June 17, 2008

PAGE ONE

Shakeout Roils Hedge-Fund World Big Firms Gain Clout as Field Matures; Parking the Maserati By GREGORY ZUCKERMAN June 17, 2008; Page A1 The hedge-fund business -- among the most reliable fortune-producing machines in recent years -- is going through a brutal shakeout. Just a few years ago, traders found it relatively easy to quit Wall Street jobs, hang out a hedge-fund shingle and cash in. Investors beat down the doors with eagerness reminiscent of the late-1990s dot-com frenzy. It took only a decade for the industry to grow to 8,000 funds from a few hundred. But now smaller hedge funds, including top performers, are shuttering, and even brand-name traders are finding it tougher to get new ones off the ground. Only 1,152 new funds were launched in 2007, down almost 50% from a 2005 peak, according to Hedge Fund Research Inc. Because so many funds closed last year or merged into others, the business expanded by just 589 funds overall, the smallest increase in six years. The next test: The possibility of a wave of withdrawals at the end of this month, the next quarterly date on which many investors are permitted to pull out their money. The inflow of new money from investors has already been slowing during the past two quarters. At the same time, hedge-fund returns have been flat, adding to the pressure. Managers of hedge funds -- private partnerships that cater to wealthy individuals and institutions and are less regulated than, say, mutual funds -- like to think of themselves as a unique breed, capable of racking up big profits from opportunities that ordinary investors overlook. But in fact their profession is tracing the path of other businesses, whether autos or computers, that enjoyed rapid growth, led by aggressive entrepreneurs, before confronting deep challenges. And just as, say, eBay Inc. and Yahoo Inc. left rivals in the dust, or Vanguard Group and Fidelity Investments came to dominate the mutual-fund world, the largest hedge funds, such as Och-Ziff Capital Management, D.E. Shaw & Co. and Paulson & Co. are pulling away from the pack. By the end of last year, 87% of all the money in the business was handled by funds managing $1 billion or more, and 60% was held by managers sitting on $5 billion or more. The dominance by the largest funds has been accelerating: In the past two months alone, the world's largest public hedge-fund company, Man Group PLC, increased assets by $4 billion, to $78.5 billion. The shift is helping the big funds play a more powerful role in shaping the business and financial landscape. Last month, for example, Carl Icahn's fund, Icahn Associates, launched a bitter fight with Yahoo to try to gain control of its board. His hope is to entice Microsoft Corp. to revive its interest in buying Yahoo. Although that looks increasingly unlikely, it would theoretically yield a payday of hundreds of millions of dollars for Mr. Icahn's firm. The megafunds increasingly behave more like sprawling investment banks, replete with layers of management, rather than swashbuckling investment vehicles. Some funds even have started offering basic corporate loans, a field traditionally left to regular banks. A big difference with the banks: Hedge funds make much fatter paydays. Jim Simons of Renaissance Technologies, Steven Cohen of SAC Capital and Kenneth Griffin of Citadel Investment Group all earned at least $1 billion last year. Sterling Credentials The transformation of the hedge-fund business caught Bertrand des Pallieres off guard. For years, Mr. des Pallieres cashed hefty paychecks as a top trader at J.P. Morgan Chase & Co. and then at Deutsche Bank AG, before leaving last year to launch a hedge fund of his own. He had sterling credentials -- and a terrific running start: Deutsche Bank indicated it would invest hundreds of millions of dollars with his new firm, SPQR Capital LLP, according to Mr. des Pallieres. He rented swanky office space in London's upscale Mayfair district and dangled generous pay packages to staff his fund. Mr. des Pallieres got so distracted launching the business that, last summer, he forgot to pay the parking bills on his $160,000 blue Maserati Cambiocorsa. The coupe was impounded for three months before he noticed. Mr. des Pallieres set lofty goals for his fund. "We thought a billion dollars was a good figure to count on," he says. But just over a month ago he shelved the project and fired half his staff. Deutsche Bank had second thoughts about becoming an investor, Mr. des Pallieres says, and he couldn't find other takers. Deutsche says it never committed to making the investment. Today, Mr. des Pallieres has a more modest goal of investing smaller sums in infrastructure assets such as ports and bridges, a longer-term play. "You benchmark yourself against the firms that started two or three years ago, and you get depressed," he says. On the winning side are goliath funds run by money managers like Daniel Och. The 47-year-old Mr. Och, who left Goldman Sachs in 1994 to launch Och-Ziff, made $1 billion last year when his firm went public. While the general perception is that successful hedge funds post eye-popping gains, that's not his selling point. So far this year, none of his funds have gained more than 1.2%, though he is still beating the overall market. When Mr. Och meets potential investors, he emphasizes his firm's risk-management skills, including a track record that includes only 20 losing months in its 15 years. Over the same period, the S&P 500 has had 59 losing months. Investors like the sound of that. Och-Ziff managed $33.3 billion at the end of the first quarter, up 30% from a year earlier. Investors "particularly appreciate how we preserve their capital" in market dips, Mr. Och says. Indeed, simply racking up top returns isn't enough in the current mood. Xerion Capital Partners LLC scored compounded annual returns averaging 21%, after fees, in its five years of existence. Nevertheless, last year its founder, Daniel Arbess, saw that large institutions such as pension funds and endowments were becoming reluctant to put in new money. They told Mr. Arbess they wanted to see a bigger client-service team and that Xerion, with several hundred million in assets, was simply too small. So in October, Mr. Arbess sold his firm to much bigger Perella Weinberg Partners, a $3 billion firm formed by banker Joseph Perella. Now, institutional investors are once again showing interest. 'Tough to Manage' "The bar has gone up, it's tough to manage $250 million to $500 million," says David McCarthy, a 20-year hedge-fund pro. He recently shuttered his own fund, which invested in other hedge funds, even though its returns topped the market last year. The reason: Investors kept telling him the $300 million firm was too small. Pressures like these reflect the changing nature of hedge-fund investors themselves. Traditionally, the investors were wealthy individuals seeking the hottest funds with the biggest returns. Pension funds often were wary, viewing hedge funds as risky. Now, however, institutional investors are changing that view. Pensions, charities and endowments increasingly are investing in hedge funds in part because of the potential to make money even in a down market. (The funds attempt to do that by making bets on both rising and falling prices.) However, institutional investors tend to prefer larger funds with brand-name recognition, and avoid scrappy upstarts. "We used to be more hesitant to give money to large funds, the fear was they wouldn't perform as well as others, but that hasn't been the case lately," says Brett Barth, who helps run BBR Partners LLC, a $4 billion New York firm that invests in hedge funds. That said, the larger the hedge funds get, the tougher it likely will be to stay nimble and generate outsized returns. Despite the tougher environment, hedge funds remain an extremely lucrative business. Most charge investors a management fee of least 1% of assets invested, then 20% or more of any gains. Overall, the $1.9 trillion hedge-fund industry is holding up. The average fund is flat this year, through May, according to Hedge Fund Research. That beats the decline of 3.80% in the Standard & Poor's 500 in that period, though it's below the gain of 0.94% in the Lehman Brothers bond index. Last year, the average hedge fund gained 10%, compared with returns of 5.5% for the S&P 500 and 7.8% for the Lehman index. But because of their fee structure -- which includes a percentage of gains -- many funds find it hard to pay their employees if they can't generate gains. At the same time, the debt-market turmoil of the past year has undermined a key hedge-fund investing strategy. Until recently, funds routinely amplified their returns by investing lots of borrowed money. However, as bank lending has tightened, that strategy has taken a serious hit. Smaller and newer funds are having the most trouble arranging this kind of borrowing. The more challenging market conditions mean the gap between winning and losing funds is widening. Last year saw the widest divergence between top-performing funds and bottom-performing funds in more than five years, according to Hedge Fund Research. The top 10% of funds scored gains averaging 62% last year, while the bottom 10% had losses of 14%. Brad Alford, who once picked hedge funds for Duke University's endowment and now runs Alpha Capital Management LLC, an Atlanta financial-services company that caters to wealthy individuals, says he is placing fewer clients in hedge funds. That is partly because there has been a rush of competitive products, such as low-cost mutual funds that try to act like hedge funds. "We used to invest in hedge funds because we got stocklike returns with bondlike volatility," Mr. Alford says. "Now we're getting bondlike returns with stocklike volatility." Another reason he's turning away from hedge funds is tax-related: Short-term profits from hedge funds are taxed at a 40% rate, which is higher than taxes on long-term trading gains from other kinds of investments. Pushback From Investors Mr. des Pallieres, the founder of SPQR Capital, didn't expect so much pushback from investors. He had been in a division at Deutsche Bank that had anticipated -- and therefore profited from -- last year's mortgage-market crisis, and imagined there would be rich investment opportunities in the aftermath. So last year he rushed to launch his own hedge fund. Deutsche Bank's interest in his firm gave him confidence, he says. Early meetings with other potential investors also seemed positive. By last fall, however, the outlook darkened. He read a news report that the Deutsche Bank executive he was negotiating with had left the bank. It soon became clear that the big German bank wasn't going to ante up. "Deutsche Bank invests in hedge funds and other investment vehicles whenever we think the opportunity is attractive," a bank spokeswoman said. Executives at other banks still seemed interested in investing in his fund. Until, that is, Mr. des Pallieres realized that some of them were suddenly fighting to keep their own jobs, rather than focusing on his hedge fund. "People kept getting fired" in the middle of negotiations, Mr. des Pallieres recalls. To boost morale of his staff, he told employees he was confident investors would turn up. But Mr. des Pallieres was spending as much as $1 million a month keeping the firm operating. Then, in January, when fellow London-based hedge fund Peloton Advisors suffered billions of dollars of losses in a matter of days, his remaining investors backed out. Mr. des Pallieres and his girlfriend went to a resort on the Maldives for a week's vacation, trying to figure out what to do. When he returned, he called a meeting for the firm's employees, telling them he wasn't willing to fund the business anymore. Mr. des Pallieres is refocusing the firm on the narrower business of investing in infrastructure assets such as bridges. He's also cutting his expenses. But he's hanging on to the Maserati. "It's not that bad," Mr. des Pallieres says.

