Channel Checks

The scope, scale and focus of the insider trading investigation continues apace.  Of the reports we have read, we wanted to quickly highlight something from the tech industry which shows a different direction.

According to "Fast Company", analysts who cover Apple are being investigated for using possible "channel checks":

Apple analysts on Wall Street are under increased SEC scrutiny for insider trading, centered on the "normal" habit of channel checks--working out what Apple may be up to by speaking to its suppliers. Is this unfair? Or are the analysts really cheating?


We're used to reading analyst reports about Apple that cite Apple's (mainly Far Eastern) suppliers, leading to rumors about how many units of such-and-such an iDevice are being sold, or if components of an upcoming piece of Apple hardware can tell us what capabilities it will have--thus revealing information about how it'll fare against its competition. Wall Street analysts use these data to form opinions about how Apple's business will perform in the future, and thereby guide their clients on whether to buy or sell Apple stock. The rest of us use their data to learn about upcoming Apple gear, and you can be sure Apple's rivals pay attention for the same sorts of reasons.


But the Securities and Exchange Commission is now busily involved in scrutiny of this "channel check" habit, on the grounds that it's a form of insider trading. The argument runs that Apple's suppliers should be keeping this information confidential, and are probably breaking their confidentiality agreements with Apple by revealing any facts. By involving themselves in this NDA breaking, the analysts are accessing privileged information in exactly the same way they'd be committing insider trading if they recommended stock activity based on information leaked from inside Apple's executive team.


So, in this analysis, will we reach a point where speaking to a janitor at a Taiwan fab plant to get a sense of production volumes is a criminal act - equivalent before the law to receiving a copy of Apple's draft 10K 2 days before it's issued direct from the firm's CFO?  We seem to be reaching the law of unintended consequences very quickly.
We like how Fast Company concludes:

Is this too much of an expansion of the SEC's powers? We know Apple's a hot topic in terms of investment, but we wish that the authorities treatment of intellectual property laws was as sensitive to the intricacies of the dynamic world of high tech as the SEC is--then we'd see less patent trolling, like the anti-Apple cases that are popping up all the time.

Top fund manager?

Who's better? Warren Buffett or George Soros? Why invest capital with people who are not the world's best at what they do? Warren and George searched for successors from hedge funds and their liquid net worth is ALL in absolute return. If you want the best sportspeople you look in Major Leagues not Minors and where are you likely to find the best portfolio managers? George and Warren's talents were proven long ago so there was plenty of time to invest. Their successful careers as hedge fund managers have had major philanthropic effects on society and economic benefits for clients.

Those claiming Warren is not a hedge fund manager seem unaware that arbitrage, leverage, derivatives, event-driven, special situations and macro trading added much to his returns and he short sold cocoa for a capital structure arb as far back as 1954. Neither has a PhD or CFA but both Warren and George have exceptional quantitative skills. I have never found a good trader that doesn't, even if they run "discretionary" styles. Below is net of any fees ACTUAL growth of $1,000 since 1969 from George and team, Warren and team versus the long only "passive" S&P 500 team.



George's track record is better but Warren is richer. Why? The miracle of POSITIVE compounding. Warren set up his hedge fund in 1957 but George wasn't in a position to set up his firm until 1969. Warren is from Omaha while Dzjchdzhe Shorash is from Budapest, a city more fraught by WW2. Warren got into currency trading and global diversification about ten years ago while George was buying Japanese and other countries' stocks in the 1950s. George's outperformance is mainly due to a deeper international knowledge edge and the fact that his investment philosophy, REFLEXIVITY, is still ignored by the crowd despite its success. Value investing is widely followed and therefore more imitated than reflexivity investing. For those "shocked" by the current Euro debt crisis in Ireland, Greece etc., George saw the dangers many years ago.

Warren ran the absolute return fund from 1957-1969 and has since implemented his strategies via Berkshire Hathaway. He first bought BRKA shares in 1962 at $7.60 and now it's $120,000 for a 22% CAGR. But the Buffett Partnership did better with all 13 years positive. With a 25% incentive fee on 6% hurdle, gross returns of 29.5% were net 23.8% to investors. What if, instead of "retiring" in 1970, Warren had continued the partnership and that performance had persisted? Investing $1,000 in 1957 would now be $100 million. Fees that Warren might have compounded for turning $1,000 into $100 million would be $1 billion. That's fine by me since I would have $99.9 million more than if I had wasted time in a low fee unskilled fund. Here is Warren's 54 year track record.



Nobel Prize economists say Warren is just a lucky outlier but some people DID seed him in 1957. The S&P 500 also began in 1957 but has performed poorly by comparison - $1,000 would now be about $100,000, obviously a huge opportunity cost. Investing with an absolute return objective using competitive edges and outside the box skills has existed for many centuries. Relative return is the fad. Passive indexing is even newer. The trouble with owning the dart board is that you do get the treble twenty and bullseye but you also tie up precious capital in many more 1s, 2s and 3s. The average hedge fund is to be avoided just like the average stock. I prefer to look for the Phil Taylor of finance. How many darts must you throw to show skill?

Some hedge funds shut down due to SUCCESS. Warren closed his fund in 1969 despite a strong track record as Stanley Druckenmiller did recently with Duquesne. The Buffett Partnership was set up when the Graham-Newman hedge fund closed, around long before AW Jones' "first" hedge fund. Warren wants to be judged on book value but you can't eat book value and I judge by what investors really receive. Partnerships are marked at NAV but the switch to BRKA subjected clients to the higher risk of public markets. In 2008 BRKA book value dropped -9.6% but shareholders lost -31.8%. While the stock has returned more than book value due to the premium valuation, volatility has been high. Warren's TRUE Sharpe ratio is much lower than the book value "Sharpe ratio". It drops from 1.4 to the 0.6 actually delivered.



