Have Hedge Funds Grown Too Large?

The Vancouver Sun published an article from Laurence Fletcher of Reuters, Have hedge funds grown too large?:

The hedge fund industry's strong rebound from the credit crisis has prompted investors to ask whether some funds have grown too large and inflexible to keep delivering bumper returns for which the sector is famous.
The growth of big funds -- helped by strong returns during the credit crisis and some clients' belief that risks are lower than in start-ups -- helped push industry assets to $1.92 trillion at end-December, close to the all-time high in 2008, according to Hedge Fund Research.

However, with the growth of big funds has come the old question of whether they could be stuck if another crisis hits, whether liquidity forces them into less profitable markets and whether their prized trade ideas will be discovered by rivals.

"By definition a supertanker can't be as nimble as a speedboat," said Ken Kinsey-Quick, fund of hedge fund manager at Thames River, part of F&C, who prefers to invest in funds below $1 billion in size.
"They won't be able to respond to market conditions, especially as markets become illiquid. They can't get access to smaller opportunities, for example a new hot IPO coming out of an investment bank -- if everyone wants it then you'll only get a few million dollars (worth)."

Funds betting on bonds and currencies, and CTAS -- which play futures markets -- in particular have grown strongly.

Brevan Howard's Master fund, which is shut to new clients, has grown to $25 billion after gaining around 20 percent in 2008 and 2009, while Man Group's computer-driven AHL fund is now $23.6 billion, helped by a 33 percent return in 2008.

Meanwhile, Bluecrest's Bluetrend fund, which has temporarily shut to new investors in the past, has nearly tripled in size since the end of 2007 to $8.9 billion after a 43 percent gain in 2008. And Louis Bacon's global macro firm Moore Capital has grown to $15 billion after a good credit crisis.
LIQUIDITY
While capacity varies between strategies, some clients worry about the time it can take a big fund to sell a security in a crisis. Even in today's markets a small fund can sell a position with one phone call while it may take a big fund a morning.

"It's even more difficult than before the crisis to turn around your portfolio. Liquidity in the market is not back to where it was. A fund of $20 billion in 2007 was easier to manage than it is now," said Philippe Gougenheim, head of hedge funds at Unigestion.

"Because of poorer liquidity you're paying a higher price to get in and out of positions. Given the current political and macroeconomic environment it's important to be able to turn around your portfolio very quickly."

Big funds may find it hard to keep trades secret long enough to implement them, especially when buying or shorting stocks.

One hedge fund executive told Reuters his firm's flagship fund, once several billion dollars in size, used to break up trades between a number of brokers or initially sell a small amount of the stock -- which could give the market the impression it planned to sell more -- before buying heavily.

Meanwhile, Unigestion's Gougenheim said fixing a meeting with managers of big funds can be hard -- if a manager runs most of the money they can be hard to pin down, while if they run a small part it can be hard to find out who runs the rest.
"NOT AN ISSUE"
However, fund executives say markets are liquid enough.

"Size is not an issue whatsoever," Nagi Kawkabani, founding partner at Brevan Howard, told Reuters, adding that the fund's gross exposure -- the sum of bets on rising and falling prices -- was lower than at the start of 2008.

"Markets are much bigger and deeper than they were five or 10 years ago." Brevan would return money to clients if funds became too big, although there are no plans at present, he said.

Thames River's Kinsey-Quick said big CTAs could find it hard to trade smaller markets, although they may take small bets in these markets to show clients they can play them.
An AHL spokesman said size was "a major advantage... It gives us great purchasing power with brokers which translates into tighter spreads whilst paying pay lower commissions."

Hedge funds are one of my favorite topics. One of the best jobs I ever had in the pension industry was working with Mario Therrien's group at the Caisse de dépôt et placement du Québec, allocating to external hedge funds. I was the senior analyst responsible for analyzing and covering directional hedge funds: Long/Short equity, short sellers, global macro and commodity trading advisors (CTA) funds. It was a fun job because I got to meet a lot of managers from different backgrounds and talk markets with them. I also learned about their strategies and the differences between directional and market neutral alpha strategies.

No matter who was sitting across the table from me, I never shied away from asking tough questions on their organization, operations, investment process and risk management. Allocating money to hedge funds isn't a job for the shy and timid; you got to be able to grill them when you need to. But I also listened carefully to their responses, paying close attention to how they addressed difficult periods. The best hedge fund managers aren't uncomfortable talking about periods where they lost money and how they coped. Anyone can talk up a great game when they're making money but very few managers have the self assurance to talk about the difficult periods. For me, those discussions were crucial and told me a lot about the manager, and more importantly on the organization's culture and depth. The toughest part of that job was the constant traveling which takes its toll.