As Banks Shun Loans, Hedge Funds Move In

By LOUISE STORY

Published: June 13, 2008

Companies traditionally get loans from banks, but with so many lenders stretched and with credit so tight these days, businesses are turning to what might seem like an unlikely source for cash: hedge funds.

As banks retrench, hedge funds increasingly are offering loans to companies, usually at interest rates that are far higher than those that banks charge. More than 100 funds specialize in lending, and several big ones, like Fortress Investment Group and Citadel Investment Group, are starting to follow suit.

While some funds have been offering loans for a few years, more are moving in because the credit squeeze has hobbled many banks and left hard-pressed companies hungry for cash.

“Anybody who needs money is going to a hedge fund now,” said Matthew T. Hoffman, chief investment officer of Weston Capital Management, a fund of hedge funds in Westport, Conn. “These funds have been inundated with requests. The volume of requests has gone up probably five times.”

The hedge funds are hardly being generous. They often charge rates of as much as 3.2 percentage points more than bank rates.

“You’re talking to people who are very thirsty or hungry to get double-digit returns,” said Ed Banks, chief investment officer of Washington Corner, a hedge fund in New Jersey. “And they know you’re coming hat in hand.”

Economists predict that it is only a matter of time before the cutback in bank lending causes a slowdown in industries far from Wall Street. Just over half of domestic banks reported that they tightened standards on commercial lending in April in a Federal Reserve survey, up from 30 percent in January.

But hedge funds may fill a small part of the void. The number of hedge funds that specialize in what is called “asset-based lending” has quadrupled in the last three years, according to HedgeFund.net, a hedge fund information service owned by Channel Capital Group. New funds of this sort include the Weston Fund in Riverside, Conn., founded in January, and the Genesis Merchant Partners fund, which opened in Greenwich, Conn., last week.

These banklike hedge funds had about $12 billion in assets to lend as of the end of last year, up from $900 million three years ago, according to HedgeFund.net. Big funds like Citadel and private equity giants like Cerberus Capital Management have even more. Unlike banks, which raise money from depositors, hedge funds are not regulated. The funds get their capital from wealthy investors.

Y. Judd Shoval founded a lending hedge fund, Ambit Funding, in early 2005 after a career running local banks. Consolidation in the banking industry left a niche for hedge funds for a variety of loan types, he said, and his fund makes commercial loans in 12 states.

Mr. Shoval does much the same type of lending he did at banks. His depositors are not banking customers who can access their money 24 hours a day, but rather investors who have a six month lock-up on their money. And he charges the standard hedge fund fees to investors.

“We are a hedge fund, but we look at each situation through the prism of a bank,” Mr. Shoval said.

To be sure, there were hedge funds that jumped in during the loose lending of recent years and lost money on loans, just as the banks did. And hedge funds may find their investors weary of investing more heavily in loans because such debt is often illiquid and hard to value, said Michael Zupon, a managing director and head of the domestic leveraged finance group at the Carlyle Group.

And hedge funds, those often secretive, sometimes volatile investment vehicles, often arouse suspicions. Some companies still remember tales that circulated in the late 1990s about hedge funds that purchased stakes in small companies through what was known as a “death-spiral convertible.” These shares can be converted into common stock as a company’s share price drops, and that strategy is said to be returning now.

“Hedge funds have been known to come in and profit from a company’s demise,” said Meredith Jones, managing director of PerTrac Financial Solutions, a financial software company.

But, Ms. Jones said, may distressed companies have little choice but turn to hedge funds.

“It’s kind of like: do you sign a lease with your landlord? Well, if you don’t, you don’t have a place to live,” she said.

Some hedge funds have been hoarding cash for the time when companies are desperate, said Michael Fuller, managing director of Private Advisors, which manages a fund of funds of direct-lending hedge funds. The terms banks were offering in recent years were so generous, with such low interest rates, that some hedge fund managers refrained from lending, he said.

“Up until six months ago, they couldn’t compete,” Mr. Fuller said. “So they just waited and held lots of cash on their books. Now Wall Street is spitting stuff out. Some are great investments.”

Commodity ETF Volume

As we all know, there has been a boom in commodity ETFs and ETNs over the last few years, and we recently counted 53 that trade on US exchanges. Investors have increasingly plowed into these securities to trade the run-up in commodity prices as well as easily gain exposure to an asset class that was once difficult to get into. We gathered the daily volume of these 53 commodity ETFs and ETNs from the start of 2006 and then calculated a 30-day moving average of the total daily volume of all 53 securities. As shown in the first chart below, volume has soared since the start of 2006. Given the significant rise in commodity prices, it's not hard to see why volume has surged.

Recently, there has been talk that the large number of new commodity ETFs has added to the rise in prices. While it's hard to quantify the impact that they have had, it's important to note that relatively speaking, the volume is really not that big. As shown in the chart below, the average daily volume of all commodity ETFs and ETNs is just 1/6th of the average daily volume for the S&P 500 tracking SPY ETF.

Nasdaq vs Homebuilders vs Oil

The price of oil has risen 729.58% from its low on November 19th, 2001 to its closing high of $138.54 on June 6th. When compared to the tech bubble of the '90s and the real estate bubble earlier this decade, oil's rally is just about in between the two. As shown below, from the Nasdaq's significant bottom on June 24th, 1994 to its peak on March 10th, 2000, the index rallied 639% over 2,086 calendar days. From its bottom on March 14th, 2000 to its peak on July 20th, 2005, the S&P 1500 Homebuilder index rallied 839% over 1,954 calendar days. Surprisingly, oil's rally is now longer in duration than both the tech and real estate bubbles at 2,391 calendar days. As we all know, the tech and real estate bubbles eventually burst and fell by as much as they rose. Their declines were very similar in both duration and size as well. While significant gains in any asset class carry their own set of circumstances and positive arguments, it's hard to look at this chart and not expect to see oil's red line come down significantly at some point. The demand argument for oil might be strong, but there were no shortage of "demand" arguments during prior bubbles either.

Percent of World Market Cap by Country

Yesterday we highlighted that the United States' market cap as a percentage of global market cap has been on the decline. Below we provide a table of the numbers for 29 other countries. As shown, US stocks still dominate world market cap by a wide margin at 29.9%. Japan has the second largest stock market representation at 8.2%, followed by the UK (6.8%), China (5.4%) and France (4.4%). China is noteworthy because it made up just 1.7% of global market cap at the start of 2004, and now it has the fourth largest representation.

We also sorted the list of countries by how much their % of world market cap has changed since the start of 2004. As shown, Saudi Arabia has increased the most at 877.5% -- going from 0.1% to 0.9%. Saudi Arabia is followed by Egypt, Qatar, Brazil, UAE, China, Russia and India. With oil's enormous rise over the last few years, it's no surprise that many of the countries with the biggest gains are major oil producing countries. The US is at the very bottom of the list with a significant decline of 31.6%. Japan is down 20%, the UK is down 12%, Italy is down 10%, and France is down 5%.

Peloton founder launches new fund

One of the founders of collapsed hedge fund Peloton Partners has already begun marketing a new fund, in the latest example of how quickly investors can forgive managers of failed funds. Geoff Grant, chief investment officer of Peloton, plans to launch LiquidMacro in September, just seven months after Peloton’s $2bn ABS fund became the largest European hedge fund failure. The new fund is being selectively pitched to investors but is likely to start with money mostly from family and friends of Grant and his team of nine, who previously made up Peloton’s California office.