George and Warren were born in August 1930 and have long track records of alpha generation from low frequency trading in various fund structures. Double Eagle -> Quantum, Buffett Partnership -> Berkshire Hathaway. Both have "retired" before and been searching for "successors" for a long time. George has been hiring "replacements" since 1981 and the extent of his fund management involvement has fluctuated since though never without close knowledge of and implied agreement with the portfolio. For every Li Lu or Todd Combs there was a Jim Marquez or Stanley Druckenmiller. No man is an island and both sought out strong colleagues and talented employees from early on. Accredited investors -anyone with $80 - can access Warren's talents through BRKB, a listed closed-end hedge fund.

Those "outrageous" fees? George charged 1% and 20%, no hurdle, while Warren charged 0% and 25% on 6% hurdle, then offered his money management skills for FREE in return for permanent, leveraged capital. But you would have done much better going with George Soros in 1969 and paying him those "high" fees than you would with BRKA. I am happy for people to be compensated well for delivering what I need, ABSOLUTE ALPHA, from their RARE abilities. If someone turns $1,000 into $100 million from skill not luck or riding the market, they deserve $1 billion. Especially when interests are aligned with clients by them being the largest investor in the fund.



This assumes fees compound without the manager needing any money to eat, live, pay employees, run the business etc. which of course they do. In recent years, with investor demands for larger teams, deep benches and operational infrastructure, fixed costs for hedge funds have risen to the modal 2 and 20. A few people, a computer and a phone would not get pension fund money today. Sad to see an Omaha pension in $600 million deficit when they could so easily had a local hedge fund run by Warren get them into surplus. Avoiding "high" fees for alpha is like saying to a Porsche dealer you will only pay $100 for a new car because that is what the raw materials cost. Or that Shakespeare was just a lucky fool who "randomly" chose words from the dictionary.

I am writing this on Apple AAPL hardware using Microsoft MSFT software uploaded to a service owned by Google GOOG. Using those products may further enrich several people who are already billionaires. Does it matter? Would Warren and George have bothered taking outside money if they hadn't been incentivized to do so and perform? High absolute returns are helpful and I'll take $100 million over $100,000 every time. I assume you would too. So what if the fund manager becomes a billionaire? They deserve it for the essential entrepreneurial service they offer. If clients get rich, it is fine by me if the manager gets richer. Plenty of "cheap" funds available but at what performance?

It's skill that adds value. No alpha, no incentive fee. George's partnership fees were lower than Warrens's for gross returns above 25%. Since George and Warren's gross performance was in excess of 25%, so George's deal was actually cheaper. Jim Simons and team outperformed both for the past 20 years with much higher fees and the net returns were superior. The technological and personnel infrastructure requirements for high frequency strategies cost far more than low frequency trading. If you don't like the fees, don't invest in hedge funds. Capacity for a good strategy is limited and demand exceeds the supply of alpha. You CAN spend absolute returns. Expensive and dangerous waiting to find out WHETHER beta might one day deliver.

It is hard to prove a theory for all cases but to DISPROVE it a single counterexample suffices. Warren, George, Jim and many others have destroyed efficient market hypotheses, random walk assumptions and the mistaken idea that long term policy asset allocation drives portfolio returns. Brinson BHB et al have cost too many investors too much money. In truth people want 100% of their capital in attractive opportunities. George and Warren's alpha capture from security selection and market timing worked better than static beta bets. No-one says it's easy but if you are smart and work hard enough it is possible. Such investment teams CAN be identified at an early stage and charge whatever hedge fund fees their clients are prepared to pay.

No-one is forced to invest in hedge funds. Investors are free to make do with passive beta and relative return if they so choose. Some academic outliers even say alpha is due to luck! If you flip a coin 10 times and get 8 heads it might be but NOT if you flip 100,000 coins and get 80,000 heads. Warren and George have flipped too many coins for their AFTER FEE returns to be considered luck. They made their clients rich, deservedly got richer themselves and are giving that wealth away for the social benefit of the world. A rare financial win/win/win.

How expert networks came to dominate Wall Street

The latest insider trading investigation is focusing on the new hub of Wall Street information: independent research networks that pay so-called experts for information on public companies. 
 
