Tuesday, July 12, 2011
Thursday, July 07, 2011
Are Hedge Funds Too ‘Safe to Fail’?
A global hedge fund association, seeking to deflect efforts to increase regulation of the investment vehicles, said today hedge funds aren’t “systemically important financial institutions” that would require special government oversight.
While more than 1,400 hedge funds closed during the recent financial crisis, the Alternative Investment Management Association said, they did so in “an orderly manner.”
“The 2008 experience shows that hedge funds are ‘safe to fail,’ even if they are not fail-safe,” said Todd Groome, chairman of the association, said in a statement. “This difficult period provided a very up-to-date and significant stress test concerning hedge fund risk to markets.”
AIMA’s argument comes as regulators continue to mull which organizations should be deemed systemically important, in a bid to better devise rules to rein in financial companies that are “too big to fail.”
The Dodd-Frank financial-overhaul law automatically designates banks with $50 billion or more in assets as systemically important, but gives regulators authority to decide which nonbank financial firms pose systemic risks.
Some regulators have told Congress they want a larger number of non-bank firms, such as hedge funds, to provide data to regulators even if they escape the systemic designation.
AIMA, a London-based lobbying organization with over 1,250 corporate members worldwide, is arguing that registration alone already allows for improved monitoring of hedge funds in the $2 trillion industry.
A registration-and-reporting regime for hedge fund advisers was put in place last month in which funds with $150 million or more in assets will have to report to the Securities and Exchange Commission.
One often-cited example in the argument to boost regulation of hedge funds is the 1998 rescue of Long-Term Capital Management L.P. organized by the Federal Reserve, which had feared its failure might cause a chain reaction in markets and among counterparties on Wall Street.
Roger Lowenstein’s book, “When Genius Failed: The Rise and Fall of Long-Term Capital Management,” said leverage at the fund manager reached 250-to-one after worried investors began withdrawing funds.
Industry participants argue hedge funds have been far more tame in their use of leverage since then. Hedge Fund Research Inc. said in May that funds on average employed leverage that is 1.1 times investment capital, while large funds’ leverage utilization stood at two to five times.
AIMA, in its statement Thursday, also contended that “hedge funds collectively represent a relatively small group of extremely heterogeneous and often very small businesses, and even their collective positions and exposures are not such that individual failures pose a risk to financial stability.”
It added that hedge fund firms have much smaller balance sheets than some individual financial institutions and employ significantly lower levels of leverage than banks and some other financial institutions.
According to the National Information Center, which holds data collected by the Federal Reserve System, the country’s two largest banks–Bank of America and J.P. Morgan Chase –each had more than $2 trillion in assets as of March 31. The hedge fund industry’s total assets in April, the latest data available, were $2.02 trillion, according to HFR.
While more than 1,400 hedge funds closed during the recent financial crisis, the Alternative Investment Management Association said, they did so in “an orderly manner.”
“The 2008 experience shows that hedge funds are ‘safe to fail,’ even if they are not fail-safe,” said Todd Groome, chairman of the association, said in a statement. “This difficult period provided a very up-to-date and significant stress test concerning hedge fund risk to markets.”
AIMA’s argument comes as regulators continue to mull which organizations should be deemed systemically important, in a bid to better devise rules to rein in financial companies that are “too big to fail.”
The Dodd-Frank financial-overhaul law automatically designates banks with $50 billion or more in assets as systemically important, but gives regulators authority to decide which nonbank financial firms pose systemic risks.
Some regulators have told Congress they want a larger number of non-bank firms, such as hedge funds, to provide data to regulators even if they escape the systemic designation.
AIMA, a London-based lobbying organization with over 1,250 corporate members worldwide, is arguing that registration alone already allows for improved monitoring of hedge funds in the $2 trillion industry.
A registration-and-reporting regime for hedge fund advisers was put in place last month in which funds with $150 million or more in assets will have to report to the Securities and Exchange Commission.
One often-cited example in the argument to boost regulation of hedge funds is the 1998 rescue of Long-Term Capital Management L.P. organized by the Federal Reserve, which had feared its failure might cause a chain reaction in markets and among counterparties on Wall Street.
Roger Lowenstein’s book, “When Genius Failed: The Rise and Fall of Long-Term Capital Management,” said leverage at the fund manager reached 250-to-one after worried investors began withdrawing funds.
Industry participants argue hedge funds have been far more tame in their use of leverage since then. Hedge Fund Research Inc. said in May that funds on average employed leverage that is 1.1 times investment capital, while large funds’ leverage utilization stood at two to five times.
AIMA, in its statement Thursday, also contended that “hedge funds collectively represent a relatively small group of extremely heterogeneous and often very small businesses, and even their collective positions and exposures are not such that individual failures pose a risk to financial stability.”