Shrinking U.S.A.

Below we highlight a chart of world market cap since 2004 along with the percentage of world market cap that US stocks make up. The current value of stocks worldwide is just over $54 trillion according to Bloomberg. US market cap currently stands at a little more than $16 trillion, which puts it at 29.9% of world market cap. While 29.9% still puts the US at more than 3 times the market cap of the second biggest country, Japan, it is much lower than it was just a few years ago. As shown in the chart, US market cap as a percentage of the world has steadily drifted lower over the last four years as global stocks have risen more and the dollar has declined in value. At the start of '04, the US made up nearly 45% of global market cap. Only time will tell if the world will continue to get flatter or if the US will widen its market cap lead again.

Oil's Sixth Largest Point Drop!

If someone told you oil had its sixth largest point drop in over 20 years today, you wouldn't expect the chart to look like the one below, but after gains of $5.5 and $10.75 last Thursday and Friday, you have to squint to see today's loss of over four dollars.

Buffett's big bet

The celebrated investor wagers a tidy sum that even carefully chosen hedge funds won't return more than the market over time.

By Carol J. Loomis, senior editor at large

(Fortune Magazine) -- Will a collection of hedge funds, carefully selected by experts, return more to investors over the next 10 years than the S&P 500?

That question is now the subject of a bet between Warren Buffett, the CEO of Berkshire Hathaway, and Protégé Partners LLC, a New York City money management firm that runs funds of hedge funds - in other words, a firm whose existence rests on its ability to put its clients' money into the best hedge funds and keep it out of the underperformers.

You can guess which party is taking which side.

Protégé has placed its bet on five funds of hedge funds - specifically, the averaged returns that those vehicles deliver net of all fees, costs, and expenses.

On the other side, Buffett, who has long argued that the fees that such "helpers" as hedge funds and funds of funds command are onerous and to be avoided has bet that the returns from a low-cost S&P 500 index fund sold by Vanguard will beat the results delivered by the five funds that Protégé has selected.

We're way past theory here. This bet, being reported for the first time in this article (whose author is both a longtime friend of Buffett's and editor of his chairman's letter in the Berkshire annual report), has been in existence since Jan. 1 of this year.

It's between Buffett (not Berkshire) and Protégé (the firm, not its funds). And there's serious money at stake. Each side put up roughly $320,000. The total funds of about $640,000 were used to buy a zero-coupon Treasury bond that will be worth $1 million at the bet's conclusion.

That $1 million will then go to charity. If Protégé wins, it has asked that the money be given to Absolute Return for Kids (ARK), an international philanthropy based in London. If Buffett wins, the intended recipient is Girls Inc. of Omaha, whose board includes his daughter, Susan Buffett.

And who's holding the money, by way of owning the zero-coupon bond? That's an esoteric institution most readers of this article will never have heard of, the Long Now Foundation, of San Francisco, which exists to encourage long-term thinking and combat what one of its founders, Stewart Brand (of the Whole Earth Catalog), calls the "pathologically short attention span" that seems to afflict the world.

Six years ago the foundation set up a mechanism for - what else? - Long Bets. The foundation receives wagers as donations, oversees the bets until they are decided, and then pays off the winner's designated charity. For this work, the foundation normally gets a $50 fee from each side and then shares fifty-fifty with the charitable winner-to-be in the returns earned on the funds being held. In the Buffett-Protégé bet, however, there will be no such sharing; each side simply made a $20,000 charitable gift to the Long Now Foundation.

To see today's Long Bets listings, go to http://www.longbets.org/. Some bets catalogued there sound as though they were made in sports bars: Actor Ted Danson garnered $2,000 for a charity when the Red Sox won the World Series before a U.S. men's soccer team won the World Cup.

On a more cosmic front, Lotus founder Mitchell Kapor and inventor and futurist Ray Kurzweil have a $20,000 bet on the proposition that "by 2029 no computer - or 'machine intelligence' - will have passed the Turing Test," meaning that a computer won't have successfully impersonated a human. Kapor made that prediction; Kurzweil disagrees with it. Each man, following the rules of Long Bets, has supported his point of view with a brief statement that is posted on the Web site. Buffett's and Protégé's arguments will appear there as well (and are listed here).

Through 2007 the Kapor-Kurzweil bet of $20,000 was the largest on Long Bets. The Buffett-Protégé bet obviously vaults the stakes to the stratosphere. And to that there is a certain history, which began at Berkshire's May 2006 annual meeting.

Expounding that weekend on the transaction and management costs borne by investors, Buffett offered to bet any taker $1 million that over 10 years and after fees, the performance of an S&P index fund would beat 10 hedge funds that any opponent might choose. Some time later he repeated the offer, adding that since he hadn't been taken up on the bet, he must be right in his thinking.

But in July 2007, Ted Seides, a principal of Protégé but speaking for himself at that point, wrote Buffett to say he'd like to make the bet - or at least some version of it.

Months of sporadic negotiation ensued. The two sides eventually agreed that Seides would bet on five funds of funds rather than 10 hedge funds.

Seides, stepping way beyond his usual stakes - say, the cost of a meal - suggested that he and Buffett make the bet for $100,000 (which, he noted, was Buffett's annual salary). Buffett, not knowing then that Long Bets even existed, said that considering his age - he's now 77 - and the complications that a 10-year bet might add to his estate's being settled, he'd only be interested in wagering at least $500,000. Even then, he wrote Seides, "my estate attorney is going to think I'm out of my mind for complicating things."

If $500,000 seemed too steep to Seides, Buffett (for whom it's obviously more of a trifle) had no problem with Seides recruiting partners to help out. And that's what in effect happened, by way of Protégé Partners LLC making the bet rather than Seides.

Protégé, which manages around $3.5 billion, is principally owned by Seides, 37, and two other men, CEO Jeffrey Tarrant, 52, and Scott Bessent, 45. Each has a strong investment background, and two of the three have worked with well-known market practitioners: Seides learned the world of alternative investments under Yale's David Swensen; Bessent worked with both George Soros and short-seller Jim Chanos.

Upon its founding in 2002 by Tarrant and Seides, Protégé set up a fund of funds and began recruiting the kind of sophisticated investors - both institutions and wealthy individuals - who put their money in such funds.

Very aware that the Securities and Exchange Commission prohibits broad-scale marketing by hedge funds and funds of funds, neither Seides nor Tarrant will disclose the precise names of the funds they now run, much less their performance records.

But a London publication, InvestHedge, whose parent runs a hedge fund database, provided Fortune with several years of returns for the firm's flagship U.S. fund, Protégé Partners LP.

From its inception in July 2002 through the end of 2007, the Protégé fund gained 95% (after all fees), soundly beating the Vanguard S&P 500 index fund's 64%.

Protégé's performance was hugely helped by the fact that by mid-2006 the firm was extremely bearish on subprime mortgage securities, including CDOs, and had dispersed its investments in hedge funds to capitalize on that opinion. Most significant, it made an investment in Paulson & Co.'s hedge funds, which under John Paulson made a highly publicized killing in 2007 by short-selling securities linked to subprimes.

All that's history, of course, so let's get back to the bet: Buffett and Seides agreed that they'd periodically disclose where the wager stood. Seides wanted this disclosure to take place whenever the market fell by 10%, because he believes that one of the virtues of hedge funds is their ability to weather tough times. Indeed, in the first quarter of this year, during a down market, Protégé Partners LP fell by only 1.9%, while the Vanguard fund dropped 9.5%.

Buffett insisted, though, that the logical time for disclosure was at Berkshire's annual meeting every spring - and that was the final agreement.

Just how much Buffett will have to say about the bet every year may be limited by one fact: The names of the five funds of funds that Protégé has selected are to be kept confidential. Of course, Buffett knows what the names are, because Protégé must supply him with the audited results of these funds every year. But other than that, the designated funds of funds saw no advantage (at least for now) to declaring their participation in the bet and agreed to go along only if confidentiality was promised. The first fund that Protégé tried to recruit, in fact, wouldn't sign up even then.

Seides and Tarrant do have a few general things to say about the five funds picked. They are equity-oriented (favoring stocks over bonds), tend to invest in hedge funds that avoid in-and-out trading, and are run mostly run by seasoned investment folk rather than tenderfoots.

And we can probably assume that Protégé Partners LP is one of the five, if only because its exclusion would leave the firm with the difficult job of explaining to its investors why the firm didn't care to bet on the success of its own hedge fund choices.

Fees: Big hurdle for Protégé

As for the fees that investors pay in the hedge fund world - and that, of course, is the crux of Buffett's argument - they are both complicated and costly.

