Report suggests alternative investment allocations could be impacted by new pension accounting rules

You don’t have to be a licensed accountant to figure out that many pension funds are being squeezed from both sides.  Assets are down and lower future return assumptions mean the present value of those assets is down even further.  And pension liabilities are up due largely the same thing: low discount rates leading to higher present value of future liabilities.   These phenomena have conspired to create what Michael Moran and Abby Joseph Cohen at Goldman Sachs called “challenges and changes” for pensions in 2011.  Anyone who manages the overall health of their pension fund, or anyone who thinks they can help the managers of those funds get out of their pickle, should definitely read this report.  What follows is a quick taste of what you’ll find in the report.

Despite the hysteria surrounding pension under-funding over the past decade, the report ^[2] begins by showing that the average funded status was actually over 100% in both 2007 and 2008 – for US pensions at least.  However, the market calamity of 2008 means that average funded status is now around 82% with the median approximately 75%.  As if that weren’t bad enough, pension funds are beginning to acknowledge that their traditional return assumptions will have to be revised downward even further than they have been already.  The chart below from the report shows that average expected return assumptions have fallen around 1% since 2002.

 ^[3]

Of course, a tiny drop in the expected future annual return will have a dramatic impact on the present value of the fund’s assets, and thus on its long-term funding gap.  The report contains several examples of public pension funds (totaling over $550 billion) that have recently dropped return assumptions.  In 2003, says Goldman, 95 of the pension funds of S&P 50 firms used a return forecast of 9% or higher.  By 2009, that number plummeted to 3.  You can imagine how these recalibrations alone would open up a funding gap the size of the San Andreas Fault.

One way of dealing with this is to decouple fund returns from market returns.  Or, as Goldman says,

“This means that plan sponsors have a greater incentive to have assets with characteristics similar to the characteristics of the plan’s liabilities.”

This means a shift into less volatile assets such as fixed income and alternative investments.  We’ve chronicled the shift out of long-only equities several times over the past few years, so regular readers will find the chart below showing a drop in equities and corresponding increase in fixed income and alternative to be vaguely familiar:

 ^[4]

But while this was clearly the trend up to and including 2008, check out what happened in 2009:  Equity allocations bounced back a little, fixed income allocations dropped like a rock and, through it all, “other” jumped by over 50%. This indicates that, although Goldman classified non-fixed income assets as “risky” for the purposes of the report (and hedge funds as even riskier “Level 3″ assets), allocators seem to be increasing hedge fund allocations as part of their “de-risking” strategy. Go figure!

It’s easy to assume, like we did, that much of the precipitous drop in long-only equity allocations was a passive effect of falling markets.  But the chart below from the Goldman report shows that it wasn’t just “actual” equity allocations that were falling, it was the “target” allocations themselves.

 ^[5]

Okay, you don’t have to be an accountant to understand the challenges facing pension fund portfolio managers, don’t worry.  But you might actually need a CPA to figure out the implications of these challenges for the plan sponsors such as the S&P 500 companies who likely now regret ever starting a pension plan.  It turns out that pending accounting changes could impact the future of pension plans far more than either the return assumptions or the discount rates applied to liabilities.

The report explains how pending changes to international accounting rules (i.e. the International Financial Reporting Standards  or “IFRS”) could make their way to US plans.  One such change would do away with the ubiquitous return assumptions that got plans into a bind in the first place.  These changes, says Goldman, will remove the incentive to see the world through rose-coloured glasses and pave the way for pension funds to abandon what many believe is an overly-optimistic perspective.  If this were to occur, Goldman Sachs says a “powerful incentive for some plans to maintain exposure to equities would be removed” and we would see an acceleration in the aforementioned move out of the asset class.

The pending proposals would have pension plans recognize profit and loss on pension funds in the period they occur.  But to avoid the resulting excessive volatility, that profit or loss would be recognized as other comprehensive income and would therefore not directly impact the company’s bottom line every year.