Getting back to the article above, there are several things I want to bring to your attention. First, back in September 2008, I wrote a comment that the shakeout in the hedge fund industry will be brutal. Last March, I wrote on their incredible comeback as institutions were increasingly horny for hedge funds. And institutional funds keep pouring billions into hedge funds. According to a recent survey by Preqin, an independent research firm focusing exclusively on alternative assets, there was a 50% rise in public pension plans investing in hedge funds over the past four years:

Preqin research shows that the number of public pension systems investing in hedge funds has increased significantly over the past four years. There are now 295 public pension plans worldwide known to be allocating to hedge funds, up from 196 in 2007. The mean allocation to the asset class has also grown in the same period from 3.6% to 6.6%; it is now one percentage point higher than the average private equity allocation of these investors.
Public pension systems and hedge funds:

• Pension systems generally invest in hedge funds for capital preservation and portfolio diversification purposes.
• They seek absolute returns of 6.1%, lower than the average expectations of other investor types which stand at 7%.
• Funds of hedge funds are popular with pension funds – four-fifths of public pension systems that made their first hedge fund investments in 2010 did so through multi-manager allocations.
• 70% of all pension funds investing in hedge funds have funds of funds commitments in their portfolios.
• The top 10 public pension system investors in hedge funds have a collective $836bn in AUM

Public pension systems’ hedge fund portfolio performance:

• As of Q2 2010, hedge funds showed positive one-year returns.
• Hedge funds have outperformed listed equities over a three- and five-year period.
• Hedge funds have outperformed public pension funds’ average annualized return expectations of 6.15% by producing average returns of 9.8%.
• Despite negative returns over a three-year timeframe, public pension system investors have increased their allocations to the asset class; this is in stark comparison to the many high-net-worth counterparts that have reduced their hedge fund commitments during the period.

You can download the full Preqin report by clicking here. I'm not shocked to see public pension plans allocate aggressively into alternatives, which include hedge funds, private equity funds, real estate funds and infrastructure funds. Why are they doing this? Many plans are underfunded so to make up for the shortfall, they're reducing their fixed income allocation and going into hedge funds and other alternatives. As the big beta boost in the stock market matures, pension funds are focusing more on alpha strategies that can deliver returns in turbulent markets. Also, many pension funds have investment policies that limits the amount of leverage they can take internally, which is why they allocate to external hedge fund and private equity managers to increase their leverage.

Not surprisingly, the bulk of the assets have been going to liquid hedge fund strategies like global macro, CTA and L/S equity. It was two years ago when I wrote a comment on the death of highly leveraged illiquid strategies. Nothing has changed; they're still dead. Post 2008, there is a premium for liquid alpha strategies and most of the smarter institutional investors are managing their liquidity risk very carefully.

Some public pension funds know what they're doing, scoring big with hedge funds. I cringe, however, when I read that Preqin finding that four-fifths of public pension systems made their first hedge fund investments in 2010 did so through multi-manager allocations and that 70% of all pension funds investing in hedge funds have funds of funds commitments in their portfolios. I'm not a big fan of fund of funds which add another layer of fees. If by "multi-managers" Preqin meant mutli-strategy hedge funds, then that's fine (standard 2 and 20 fee structure). Keep in mind, fund of hedge funds were facing extinction in December 2008. It's amazing how fast things have turned around.

It's true, the top hedge fund managers know about making money, generating huge brokerage commissions that gives them access to some of the best investment ideas Wall Street generates. But even the best hedge fund managers can experience a serious hiccup (witness Philippe Jabre's recent $300 million Japan mistake). And I get really nervous when I read that GAM just launched another retail fund of funds. Just tells me things are getting frothy again in hedge fund land, but it also confirms my suspicion that we're heading towards another 1999, as all this liquidity finds its way into stocks, bonds, currencies and commodities.

Have hedge funds grown too large? Maybe, we'll see during the next crisis, but I still favor liquid over illiquid alternatives. I would however look at allocating more to market neutral funds in this environment but be careful with the leverage they're taking. Moreover, institutional investors, especially those with little or no experience with hedge funds, should strongly consider the merits of a managed account platform that allows them to control operational and liquidity risk. The last thing you need is to invest in some fake hedge fund that defrauds you.