What is it with Wall Street these days that it won't let a record stand for the usual amount of time? First, Marc Dreier gets one-upped by Bernie Madoff. Then, Bear Stearns gets bested by Lehman Brothers. And now the Galleon insider trading scandal—only a year old!—looks like it's going to get dusted by the latest insider trading probe on Wall Street.
According to the Wall Street Journal, one of the Feds' targets in this probe is not a new one: so-called expert networks, which provide research "services" to hedge funds and mutual funds. Such services can include data and analysis, but very often consist merely of connecting a hedge fund analyst with an "expert" who might be a customer, client, or even employee of a company that the fund is an investor in. The networks reportedly being investigated are ones that most of us have never heard of: Primary Global Research and Broadband Research, both outfits that provide customers with intelligence about the technology industry.
This is not the first time these kinds of companies have found themselves under the legal microscope. Nearly four years ago, the New York attorney general took a look at a couple of the big players in the third-party research space, Gerson Lehrman Group and Vista Research. Nothing much came of it at the time. And neither has been mentioned in this go-around. (Not that they're not on high alert: An email has circulated at Gerson reminding employees that they are not to speak to the press.)
The one remarkable constant in these investigations: the hope that all roads will eventually lead to SAC Capital Advisors, the high-velocity trading firm run by reclusive hedge fund billionaire Steve Cohen. Never has a target proven so tempting yet so elusive. Even Goldman Sachs (GS) pays a $550 million fine every now and then.
But I digress. It's no wonder that expert networks have taken off in recent years as an adjunct to the traditional equity research process. For one, sell side research has never been the same since the scandals of a decade ago, when the likes of Henry Blodget and Jack Grubman were exposed as mere agents of their firms' investment banking and trading franchises. The resulting investigations and fines changed that business for good.
Regulation FD also cut the phone lines that used to run directly between Wall Street and company management. The result: a game of broken telephone where the corporate intelligence has to be sourced in other ways.
The third reason Wall Street took to expert networks is because they are birds of a feather: facilitators in the flow of something—money or information—between two large groups. Wall Street has historically stood between those who have money and those who want money, and introduced hither to yon. Expert networks purport to perform the very same function, but the product is not money but expertise. A late 2009 report by Integrity Research demonstrated just how important a part of the process expert networks had become: 40% of investors in a survey considered the networks either "very" or "extremely" important.
Illegal, unethical, or above board?
The nub of the question, then: is there anything wrong with the expert network per se? No, of course there isn't. Everybody wants an edge, and if the price is right, everybody is willing to pay someone to act as a "consultant" in pursuit of that edge. Every single one of us pays "experts" pretty much every day of our lives because it helps us to make decisions that are better informed.
Problems arise, though, when people do what people are sometimes wont do to, which is to step over the ethical or legal line. Selling someone expertise is one thing. Selling illegal information is another. And while there's always plausible deniability, these people generally know quite well what they are doing. It's unlikely that Dr. Yves Benhamou told his friend at hedge fund FrontPoint partners that hepatitis drug Albuferon wasn't working because he was worried his friend might end up taking the drug himself. Far more believable: that he knew his friend's fund owned shares in Albuferon's maker, Human Genome Sciences (HGSI), and could avoid a loss by selling before the information broke. The FrontPoint partner has not been charged but remains under investigation.
It's sad to say, but if arrests do come and convictions are found in the size that the Journal suggests, it's just another confirmation that believing in a basic inclination to human decency is naive, at least when it comes to the investment world. It's the same conclusion one can draw from Bethany McLean and Joe Nocera's excellent new book about the mortgage crisis, All the Devils Are Here: the real surprise isn't that there's a new scam being run, but that there are so many willing participants. For those of us who try to give people the benefit of the doubt—even those who choose to work on Wall Street—this is nothing but demoralizing news.
One guy who doesn't seem to think he's in too much trouble is Broadband Research's John Kinnucan. He's bragging to the press that the Feds couldn't make him roll on his clients in a way that suggests he doesn't actually have much to hide. Still, Mr. Kinnucan qualifies for the dubious judgment award by virtue of his decision to alert every one of his clients that the FBI was sniffing around at all. He told the Wall Street Journal that he was "contractually obliged" to inform them of the fact. That seems a little far-fetched, as well as a little ethically challenged.
But, like I said, we live in ethically challenged times.

Dead air on Lake Hedgistan as managers wait for a breeze

Those who sail near large cities know that one of the biggest challenges you face on a typical summer afternoon is the dreaded “thermal.” When the downtown core heats up, air rises and prevailing winds all but disappear.  Pilots experience the same thing on a hot summer day – they call it turbulence.  But sailors often refer to it as a “hole” in the wind that stalls all but the most skilled mariners. It appears as though Hedgistan City heated up so much last year that it has caused a thermal for hedge funds.  Individual strategy returns, fund returns and even stocks themselves are so uniform this year, it’s as if the industry were stuck in a thermal.
In a year with so many blockbuster financial stories, one of the subplots has been the incredible shrinking stock dispersion. It turns out that beta trumped alpha this year as stock pickers search for ways to eke out a living.
In its Q3 update on the hedge fund industry, Credit Suisse showed that the average cross-correlation of S&P stocks is coming off highs not seen even before the financial crisis. High correlations make sense in times of crisis when disappearing liquidity and spiking volatility has market-wide effects, but during relative calm periods?

The tight coupling of stock prices is likely what’s behind the equally tight range of hedge fund returns. As Credit Suisse illustrates, the YTD 2-standard deviation range of returns among managers of the same strategies is dramatically smaller than it was in Q4, 2009. And even more so for the outliers:

Just in case you thought 2009 was an anomaly, that somehow inter-strategy returns were more divergent than average that quarter, check out the chart below from the report. The range between best and worst strategies this year was around 22% by the end of Q3, 2010. Last year, this number was 72%, and the year before 68%. In fact, if things hold up until the end of the year, this year’s best-worst range will be the lowest since 2005.
This makes life a little less risky for managers of multi-strategy funds and funds of funds. But by the same token, it makes it hard to differentiate themselves. More importantly, it also suggests that a passive investment in a broad hedge fund index might end the year not far off from an active manager that rotates between strategies. (click to enlarge)

So what?
In this post, we covered an article from the Journal of Alternative Investments arguing that, unlike with long-only funds, hedge fund manager dispersion is higher than hedge fund strategy dispersion. This, the authors contend, favoured funds of funds over multi-strategy funds since funds of funds are able to rotate both among strategies and managers.
But as Credit Suisse showed above, dispersion has taken a vacation from both strategies and managers.  So, should investors give up on active management of hedge fund allocations and go back to long-only? That would be an interesting idea if it weren’t for the fact that stock dispersion is low and that long-only manager dispersion is notoriously low to begin with.
Hopefully, 2011 will bring in a new breeze.  Otherwise, it might be another boring year near the water.

Municipal Bonds Get Crushed

Couple the increased likelihood of an extension of the Bush tax cuts with a new Congress that has at the least put on a front of opposing further bailouts, and you get the kind of municipal bond performance we've seen in recent days.  After drifting lower from late August to early November, the National Municipal Bond ETF (MUB) has tanked this week.  The California Municipal Bond ETF (CMF) has tanked as well.   So far the investment world hasn't paid much attention to this big move lower in the muni-bond market, but it's likely to get coverage soon if the declines continue.

Stock-picking alpha in a life or death struggle?