A fund of funds normally charges a 1% annual management fee. The hedge funds it puts that money into charge an annual management fee of their own, which for funds of funds is typically 1.5%. (The fees are paid quarterly by an investor and are figured on the value of his account at the time.)

So that's 2.5% of an investor's capital that continually goes for these fees, regardless of the returns earned during a year. In contrast, Vanguard's S&P 500 index fund had an expense ratio last year of 15 basis points (0.15%) for ordinary shares and only seven basis points for Admiral shares, which are available to large investors. Admiral shares are the ones "bought" by Buffett in the bet.

On top of the management fee, the hedge funds typically collect 20% of any gains they make. That leaves 80% for the investors. The fund of funds takes 5% (or more) of that 80% as its share of the gains. The upshot is that only 76% (at most) of the annual return made on an investor's money accrues to him, with the rest going to the "helpers" that Buffett has written about. Meanwhile, the investor is paying his inexorable management fee of 2.5% on capital.

The summation is pretty obvious. For Protégé to win this bet, the five funds of funds it has picked must do much, much better than the S&P.

And maybe they will. Buffett himself assesses his chances of winning at only 60%, which he grants is less of an edge than he usually likes to have.

Protégé figures its own probabilities of winning at a heady 85%. Some people will say, of course, that just by making this bet, Protégé has acquired some priceless publicity.

But then, Protégé clearly wants to win, and it's up against a man who hasn't made a lot of losing bets in his life.

Seides himself sees one strong ray of light: "Fortunately for us, we're betting against the S&P's performance, not Buffett's."

Buffett's bet: The prediction and the arguments

Oil spike

Why did oil breach $138?

Price of NYMEX light crude. Source: ino.com.

One key impetus certainly came from news about U.S. interest rates and the dollar. European Central Bank President Jean-Claude Trichet Thursday cautioned that the ECB may raise interest rates next month in order to contain inflation, while Friday's U.S. unemployment numbers may have put further U.S. rate cuts back on the table. The twin developments sent the dollar plunging 1.1% against the euro and the dollar price of many commodities soaring. Gold was up 2.6% and the Commodity Research Bureau Index up 3.5% (numbers from ino.com). Still, oil's 7.5% rise was clearly the Homecoming Queen.

In terms of news specific to the oil market, this story out of Saudi Arabia could be significant:

Saudi Arabia's Shura council (parliament) will hold a series of meetings over the next two weeks to discuss a controversial proposal by a key member to curb oil production to save reserves for better prices.

Also noteworthy is an increasing likelihood of military conflict involving Iran:

An Israeli deputy prime minister on Friday warned that Iran would face attack if it pursues what he said was its nuclear weapons programme.

"If Iran continues its nuclear weapons programme, we will attack it," said Shaul Mofaz, who is also transportation minister.

"Other options are disappearing. The sanctions are not effective. There will be no alternative but to attack Iran in order to stop the Iranian nuclear programme," Mofaz told the Yediot Aharonot daily.

If Saudi production has indeed peaked, or if military conflict involving Iran is indeed imminent, that would unquestionably be the kind of news that should send the price of oil soaring. But this much of a move on just the whiff of a rumor?

It seems likely that the fundamentals above warranted a big move in the price of oil, but the momentum then caught some traders short who had to scramble to buy oil to cover their positions. But who? Via Brad Setser, the Financial Times reports:

Traders who had bet on falling oil prices through short sales-- in which they sell the commodity in hopes of buying it back later at a lower level-- were forced to cover their positions, sending oil prices skyrocketing.

Wall Street banks contributed to the rally as they bought crude oil futures to cover their obligations under agreements that compensate investors and companies such as airlines if crude rises above $140 a barrel.

Hmmm.... you mean some of the big guys have been quietly raking in cash by selling far out-of-the-money options? Now where have I heard that strategy before?

I remember-- it was Capital Decimation Partners.

Subprime Index Is Overstating Losses, BIS Says

By JOELLEN PERRY
June 9, 2008

FRANKFURT -- A key measure of estimating the value of subprime mortgage-backed securities may be overstating potential losses of triple-A securities by more than 60%, according to the Bank for International Settlements, which puts its own estimate of such losses at $73 billion.

The BIS, often called the central bankers' central bank, has few formal banking duties but is a hub for economic and monetary research as well as for global policy makers. Its most recent quarterly report adds to growing criticism of a key measure of the subprime-mortgage market called the ABX.

Launched more than two years ago by Markit Group Ltd., the ABX is an index that tracks the value of securities backed by subprime loans. ABX is based on credit-default swaps: actively traded instruments that insure against default on the securities.

The index often is used by banks and other organizations as a proxy for the value of mortgage-backed securities. Echoing other concerns, the BIS says the ABX prices may be unreliable because the indexes only cover a small percentage of the market.

Some observers also contend that ABX prices have been driven lower largely by bearish traders.

The BIS also says the ABX indexes may misrepresent the structure of the securities they claim to reflect. The specific triple-A securities referenced by the index, in the case of a default, would be paid only after all other triple-A obligations had been met. Recalculating with new data for triple-A securities that would get paid faster, the BIS says the ABX overestimates triple-A losses by 62%.

The BIS says the value of subprime mortgage-backed securities outstanding issued from 2004-07 is about $600 billion. At the end of May, the report says, ABX prices suggested a value of about 59 cents on the dollar for such securities, indicating losses of about $250 billion, almost half of which -- $119 billion -- would come from triple-A securities.

Under the BIS's new calculations, losses on triple-A securities total only $73 billion. That would bring the total subprime-mortgage-related losses down some 18%, to $205 billion.

Write to Joellen Perry at joellen.perry@wsj.com

Did Senate Call Oil Market Top?

Crude oil prices are off 2.7% percent today, touching $124.30. There has been a more or less straight line crude oil decline for two weeks now, dating back to May 21st, with prices down 7.5% in the period.

Hmm, May 21st. Now what could have been special about that day? I wonder, I wonder. Oh, now I remember: That was the day the Senate Judiciary committee hauled in some oil executives so they could do a little election-year posturing.

Bill Miller Datapoint of the Day

From Evan Newmark:

Miller's Value Trust Fund, Legg Mason's flagship, just passed another milestone. As of the end of May, according to Morningstar, the fund is now underperforming the S&P 500 over a 10-year period.

US Dollar: Marathon Update

About a month ago, we posted a chart on the US Dollar pointing out that bulls should treat a rally in the currency as a marathon and not a sprint. After declining in the latter half of May, the Dollar was able to hold the bottom of its newly formed uptrend and head slightly higher again. Below we provide a chart of the currency, highlighting its trend channel. If things continue in their current direction, we have a little more to go on the upside before the Dollar reaches the top of its uptrend channel.

S&P 500 vs S&P 500 Equalweight

Through most of 2007, the cap-weighted S&P 500 finally began to outperform the S&P 500 Equalweight index for the first time during the bull market. This meant that the biggest stocks in the index were doing much better than the smaller ones (falling line in top chart). In 2008, the trend has once again reversed, however, as smaller companies in the index have begun to outperform again (rising line in upper chart).

The bottom chart below compares the prices of the S&P 500 (cap weighted) and S&P 500 Equalweight index since the end of 1989. Through most of the 90s, the two traded pretty much inline with each other until the cap-weighted index began to do better in the late 90s. The bull market that began in October 2002, however, has been dominated by the equalweight index. For those interested, RSP is an ETF that tracks the S&P 500 Equalweight index.

Chart of the day from St. Louis Fed (may need to click to open)

Deja Vu: Ten-Year US Treasury Yields

As the yield on the the 10-Year Treasury climbs above 4% for the first time this year, we couldn't help but notice how the path of long-term interest rates bears a striking similarity to last year. The one major difference seems to be that this time less people are talking about it. Last year, there was near hysteria when long term interest rates rose to their highs of the year and above 5%. This year, rates are once again at their highs of the year (although 100 bps lower), but this time around its not nearly as big a story...yet.

Bear or Superbear? The new Draaisma-land

Beyond the call of duty!

Apart from analyzing valuations, interest rates, and growth, the author has also read all the daily Wall Street Journals in the four months surrounding the identified bear market bottoms…

This is Teun Draaisma, Morgan Stanley’s European strategist, reflecting in his latest note to MS clients on his own lessons from reading Anatomy of the Bear, published in 2005 by Russell Napier.

Napier analysed US equities over the last 100 years, observing along the way that every now and then markets go to levels of gross overvaluation - overvaluation events that are invariably followed by a bear market that ends at levels of gross undervaluation.

Four great bear market bottoms are identified - the four best moments in the last 100 years to buy and hold equities for at least ten years: 1921, 1932, 1948 and 1982. The year 1974 almost also made the grade, but didn’t make it into the final selection because the subsequent returns over the next 10-15 years were low in real terms.