It added that hedge fund firms have much smaller balance sheets than some individual financial institutions and employ significantly lower levels of leverage than banks and some other financial institutions.
According to the National Information Center, which holds data collected by the Federal Reserve System, the country’s two largest banks–Bank of America and J.P. Morgan Chase –each had more than $2 trillion in assets as of March 31. The hedge fund industry’s total assets in April, the latest data available, were $2.02 trillion, according to HFR.
Pimco Total Return ETF To Cost 0.55%
Pimco, the world’s-biggest bond fund manager, revealed in a regulatory filing today that the ETF version of its flagship Total Return Fund will have an annual expense ratio of 0.55 percent, or 40 basis points lower than the “A” class mutual fund version that’s most appropriate for retail investors.
Pimco also said the new ETF will trade on the New York Stock Exchange’s electronic trading platform, Arca, under the symbol “TRXT.” The regulatory paperwork the company submitted to the Securities and Exchange Commission over the past week suggests the Pimco Total Return Exchange-Traded Fund (NYSEArca: TRXT) is nearing launch. However, company officials weren’t immediately available to comment on when Pimco might bring the ETF to market.
Depending on the share class, investors can pay a front-end load and up to 85 basis points for the privilege of owning the Pimco Total Return mutual fund, although it’s possible for institutional investors to get that down to a no-load 46 basis points, in size.
As we wrote in April when TRXT went into registration, Pimco Total Return’s mutual fund version is the largest fund in the world, at about $236 billion. It launched in 1986, the heyday of the active mutual fund boom. It’s one of the most successful fixed-income funds in the world. It’s returned 3.32 percent year-to-date, and had gains of 8.36 percent in 2010, 13.33 percent in 2009 and, surprisingly, 4.33 percent in 2008.
Total Return is the poster child for Bill Gross, Pimco’s bond-picking maven. Gross’ moves are followed by fixed-income watchers the way Warren Buffett’s stock picks are. When Gross moved Total Return out of U.S. government debt in March of this year, it made international headlines.
It’s worth noting that the Pimco Total Return ETF won’t technically be the same portfolio as the Total Return mutual fund. That kind of hub-and-spoke arrangement is still unique to Vanguard, until Vanguard’s patent on the process expires in a few years.
Part of the Total Return strategy is to step away from fixed income when it makes sense. The fund will only target 65 percent of fixed-income exposure, and can put up to 15 percent of its assets in securities deemed illiquid.
This go-anywhere strategy has served the fund well performancewise, and has led some to call Total Return a hedge fund in mutual fund clothing. The fund has experienced periods of very high turnover, and it’s not uncommon for an entire sector of debt to go from 25 percent of the portfolio to nothing in a quarter, should Gross make a tactical call.
Pimco also said the new ETF will trade on the New York Stock Exchange’s electronic trading platform, Arca, under the symbol “TRXT.” The regulatory paperwork the company submitted to the Securities and Exchange Commission over the past week suggests the Pimco Total Return Exchange-Traded Fund (NYSEArca: TRXT) is nearing launch. However, company officials weren’t immediately available to comment on when Pimco might bring the ETF to market.
Depending on the share class, investors can pay a front-end load and up to 85 basis points for the privilege of owning the Pimco Total Return mutual fund, although it’s possible for institutional investors to get that down to a no-load 46 basis points, in size.
As we wrote in April when TRXT went into registration, Pimco Total Return’s mutual fund version is the largest fund in the world, at about $236 billion. It launched in 1986, the heyday of the active mutual fund boom. It’s one of the most successful fixed-income funds in the world. It’s returned 3.32 percent year-to-date, and had gains of 8.36 percent in 2010, 13.33 percent in 2009 and, surprisingly, 4.33 percent in 2008.
Total Return is the poster child for Bill Gross, Pimco’s bond-picking maven. Gross’ moves are followed by fixed-income watchers the way Warren Buffett’s stock picks are. When Gross moved Total Return out of U.S. government debt in March of this year, it made international headlines.
It’s worth noting that the Pimco Total Return ETF won’t technically be the same portfolio as the Total Return mutual fund. That kind of hub-and-spoke arrangement is still unique to Vanguard, until Vanguard’s patent on the process expires in a few years.
Part of the Total Return strategy is to step away from fixed income when it makes sense. The fund will only target 65 percent of fixed-income exposure, and can put up to 15 percent of its assets in securities deemed illiquid.
This go-anywhere strategy has served the fund well performancewise, and has led some to call Total Return a hedge fund in mutual fund clothing. The fund has experienced periods of very high turnover, and it’s not uncommon for an entire sector of debt to go from 25 percent of the portfolio to nothing in a quarter, should Gross make a tactical call.