Stock-picking skill is increasingly tested by a low dispersion of stock returns. Everything, junk and quality, seems to rise or fall in almost exactly the same measure, despite divergent fundamentals. Blame it on macro-oriented investors, and particularly ETFs, the most convenient way to express a macro view.
ETFs may be emblematic of efficient market investing – a cheap beta play to tap the equity risk premium. But they appear to be wreaking havoc on the efficiency of markets – by keeping clapped-out clunkers from moving over for high-performance vehicles.
Since the Great Bust of 2008, stock markets – at least in the U.S. – have been notable for a dwindling of dispersion.  Some are calling this the death of alpha (or at least, of stock-picking).
Murray Coleman reports, in his blog at Barron’s, on an October study by Birinyi Associates Inc. that indicates that on the Russell 3000: “correlations between the index and its members were averaging 0.63 at the end of last month. … The Russell 3000, designed to represent the total U.S. stock market, has a long-term average correlation of 0.32 to its underlying stocks, according to Cleve Rueckert, a Birinyi analyst.”
Tyler Durden at ZeroHedge has been following this theme as well, citing the analysis of Matt Rottman at Barclays Capital:

“The riskier the stock (e.g. the higher its beta), the better its return was this month. The greater the investor skepticism and the more negative the sentiment surrounding a name at the beginning of the month (e.g., the higher its short interest), the better a stock’s return was in September. It was that simple.”

That has lead some in hedge fund land to complain that market-neutral returns, long/short and arbitrage returns are being squeezed.
Speaking at a recent ETF conference, Jim McGovern, managing director and CEO of Arrow Hedge Partners Inc., said:

“Because there is so much trading in the ETFs right now, there is a lack of dispersion in the markets. So the separation of winners and losers, great companies from less-great companies, if you will, has been obscured. … [I]t makes no difference how it works, how it trades or whether it works because they all go up and down at the same amount as the ETF does. The ETF is driving the flows until something happens.”

Still, is alpha dead? Are ETFs killing the hedge fund industry?
A recent study from Hennessee Group tries to make the case:

“The spike in correlation between individual stocks has made alpha generation a challenge in 2010, particularly for fundamentally based long /short equity hedge funds…The ‘risk on-risk off’ trade, driven largely by macro sentiment, continues to dominate the financial market…Until we see fundamentals return to the forefront of investing, we believe hedge funds will have difficulty executing their investment strategy, particularly on the short side.”

Continues the Hennessee Group:

“Another factor contributing to the spike in correlation is the use of exchange-traded funds (ETF’s).  As the markets have become increasingly correlated and individual stock selection has proven challenging, investors have sought the use of ETF’s to make broad-based bets on the financial markets.”

Which makes sense, since ETFs now account for 30% of the daily volume on U.S. exchanges.
What’s interesting, Hennessee suggests is that “as can be seen in the chart below, low quality stocks (B- and C based on S&P ratings) have consistently outperformed high quality stocks (A and A+ based on S&P ratings) since the beginning of 2009. This can be partly attributed to the use of exchange-traded funds as these passively managed funds buy into and sell out of broad-based indices, which leads to erratic moves for the underlying securities, irrespective of fundamentals.” (click to enlarge)

“Hedge funds seeking to generate gains in their short portfolios have found this to be an increasingly frustrating development as stocks with poor fundamentals continue to outperform as they benefit from investor flows into broad based investment vehicles,” Hennessee concludes.
Dead alpha, or just difficult alpha?
ETFs cut both ways: “For the hedge fund industry, who are really power users on the short side, you’ll find many ETFs are almost impossible to borrow because they’ve all been locked up by hedge funds,” says McGovern.
In other words, the alpha potential is there – just not the liquidity. Back to the future – or rather, the futures market.

A Hedge-Fund Manager's New Groove

A former hedge-fund manager who made a fortune shorting stocks has switched to the long side, and is raking in money in the process.
William von Mueffling surprised clients and competitors last June by announcing he would close his hedge funds and return $3.5 billion to investors. His firm, Cantillon Capital Management of New York, kept managing $1 billion in long-only assets, typically considered the unsexy piece of the business.
Now, the 42-year-old stock picker controls more money than he did before he closed his hedge funds. Cantillon has raised billions of dollars from pension funds in the U.S. and abroad, and from sovereign-wealth investors, according to clients and other people familiar with the matter.

The inflows, helped by a 21% return this year, have boosted Cantillon's assets to more than $5 billion, the people said. The average stock mutual fund focused on world-wide equities is up 8.6% this year, according to Morningstar.
Cantillon is now a firm with an altered investment process and much lower fees.
After years of "long-short" investing, Mr. von Mueffling and his analysts and traders no longer short, or bet against, stocks at all. Instead, like a typical stock mutual fund, they stick to buying company shares they expect will rise. Mr. von Mueffling said the strategy is "the right long-term decision."
"I'm not saying there aren't overvalued stocks out there," he said in an interview. "There are, but trying to short them when the government is printing money is a very, very challenging game," he said, referring to, among other things, Federal Reserve programs to buy government bonds, which the Fed is widely expected to announce this week.

William von Mueffling

The remade Cantillon pulls in much lower fees than a hedge fund with similar returns would. Hedge funds typically get to keep 20% of profits, on top of a flat management fee, usually 1.5% to 2% of assets, that clients pay. In contrast, the majority of Cantillon investors pay just a management fee of 1.25% or less, according to fund documents.
That means that no matter how well the fund performs, Mr. von Mueffling and his team won't take in anywhere close to what they used to in their heyday as hedge-fund managers.
But Cantillon has multiplied its size during a period when many hedge funds and mutual funds continue to shrink and as investors have fled stocks in droves.
Managers might expect institutional long-only money to stick around during down markets, compared with the urge by some hedge-fund investors to pull out amid losses. Mr. von Mueffling, by focusing on institutional long-only money, appears focused on building an asset-management business less prone to clients bolting after a bad year.
Last week, Mr. von Mueffling told clients he would stop taking money from new investors. He has discussed barring inflows altogether next year, even from existing clients, to cap assets in his fund, Cantillon Global Equity, at about $7.5 billion, said people familiar with the matter.
The former hedge-fund manager was born in Munich to a German investment-banker father and an American mother. His father died when he was a toddler, and his mother moved William and his siblings to New York.