Anyway, Mr Draaisma, now famous for his Sell, Sell, Sell last June and his Buy, Buy, Buy last September, enjoyed the book. He has now used the lessons learned as a framework for the “superbear” scenario within his current market thinking — namely that this ‘bear market rally’ is coming to a juddering halt and that steep price falls will follow as real economic slowdown overcomes the underlying economy.

Here are Mr Draaisma’s eight lessons from the great bear markets of the past 100 years:

1. Valuations get very very low indeed. The cyclically-adjusted PE, aka the Shiller PE, represented by the latest price divided by the average earnings of the last 10 years, reaches 10 or even less at bear market bottoms, while Tobin’s Q, the price divided by the replacement value of assets (or price over net worth defined as assets minus liabilities), gets as low as 30% or less. These valuations are the biggest problem with today’s market, as the Shiller PE is more than twice that. Today’s message: Shiller PE is above 20 still, while true bear markets tend to end at less than 10 times (see Exhibits 12 and 13). Equities are not cheap enough and need to decline by at least 50 percent.

2. Equities become cheap slowly. The average duration of bear markets has been 14 years, with the much more rapid 1929-32 episode, when equities went down 89%, the exception. Today’s message: we are in year 8 of a 14 year bear market.

3. Sentiment is not hugely negative at the bottom of the bear market. The popular myth that there are no bulls left at the bottom of the bear market is wrong. Many market commentators are correctly bullish right at the bottom of the bear market. Popular myth has it that talk of ‘equities are dead’ and ‘there is no future for equities’ should be widespread and are classic signals of the end of the bear market. This is far from the truth, it turns out. In related fashion, there is no climactic last and final sell-off on high volumes. Quite the contrary, the final slump is on lower and lower volumes. Subsequent higher volumes at higher levels confirm the bear market is over, with hindsight. Today’s message: do not take any ‘contrarian comfort’ from the fact that many people are quite bearish on the macro outlook, contrary to conventional wisdom, that is not a classical sign of a bear market trough.

4. Patience! Equities do trough during economic recessions, but they do not anticipate economic recovery by 6-9 months. The lead time is much shorter, and often equity and economic recoveries are coincident, and sometimes economies bottom before equities do so. Patience is key. Today’s message: indeed, this is consistent with our finding that one should be patient in bear markets as there is not much discounting of the upturn going on at the end of the bear market, after numerous failed rallies and false hopes (see Exhibits 9 and 10).

5. Times have changed, but most rules have not. Although times have changed dramatically over the last century, and economies have been functioning differently, while investors have arguably become more sophisticated, there are many common signs and characteristics at the bottom of bear markets.

6. Don’t fight the Fed. When the Fed cuts rates and equities are cheap, you should buy. There have been some major exceptions, such as in Nov-1929 (as in Jan-2001 and March-1980), when Fed easing was a false signal to start buying equities. Today’s message: if equities are cheap one should not fight the Fed, but arguably equities are not cheap enough yet (see lesson 1).

7. There are some consistent early signs of economic improvement. The three best are the copper price bottoming out, auto sales improving (or at least getting less bad), and inventories being very low. Today’s message: the copper price has not even fallen yet, so we are far away from the bear market trough.

8. Fixed income markets have given some good warnings signals. Government and corporate bonds rally on average 10 and 4 months, respectively, before equities reach their final trough. Today’s message: similar to the copper price in lesson #7, government bonds have not even sold off yet. Corporate bonds have, of course, and troughed in the middle of March, which in isolation means that equities are close to a trough too. However, in conjunction with the other lessons, we think this does not stack up at all, as valuations are simply too elevated.

Finding Potential for Debt in Distress

---

May 25, 2008

By NORM ALSTER

THE credit crisis and economic slowdown have sunk billions of dollars of debt into distressed status — deep in the junk-bond pile. Money managers have traditionally profited in such markets by buying debt on the cheap.

Individual investors can get into the game indirectly, through a small number of mutual funds, including BlackRock High Yield, Mutual Recovery and Northeast Investors Trust, which hold some distressed debt.

“Right now, we think there is going to be tremendous opportunity over the next 12 to 18 months,” said James Keenan, manager of BlackRock High Yield, which has returned 0.41 percent in 2008 and 7.15 percent, annualized, over the last three years, according to Morningstar. (All figures are through Thursday.)

Mr. Keenan foresees raising the fund’s current investment in distressed debt to 10 to 15 percent of assets, from the current 2 to 3 percent, as opportunities arise.

Distressed debt is often defined as the obligations of companies in default or perilously close to it. The term may also be used for debt paying a very high yield — 10 percentage points more than 10-year Treasuries.

Investing in such debt is risky, but handsome profits can be made by converting it into equity ownership as restructured companies leave bankruptcy.

The sharp rise in interest rates on lower-rated debt issues in recent months probably presages a rising tide of defaults, said Kenneth Emery, director of default research at the Moody’s Corporation.

“Historically, there’s a tight correlation between high-yield spreads and default rates,” Mr. Emery said. Already, the global pool of distressed bonds and bank loans is approaching $600 billion, he said.

Little cash has actually been drawn down to buy distressed debt thus far. “There have been a lot of funds raised,” said Michael Embler, chief investment officer for the Mutual Series funds of Franklin Templeton. “Most of the money has not been deployed.”

Oaktree Capital Management, based in Los Angeles, is a longtime investor in distressed debt. The firm has unspecified billions invested in such debt, said Howard S. Marks, its chairman, with $10 billion more ready to be deployed.

The question for Mr. Marks and others is when to start buying in earnest. Early buyers risk “catching a falling knife,” in market parlance, if prices keep tumbling. But late buyers risk losing out on the best deals and the best returns. “We think we have to catch a falling knife,” Mr. Marks said.

Other deep-pocketed buyers seem to be coming to the same conclusion. For example, the Blackstone Group, the big private equity group, has been finding good investments in distressed debt, Stephen A. Schwarzman, the chairman and chief executive, said in a recent conference call.

At Mutual, Mr. Embler is waiting for some of the debt that financed buyouts in the last year to tumble into distressed status.

“There was a tremendous amount of leverage in those buyouts,” he said. “Some of them will hit the wall.”

Just nine months ago, Mutual Recovery held virtually no distressed debt, but with recent purchases of leveraged-buyout-related bank loans, it now has “5 to 10 percent” of its portfolio in the lowest-rated obligations, he said. “We do think there will be more opportunities in the next 6 to 12 months,” he added.

The fund is down 4.31 percent this year and has returned 6.33 percent, annualized, over the last three years.

ALSO prepared to buy, but not convinced that prices have bottomed, is Bruce H. Monrad, who manages the $1.5 billion Northeast Investors Trust fund with his father, Ernest E. Monrad. The fund is up 0.14 percent this year and has returned 5.59 percent, annualized, over the last three years.

“We’re still in the very early innings,” he said. “We’re probably going to see 30 percent of the total junk bond market default over the next five years. And yet fewer than 30 percent of junk bond issues are selling at distressed prices. There may still be a lot of overpriced junk.”

The Northeast fund holds debt from one issuer — the Trump casino empire — that produced a big payday in the past. After Trump Hotels and Casino Resorts filed for bankruptcy in 2004, Northeast received a package of stock and bonds in the restructured company, Trump Entertainment Resorts. Northeast sold the stock but still holds some bonds, whose current yield is roughly 14 percent.

In terms of the broader credit market, Mr. Marks of Oaktree Capital said he saw a possible silver lining in the current situation, at least for investors in distressed debt.

“This could be the biggest credit crisis of our lives,” he said. “And if it is, that argues for higher returns.”

Macklowe to sell GM building to Boston Properties

By Michelle Coffey, MarketWatch

Last update: 4:27 p.m. EDT May 24, 2008

SAN FRANCISCO (MarketWatch) -- Boston Properties said Saturday it has reached a deal to buy the landmark General Motors building and three other Midtown skyscrapers from high-profile New York developer Harry Macklowe for $3.95 billion in cash and debt.

Macklowe will be able to use proceeds from the deal to repay some of the $7 billion he borrowed last year to purchase seven Manhattan towers from the Blackstone Group , as part of Blackstone's acquisition of Equity Office Properties Trust. These included short-term, high-interest loans from Fortress Investment Group and Deutsche Bank in which the GM building and other towers were used as collateral, according to media reports.

Boston Properties will pay $1.5 billion in cash and assume about $2.5 billion in debt, the company said in a statement. The real estate company's partners include Goldman Sachs, the Kuwait Investment Authority and a Qatari sovereign wealth fund, The Wall Street Journal reported, citing people familiar with the situation. The GM deal is expected to close in June, with the purchase of the other properties closing shortly after.