***UPDATE***

An industry expert shared these comments with me, which I share with my readers:

I agree with you, favoring liquid strategies vs illiquid ones. The biggest problem with illiquidity is that investors were not getting paid for providing liquidity to others. At the very least, if you take the risk of doing it, get compensated for it!!!
In terms of who can use managed account platforms (MAP), I believe it applies to all kinds of investors, not only to those with little or no experience. What we’re seeing this year is the very large and very experienced going to MAP in order to better control their risks. The “cash on steroids” approach.
Finally, the size debate is a hot topic, with arguments going both ways. My take is the following: returns will necessarily diminish with the size of the HF. You can have a Bridgewater one year, but that’s just one exception rather than the norm. On the other hand, I do not agree that they are getting too big for the financial system. Goldman is the largest HF, they have permanent capital (or I should say they act like if they have permanent capital…) and their size dwarfs any hedge fund. I would be much more worried about Goldman, vs the others who manage their liquidity risk much more carefully now.

I thank him for sharing his insights with me and letting me post them here. He also sent me this Infovest21 article, which discusses how large US pension funds are increasing direct allocations to hedge funds and some are using fund of funds as subadvisors to facilitate knowledge transfer so the pension may eventually take on the internal management of the hedge fund program.

Not All Emerging Markets Are Equal

While emerging markets actually provided a safe haven during the equity market's most recent sell off, not all emerging markets have been performing equally.  While the BRIC countries have become synonymous with emerging markets, most of the BRICs have been lagging.  In US Dollar adjusted returns, the only BRIC that has outperformed the United States over the last year is Russia, which has rallied more than 28%.

Crispen Odey

The founder of UK based hedge fund firm Odey Asset Management, Crispin Odey, is out with his latest market commentary and investment outlook. Penned on the 28th of February, Odey writes on the slightly tangential, yet increasingly talked about topic of farming and agricultural commodities.

We've detailed how legendary investor Jim Rogers is bullish on agriculture and has also bought farmland. Also, the now famous subprime short-seller Michael Burry also bought farmland. While these well-known investors focus on arable land, Odey's recent commentary expresses concern regarding agricultural commodities and supply/demand imbalances.

Here's Crispin Odey's outlook:

"This is always the time of year when my farming friends ring me up every day to ask 'should they be selling forward their harvest?' The truth is that at this time of year they have little to do other than worry about it, and because they worry they are always early sellers. Like everyone, they are risk averse. By now with the harvest less than six months away, they are probably 65% pre-sold and yet they watch the price rising and falling and of course on weak days they kick themselves for not selling more.

In my hedge fund we are also forced to get involved. We are shareholders in a station in Australia which this year has grown over 23,000 acres of cotton, and plans to grow 25,000 acres next year. Cotton has nearly tripled in price in eighteen months and it is no surprise to find that we sold this year's harvest, which is just about to start, at half the current prices. Why? Because we had sold 2/3 of our crop forward by November of last year. We were the lucky ones because our neighbours further down the Darling River lost most of their crop, thanks to the flooding, and the rise in the price from $100 to $220 per bushel was nothing more than them covering that shortfall. Like many people, they hated taking a loss and the same conservatism that had led them to sell forward, led them to sit and hope that the price would come down before delivery in April. Many of these farmers face bankruptcy, in the best year for cotton in 30 years. This year the farm will make a 30% return on our investment made nearly four years ago. If prices hold into next year we would almost earn what we paid for the farm, in one year. In other words prices are very unlikely to hold!

However, if you look generally at where we are globally, soft commodities are suffering from the same kind of demand/supply imbalance that has driven steel production worldwide to go from 580 million tons to over 1350 million tons in less than a decade. Taking grain production last year globally, the world produced 2.179 billion cubic tons, down 2.4% from the previous year, but up from 1.87 billion cubic tons, produced in 2000. However, consumption was 2.235 billion cubic tons and inventories in thenorthern hemisphere are now 27% below where they were in 2000 and down 15% in a year to 425m tons. The importance of China can't be overstated. The USA increased exports of corn, soy beans, wheat and cotton by 18% last year, but China's share of exports rose by 34%.

Over ten years China's urban incomes have risen threefold; their agricultural incomes have doubled. If you believe like I do that China's growth will not falter until their current account deficit goes negative, my farming friends may have to devise an alternative pastime after the shooting season ends in January, to selling their harvest early.