Mr. von Mueffling started Cantillon in 2003 after gaining fame as an investor in his early 30s at Lazard Asset Management. He made a killing shorting technology stocks, posting average annual returns of more than 30% from 1998 to 2003. When he left Lazard, money followed him, and so did ex-Lazard peers Rob Cope and Tom Ellis, now both at Cantillon.
At its peak, strong returns and client inflows helped Cantillon expand to manage $10 billion in assets. In 2008, the five-year-old firm lost less money than most hedge funds did, but clients withdrew funds nonetheless amid a broader exodus from hedge funds.
Then last year through May, its hedge funds were down about 7%, trailing most peers. In Mr. von Mueffling's eyes, the markets had changed, and his business needed to transform, too.
"Our strategy has run its course," he told clients last June, according to people familiar with the private conversations. He discussed how in 2008 and early 2009, Cantillon had a hard time finding stocks to short profitably, despite hiring more analysts to do more research. More broadly, hedge funds face a harsh reality when losses persist: They can't earn big fees again until they make up for those losses.
Short selling has, for many hedge funds, been treacherous recently, said fund managers and investors. Hedge funds that specialize in short selling have had the worst performance during the past rolling 12 months, with an average return of negative 14%, of any strategy tracked by Hedge Fund Research Inc.
Part of the pain has come from macroeconomic issues, such as low interest rates, that have overwhelmed company-specific factors that can drive stocks. At the same time, markets driven increasingly by computer programs have undermined some investors' abilities to predict how stocks will move on a short-term basis. Shorting also has come under fire around the world, with some governments proposing bans on short selling altogether.
Cantillon's strategy is to dig around for companies that, regardless what business they are in, produce higher-than-average returns on shareholder equity, while they are priced cheaply relative to their earnings streams.
"You want to be in businesses that can pass through inflation, and also that have exposure to currencies in parts of the world that are growing," which in this environment helps protect against the declining value of the U.S. dollar, Mr. von Mueffling said.
Cantillon holds 50 to 110 stocks at any given time. Right now, they include Intertek Group PLC, a firm that tests everything from shoes to chemicals; toothpaste-maker Colgate-Palmolive Co.; and brewer Heineken NV.
Other hedge-fund managers have started long-only funds. They include ex-Tiger Management LLC stock pickers Steve Mandel and Andreas Halvorsen and quantitative investor Cliff Asness. But unlike Mr. von Mueffling, they didn't shut down their hedge funds.
"Diversifying products means diversifying business risks," said Stuart Hendel, head of UBS AG's prime brokerage business, a unit of the bank that caters to hedge funds.
Most of Cantillon's standard hedge-fund-only investors are gone, including the funds of hedge funds. EnTrust Capital Inc., a New York fund of funds, is an exception.
"I think his analysis of securities is very disciplined," said Gregg Hymowitz, EnTrust managing partner. "We're not getting the short exposure, but we're also not paying the hedge-fund fees."
Cantillon held onto at least one trait typical of hedge funds: Investors didn't get in cheaply. The minimum to invest was $10 million.

the steep yield curve of the 1930s

richard shaw seeking alpha ran an article back in 2007 with a providential chart of the yield curve spread dating back to 1927.

what's worth noting is that the curve steepened throughout the deleveraging of the early 1930s with absolutely no inflationary implication, and stayed steep through the second world war. this feeds directly into the rationale of removing the yield curve from leading economic indicators during deleveraging cycles.

a steep curve is normally indicative of a large spread to be harvested by banks if they have the wherewithal to lend. lending growth drives growth in financial assets, income and aggregate demand, and can indeed foment inflation if such growth outpaces capacity. as such, it has a rightful place among leading economic indicators under normal circumstances.

but "normal circumstances" is very far from where we are today. other factors in a balance sheet recession -- notably the lack of private sector loan demand as the private sector attempts to improve balance sheets and the lack of borrowers creditworthy on the stricter standards of banking resultant of banks protecting themselves from further losses -- are driving net financial assets down in a secular deleveraging. and there can be little doubt that we are in fact deleveraging.

ft alphaville highlights the steepening US curve along with a multifaceted take on how the shape of the curve could influence bank behavior, but the critical observation remains that there is no loan demand -- that is, loan demand is net negative, with the private sector preferring even with very low interest rates to reduce debt -- meaning that the steep curve the federal reserve is trying to engineer will have no beneficial effect.

For Tepper, Washington Is an Investment Guide

The hedge fund manager David Tepper has done well again by betting on the moves of Washington.
Mr. Tepper, who runs Appaloosa Management, a $14 billion hedge fund in Short Hills, N.J., told CNBC in late September that the Federal Reserve’s willingness to intervene in the market with quantitative easing meant that most investments — except for Treasury bonds — would do well.

At the time, Mr. Tepper told CNBC that his hedge fund had slightly increased its investments in stocks.
Judging by his fund’s results for October, Mr. Tepper has been riding the stock market rally, which took off last week after the Federal Reserve announced plans to pump $600 billion into the economy through the purchase of Treasury bonds.

Mr. Tepper’s flagship fund, Appaloosa Investment, had a return, after fees, of 5.10 percent last month, which brought its return for the year to 20.90 percent as of the end of October, according to the monthly results released by the fund to its investors. His offshore fund, Palomino, returned 5.07 percent after fees last month for a 20.98 percent increase for the year as of the end of October. And his Thoroughbred fund had a net return of 3.07 percent in October and 18.23 percent for year.

By comparison, the Standard & Poor’s 500-stock index rose about 3.7 percent in October; it is up 9.7 percent for the year.