Again, not directly.  But if the running balance in that “other comprehensive income” account is negative (i.e. if the fund was under-funded), then the company would have to recognize an “interest charge” for the balance – as if it was borrowing the money from outside. If, on the other hand, the balance was positive (i.e. if the fund was in surplus) then the company would recognize interest income from its pension fund.

This sounds like a win for sponsors since many are currently amortizing the full value of recent losses.  Using the new standards, they would no longer have to amortize those losses and would only have to recognize the “interest” on the resulting funding gap.  But as Goldman points out, without the benefit of being able to recognize 8.5% returns, regardless of actual returns, many plans would actually be worse off in the short term.  (The firm includes a simple example of how the accounting would work.)

Had the IFRS proposal been instituted in the US in 2009, 34 S&P 500 companies would have seen a hit to net income in excess of $100 million.  Even more-so, two of them would have seen a hit of more than$1 billion.  We’d venture to guess that most of these companies would likely lobby against such a proposal.

The bottom line is that pension fund portfolios aren’t managed in isolation.  Asset allocation can increase or decrease funding gap and the accounting treatment of that gap can, in turn, drive the asset allocation decisions made by US pension funds.  Advocates of alternative investments would be well advised to keep an eye on this evolving story. As always, the impact hinges on whether you believe alternative investments are “risky” or they are part of an overall “de-risking” strategy.

Hedge fund manager-diversification vs. hedge fund strategy-diversification

Pundits often like to say that long term investing success is usually the result of sector selection, not security selection.  Perhaps that’s why so many mutual fund managers are accused of being closet indexers.  But hedge funds are different.

As Girish Reddy, Peter Brady and Kartik Patel pointed out in the Winter 2007 edition of the Journal of Alternative Investments (“Are Funds of Funds Really Multi-manager Funds with Extra Fees? ^[2]“) there is a relatively tight dispersion of returns among managers using the same traditional strategy, e.g. equities, fixed income, etc., and a relatively wide dispersion of returns across those traditional strategies.  Conversely, they found a relatively wide dispersion of returns among managers using the same alternative strategy, e.g. long/short equity, market neutral, and a relatively small dispersion of returns across those different alternative strategies.

The trio concluded that multi-manager hedge funds – which can rotate between strategies, but not across managers other than a select few in-house managers – may miss-out on these opportunities.  Funds of funds, which can rotate across both strategies and managers, are better able to exploit opportunities across both dimensions according to the trio of authors.

Which begs the question: What about a fund of funds that is constrained from rotating among strategies altogether? Assuming Reddy, Brady and Kartik are correct that the opportunity for hedge funds of funds lies in manager selection, not strategy selection, then one might expect a sector-specific fund of funds to perform nearly as well as an unconstrained fund of funds.

But a recent paper ^[3] by Na Dai and Hany Shawky of the University at Albany finds this intuition may be off.  The duo finds funds of funds that diversify across both strategies and managers are able to generate higher alphas.  The chart below, created with data in Table 2 of the paper, shows that funds of funds with more numbers of “focuses” (TASS) and which are “diversified” (CISDM) produce higher Fung & Hsieh Alphas:

 ^[4]

But they also found that the benefits of strategy diversification applied mainly to large funds of funds.

 ^[5]
Finally, Dai and Shawky confirm the intuition that more diversified funds of funds had lower failure rates; anyone who invested in a Madoff feeder fund they believed was a “diversified” fund of funds doesn’t need any further evidence. While traditional long-only investments may be all about beta, alternative investments are all about alpha or idiosyncratic manager risk.  So any portfolio of hedge funds that is able to rotate among managers is sure to offer alpha opportunities.  But it also appears that the ability to rotate among different hedge fund strategies remains an important source of out-performance.

“Serious doubts” raised about hedging potential of long-only commodities

Regular readers of this website know that managed futures strategies have almost always provided a stellar downside protection when the equity markets fall out of bed.  While many managed futures funds trade in physical commodity futures, many others trade in futures based on financial instruments.  Still, many (including, admittedly, us) sometimes treat managed futures as a hedged version of long-only commodity investing, like comparing a market neutral equity fund to a long-only equity fund.