The corollary of all of this is of course that the cost of living is rising for the developing world at an alarming rate. Most of these countries exacerbate their problems by subsidising food prices. Investors must expect that revolutions, sparked by bread riots, will be part of their diet, for as long as China's demand continues to grow."

More insight from this manager can be found in Odey's previous commentary.

Historical REAL Drawdowns in Stocks and Bonds, US and UK

Shrinking Margins Make Stocks’ Cheapness Just A Mirage

Thinner margins got WAG whacked Tuesday

Profit margins are a tick away from all-time highs and are creating the impression of cheap equity valuations.   That impression is a mirage, however, because today’s generous margins are destined to shrink.

I first wrote about this in January 2008, and this is an update to that article.  All I had to do was to update a chart and the numbers in the article and add a few comments – all of them are underlined.

Stocks are allegedly cheap now, at 15.7 times 2010 earnings. And they are cheap by historical standards. Only 10 years ago, their price/earnings ratios were double today’s; they are even cheaper if you compare their forward (2011) earnings yield of 7.3% to the 10-year Treasury yield of3.40%. They are cheap, cheap, cheap!

Or so we’ve been told.

Unfortunately, the cheapness argument falls on its face once we realize that pretax profit margins are hovering close to an all-time high of 13.3% (the all-time high was 13.9% in 2007), almost 58% above their average of8.4% since 1980.

Once profit margins revert to their historical mean, the “E” in the P/E equation will decline. If the market made no price change in response, its P/E would rise from 15.7 to 24.9 times trailing earnings.

Many disagree that profit-margin reversion will take place. Here are their most common arguments, and some food for thought on why this supposed common sense doesn’t translate to sensible logic.

Who said that margins have to revert to a mean; why can’t they just remain high?

“Profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism. If high profits do not attract competition, there is something wrong with the system and it is not functioning properly.” – Jeremy Grantham

Profit margins revert to the mean not because they pay tribute to mean-reversion gods, but because the free market works. As the economy expands, companies start earning above-average profits. The competition reacts to fat margins like bees sensing sugar water. They want some, so they fly in and start cutting into these above-average margins.

What about the billions of dollars U.S. companies poured into technology – weren’t they supposed to make their operations more efficient and bring higher profit margins?

Those billions of dollars did not go to waste; companies are more productive now than ever before. Efficiency gains stemming from productivity were a source of competitive advantage and higher margins when access to proprietary technology was a competitive advantage.  For example, Wal-Mart’s rise in the retail industry was achieved through a very efficient inventory-management and distribution system that passed cost savings to consumers and drove less-efficient competitors out of business.

Today, however, that same – or even better – technology is available off-the-shelf to retailers like Dollar Tree and Family Dollar, whose outlets are about the same size as a couple of Wal-Mart restrooms put together. Oracle or SAP will gladly sell state-of-the-art distribution/inventory software systems to any company able to spell its name correctly on a check. Increased productivity didn’t and won’t bring permanently higher margins to corporate America – the consumer is the primary beneficiary of lower prices. If profit margins didn’t respond as they do, Wal-Mart’s net margins would be 25% today, not 3.5%.

Over the past 70 years, growth in corporate earnings and GDP haven’t differed significantly. On the other hand, there has been a permanent benefit from increased operating efficiency: It lets companies hold less inventory and adjust more quickly and precisely to changes in demand. This has led to less volatile GDP.

Shouldn’t average profit margins be higher now, as the U.S. economy has transitioned from an industrial (low-margin) economy to a service (higher-margin) economy?

It is not as much of a change as we might think. In 1980, services represented about 51.3% of GDP. After 30 years and a lot of changes like outsourcing, services have increased to 65.3% of GDP. If we assume that the service sector has double the margins of the industrial sector (a fairly conservative assumption), increases in the service sector should have boosted overall corporate margins by about 40 to 80 basis points above their 30-year average – to between 8.8% and 9.2%, but still far below today’s 13.3% margin. Thus, if we adjust corporate margins to reflect the transformation toward a service economy, corporate profit margins are still 45% above their long-term mean.

Shouldn’t globalization allow U.S. companies to increase margins?