“Despite an under emphasis in equities through most of the third quarter, performance was good,” according to an investor letter dated Oct. 28 from the Palomino fund. The letter said that “towards the end of the quarter, particularly after the Federal Reserve statement, we became more constructive on equities.”
The letter noted that the fund was “more bullish in general” but was monitoring its positions.

In recent years, Mr. Tepper has done well by betting that the government would follow through with its stated moves. For instance, he told CNBC that he bought bank stocks in 2009 because the federal government published its plan to prop up the financial sector after the credit crunch. (His fund produced a whopping 132 percent return last year, largely because of the bet.)

“It was easy,” Mr. Tepper said in the interview. “The government told you what they were going to do.”
Similarly, in recent months, he has banked on statements from the Federal Reserve that it was prepared to add more fuel to fire the economic recovery. More than a month before it introduced plans to buy bonds, the Fed gave the public a first clue to its thinking. After a meeting in late September, the Fed released a statement saying the Federal Open Market Committee was “prepared to provide additional accommodation if needed to support the economic recovery.”

Then, a few weeks later, when the minutes of the Fed meeting were released, more evidence emerged that the central bank was likely to act — sooner rather than later. The minutes revealed that Fed members “generally” sensed accommodation might be needed “before long.”
Mr. Tepper’s recent move into stocks is notable because Appaloosa has been known for investing in distressed securities, particularly bonds. That is not surprising given that Mr. Tepper got his start in life trading junk bonds at Goldman Sachs & Company.
Appaloosa Investor Letter

Bridgewater founder to hedge funds: Be more than index funds

Some harsh words of advice for the hedge fund industry from one of its own: it's not all about making money. Bridgewater Associates founder Ray Dalio told hedge fund industry leaders to stop being glorified index funds. His challenge to his peers was issued during the HFM 2010 US Performance Awards at the end of October, reports HFMWeek. Since Dalio did not attend, his co-chief investment officers delivered his message to the some 650 managers who attended the ceremony.
In his prepared statement, Dalio wrote that it's a tragedy that "the average hedge fund is about 70% correlated with equities," says the report, adding that jettisoning this strategy will make the industry much more attractive to institutional investors. Bridgewater's investors are large institutions and sovereign wealth funds.
Dalio's remarks were presented by Robert Prince and Greg Jensen, who was Number 11 on Fortune's 40 Under 40 list, and he was honored that evening with HFM's Special Contribution Award.
Greed was also on Dalio's mind. According to HFMWeek, he wrote that hedge funds must evolve from "owner-operated boutiques primarily focused on making lots of money for their owners to rock-solid institutions that have cultures that put meaningful work and meaningful relationships above all else." And he added: "Just because we are in the money-making business doesn't mean that we have to put making money above all else."

Bridgewater declined to comment.
Dalio is considered a quirky guy, even within an industry that attracts the finance people who don't fit in with Wall Street's more straight-laced culture. He runs his $86 billion firm in accordance with 295 personal principles that place the pursuit of truth above all else.
Bridgewater's flagship fund is up about 38% so far this year (versus the hedge fund industry's average return of about 5%,) thanks to a big bearish bet on the economy that reflects the firm's belief that we're in the midst of an extended period of negative economic adjustments. To make money, he was bullish this year on Treasuries, the yen, and gold.
When Dalio talked to Fortune about this phenomenon back in March, he referred to it as the D-process. While a recession is a contraction in real GDP brought on by central bank tightening that ends when the central bank eases, a D-process happens when an economy has an unsustainably high debt burden and monetary policy stops working. In Dalio's view, the bank must then print money or the country must write down the value of its debt, or some combination of the two. Dalio followers are convinced that the current ultra low rate environment and Federal Reserve decision to buy $600 billion in long-term Treasuries over the next eight months are evidence that the Dalio is right about the economy.
It's unlikely that the D-process was top of mind at an event that was held at Manhattan's swanky 583 Park Avenue. Even so, hedge funders may want to take Dalio's latest edict seriously. It seems, after all, that he was right about the economy's massive structural shift. Why bet against him when it comes to the hedge fund industry's current sea change?

Market Wisdom

“Wall Street people learn nothing and forget everything.”  Ben Graham

“ Buy on the cannons, sell on the trumpets.” Old French Proverb

“A stock broker is one who invests other people’s money until its all gone.”  Woody Allen

“It is fortunate for Wall Street as an institution that a small minority of people can trade successfully and that many others think they can.” Ben Graham

“Wall Street indices predicted nine out of the last five recessions!” Paul Samuelson

“ There are two kinds of investors, be they large or small: those who don’t know where the market is headed, and those who don’t know that they don’t know. Then again, there is a third type of investor –the investment professional, who indeed knows that he or she doesn’t know, but whose livelihood depends upon appearing to know.” William Bernstein

“The point is, ladies and gentleman, that greed, for lack of a better word, is good. Greed is right, greed works. Greed clarifies, cuts through, and captures the essence of the evolutionary spirit. Greed, in all of its forms; greed for life, for money, for love, knowledge has marked the upward surge of mankind.” Gordon Gekko

“It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.”  George Soros

“October: This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August and February.”  Mark Twain

“If past history was all there was to the game, the richest people would be librarians.” Warren Buffett

“Wall Street is the only place that people ride to in a Rolls Royce to get advice from those who take the subway.”  Warren Buffett

“A market is the combined behavior of thousands of people responding to information, misinformation and whim.”  Kenneth Chang

“The four most dangerous words in investing are “This time it’s different”.   John Templeton

“Money can’t buy you happiness but it does bring you a more pleasant form of misery.” Spike Milligan

“If you don’t follow the stock market, you are missing some amazing drama.”  Mark Cuban

“The average man doesn’t wish to be told that it is a bull or a bear market. What he desires is to be told specifically which particular stock to buy or sell. He wants to get something for nothing. He does not wish to work. He doesn’t even wish to have to think.”  Jesse Livermore