It’s No Different This Time
The Leuthold Group’s July Green Book takes an updated look at the 20-year trailing stock/bond differential:
As we’ve noted before, when ten-year Treasuries outperform stocks over long periods of time, it is a pretty rare condition deserving of attention. Historically, when this occurs it has been a pretty good time to buy stocks.
(Click to enlarge)
Since 1926, the stock/bond performance differential has fallen to negative on three occasions. In 1933, the differential dipped negative and stocks went on to deliver a +34% total return ACR over the next five years. However, ten-year Treasuries lagged substantially, turning in a much lower +4.6% ACR. The differential fell negative a second time in 1949. As before, stocks subsequently went on to deliver sharply higher returns in the ensuing 5-year period. The total return ACR in this five year period was +23% for stocks, compared to a meager +1.6% ACR from ten-year Treasuries.It’s no different this time. Although five years have not elapsed since the differential plunged to a 62-year low, stocks have handily outperformed ten-year Treasuries in the nine quarters since then. Since Q1-2009’s low, the S&P 500 has turned in a +27.7% annual compound total return, while ten-year Treasuries have delivered a 1.4% total return gain on an ACR basis. It appears history is repeating itself once again.
If PIMCO’s New Fund Loses Money Bill Gross Will Eat These Fees Himself
Pacific Investment Management Co., seeking to raise $600 million for a fund that would invest in residential mortgages, agreed to slash its management fee should the fund suffer losses. Pimco REIT Inc., which filed for an initial public offering in April, disclosed last week that its annual management fee would decline to 1.0 percent from 1.5 percent if the fund loses money over a one-year period…“Investors have complained that you shouldn’t be able to earn a fee if the entity is losing money,” said Merrill Ross, a REIT analyst at Wunderlich Securities Inc., a regional brokerage based in Memphis, Tennessee. “But no one has ever offered this as a resolution before.” [Bloomberg]
Third Point Reduces Equity Exposure Further
For the month of June, Dan Loeb's Third Point Offshore Fund returned -2.6% but is still up 6.8% for the year and has seen 18.5% annualized returns. The Offshore fund manages just under $4 billion and Third Point recently closed to new investors.
Equity Exposure
At the end of June, Third Point's total equity exposure was 56.3% long and -25.6% short, resulting in 30.7% net long exposure. Their largest net long exposure comes in the consumer sector at 7.1% net long and the energy sector at 6.5% net long. The only sector they were net short was technology.
This marks a reduction in Third Point's equity exposure for the second consecutive month. At the end of May, they were 42.6% net long equities and so they've decreased exposure by almost 12% month over month.
Credit Exposure
Dan Loeb's firm also reduced credit exposure during the quarter down to 21.7% net long (down from 34.4% net long at the end of May). Their largest exposure this time around was 18.1% net long asset backed securities and 10.2% net long distressed debt. On the other side of things, they continue to be -10.1% net short government securities.
Top Positions
1. Delphi
2. El Paso (EP)
3. Gold
4. CIT Group (multiple securities held)
5. Technicolor (multiple securities held)
While at the end of May gold was Third Point's largest position, the slide in the precious metal caused it to slip to their third largest position a month later. CIT Group moves into their top 5 holdings this month, replacing CVR Energy (CVI).
Delphi is Loeb's largest holding and David Einhorn's Greenlight Capital also recently took a stake. In fact, Third Point and Greenlight share a few other common positions such as gold and CIT Group.
Top Winners & Losers
In the month of June, Third Point's positions in CVR Energy, Volkswagen, and various asset backed securities were their top winners. Their top losers in the month included Delphi, LyondellBasell (LYB), El Paso (EP), gold, and Technicolor.
Equity Exposure
At the end of June, Third Point's total equity exposure was 56.3% long and -25.6% short, resulting in 30.7% net long exposure. Their largest net long exposure comes in the consumer sector at 7.1% net long and the energy sector at 6.5% net long. The only sector they were net short was technology.
This marks a reduction in Third Point's equity exposure for the second consecutive month. At the end of May, they were 42.6% net long equities and so they've decreased exposure by almost 12% month over month.
Credit Exposure
Dan Loeb's firm also reduced credit exposure during the quarter down to 21.7% net long (down from 34.4% net long at the end of May). Their largest exposure this time around was 18.1% net long asset backed securities and 10.2% net long distressed debt. On the other side of things, they continue to be -10.1% net short government securities.
Top Positions
1. Delphi
2. El Paso (EP)
3. Gold
4. CIT Group (multiple securities held)
5. Technicolor (multiple securities held)
While at the end of May gold was Third Point's largest position, the slide in the precious metal caused it to slip to their third largest position a month later. CIT Group moves into their top 5 holdings this month, replacing CVR Energy (CVI).
Delphi is Loeb's largest holding and David Einhorn's Greenlight Capital also recently took a stake. In fact, Third Point and Greenlight share a few other common positions such as gold and CIT Group.