A larger portion of U.S. companies’ profits is coming from overseas than ever before. However, globalization is a double-edged sword – U.S. companies are expanding and will continue to expand overseas and capitalize on new opportunities. But as the world flattens, they also face new competition at home and abroad. For example, Motorola – a company that used to represent American might in the telecommunications arena – has been marginalized in the U.S. and around the world by companies whose names we didn’t recognize 15 years ago – Finland’s Nokia and South Korea’s Samsung. (It’s very interesting how much the smartphone industry has changed in three years: Apple, a company I did not even mention in my 2008 article, has transformed the industry. Motorola, which was almost dead then, is coming back to life. Nokia is becoming irrelevant very quickly, and LG and HTC are important players.)

Although Wal-Mart is rapidly expanding overseas, it will soon face a new breed of competition. U.K. retail giant Tesco recently entered the American market (Cisco Systems has been successful in Asia, but its home turf has been attacked by the Chinese company Huawei.)  U.S. companies may get a larger portion of their earnings from overseas (the weak dollar will help), but they’ll have to fight to defend home turf.

International expansion doesn’t guarantee fatter margins;  quite the opposite: We are facing competition from countries such as Korea and China that may be more concerned with increasing market share, even at the expense of short-term profitability.

Higher oil prices are here to stay, so maybe multiyear higher margins in the energy sector are here to stay as well.

This would be the case if energy companies sold their products to customers in another galaxy where somebody else bore all the costs of high-energy prices. Petroleum products are consumed by corporations and individuals. The benefits of higher profit margins to the energy sector are achieved at the expense of lower margins for companies that consume their products – which is the rest of the corporate world, to varying degrees.

Today’s stock valuations are a lot higher than it appears if you normalize earnings to lower profit margins. And while it’s hard to tell when earnings will embark on a fateful journey to their historic mean, competitive forces will make that happen sooner than later. Earnings will either decline or grow at much slower pace than GDP.

Companies that don’t have a sustainable competitive advantage will not be able to keep their competition at bay, and will face margin compression, along with lower earnings growth or declining earnings. Look at your portfolio: Can the companies whose margins are hitting all-time highs sustain them?

P.S.

Robust (above-average) earnings growth from the depth of a recession creates a false appearance, usually reflected in forward earnings estimates, that earnings can and will grow at a faster rate than the economy for a long period of time – but they don’t (see chart below, the growth of $1 of earnings and GDP from 1950 to 2010).  For earnings to grow at much higher rate than the economy (GDP) for a long time, profit margins have to keep expanding, and as I’ve discussed in the past, capitalism (i.e. competition) doesn’t allow that to happen.

Seth Klarman & Baupost Group's 2010 Letter Excerpt

"Two problems are upon us at once: short-term stimulus that is unaffordable over the long run and runaway entitlements that must be reined in. But restoring fiscal sanity will be bad for the economy and financial markets. What Treasury official or politician would want the cash spigot turned off before a recovery is certain? Recipients of government handouts – a large percentage of the population – would grumble at the termination of policies that offer them outsized benefits. So prepare for a chorus of "but not yet.” One already sees this in editorials and commentaries, such as the ones saying it's time to close down bankrupt Fannie Mae and Freddie Mac, but not yet, because doing so would harm the still-weak housing market. There will never be a good time to end housing support programs, reverse quantitative easing policies, end fiscal stimulus, or reduce massive budget deficits – because doing so will restrict growth and depress share prices. Nor will there be a good time to cut entitlement programs or to solve Social Security or Medicare underfunding. All will agree the stimulus cannot go on forever, that excessive entitlements must be reined in, “but not yet."

The financial collapse of 2008 highlighted our national predicament. The sudden decline in consumer activity that followed the plunges in the housing and stock markets represented a reasonable – indeed a desirable – response to overindebtedness. Yet the federal government saw this well-advised retrenchment as cataclysmic, because the national economy had grown dependent on our living beyond our means. The imagination of our financial leaders remains so shallow that their response to a crisis caused by overleverage and excess has been to recreate, as nearly as possible, the conditions that fomented it, as if the events of 2008 were a rogue wave of financial woe that can never recur. It is only in Fantasyland that the solution to vastly excessive debt is more debt and the answer to overconsumption is less saving and more spending. Worse still, we have yet to see a serious assessment by policymakers of the causes of the 2008 financial market and economic collapses so that we might take action to ward off a repeat performance. The government’s knee-jerk response to contraction was to prop up economic activity by any and every means possible; the hole in consumer activity had to be materially repaired on the government tab. While Treasury Secretary Timothy Geithner ingenuously professes a belief that the U.S. will never lose its AAA rating, Moody's recently warned that, absent a change, a downgrading could be just around the comer. Or, in the words of David Letterman, "I heard the U.S. debt may now lose its triple-A rating. And I said to myself, well who cares what the auto club thinks."