“In this business if you’re good, you’re right six times out of ten. You’re never going to be right nine times out of ten.” Peter Lynch

“ Markets can remain irrational longer than you can remain solvent” John Maynard Keynes

“The markets will return to rationality the moment you have been rendered insolvent.” Dennis Gartman

“Risk is good. Not properly managing your risk is a dangerous leap” Evel Knievel 

“Sometimes your best investments are the ones you don’t make.” Donald Trump

“The most predictable thing about the stock market is the number of experts who take credit for predicting it.” Dave Weinbaum 

“I have probably purchased fifty ‘hot tips’ in my career, maybe even more. When I put them all together, I know I am a net loser.” Charles Schwab

“Money talks… but all mine ever says is good-bye.” Anon

“Don’t gamble! Take all your savings and buy some good stock and hold it ‘till it goes up, then sell it. If it don’t go up, don’t buy it.” Will Rogers

“Give me a stock clerk with a goal and I’II give you a man who will make history. Give me a man with no goals and I’II give you a stock clerk.” James Cash

“Never make forecasts, especially about the future.”  Samuel Goldwin

“Stocks are bought on expectations, not facts.” Gerald M. Loeb

“Your success in investing will depend in part on your character and guts, and in part on your ability to realize at the height of the ebullience and the depth of despair alike that this too shall pass.” John Bogle

“You make most of your money in a bear market, you just don’t realize it at the time.” Shelby Davis

Grantham: Yes, Stocks Are Overvalued, But You Have To Buy Them Because Bond Prices Are Ridiculous

In his latest quarterly letter, Jeremy Grantham says stocks are still overvalued, but are a better long-term choice than bonds--because bond prices are absurd.  Of course, you'll also want to keep a bigger-than-normal pile of cash in the hope that prices will crash and you'll get a chance to deploy it and not get screwed.
As the asset class forecast chart shows (click for a larger version), the most promising classes of stocks are "high quality" (no debt, high cash flow) and emerging markets.   Basically there's nothing attractive in bond land.
Here's Jeremy:

Should we buy overpriced stocks when bonds are
even worse?

We plan to write more substantively on this topic in the near future, but for now the short answer is that bond prices are currently manipulated, and are yielding less than any market clearing price would suggest. 

They absolutely do not refl ect the substantial fears in many quarters about inflation in the long term.  Even in less manipulated times, bond prices can be quite silly for the usual behavioral reasons, as demonstrated most clearly by the 15% yield on the 30-year Treasury in 1982!  Bonds are thus emphatically not a reasonable yardstick for measuring value in stocks. 

We use the long-term returns for stocks to decide what their fair value is.  They are currently overpriced.  Bonds are even less attractive.  Yet, remember that in a strongly mean-reverting world, you need to be careful about enthusiastically buying the less ugly of two overpriced investments.  Cash has an option value: on the chance that stocks or bonds or, better yet, both, decline, the investor will need resources from which to buy.

Specifically, here are Jeremy's general recommendations:

1) Emphasize U.S. quality companies, which are still
cheap in an overpriced world.

2) Moderately overweight emerging market equities.

3) Moderately underweight the balance of global equities.

4) Heavily underweight lower quality U.S. companies.

5) Carry extra cash reserves for a volatile market with
insecure fundamentals.

6) For the very long term (20 years) overweight
resources, particularly if they have a sharp decline. 
(This is my personal view rather than that of GMO,
which on this topic is agnostic.)