Macklowe purchased the highly coveted, 2 million-square-foot GM building in 2003 for $1.4 billion.

Boston Properties is also purchasing Macklowe properties at 540 Madison Ave., 125 W. 55th St. and 2 Grand Central Tower. The GM building is at 767 Fifth Ave.

Goldman Oil Bull a Nutcase: Here's Why Crash Coming Soon

Henry Blodget | May 22, 08 9:24 AM

China and India scarfing up so much oil that we're headed to $200+ a barrel? Please. Supply is increasing and demand is about to crash. So argues Ambrose Edwards Pritchard in this Telegraph assault on the peak oil story.

Pritchard's bottom line? That crap you're hearing about supply constraints is flat-out wrong: In fact, there's more supply coming online all the time. And then there's the other half of the equation: demand. What do you think will happen to demand when the US, Europe, China, and dozens of emerging economies finally lower the boom on spiraling inflation?

Pritchard:

The perfect storm that has swept oil prices to $132 a barrel may subside over the coming months as rising crude supply from unexpected corners of the world finally comes on stream, just as the global economic downturn begins to bite... The forces behind the meteoric price rise this spring are slowly receding.

Specifically?

• Nigeria has boosted output by 200,000 barrels a day (BPD) this month, making up most of the shortfall caused by rebel attacks on pipelines in April.
• Iraq has added 300,000 bpd to a total of 2.57m as security is beefed up in the northern Kirkuk region.
• Saudi Arabia is adding 300,000 bpd in response to a personal plea from President George Bush, and to placate angry Democrats on Capitol Hill.
• The US Energy Information Agency says non-Opec supply will edge up by 600,000 bpd over coming months as Brazil, Azerbaijan and the Sudan raise production. By next year, the US itself will be producing enough extra oil to shave its import needs.

This increased supply has actually created a surplus in recent months:

• Opec's monthly report says that demand this quarter will average 85.75m bpd. Supply was 86.8m bpd in April. The fresh output from Nigeria, Iraq and Saudi Arabia may push it significantly further into surplus.
• Opec says that stocks held by the OECD club of rich countries are above their five-year average, with "comfortable" cover for 53 days' use. US stocks have edged up for the last four months, though they fell last week.

So what's driving those crazy prices CNBC can't stop talking about? Speculation. Specifically, the oceans of cash flowing into commodity index funds, as investors agree that commodities are a sure thing

Lehman's latest report - Is it a Bubble? - says commodity index funds have exploded from $70bn (£36bn) to $235bn since early 2006. This includes $90bn of fresh money. Energy takes the lion's share. Every $100m flow of investment money into oil lifts crude prices by 1.6pc, it said.

"We see many of the ingredients for a classic asset bubble," said Edward Morse, Lehman's oil expert.

Meanwhile, demand is actually falling:

The International Monetary Fund has cut its forecast for world growth for 2008 three times since last autumn to 3.7pc, and the United Nations is predicting just 1.8pc - technically, a global recession. The major oil forecasters have halved their estimates for crude demand growth to 1.2m bpd.

The bulls say that the US housing crash and spreading contagion in Britain, Spain and Japan do not matter much for oil in the changed world of rising Asia. The US added just 7pc of crude demand growth from 2004 to 2007, compared with 34pc for China, 25pc for the Middle East and 17pc for emerging Asia....

But this could change. Egypt - the most populous Arab country - has just raised petrol prices by 40pc. Rumours swept China yesterday that Beijing was preparing to lift fuel prices.

And then there's that spiraling global inflation thing, which will cause central banks to hit the brakes:

Almost all emerging nations have to slam on the brakes in coming months to curb inflation before it starts spiralling out of control. Inflation has hit 30pc in Ukraine, 22pc in Vietnam, 8.5pc in China, and double digits across most of the Gulf.

The countries that account for the most of the growth in oil demand over the last two years are almost all nearing the limits of easy economic growth.

Pimco’s chief piles into mortgage debt

Bill Gross, the manager of the world’s biggest bond fund, has switched gears to make a big bet on mortgage debt, almost tripling his holding to more than 60% of the fund. Gross’s $130bn Pimco Total Return fund pulled sharply ahead of rivals in the past year after the manager predicted a housing downturn and sold out of housing-related securities and corporate bonds. The fund has returned 12.6% over 12 months, beating 99% of its peers, according to fund tracker Morningstar. Gross said his decision to raise exposure to mortgage debt in recent months was based on the US government’s implicit guarantee of Freddie Mac and Fannie Mae, the government-sponsored mortgage agencies.

Top 100 hedge funds have 75% of industry assets

21 May 2008

The largest hedge funds in the world account for 75% of hedge fund industry assets, compared with 69% the previous year, continuing the trend of larger funds eclipsing smaller players.

The largest 100 hedge funds have $1.3 trillion (€856.4bn) in assets under management, a 35% increase over 2007, according to Alpha magazine’s Hedge Fund 100 report.

JP Morgan Asset Management topped the list with $44.7bn in assets, boosted by Highbridge Capital. The 10 largest hedge funds had assets of $324bn, a 29% increase over last year.

There were some dramatic shifts in the rankings over the previous year.

Paulson & Co rocketed to number eight in the list from 69 last year, with nearly $29bn in assets under management. The fund was boosted by its positions against the sub-prime mortgage market.

Harbert Management, a hedge fund with investments across real estate, private equity, convertible arbitrage and distressed debt and special situations. Its assets have increased from $1.5bn in 2002 to nearly $23bn as of March 1, according to its Web site. Its ranking rose sharply to 16 from 94 last year.

The asset growth reflects the growing number of institutional investors, particularly pension funds making allocations to hedge funds, either directly or through funds of hedge funds.

Separately, hedge fund industry assets declined 1.4% to $2.8 trillion in the first three months of the year, according to a report by hedge fund news service HedgeFundNet.

The decline followed substantial redemptions in the first quarter, following poor performance across the industry.

HedgeFundNet's estimate of total industry assets is relatively high compared with other assessments, which vary from from $1 trillion to $2 trillion.

Deciphering Global Hedge Fund Statistics

"The secret of staying young is to live honestly, eat slowly and to lie about your age."

Lucille Ball
Actress (1911-1989)

One of the biggest problems in the hedge fund space is data mining. Aside from the crazy assumption that historical data and returns can extrapolate into the future, many users of commerically available databases somehow think that they have discovered or uncovered rare secrets from within a mystical hedge fund black box. This is hubris.

Take the latest example unleashed on the world by Pertrac. There are a vast litany of negative concerns related to hedge fund data including self-selection bias, sample selection bias, survivorship bias , backfill bias, and infrequent pricing bias.

Added to these, there are additional very serious classification issues that exist when you have two or more totally different databases with their own labels and you try to fit them together. For instance, where does one put an ABS fund in the HFR database, MSCI database and the Lipper TASS Hedge Fund Database? Is it a fixed income arbitrage fund, a multi-strategy fund or a relative value fund? No-one really knows. But where you put it will certainly impact the data results of risk and return across a number of strategies.

Perhaps the biggest "problem" leveled at databases is that of self-selection bias. While critics point out that only the better funds tend to provide their data to the outside world a reverse argument (and equally legitimate one) is that the best funds do not report to the same databases and so perhaps there are under-reporting biases that should be considered.

Of course, you don't hear much about these funds whenever a news releases comes out!

Which brings me to the case in point. Pertrac, recently analyzed hedge fund data reported to a large number of databases which are consolidated in their analytics package. They claimed that hedge funds report their best performance in their first 2 years. They claimed that a track record of less than two years produced, on average, 11.7% while performers over 2 years produced 10.2% return - a difference of 1.5% on average annual performance.

What the study did not point out was quite a lot. Namely what about the risk-adjusted performance? What about the fact that the smaller funds probably had significantly lower AUM and so in simple numerical terms starting from a lower base their performance was over emphasized. And what about all those closed big funds out there which are not in the databases? The Kensington Global and Medallian Funds of the world...what happens if you include this data into the results?

In fact in an alternative view of the data world a recent comment at a forum in Hawai'i by a academic pointed out just how much of a gap in our understanding of these big closed funds might be out there.

In the presentation covering 20 of these large single manager funds with AUM of over US$6.4 billion there was a definitive performance advantage favoring larger funds. How much? Apparently, an average of over 2.50% per year and for the top performing single managers (top quartile) the number was a staggering 6.00% outperformance per year since 2003!

The reference point for these returns was over the Credit Suisse-Tremont Hedge Fund broad hedge fund index, and, if true, it points to a very significant advantage of big over medium and presumably small too.