But an article in the Winter 2011 edition of the Journal of Alternative Investments provides some helpful clarity on this topic.  In “Protection Potential of Commodity Hedge Funds,” Pierre Jeanneret and Stefan Scholz of Man Investments team up with Pierre Monnin of Swiss National Bank to create an index comprised solely of hedge funds that trade in commodities. (Available for free by registering at CAIA.org ^[2], then clicking here ^[3].)  What they found both confirms intuition and challenges our thinking on the downside protection of commodities.

Firstly, they reaffirm the notion that commodity hedge funds have outperformed long-only commodities over the past decade.  They create a new index of all types of hedge funds (not CTAs) that report to invest in commodities via futures, equities, options, fixed income, etc.  This “peer” group contained 92 funds.  As you can see from the chart below, they creamed long-only commodities indexes such as the S&P/GSCI.

 ^[4]

You can see that the trio’s proprietary “commodity hedge fund” index had some serious downside protection during the financial crisis.  As a result, it has basically regained all of it’s (modest) loss since 2008.

So did the managers of these hedge funds reverse their exposure at exactly the right time?  Not really.  In fact, the chart below from the article shows that the 24-month rolling correlation between the commodity hedge fund index and various long-only indexes remained largely unchanged during the financial crisis.

 ^[5]

So what gives?  How did these commodity hedge funds beat their long-only brethren so handily during the crisis?  The answer is that they took some serious volatility off the table.

Recall that beta is a factor of benchmark correlation (above) and volatility relative to that benchmark.  By dramatically reducing volatility during the credit crisis by, for example, moving quickly into cash, the commodity hedge funds managed to reduce their beta very quickly during 2008  - note that this actually began in early 2008, even before the full brunt of the financial crisis hit.

 ^[6]

Other charts in the article by Jeanneret, Monnin and Scholz show that this was indeed true.  Amazingly, the annualized standard deviation of their new commodity hedge fund index (on a rolling 24-month basis) remained at historical averages of around 10% during 2008, while the annualized standard deviation of the various long-only commodities indexes spiked to around 30% in late 2008 – and remains there today.

The bottom line is that the ability for commodity-focus hedge funds to take money off the table seems to have been a significant advantage.  The chart below created with data from Exhibit 1 of the article makes the point.  Notice how a high volatility seems to buy you a low return when it comes to long-only commodity index investing. CAPM be damned!

 ^[7]

The article concludes with an interesting discussion about the true ability of long-only commodity investments compared to hedge inflation.  While commodities are generally thought of as a hedge againstinflation, Jeanneret, Monnin and Scholz show that over the past decade this has only been true when “inflation surprises are positive,” or when inflation comes in lower than was anticipated.  Put another way, long-only commodity investments can hedge expected inflation, but are relatively powerless against inflation surprises.  The trio is quick to point out that the past decade has been a period of low inflation and so their results need to be taken with a grain of salt.  Nonetheless, they write, the results “…raise some serious doubts about the hedging potential of long only commodity investments…”

CSCO vs. AAPL = 1,000 DJIA Points

The DJIA is currently down more than 17% from its all-time high of 14,198.10 back in October 2007.  Given the declines we saw in the prior bear market, the fact that the DJIA is less than 20% from its highs is impressive enough, but there are some who believe the index would be even higher if it weren't for an error of omission back in 2009.
For a little background, back in June 2009, the keepers of the DJIA removed General Motors (GM) from the index and replaced it with Cisco (CSCO).  To many observers, the substitution of a Technology company for an Industrial company made sense given that today's economy is more technology focused than it was when GM was originally added to the index.  Where many people took issue, however, was with the selection of CSCO.  While CSCO is certainly established enough to be included, many believed Apple Computer (AAPL) should have gotten the nod given its size and its reach on the American consumer.  Just as there used to be a General Motors vehicle in nearly every American driveway, there's now an Apple product in practically every American household.
While we can't go back and change the past, we can always ask what would have been.  With that in mind, where would the DJIA be today if AAPL had been added to the index instead of CSCO?  The answer is a lot higher.  The chart below compares the current DJIA (blue line) to where the DJIA would be had AAPL been added to the index instead of CSCO (red line).  Although the index would still be below its all-time high, the depth of the hole would be much more shallow.  Instead of trading at 11,725 (2,500 points below its all-time peak), the DJIA would be more than 1,000 points higher at 12,805, and only 9.8% from its all-time high.
The question now is whether or not investors would be better off with AAPL in the Dow or not.  Investors that only hold the Dow tracking ETF (DIA) would definitely be better off.  But outside of those few investors who invest solely in DJIA index funds, performance for most would likely be little changed.  At the same time, would investors who are on the sidelines be even more reluctant to get back into the market if the DJIA was already within 10% of its all-time highs less than two years after the low?