See Also: Jeremy Grantham on Gold

`Must Have' Hedge Funds Get Fifth of New Cash

Och-Ziff Capital Management Group LLC, Elliott Management Corp. and Comac Capital LLP pulled in almost a fifth of the money going into the $1.7 trillion hedge- fund industry this year, showing how selective the richest investors have become when allocating assets.
The three funds, which have combined assets of about $49 billion, together attracted $7.6 billion in net new money, according to investors, who asked not to be named because the funds are private. Investors poured $42.3 billion into hedge funds overall in the first nine months of 2010, about 2 percent of total assets, data from Chicago-based Hedge Fund Research Inc. show.
While this is the first year that hedge funds have experienced net deposits since 2007, the amount of money raised as a share of assets is the lowest since 1998, when new capital from investors accounted for 1 percent. Some of the best-known managers, among them Paulson & Co. and D.E. Shaw & Co., have seen net redemptions. The number of startup funds has declined by a quarter, as investors shun managers without a track record.
“The universe of funds that has raised capital is very small,” said Steve Keller, head of financing sales for the Americas at Bank of America Corp. “The market environment is incredibly choppy, and until investors have a better sense of clarity around key issues like the elections, currencies and financial regulation, few will likely be rushing into the market.”
Popular Strategies
About 75 percent of the $19 billion of net deposits in the industry in the third quarter went to managers overseeing $5 billion or more, according to Chicago-based Hedge Fund Research Inc.
Och-Ziff, the $26 billion firm run by Dan Och, 49, has pulled in a net $2.7 billion, making the New York-based firm one of the most successful money-raisers so far in 2010, according to investors. London-based Comac, with $6 billion, has attracted about $2.5 billion, and New York-based Elliott, with more than $17 billion in assets, has raised about $2.4 billion.
Executives from the firms declined to comment on the fundraising.
The three firms have been helped by the popularity of their strategies. Both Och-Ziff and Elliott are multistrategy funds, and Comac is a macro fund. The two groups, along with event- driven funds, are among the most popular for investors this year, according to Hedge Fund Research.
Money Magnets
Macro-fund managers seek to profit from broad economic trends by trading everything from bonds to commodities, while event-driven funds seek to capitalize on company events such as mergers, spinoffs and bankruptcies. These strategies allow managers to invest in a wide array of markets and securities, and clients are betting that flexibility will increase traders’ likelihood of making money at a time when stock prices have been volatile and interest rates globally are low.
In the first four months of the year, stocks, as measured by the Standard & Poor’s 500 Index, climbed 6.4 percent. In the following four months, they dropped 12 percent, and since the end of August, they’ve climbed 13 percent. Interest rates on 10- year government bonds in the U.S. and Europe are under 3 percent and in Japan are less than 1 percent.
For a fund to attract money in this environment, past returns must be strong, and the firm needs to be big enough to absorb large investments from institutions, said Brad Balter, who runs Balter Capital Management LLC in Boston.
Singer’s Track Record
The Comac Global Macro Fund, run by Colm O’Shea, 40, gained 3 percent this year through September. Macro funds, on average, climbed 3.5 percent, according to Hedge Fund Research. In 2008, when macro funds gained 4.8 percent on average, it climbed almost 31 percent.
Other funds attract money because of their longevity and strong returns. Elliott, founded by Paul Singer, 66, in 1977, boasts one of the longest track records in the industry, with an average annual return of around 14.5 percent. The inflows this year are commitments from clients, and not all of the $2.4 billion has been called yet, the investors said.
Och-Ziff has attracted new money even as it underperformed peers. The OZ Master Fund has returned 4.2 percent this year, while multistrategy funds jumped 9.6 percent, on average, through September, according to Hedge Fund Research. Och-Ziff didn’t block redemptions from its funds in 2008, when many other firms limited withdrawals.
Managers that treat their investors well, including a willingness to cut fees for large allocations, tend to be popular, Balter said. On top of that, he said, there are a few must-have funds every year that everyone seems to add to their portfolios.
‘Money Begets Money’
“Money begets money,” said Balter, who farms out money to hedge funds. “If an investor sees other large investors flocking to a fund, then the perception is that his decision to invest is validated.”
Highbridge Capital Management, the New York-based firm owned by JPMorgan Chase & Co., raised about $1.5 billion this year for its hedge funds, which include a multistrategy fund and four smaller single-strategy funds, according to investors. Together, its hedge funds manage about $11 billion.
While institutions tend to put money with the largest managers, some of the biggest funds haven’t been able to attract capital this year.
Assets at New York-based D.E. Shaw have tumbled by 46 percent to $21 billion from their 2008 peak, as investors, angered by the firm’s decision to limit withdrawals in 2008, exited.
Paulson’s Withdrawals
Paulson & Co., the $32 billion New York-based firm run by John Paulson, has had moderate redemptions this year because of losses in its flagship fund, according to an investor who asked not to be named because the information is private. Paulson’s Advantage Plus Fund had fallen 11 percent through August before recouping the loss in September.
SAC Capital Advisors LP, the $12 billion firm run by Steven Cohen, attracted a net $500 million this year, according to investors, compared with $1.3 billion in the last six months of 2009. Hedge-fund investors said the drop-off in new assets this year may be because clients are putting less money into equity funds, and are steering away from firms with higher-than-normal fees.
SAC, based in Stamford, Connecticut, charges 3 percent of assets and as much as 50 percent of profits. Most managers demand 2 percent and 20 percent. SAC’s flagship fund returned about 9 percent through September, investors said.
Other hedge-fund firms have closed to new investments to preserve their ability to produce returns, including London- based Brevan Howard Asset Management LLP. The company isn’t taking any more money for its Brevan Howard Master Fund, which now has about $25 billion in assets.
Dalio Closes
Bridgewater Associates Inc., the Westport, Connecticut- based firm run by Ray Dalio, closed its flagship Pure Alpha Fund II, a macro fund with $35 billion in assets that has climbed about 38 percent so far this year.
Some smaller funds have bulked up. The $6.6 billion Caxton Global Investment Ltd., run by Andrew Law, has pulled in a net $700 million this year as the fund climbed 8.5 percent through Oct. 20, according to investors.
Dan Loeb’s $3.7 billion Third Point LLC pulled in a net $760 million for its flagship event-driven fund, investors said. The fund has climbed more than 21 percent this year. Dallas- based Carlson Capital LP, run by Clint Carlson, raised a net $500 million for its $5.7 billion multistrategy fund, which has jumped 8 percent this year.
Topping Up
Overall, most allocations are coming from current investors who are topping up their holdings as they seek to concentrate their portfolios, according to a monthly report on the hedge- fund industry published by Credit Suisse Group AG.
That makes it difficult for startups. Hedge-fund launches have declined to 340 from 453 in the same period last year, according to data compiled by Bloomberg.
“Smaller hedge funds have put off launching until the environment improves,” said Don Steinbrugge, managing partner of Agecroft Partners LLC, a Richmond, Virginia-based consulting firm that advises hedge funds and investors. “The environment to raise money for launches is very difficult.”

Junk

While the S&P 500 has yet to take out its bull market highs, the high yield junk bond market has been making new highs for weeks now.  A six-month chart of the high yield bond ETF (HYG) is shown in the first chart below.  HYG has now been in a nice uptrend for the past five months, and within the last few weeks it made a new bull market high.  The less risky investment grade ETF (LQD) has struggled recently and can't seem to break away from its 50-day moving average.  Since the March 9th, 2009 financial crisis low, the junk bond market (HYG) is up 47%, while investment grade corporates (LQD) are up 24.1%, and this doesn't even include dividends (interest payements).  With junk breaking out to new highs recently, the equity market shouldn't be far behind, right?

No Bounce in Income

The savings rate for U.S. households fell to its lowest level in more than a year in September as incomes fell and spending increased, the Commerce Department said Monday. Personal income fell 0.1% in September. This is the largest decline since July 2009. Consumer spending rose 0.2%. Wall Street economists had expected a 0.2% increase in income and a 0.3% gain in spending.
Real disposable incomes fell 0.3% in September. Inflation moderated further in September. The personal consumption expenditure price rose 0.1% in September after a 0.2% gain in August. Inflation is up 1.4% in the past year. The core PCE was flat in September after rising 0.1% in August. Economists expected a 0.1% gain.

Source: BEA