Data mining too? Could be. But it might at least shed some light on why the biggest institutional investors in the world are willing to pay higher fees and take on longer lock-ups in order to get access to such funds. It might also explain once and for all the key competitive advantage of the best performing fund of hedge funds - real estate- or simply being invested in the right funds.

And if one wants to focus on age then the average age of those best performing big funds was 13 years. So maybe as Lucille Ball and Marlene Dietrich would have said size and experience matters too. Mahalo.

Largecap, Midcap and Smallcap Performance

As we did yesterday with growth versus value, below we highlight the performance of large, mid and smallcap indices over the entire bull market and since the correction started last October. As shown in the first chart, largecap stocks (as measured by the S&P 500) have lagged mid and smallcap stocks significantly since October 2002. The S&P 500 is up 83.7%, the Smallcap 600 is up 129.2%, and the Midcap 400 is up 136.3% since 10/9/02.

Since the October 2007 top, smallcap stocks have fared the worst and are still down 11.45%. The S&P 500 is down 8.85%, while the Midcap 400 is down just 3.95%.

A beguilingly simple Chart of the Day - real and adjusted gasoline prices.

John Kemp at Sempra Metals notes that the Bureau of Labor Statistics does some serious smoothing of gasoline prices each spring to account for the usual surge associated with America’s driving season — from Memorial Day to Labor Day. In calculating CPI, the gasoline adjustments are substantial, with prices cut by up to 10 per cent in May and then increased them by as much as 9 per cent in Dec and Jan.

The actual gasoline price rose by 12.6 per cent between Jan and Apr, but BLS adjustments turned that into a 2.7 per cent fall.

From next month, however, the seasonal factors will become increasingly adverse. As Kemp pointed on in a note to clients on Tuesday:

Even if gasoline prices level out at the current level (about 385 cents per gallon) BLS will start to escalate them to reflect the seasonal adjustment path. By Dec, BLS will increase its recorded gasoline prices by as much as +15.5% EVEN IF THERE IS NO FURTHER RISE IN PUMP PRICES.

The increase in seasonally adjusted gasoline prices will feed through directly into a steady increase in the headline inflation rate. Gasoline prices account for around 5.5% of the total CPI. If they increase around +15.5% by the end of the year (on an adjusted basis) that will add +0.85 percentage points to the headline inflation rate taking it from +3.9% in the twelve months to Apr to as much as +4.8% in the twelve months to Dec (other things being equal).

So stand by for more benign inflation news in the short term (May’s data will be favourably adjusted) and then a delayed shock thereafter.

Growth Vs Value Performance

Since the bull market began on October 9th, 2002, the S&P 500 is up 84.4%, the S&P 500 Value index is up 102.8%, and the S&P 500 Growth index is up 68.2% (not total return). Since the October 9th, 2007 peak in the S&P 500, however, growth stocks have handily outperformed both the S&P 500 and the S&P 500 Value index. As shown in the second chart below, the Growth index is down 4.93%, while the Value index is down 11.99%. If the market ends up making new highs before hitting the -20% bear market threshold (keeping the longer-term bull market intact), will the second act be led by growth instead of value?

P/E Divergence Between Growth and Value Stocks -- The Wrong Way

Recently, growth and value stocks have seen a big divergence in valuations. One index has an as-reported P/E ratio of 33.66, while the other is at 18.92. The only problem is that it's the value stocks that have the 33.6 P/E, while the growth stocks have the 18.9 P/E. Below we highlight a historical chart of trailing 12-month P/E ratios for the S&P 500 Growth and Value indices. As shown, the Value P/E has spiked significantly in recent months, as supposed value names that typically pay high dividends (financials, etc.) have seen a big drop in earnings. This isn't the first time the divergence has happened, however. After growth valuations spiked during the tech bubble, value stocks followed with their own surge in P/E ratios in late '01 and '02. Ironically, growth stocks have held their value much better than value stocks have in 2008.

The credit crunch in context: banking writeoffs per employee

The credit crunch in context: banking writeoffs per employee

Incredible chart porn from Here Is the City (HT Felix), showing how much firms have either written down or lost, per wholesale banking employee:

The breakdown (headcount estimates are Here Is the City’s own):

1. Mizuho Financial Group - $5.5bn in writedowns / credit losses, 2,000 wholesale banking employees, $2,750,000 per employee.

2. Wachovia - $7bn, 3,900, $1,794,872 per employee

3. UBS - $37bn, 22,000, $1,681,818 per employee

4. Citi - $40.9bn, 30,000, $1,363,333 per employee

5. Bank of America - $14.8bn, 20,000, $740,000 per employee

6. Merrill Lynch - $31.7bn, 48,100, $659,044 per employee

7. Dresdner Kleinwort - $3.3bn, 6,000, $550,000 per employee

8. Credit Agricole - $6.9bn, 13,000, $530,769 per employee

9. Barclays Bank / Barclays Capital - $7.7bn, 16,200, $475,309 per employee

10. JPMorgan Chase - $9.8bn, 25,000, $392,000 per employee

11. Deutsche Bank - $7.6bn, 20,000, $380,000 per employee

12. SG Corporate & Investment Banking - $3.9bn, 10,500, $371,429 per employee

13. Morgan Stanley - $12.6bn, 38,050, $331,143 per employee

14. Credit Suisse - $6.3bn, 20,000, $315,000 per employee

15. Lehman Brothers - $6.6bn, 30,000, $220,000 per employee

16. Goldman Sachs - $4.1bn, 30,000, $133,667 per employee

17. BNP Paribas - $1.7bn, 13,000, $130,769 per employee

The latest missive from UniCredit’s Jochen Felsenheimer argues that times are hard for bears, not least since the recovery in synthetic credit markets

The latest missive from UniCredit’s Jochen Felsenheimer argues that times are hard for bears, not least since the recovery in synthetic credit markets is lasting longer than anticipated.

Moreover, “we are close to very critical levels which might squeeze out the “last bear standing”. This would be the end of the bear market rally!”

The most common arguments why the worst should already be behind us are the following, says Dr Felsenheimer:

i) the recapitalization of the global banking system is in full swing and the fact that financial institutions are able to raise capital in such difficult times shows that the banks are on their way out of the subprime swamp.ii) loss-estimates are exaggerating the severity of the crisis as many losses are only m-t-m losses. Pull-to-par will reduce losses over time, even generating valuation gains in the future.

iii) companies are still in very good micro-fundamental condition. Default rates will not climb to 2002 levels as balance sheet leverage of nonfinancials is not a major threat in this crisis.

But not so fast, because something is different this time - and that’s good news for bears. In other words, the light at the end of the tunnel is the locomotive which is on a confrontation course and will hit us soon:We think that further spread widening is highly likely. While we do not ignore the possibility that we have already seen the spread highs in the synthetic (overshooting) markets, we think that especially cash non-financial spreads will come under pressure.

What could be the impulse for the next widening leg? As already seen two times in 2007 (when officials prematurely proclaimed the end of the crisis), the impulse might come from a side which is right now not on the agenda. In our view, a disappointment on the macro front is the most obvious potential source of further adversity for credit markets.

And it gets better (or worse, depending on whether you’re long or short the iTraxx Crossover):

The latest improvement of sentiment looks to us as wishful thinking rather than marking the spread reversal in credit markets. Many problems are still there and a solution will take longer than currently anticipated. Even US officials are less optimistic than many investors (shareholders). The head of the US Federal Deposit Insurance Corporation said that another wave of more traditional credit stress (linked to an economic slowdown) could come, including mortgage loans.

In addition, there is again bad news from the usual suspects: a Canadian court delayed yet again the restructuring decision for Canadian ABCPs. This is not a big thing, but it will further delay the full re-functioning of the Canadian CP market.

All these arguments are pointing to a longer-lasting problem, which will probably not result in a failure of a big financial institution and not in a fully-fledged credit crunch; but it will have a lasting negative impact on the earnings generation power in the financial industry and weaker growth which will be worse than the slowdown in a “normal” business cycle. This scenario, in our view, is not fully discounted in credit spreads, especially not in synthetic ones.

1990 All Over Again?

In the aftermath of the crisis in the credit markets, many economists have said that the US economy is facing the worst recession in the post WWII area. While the ultimate outcome of the current period is anyone's guess (many are now doubting we will even end up with a recession), we wondered whether investors and economists tend to think every recession (or even period of economic weakness) is the worst ever as they are going through it, and then once it's over say, "Oh that wasn't so bad after all."

For example, the 1990 recession is considered by most to have been pretty mild. But at the time, people thought it was a lot worse. For example, in February 1992 - almost a year after the recession ended - US News and World Report said that, "The current downturn is different. Many cash-strapped homeowners whose houses have fallen in value won't be able to take advantage of the refinancing bonanza promised by the Fed's rate cut. So far, unemployment remains lower than it was a decade ago, but this recession isn't over yet, and the economy's glaring structural problems will stifle growth and new jobs." US News went on to say that the recession would be "unlike any the country has experienced in the post-World War II era, the result of years of profligacy and irresponsible government policies." Sound familiar? For those interested, we highly recommend reading the entire article to see just how negative sentiment was leading up to one of the greatest decades of growth in American history.