Most of us learned about the Great Depression from our parents or grandparents who developed a "Depressionmentality," by which for decades people shunned leverage, embraced thrift, and thought twice before quitting their secure jobs to join risky ventures. By bailing out the economy rather than allowing the pain of the economic and market collapses to be felt, the government has endowed our generation with a "really-bad-couple-of-weeks-mentality": no lasting lessons are learned; the government endlessly intervenes in the economy, and, ironically, the first thing to strongly rebound from the 2008 collapse isn't jobs or economic activity but speculation.

Benjamin Graham's margin-of-safety concept – to invest at a sufficient discount so that even bad luck or the vicissitudes of the business cycle won't derail an investment – is applicable to the economy as a whole. Bridges intended for ten-ton trucks are overbuilt by engineers to hold vehicles of 30 tons. Responsible investors assume their best judgments will sometimes go awry and insist on bargain purchases that allow room for error. Likewise, an economy built with no margin of safety will eventually implode. Governments that run huge deficits, promise entitlements that will be next-to impossible to deliver, and depend on the beneficence of foreigners to stay afloat inevitably must collapse – perhaps not imminently but eventually, as Greece and Ireland have recently discovered.

It is clear, both in the financial markets and in government policy, that no long-term lessons have been drawn from the events of 2008. A friend recently posited that adversity is valuable not for what it teaches but for what it reveals. The current episode of financial adversity reveals some unpleasant truths about the character and will of our country and its leaders, and offers an unpleasant picture of the future that awaits, unless we quickly find a way to change course.

The Demonization of Short-Seller

While we rarely sell securities short – both because of the degree of execution difficulty and theoretically unlimited risk compared to limited potential return – we do believe that short-selling serves a vitally important function. Markets, of course, fluctuate; driven by human emotion, greed, and fear, they can reach significantly overvalued levels. This is bad, both because it can induce some who cannot afford losses to speculate, and because it can lead to an improper allocation of society's resources. The recent housing bubble illustrates the problem: excessive home prices led to excessive home building, eventually resulting in a price collapse, large loan losses, and great personal hardship. In addition, the decline that follows periods of market overvaluation is bad for the broader economy, for confidence, and for rational decision making; it also frequently triggers government intervention in markets, with all of its inevitable distorting effects. Just as value buyers can dampen downside volatility, short-sellers can dampen the upside excesses. They don't actually change the eventual outcomes, just help us get there sooner. This makes short-sellers unpopular, as the uninformed masses enjoy high and rising securities prices for the short-term profits they produce, without understanding the societal costs of the future reversal. The less you understand valuation, the more that overvaluation seems like a free lunch – which of course it isn't.

From our experience, much long-oriented analysis is simplistic, highly optimistic, and sloppy. Short-sellers, by going against the long-term tide of economic growth and the short-term swells of public opinion and margins calls, are forced to be crackerjack analysts. Their work product is usually top-notch and needs to be. Short-sellers shouldn't be reviled or banned; most should be celebrated and encouraged. They are the policemen of the financial markets, identifying frauds and cautioning against bubbles. In effect, they protect the unsophisticated from predatory schemes that regulators and enforcement agencies don't seem able to prevent.

Moreover, the short-seller who is fundamentally wrong, who mistakenly sells short an undervalued security, will lose money and, if the pattern continues, will eventually go broke. Short-sellers, like long-only buyers, need to be right more than they are wrong; when they are right, their actions are socially beneficial, not harmful. The only exception to this point, the only danger short-sellers pose to society, is when, in the equivalent of yelling "fire" in a crowded theatre, they spread false rumors that prevent a company that needs regular financing (such as brokerage firms) from being funded. Then, their predictions become self-fulfilling prophecies, enabling them to profit, whether or not they were fundamentally correct; they may actually be able to change the outcome. Yet, even in this situation, one may wonder whether any company – or highly leveraged government, for that matter – should employ a funding model that depends on perpetual access to the capital markets, which are notoriously fickle, volatile, subject to the influence of malicious gossip, and short-term oriented. In any event, mechanisms such as the uptick rule and rules against market manipulation already exist to prevent such misbehavior by short-sellers.

