly flocked from one bubble to the next.


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.