In fact, if we were to compare the 1990 period to today, there are many similarities. As just an example, in each period, the dollar was weak, inflation was on the high side, oil spiked, and credit markets were under stress. In both periods there was even a George Bush in the White House! With these similarities, it comes as little surprise that the performance of the stock market has been similar during both periods. In the chart below, we overlaid the S&P 500 in the current period (since October 2007) with the period from June 1990 through June 1991. As the patterns show, for the last six months, the two periods have tracked each other closely. While this is not meant to imply that the S&P 500 is poised for a monster rally, the correlation between both periods is certainly worth noting.

Opportunities from the Credit Crisis?

A presentation entitled: “The Credit/Liquidity Crisis of 2007: Opportunities for US Bond Investors” sounds as though it would leave you with grounds for optimism. Not quite.

Instead, Michael Lustig, a managing director at BlackRock, made it clear that he is extremely pessimistic. The heading for one slide – “Things Are Terrible – And There’s No Sign of a Bottom” – adequately catches the spirit. .

Echoing the Fed’s Janet Yellen earlier in the day, he said he believes the outright falls in US house prices are significant, and make this crisis different from its predecessors. As he said, Americans’ percentage of equity in their homes has fallen below 50 per cent for the first time on record since 1945. This means there is a real danger of negative equity. This time, he fears, is different.

All this being said, he did as promised identify a number of opportunities. They are as follows:

- Cash corporate bonds are cheap compared to synthetic equivalents

- Investment-grade financials may be cheaper than high-yield bonds

- Credit card ABS spreads are at record wides, but biased towards more widening. There is fundamental value in the top-tier names.

- Agency fixed-rate mortgages are cheap, and offer fundamentally good value “even when taking into account the elevated level of volatility, prepayment risk, and negative convexity.”

- Non-agency MBS are historically cheap.

Is this global inflation thing over cooked?

A serious question, in our view, since predictions of Farmageddon (© Donald Coxe) are suddenly everywhere. But witness this chart, using data from the Economist, knocked up by Albert Edwards at Societe Generale:

That’s right - ex-oil, industrial commodity prices have gone precisely nowhere in the past two years.

As Edwards notes in a recent strategy note to SocGen clients, while many general commodities indices have risen some 30 per cent over the past year, the upward move is now very narrowly focused in food and energy. His contention - as controversial as ever:

As US consumption goes into recession, a decline in the US current account deficit will impart a global liquidity squeeze which will, in all likelihood, pop the food and energy bubbles.

Now, Edwards has been around a bit. He’s mindful of the fact that history is littered with examples of protests about food shortages and inflation turning into a fully fledged political protests and ultimately violent revolution:

Amid the mists of time we often forget that it is people’s stomachs rather than notions of political reform that are the catalyst for revolution.

But, while acknowledging the structural arguments underpinning the rise in commodity prices, the SocGen man wonders now whether cyclical market forces might already be saving the skins of the politicos:

I believe it has been the change in the US current account deficit that has been the liquidity pump for the global economy. It is turning and is set to turn even more quickly in the months ahead as the extremely import sensitive US consumer slides into recession. The flip-side of this is that Asian/EM surpluses will decline as exports slow, reducing the rate of FX intervention. This in turn will reduce Asian/EM domestic money supply growth, asset price inflation and hence Asian/EM economic activity still further…

…Until now, continued speculation in commodities was entirely understandable as investors needed to believe in a ‘growth’ story. As in all good bubbles there is truth in the structural bull arguments. I certainly believe them. But the impact of the cycle and liquidity is ignored at investors’ peril. That liquidity pump is about to be switched off. This will be the next round in “The Great Unwind” and will come in addition to the de-leveraging of the credit bubble we have seen to date. Market forces may yet do timid politicians work for them and send food (and energy) prices sharply lower.

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Extra - For those readers expecting some Albert Edward-ian pyrotechnical prose, relax…

The Socgen strategist on UK energy policy:

In the UK for example, PM Gordon Brown recently urged his fellow G7 members to address this issue of the impact of biofuel production on food prices. He wrote “rising food prices threaten to roll back progress we have made in recent years on development. For the first time in decades, the number of people facing hunger is growing”.

Indeed, he has just cancelled the UK’s biofuel subsidy of 20p per litre (the government pockets £550m in the process). How’s that for action? Pretty weird actually when you consider that at the same time the government have introduced the Renewable Transport Fuel Obligation (RTFO) which requires suppliers of fossil fuels to ensue a proportion – initially 2.5% and rising to 5% in 2010 – comes from biofuels. Oil companies will be fined for noncompliance. Call me cynical but methinks the UK’s biofuel policy may have more to do with raising money for the hard up Treasury! Bonkers. Bonkers. Bonkers with knobs on!

The Consensus Play: Hold Tight

One more finding from the poll of CFAs at this week’s Vancouver gathering suggests that they’re still not ripe to make big contrarian plays. There is so much disagreement about where assets should be allocated at present that contrarians do not have a consensus to play against. All the CFAs were asked whether they were advising clients to increase or decrease their holdings in a range of asset classes to deal with the current market environment. The closest approaches to “consensus” plays are that you should not reduce cash (only 16 per cent agree with that) or alternative investments (only 15 per cent propose that) or raise fixed income (proposed by 17 per cent).

On equities, 29 per cent are bulls, calling to increase weightings, and 26 per cent are bears wanting to cut – within the statistical margin of error. There is similar indecision over commodities, the asset class of the moment – 26 per cent want to raise their allocations, and 20 per cent suggest reducing them. Professionals are as confused as everyone else, it appears, by the phenomenal run-up in oil and food prices.

Clients might complain that their managers are not giving them clear guidance. But at least one measure suggests that CFAs have kept their cool, and are satisified that they had it right heading into the critis. For all of the asset classes - equities, fixed income, alternative investments, commodities, or cash - the single most popular option was “no change.”

So if Taleb is so clever...

Nassim Nicholas Taleb ended his speech by predicting that he already knew what the questions would be. And he indeed had a slide ready for the most popular question which was: “If you’re so clever, now that you’ve scared us so much, tell us what we should do to guard against black swans in future?”

Here is Taleb’s list of bullet points for action, from which he swiftly deviated as he warmed to his theme:

1. Sharpe ratios (dividing a poprtfolio’s excess return over a risk-free rate by the standard deviation of the portfolio’s return) are a trap, because they do not predict future Sharpe ratios. So abandon them.
2. Don’t use standard deviations, and instead use mean variation.
3. Diversification doesn’t work. You might need as many as 12,000 companies before it truly works. Another example he uses is profits from the drug industry, which are concentrated in a tiny proportion of successful drugs - so you would need to buy a lot of drugs stocks to be truly diversified.
4. As for derivatives: “Take a walk and see if you can rid yourself of the desire to use derivatives. It’s amazing how little people who claim to know derivatives really know derivatives.”

Perhaps the biggest point he tried to get across in his presentation is that the “black swan” term has been misunderstood. He does not mean that “black swan” events happen a lot, or more often than expected, but that when they do happen they will have truly huge consequences.

Also, he says, people do not understand the link with the concept of volatility. In a market, if returns do not follow a “normal” bell curve distribution (as appears to be the case), volatility will actually be less than the bell curve would predict. For much more than the predicted two-thirds of the time, returns will be very close to the average. Such low volatility, counter-intuitively, is a danger sign that there is a greater risk of true “black swan” events, when returns do deviate from the norm, because it shows that returns do not follow a normal bell curve.

His geopolitical analogy is with Italy and Saudi Arabia. Italy has had many different governments since the war, while the same family has retained power in Saudi Arabia. This means that Italy is the more volatile but, he says, that Saudi Arabia is more risky, because if something does change in the political situation there, it will have much greater consequences.

So on his argument, risk managers should penalise exposure to “tail risks” or extreme “black swan” events. They should not be worried about minimising volatility, as this is not a problem. But, he said in exasperated tones, “we seem to go the other way”.

That, at any rate, is a very brief summary of some of his main points from a long, dense and provocative presentation. He was at least proud that the black swan has now even given its name to a boutique in San Francisco (slogan: “Expect the Unexpected”).

And he did, on occasion, relent in his criticism of his hosts. When one delegate asked if he should bother coming to the rest of the conference, or just take the opportunity to explore Vancouver, Taleb urged him to stay in the conference hall and get more information.

“But if there’s an equation, try to close your eyes until it goes away.”