Eight bond markets a-sellin’

Did you know? The recent bond market sell-off has seen a 100 basis point rise in 10-year US Treasury yields in just five weeks. And there’ve been only seven previous sell-offs of similar speed and magnitude, according to Danske Bank.

According to Danske then, those sell-offs usually last around two months and the average increase in 10-year Treasury yields is around 120 basis points. They also add that bond yields tend to decline by 20-30bps in the months after a sell-off ends.
They also tend to coincide with changes in monetary policy, as this table shows:

But there’s quite a bit of variation in terms of post-sell-off moves:

a) In the instances where the Fed switches from being on hold to enter tightening mode, the performance is rather mixed. Post the sell-offs in 1994 and 1999, yields are roughly flat or slightly higher. However, after the sell-off during spring 2004, a strong bullish trend resumed, marking the beginning of the period of “the bond yield conundrum”.
b) In the cases where the Fed switches from being in easing mode to go on hold, there is a evidence that the sell-off reverses and bullish sentiment resumes shortly after the sell-off ends.
c) Where the Fed introduced additional monetary easing via the QE1 scheme on 18 March 2009, yields were pushed sharply higher, after an initial drop on 50bp on the day of the announcement. After the sell-off ended, the bond markets reversed the bearish trend and ten-tear yields were pushed 65bp lower in just one month.

So where are we now? The Fed introduced QE2 five weeks ago and since then the market has pushed up ten-year bond yields by 100bp, in a reaction that resembles the one that occurred after the announcement of QE1.
Over the past two decades, there is only one case of a bearish sell-off that led to a prolonged bearish trend in long bond yields. This occurred in 1994, when the Fed initiated a long period of monetary tightening. We are hardly in this scenario right now, and we expect the Fed to deliver a first hike in mid-2012.

Based on this case study, we see a good case for some short-term reversal of the selloff.

Up, down, movin’ all around.
The only thing that seems certain right now is volatility.

Default and bankruptcy in the municipal bond market (part one)

A caveat: Although I cite the academic work of some well-established bond counsels in this post, I am not an attorney.  I am just writing this post to demystify a process that evidently needs demystifying.  (If I use any unexplained jargon, or if you happen to be a bond counsel and notice any mechanical errors, please let me know and I will make the appropriate amendments.)

One of the more frustrating aspects of muni market coverage in the news and blogosphere is the tendency to talk about municipal debt as if only one type of bond is issued and traded.  There is actually considerable diversity among borrowers in the muni market (e.g., they are not all government entities), and by extension, the types of commitments that are made for the repayment of the debt.  Although the relative health of the muni market has macroeconomic consequences, this is in many ways a market that defies generalization.  (That’s one reason I find the muni market unusually interesting…)  The defaults that have taken place both before and during the economic downturn are what finance-types would refer to as storied credits.  I often see people describing Jefferson County, Alabama, as the “canary in the coal mine” of muni defaults.  Suggesting that Jefferson County, which was the center of a widely-publicized securities fraud case, is a typical muni credit is kind of like portraying Enron as a typical corporate credit.  (Besides, the largest bagholder on that transaction, by far, is the same bank that that orchestrated the municipality’s distress, which is comme il faut if you ask me.)  Another example would be Florida dirt bonds, which are backed by special assessments on property in a severely depressed market.  These are not borrowers that were forced to establish their spending priorities or were muddling through difficult times; these are borrowers that experienced sudden and catastrophic losses and derived their revenues from limited sources.