A Framework for Investment Success

Two elements are vital in designing an investment approach for long-term success. First, answer the question, ''what's your edge?" In highly competitive financial markets, with thousands of very smart, hardworking participants, what will enable you to reliably outperform the field? Your toolkit is critically important: truly long-term capital; a flexible approach that enables you to move opportunistically across a broad array of markets, securities, and asset classes; deep industry knowledge; strong sourcing relationships; and a solid grounding in value investing principles.

But because investing is, in many ways, a zero-sum activity in which your returns above the market indices are derived from the mistakes, overreactions or inattention of others as much as from your own clever insights, there is a second element in designing a sound investment approach: you must consider the competitive landscape and the behavior of other market participants. As in football, you are well-advised to take advantage of what your opponents give you: if they are defending the run, passing is probably your best option, even if you have a star running back. If scores of other investors are rigidly committed to fast-growing technology stocks, your brilliant tech analyst may not be able to help you outperform. If your competitors are not paying attention to, or indeed are dumping, Greek equities or U.S. housing debt, these asset classes may be worth your attention, regardless of the currently poor fundamentals that are driving others' decisions. Where to best apply your focus and skills depends partially on where others are applying theirs.

When observing your competitors, your focus should be on their approach and process, not their results. Short-term performance envy causes many of the shortcomings that lock most investors into a perpetual cycle of underachievement. You should watch your competitors not out of jealousy, but out of respect, and focus your efforts not on replicating others' portfolios, but on looking for opportunities where they are not.

Much of the investment business is centered around asset-gathering activities. In a field dominated by a short-term, relative performance orientation, significant underperformance is disastrous for retention of assets, while mediocre performance is not. Thus, because protracted periods of underperformance can threaten one's business, most investment firms aim for assured, trend-following mediocrity while shunning the potential achievement of strong outperformance. The only way for investors to significantly outperform is to periodically stand far apart from the crowd, something few are willing or able to do.

In addition, most traditional investors are limited by a variety of constraints: narrow skill-sets, legal restrictions contained in investment prospectuses or partnership agreements, or psychological inhibitions. High-grade bond funds can only purchase investment-grade bonds; when a bond falls below BBB, they are typically forced to sell (or think that they should), regardless of price. When a mortgage security is downgraded because it will not return par to its holders, a large swath of potential purchasers will not even consider buying it, and many must purge it. When a company omits a cash dividend, some equity funds are obliged to sell that stock. And, of course, when a stock is deleted from an index, it must immediately be dumped by many. Sometimes, a drop in a stock's price is reason enough for some holders to sell. Such behavior often creates supply-demand imbalances where bargains can be found. The dimly lit comers and crevasses existing outside of mainstream mandates may contain opportunity. Given that time is often an investor's scarcest resource, filling one’s in-box with the most compelling potential opportunities that others are forced to or choose to sell (or are constrained from buying) makes great sense.

Price is perhaps the single most important criterion in sound investment decision making. Every security or asset is a "buy" at one price, a “hold” at a higher price, and a "sell" at some still higher price. Yet most investors in all asset classes love simplicity, rosy outlooks, and the prospect of smooth sailing. They prefer what is performing well to what has recently lagged, often regardless of price. They prefer full buildings and trophy properties to fixer-uppers that need to be filled, even though empty or unloved buildings may be the far more compelling, and even safer, investments. Because investors are not usually penalized for adhering to conventional practices, doing so is the less professionally risky strategy, even though it virtually guarantees against superior performance.

Finally, most investors feel compelled to be fully invested at all times – principally because evaluation of their performance is both frequent and relative. For them, it is almost as if investing were merely a game and no client's hardearned money was at risk. To require full investment all the time is to remove an important tool from investors' toolkits: the ability to wait patiently for compelling opportunities that may arise in the future. Moreover, an investor who is too worried about missing out on the upside of a potential investment may be exposing himself to substantial downside risk precisely when valuation is extended. A thoughtful investment approach focuses at least as much on risk as on return. But in the moment-by-moment frenzy of the markets, all the pressure is on generating returns, risk be damned.

What drives long-term investment success? In the Internet era, everyone has a voluminous amount of information but not everyone knows how to use it. A well-considered investment process – thoughtful, intellectually honest, teamoriented, and single-mindedly focused on making good investment decisions at every turn – can make all of the difference. Investors with short time horizons are oblivious to kernels of information that may influence investment outcomes years from now. Everyone can ask questions, but not everyone can identify the right questions to ask. Everyone searches for opportunity, but most look only where the searching is straightforward even if undeniably highly competitive.