Top Winners & Losers
In the month of June, Third Point's positions in CVR Energy, Volkswagen, and various asset backed securities were their top winners. Their top losers in the month included Delphi, LyondellBasell (LYB), El Paso (EP), gold, and Technicolor.
Tuesday, July 05, 2011
The Risks and Opportunities of Unforeseen ‘Black swan’ Market Events
The precipitous market-collapse which began the 2007 financial crisis [1] was considered to be a ‘once in a thousand year’ event. Similar ‘not in our lifetime’ rarity was also assigned to the events which followed including the failures of large financial institutions, global contagion, market interventions and (more recently) potential sovereign defaults throughout europe. All these events (on the left tail [2] of a probability distribution [3]) are united by their consequences- typically so severe that the very survival of financial systems, frameworks and portfolios are at risk.
Looking at our perception of such events, Mark Spitznagel, Founder and CIO of Universa Investments (which, according to reliable news-sources, has in excess of US$6bn under management) states, “…people like to compare such rare payoffs to lottery tickets. This is way off. We know from the availability heuristic [4] that people overestimate the likelihood of an event based on their ability to envision it—the risk of plane crash versus car crash is the best example of this. Holding that big check is easy to conjure up, but rare, deep stock market corrections not so much most of the time.”
[5]In 2008, the year Lehman brothers collapsed, when most funds were losing immense amounts of capital, the Wall Street Journal reported [6], “Separate funds in Universa’s so-called Black Swan Protection Protocol were up by a range of 65 percent to 115 percent“. Explaining his strategy, Spitznagel comments, “We are living through a profound era where speculative failure is simply not an option, and is fought tooth and nail by the government. This is a trap. Here I am the fool looking to fail frequently. I want to either hit a homerun or walk or even strike out. This means I fail far more often than I succeed. But the important point is that what I lose when I fail is trivial, epsilon compared to what I make when I succeed. This disproportionate, asymmetric payoff dominates the relative frequencies, but the frequencies are something impossible for most people to stomach, and this is the very source of my edge.”
In this article [7] for Manchester Business School, I described how, “..the globalization of capital markets, and growth of technology within them, has increased the ‘speed’ of economies to a pace never seen before.” A view supported by Spitznagel who also argues, “…We have a much more connected marketplace. We have had, what I reckon to be an extremely overvalued stock market since 2000. We very briefly came into the area of fair value in ‘09 but very quickly went extremely overvalued again. When you have that situation, you are prone to very sudden negative revaluations. This is what we see in the stock market. I made the analogy of earthquake faults- when they get aligned, they either all move, or they don’t move- we also have this diversity of micro fault-lines that fail, and I think that’s a huge problem…” Describing how he protects his clients from such risks he continues “It’s quite simple. We are hedging a systematic left tail in our equity products. The onus is on the client is to understand ‘what’ their systematic exposure is. You may have a fund of funds who don’t have any conditional data on their risk, we all know that the covariance matrices go out of the window in these conditions- which came as a shock to a lot of naive people in 2008. We don’t accept basis risk we don’t accept counterparty risk- we don’t want any fuzziness around what our payout is going to be conditional on the realizing of this systematic left tail ‘black swan’ event. We like to think this very simple, we don’t like to think too smart. It’s a huge mistake when people start assuming basis risk, for instance, thinking that they’re getting it cheaper. For instance, someone may think it’s cheaper to buy a USD call than a S&P put- if you do that, I would argue that in the next crash we see the USD will not be rallying, we may be crashing next because the dollar itself crashes! I certainly wouldn’t bet on either way- if the dollar is actually crashing when the market tumbles, you have the wrong sign on your expectation! You’d have to buy strangles on the dollar, which costs twice as much in premium…. You can see therefore why fuzziness is unacceptable. We measure the systematic tail and overlay that with index options and other instruments.”
So What?
For risk managers, it’s critically important to understand where in the market your existential (left-tail) risks come from and how big they could be. For the manager of a mortgage backed derivative portfolio pre-crash it would have been obscene to model in defaults of more than 7%, now- in retrospect- modelling defaults of even 20% could have seemed conservative. Had the manager looked at the real stresses in the market at the time factoring in 20% default risk could have seemed a reasonable assumption- and instruments could have been applied to hedge that risk, protecting the portfolio.
For investors, the opportunity is no less profound. Our highly globalized marketplace is incredibly susceptible to boom and bust on all timeframes- more frequently, and more violently than our availability heuristic would have us believe. Consideration of areas of market-stress can not only provide investment insight in this regard, but can create astonishing returns.
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Lunch is for wimps
It's not a question of enough, pal. It's a zero sum game, somebody wins, somebody loses. Money itself isn't lost or made, it's simply transferred from one perception to another.