Types of municipal bonds
The obvious starting place on this topic is to explain the types of muni bonds that are issued.  Municipal bonds are broadly divided into two classes: general obligation (GO) and revenue bonds.  The difference between GO and revenue bonds is the specific security that is pledged to repay the debt.  (Bonds may also be issued with more than one kind of security and may involve a moral obligation pledge that implies contingent financial support from another entity with stronger credit.)  GO bonds are secured by the full faith and credit of the issuer, meaning that the borrower is committing to raise taxes and other revenues sufficient to cover the amount owed.

Revenue bonds are secured by a defined stream of revenues.  Whether the principal and interest on these bonds is paid in a timely manner depends upon: (1) the reliability of the specific revenues pledged; and (2) whether that revenue stream has been pledged toward other debt or is used for other purposes.

It is important that you understand what kind of bond you have.  There are actually fewer GO bonds issued in the market than revenue bonds.  (GO bonds seem to receive a disproportionate amount of attention, which is frankly somewhat amusing considering how they are ultimately treated in bankruptcy proceedings – but more on that later.)  As of December 7, 2010, $137.9 billion of GO bonds had been issued this year, versus $251.2 billion of revenue bonds (Thomson Reuters data).  Some governments (even some states) do not issue GO bonds.  (If that seems counterintuitive to you, consider the existence of referendum requirements.)
State and local borrowers also issue what are known as “conduit” revenue bonds.  In a conduit bond issue, the government issues the bonds on behalf of a third party, generally a nonprofit entity (such as a hospital or college), a developer of government-subsidized housing projects, or a for-profit corporate entity (called industrial revenue bonds).  Conduit bonds are not government debt; they are private debts.  The bonds are actually secured by the revenues generated by the project being financed, the credit of the conduit borrower, and/or a mortgage on the property – and that is it.  (It is worth noting that the increased use of public-private partnerships has somewhat blurred this distinction – at a high price to state and local governments – but I could write a book on that topic.  I probably should – it would be the most politically scandalous book that three people ever read.)

Why do governments issue conduit bonds?  The short version is that government officials believe that the project will benefit the public in some way, and accessing the municipal bond market results in a lower interest rate for the borrower than the alternative (taxable) forms of financing.  (Read: This is a form of subsidy.)  Since the Tax Reform Act of 1986, the federal tax code has permitted states to allocate a limited amount of tax-exempt bond issuance each year for projects that will support private business activity.  The limit did not exist before this legislation, so keep that in mind when you see market statistics that reach far back in time.  Just to give you a sense of the magnitude, the cap for all states combined was $30.9 billion in 2010.  Some of that amount will be unused and carried forward, and issues for nonprofits are excluded but subject to many other geeky tax rules.  (I will exercise some restraint here.)

Just judging from news articles and my encounters in the blogosphere, the difference between government and conduit debt causes a lot of confusion with respect to the number of defaults that take place.  Conduit borrowers do not operate within the same framework of incentives as a government borrower.  (Sometimes, conduit borrowers are even just shell entities established to finance a specific project.  Compare that to a government borrower that theoretically exists in perpetuity.)  These are generally far riskier credits, and a large fraction of the defaults that actually take place in the municipal bond market are defaults on conduit bonds.  Recoveries are also likely to be smaller.  (You are more likely to see things like multiple-lien structures with this kind of debt.)


For some historical background on this point, Moody’s released a report back in February (subscription required) cataloguing municipal defaults and recoveries on bonds that the agency had rated from 1970 to 2009.  (Yes, yes, I know…  Suspend your judgment for a moment; enumerating defaults ex post facto is hardly rocket science.)  Moody’s counted 54 defaults total during that period, which included, by sector: housing – 21; healthcare – 21; utilities – 3; higher education – 1; recreation – 1; non-GO government debt – 4; and GO – 3.  (The issuer-pays model is doubly problematic in project finance because these issues generally require that an economic consultant draft a feasibility study for the project.  When has an economic consultant ever said that a project would not cash flow or that a designated district will not experience rapid growth?)