In the markets of late 2008, everything was for sale as investors were caught in a contagion of selling due to panic, margin calls, and investor redemptions. Even while modeling very conservative scenarios, many securities could have been purchased at extremely attractive prices – if one had capital with which to buy them and the stamina to hold them in the face of falling prices. By late 2010, froth had returned to the markets, as investors with short-term relative performance orientations sought to keep up with the herd. Exuberant buying had replaced frenzied selling, as investors purchased securities offering limited returns even on far rosier economic assumptions.

Most investors take comfort from calm, steadily rising markets; roiling markets can drive investor panic. But these conventional reactions are inverted. When all feels calm and prices surge, the markets may feel safe; but, in fact, they are dangerous because few investors are focusing on risk. When one feels in the pit of one's stomach the fear that accompanies plunging market prices, risk-taking becomes considerably less risky, because risk is often priced into an asset's lower market valuation. Investment success requires standing apart from the frenzy – the short-term, relative performance game played by most investors.

Investment success also requires remembering that securities prices are not blips on a Bloomberg terminal but are fractional interests in – or claims on – companies. Business fundamentals, not price quotations, convey useful information. With so many market participants fixated on short-term investment performance, successful investing requires a focus not on how one is doing, but on corporate balance sheets and income and cash flow statements.

Government interventions are a wild card for even the most disciplined investors. On one hand, the U.S. government has regularly intervened in markets for decades, especially by lowering interest rates at the first sign of bad economic news, which has the effect of artificially inflating securities prices. Today, monetary easing and fiscal stimulus augment consumer demand, increasing risks not only regarding the integrity and sustainability of securities prices but also those surrounding the sustainability of business results. It is hard for investors to get their bearings when they cannot readily distinguish durable business performance from ephemeral results. Endless manipulation of government statistics adds to the challenge of determining the sustainability – and therefore the proper valuation – of business performance. As securities prices are propped up and interest rates are manipulated sharply lower (thereby justifying those higher prices in the minds of many), prudent investors must demand a wide margin of safety. This is especially so because financial excesses contain the seeds of their own destruction. Market exuberance leads to business exuberance – production of more goods and services than demand ultimately justifies. Of course, when market and economic excesses are finally corrected, there is a tendency to over-shoot, creating low-risk opportunities for value investors who have remained patient and disciplined.

Yet another long-term risk confronts investors: the government's fiscal and monetary experiments may go awry, resulting in runaway inflation or currency collapse. Bottom-up value investors would not wish to bet the ranch on a macroeconomic view, but neither would they be wise to ignore the macroeconomy altogether. Disaster hedging – always an important tool for investors – takes on heightened significance in today's unprecedentedly challenging environment. Yet, as this insight is not unique to us, the cost of insurance is high. There are no easy ways to navigate these turbulent waters. But because the greatest risks are of currency debasement and runaway inflation, protection against a currency collapse – such as exposure to gold – and against much higher interest rates seem like necessary hedges to maintain."

JEFF GUNDLACH BREAKS DOWN A MULTI ASSET PORTFOLIO

Jeff Gundlach of DoubleLine Capital provided some detail on one of their new funds – the Multi-Asset Growth Fund (DMLIX) in a conference call today.  The presentation gave some insights into how he approaches the portfolio construction.  What differentiates Mr. Gundlach is his talent as a master allocator and risk manager.

In many ways, this fund appears similar to a lazy portfolio or an Ivy Portfolio – a broadly diversified fund that seeks to benefit from the potential growth and correlations (often inverse) of differing assets.  It removes stock picking (which I love), focuses on protecting the downside (by maintaining healthy cash levels) and utilizes a unique expertise in risk management and fixed income to generate high risk adjusted returns.  Mr. Gundlach elaborated on some of the bigger themes that drive growth:

• When he doesn’t like markets he prefers to just get out (into cash).
• The equity portion is not based on stock picking.  He sees stock picking as a waste of time and prefers to focus on sectors, industries & indices.
• Capital preservation is just as important as portfolio growth.
• You can see the composition below:

Update -  DoubleLine contacted me to clarify that the cash position will not necessarily be maintained at 30% and will likely be deployed over time.

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?