So far, this pattern has more or less held up for 2010 as well.  Of the monetary defaults that have taken place, approximately one-third were for conduit bonds and more than another third were for projects tied to property assessments.

As far as recoveries are concerned, Moody’s found that the average historical 30-day post-default trading price for municipal debt was $59.91 (par $100), versus $37.50 for corporate senior unsecured debt over the same period.

If you would like to know what the specific security for a bond issue is, look at the disclosure documents.  Many are freely available via the Municipal Securities Rulemaking Board EMMA system – use the search function, locate the individual bond issue, and follow the link to the official statement.  There will be a section devoted to discussing the security.  You can also search for continuing disclosure reports there.  (Regulators have made some strides at reeling in issuers for not reporting and in trying to have reports filed in a timely manner.)  There are also some subscription services that report on distressed debt specifically.

Monetary and technical defaults

So what happens when a government borrower defaults?  (For those among us who enjoy thinking through worst-case scenarios…)  The first thing you have to understand is that “default” is not a straightforward concept.  When most people talk about default, they are talking about monetary default, which is when a borrower fails to make a debt service (principal and interest) payment in full and on time.  Events of default, however, are actually defined in bond documents and include situations that are referred to as technical defaults.  With muni bonds, technical defaults may include (among many other things): a change in the tax status on the debt; a failure to comply with rate covenants (such as raising user fees on a project when the borrower’s debt service coverage ratio – the ratio of pledged revenues to required debt service – falls below a certain threshold); if the project being financed is not fully constructed; or if the issuer files for bankruptcy.  (A borrower can file for bankruptcy protection without there being a monetary default on a bond issue. This has happened in the past with GO defaults.)  If the bonds have a debt service reserve fund, unscheduled draws on these funds in order to make a debt service payment would also be considered a technical default.  (A debt service reserve fund is an account that is capitalized from bond proceeds or other sources of funds and provides bondholders with an additional buffer if the issuer experiences a temporary period of financial distress.)

Although these covenants generally exist to protect bondholders, it is not uncommon to see covenants that protect or (practically speaking) may even effectively give priority to other stakeholders in the deal.  A potential landmine for a bondholder (assuming the bondholder is not a bank), for example, would be a covenant that defines an event of default as nonperformance on a related financial instrument, like an interest rate swap.  If a derivative contract is associated with a bond issue (this should be disclosed, but it may be disclosed in a vague manner), then another layer of due diligence is required to gauge default risk.
There are two reasons that I mention technical default.  The first reason is that many of the statistics that are cited in market commentary will lump monetary and technical defaults together as “defaults.”  (I have done that in this post, in fact.)  Although these statistics may capture a level of distress in the market, they may also exaggerate it to the extent that there may be no meaningful risk of the bondholder not getting paid in some cases.  The second reason is that even with technical defaults a bondholder has rights that can be exercised.  For example, many issuers / conduit borrowers scrambled to refund outstanding debt when the bond insurers were swiftly being downgraded because it would be considered a technical default on the bonds if the bond insurer’s rating fell below a certain threshold, and payments on the debt could be accelerated.  (It is worth noting that such conditions were also generally carried over as a termination trigger on associated swap agreements.  This could result in the borrower having to find money to make a termination payment, depending on how the debt was structured and how interest rates have behaved since the contract was executed.)  My point here is that, in some circumstances, what could be statistically classified as a credit concern might be easily resolved with another transaction that is structured differently or simply involves different deal participants.

As an aside, one of the problems the muni market will likely face with the expiration of the BAB program and increased bank purchase limit is that market access for smaller borrowers, especially those with lower credit ratings, will be diminished.  This could place some strain on their ability to manage their outstanding debt and give smaller government entities an incentive to seek assistance from higher levels of government.  Policymakers would then have some tradeoffs to make.  This will likely have a negative impact on nonprofit borrowers for whom that is not even really an option.

Rights and remedies

Just like events of default, bondholders’ rights and remedies are defined in bond documents and state law.  These rights will be addressed in the bond resolution, ordinance, or other action through which the issuance of the bonds was authorized.  If the bond issue is part of an established debt program, there will be a trust indenture.  A trust indenture is a contract between the issuer of the bonds and the trustee (acting on behalf of bondholders) that governs the application of available revenues to the borrower’s debt service and other expenses / accounts.  (You will find a summary of the trust indenture in bond disclosure documents.  Also look for the “flow of funds” if you want to know where you rank in terms of getting paid and what other buffers against a monetary default exist in the structure.)

Attorneys with Vinson and Elkins provided a good overview of bondholders’ rights and remedies in the Summer 2010 issue of the Municipal Finance Journal (subscription required).  A common remedy in an event of default is that payment on the debt is accelerated. This pretty much means exactly what you think it means – the principal and accrued interest on the debt becomes due ahead of when it is scheduled.  (It is highly unlikely that a bondholder could force the sale of assets or take similar actions with a government borrower.  Conduit financings may involve a mortgage on the property, however.)

If it is in the bondholders’ economic interest to cooperate with the borrower, the bondholder may begin with a forbearance agreement.  With a forbearance agreement, the bondholder basically agrees not to declare an event of default while the government and its creditors negotiate a settlement.  Such a settlement could give the government some space to muddle through a temporarily rough period and not waste government resources (that could ultimately be passed on to bondholders) by addressing matters in court.  (Investors who have purchased asset-backed debt in the past few years are likely very familiar with forbearance agreements.)  This is the most likely outcome if the default occurred due to something like the timing of cash flows and the funds are expected to be recovered.  This option may be less palatable to retail (individual) than institutional investors (who can afford to wait), however.  Retail investors have a very strong presence in the muni market.

Bondholders may also seek a writ of mandamus from a court to compel government officials to take some specific action to cure whatever problem caused the default.  (Seeking court mandates to make government officials do things is practically a form of recreation in California, for matters not necessarily related to debt.)  For GO bonds, this would involve collecting taxes.  For revenue bonds, this would involve, for example, raising rates in accordance with a rate covenant (assuming this covenant exists with a particular bond issue).  Creditors can and will make life an absolute living hell for government officials and cost taxpayers a lot of money in attorneys’ fees if it comes to this. Aside from losing access to the capital markets, this is a very good reason governments do not generally repudiate their debt.  The legal process of answering for defaults only exacerbates officials’ administrative, financial, and political problems; it does not solve them, as some people have suggested.

Some government issuers are subject to legal provisions that provide bondholders with extra protections; for example, a state’s constitution may give debt service payments priority over all or most other expenditures.  Also, in some states, a state may take over the administrative responsibilities of smaller political subdivisions (cities, counties, etc.) if they run into serious trouble.  (This process may be automatically triggered by an event, such as if the local government’s credit rating falls below a certain threshold.)  Conversely, some borrowers may be subject to legal provisions that limit their ability to raise revenues.  Although this makes taxpayers happy, such provisions are major liabilities from a credit perspective, and (ironically) these taxpayers may end up paying more in interest to borrow funds in the bond market.

Another alternative to bankruptcy would be for the borrower to make a tender offer to bondholders, which is an offer to purchase the bonds back at a price that is in-between the market price of the bonds and the par value (face amount).  Bondholders may take a haircut (depending on their purchase price), but this may be better than drawing out the process, depleting the municipality’s resources, and getting even less.  Municipalities may also try to exchange existing bonds with new obligations that carry new terms (this is the capital markets’ version of a loan modification).  For muni issuers, these are much less convenient choices than you may surmise, because they are complicated by state and federal securities laws (such as getting all of the bondholders to agree to the plan) and tax issues (understatement of the year).

Some history (because history is awesome)
Since discussing the possibility of state defaults is all the rage these days, readers might be interested to know that previous state defaults did, in fact, progress through the above stages.  (Note: Federal bankruptcy law does not apply to states because they are granted sovereignty in the US Constitution.)  Many people cite Arkansas’ 1933 default as establishing the precedent for a state default, but there were others during the 19^th century.  Pennsylvania’s 1842 default on its debt prompted William Wordsworth, whose family had bought Pennsylvania bonds, to compose the colorful sonnet “To the Pennsylvanians.”  Wait a minute, you say, wasn’t Wordsworth a Brit?  While apparently quite controversial now (with respect to the BAB program), when Americans were developing the frontier, they relied on financing from abroad to do so.  Pennsylvania’s default followed the Panics of 1837 and 1839, a period wherein there were plenty of municipal defaults to go around (and an epic number of bank failures).  This turned out to be great for foreign relations.  Per James Spiotto (Chapman and Cutler), “George Peabody, an eminent financier, sought to be admitted to polite English Society only to be rebuffed, not due to his lack of social grace, but because his countrymen did not pay their debts.  It was the defaults by government bodies in the latter half of the 1800s and early 1900s which brought about the procedures that are now taken for granted, including debt limitations on municipal issues, bond counsel, and clearly defined bondholders’ rights” (Handbook of Municipal Bonds). And, of course, the Confederate states repudiated their debts following the Civil War.

Bloomberg columnist Joe Mysak provided some excellent background on Arkansas’ default in a column several months ago.  Arkansas engineered a situation wherein one of the poorest states in the nation became the most indebted.  (Remember my comments about debt capacity from the last post?  This is precisely why such policies exist today.)  The state, already very much in debt, assumed the revenue bonds sold by hundreds of road districts (backed by a first lien on automobile and gasoline taxes) so these issuers could avoid default.  (Also keep in mind that the concept of professional credit analysis was only around twenty years old at this point.)  Thereafter, when state finances were, shall we say, strained by the Great Depression, state officials tried to exchange the outstanding revenue bonds for GO bonds with a smaller coupon.  The banks and insurance companies holding the bonds were outraged.  (Yes, they preferred a specific revenue pledge to a GO pledge.)  The state defaulted and officials blamed the underwriters for allowing the state to sell too much debt.

Bondholders took the state to court and successfully obtained a permanent injunction blocking the use of automobile and gasoline taxes for anything beyond debt service and highway maintenance.  The state then caved to bondholders (because it had no choice), refunded the debt with a longer maturity, and (gasp) raised taxes.

Arkansas’ problems
continued, and the state planned to refund the bonds once more when the bonds were callable.  Per Mysak, a syndicate of 250 banks was interested in bidding on the bonds (yes, even after the default, there was investor interest in investing in Arkansas – at a steep premium), but the Reconstruction Finance Corporation (established by Herbert Hoover) surprisingly picked up the whole deal.  And that is how the federal government got involved in Arkansas’ financial woes.  The RFC later sold the bonds to Wall Street banks at a profit.

As Mysak put it, “in 1933, nobody thought Washington should get involved in a state bond default.  In 2010, that’s the first place we look for help.”  People underestimate the system we already have in place.  The moral of this story for federal policymakers today is that maintaining a robust muni market is in their best interests too.  If their plan is to force social change on state and local governments by eliminating support for the muni market (as some have suggested, and who knows if this is true) and driving the various stakeholders in public finance to court (something that I think is highly unlikely anyway), they might find state policymakers simply enacting Thank Congressional Republicans Tax Acts of 2011, which will no doubt go over well with their constituents.  But it’s not like politicians to cut off their nose to spite their face, right?

Channel Checks

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

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

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


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


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


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

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

Top fund manager?

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

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



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

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



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

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



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

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



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

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

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

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

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

How expert networks came to dominate Wall Street

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

Dead air on Lake Hedgistan as managers wait for a breeze

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

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

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

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

Municipal Bonds Get Crushed

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

Stock-picking alpha in a life or death struggle?

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

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

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

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

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

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

Continues the Hennessee Group:

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

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

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

A Hedge-Fund Manager's New Groove

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

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

William von Mueffling

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

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

the steep yield curve of the 1930s

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

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

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

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

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

For Tepper, Washington Is an Investment Guide

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

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

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

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

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

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

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

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