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Monday, 24 December 2012

Investment Sector Outlook for 2013: “Volatility in Vogue”

At FPM we understand that checking in the rear-view mirror is not only an indicator of ‘things that have come to pass’ but augurs ‘things that may come to pass’. So for the year-ahead, when investor psyche is most trained on forward-looking signs, we aim to present a strategy research. These market intelligence or views are confirmed by our Exchange Traded Product (ETP) diligence. Our use of ETFs reinforces FPM's integrity as a multi-manager / FoFs platform credentials.
A comprehensive list of all ETPs ranked by YTD performance on 14th Nov’12 serves as the starting point for short- and medium-term view recommendations. We believe this ranking-list and ETF prices as at end-month Nov’12 serves as an apt data-point in spite of year-end window-dressing noise. Following ETP data refers to these dates unless stated.

“Volatility in Vogue”

Volatility as an investment sector, according to our ranking of all ETFs performance at US equity market close on 14th November, was one of the punch-the-lights-out asset classes of 2012; but ONLY if you were in a proxy that was short a volatility benchmark like the VIX Index, as below:

XIV VelocityShares Daily Inverse VIX Short-Term ETN $16.07 -3.48% $370,052 11,384,800 146.85% Volatility ETFs

11,384,800 146.85% Volatility ETFs

VelocityShares Daily Inverse Short-Term ETN ‘XIV’ posted a staggering 151.5% annual total return for year-ending Nov’12 (see below table of all ETFs over year). With approx. $370 mn in assets it is the 2nd biggest of volatility ETFs. Our universe for this sector study, incorporated all 17 volatility ETFs, as classified by ETFdb.

FPM’s macro perspective envisages an inevitable pick-up in volatility, at least a 68% probability event, based on the volatility exhibited in VIX in the window period since Jan’09. Our expectation for increase in equity volatility in 2013, especially after the relative lull in volatility this year, stems from market-related macro concerns reverberate strongly.  
FPM recommends a SWITCH trade with accompanying trigger-event date. We favour the Barclays ETN Inverse S+P 500 VIX Short-Term Futures ETN (XXV) for expectation of benign volatility levels in 2Q13 and 3Q13:

Barclays ETN Inverse S+P 500 VIX Short-Term Futures ETN$37.75unch$4,5795,22114.39%Volatility ETFs

From our market understanding and statistical observations presented in below tables, and without looking under-the-bonnet, the ‘XXV’ is one of the smallest-hitting ETFs in the volatility class:  with only about $4.5 mn in assets we’re mindful of liquidity concerns. Yet FPM commends it for:

a) Its forerunner launch in Aug’10, beating or setting the trend for a hoard of other volatility ETF launches in Nov’10; these others exhibit poorer ‘me-too’ arrivals. We noticed 6 ETFs incepted in November that year from the VelocityShares stable alone!
b) Its relatively longer track-record through business cycles is validated with strong adjusted closing price performance 59.5% total return since inception.
c) Other favourable FPM metrics in statistical comparison with peers in the class, e.g. low market correlation, lowest monthly loss of only -2.3% across all 17 ETFs and benchmarks, further encourages us to kick-the-tyres and check-under-bonnet for allocation before by January 2013. See below for all ETF performance since their inception.

We perceive volatility increasing in 1Q13 to above 20 level as year-end dust settles and New Year optimism and hope springs eternal i.e. risk-on activity. We expect volatility surges throughout the year with the Fed’s FOMC stance about suspending its ZIRP or interest rate capping policy, or indeed other policy-drivers. Recently these factors have been prominent in capital market direction and volumes.

Barrons Focus on Funds reported on the December 21st:

“…Wall Street appeared to expect an interim deal today [on “fiscal cliff Jackanory”], followed by more meaningful resolutions in early January. Earlier, January and February futures on the Chicago Board Options Exchange’s Volatility Index were up 7%, and 6%, around 19, respectively. The “VIX” nearly surpassed 20 for the first time [since June 25th closing] in a while this morning and has pared it gain to 5% or so at this writing.”

For this 1Q13 increased volatility scenario FPM RECOMMENDS the sector bellwether, un-leveraged long volatility short-term VIX tracker, the VXX for sheer volume and liquidity for market-timing directional trading.

Volatility ETFs from Micro Perspective

Volatility as an ETF asset class ultimately tracks the CBOE Volatility Index, otherwise known as the ‘VIX’ or ‘Fear gauge’. The VIX, introduced in 1993, is calculated from prices paid for S&P 500 index options expiring in the next 30 days. Though it has been around for nearly 20 years, by the vary nature of its calculation it is not an investable asset. The ETPs in the volatility category of the ETFdb database, actually invest in VIX futures or, in the case of ETNs, are linked to indexes comprised of VIX futures.

The generally passive index-tracking nature of ETFs is somewhat algorithmic and prudently warranty case-by-case black-box examination. Traditional long-volatility funds bought derivative contracts with implied future volatility, betting price swings will increase. When volatility is steady, the derivatives lose intrinsic and time value moving to maturity, resulting in losses for the funds. Hence the reasons why the two best performing ETFs in our study are short volatility (inverse volatility), in this relatively calm markets.

Of long volatility ETFs there is distinction in whether they reference short-term duration VIX futures (usually offering exposure to 1st or 2nd month futures contracts), such as ‘VXX’, ‘VIIX’ and ‘VIXY’ etfs; or link to medium-term duration VIX futures   (exposure to 4th month through to 7th month contracts), such as ‘VXZ’, ‘VIXM’ and ‘VIIZ’

Short-term exposure generally exhibit higher correlation to changes in the spot VIX (high beta). But because contango is often steepest at the short end of the maturity curve, the adverse impact of an upward-sloping curve may be more severe. Indeed short-term exposure ETFs fared worse over the year and since inception than medium-term exposure VIX etfs. And as expected leveraged long ETFs ‘TVIX’,’TVIZ’   

VXX, and other long volatility short-term durations ETFs usually face higher rebalancing related trading costs from periodic portfolio turnover especially in contangoed VIX futures markets. This results in a premiums paid to roll-over index option positions, i.e. the “roll yield” resulting from contangoed markets. Contago in futures is when the futures price is above the expected future spot price. Consequently, the price will decline to the spot price before the delivery date. This is the opposite of backwardation.

Micro drivers for volatility performance

While volatility ETFs are not recommended as long-term buy-hold vehicles, they do provide opportune trading and hedging possibilities.

The appeal of ‘pure’ long volatility exposure via VIX futures is due to its strong negative correlation to equity markets. Correlation ratio -0.83 of VIX to S+P 500 over the past year. So volatility can be thought of as insurance for investor portfolios. Market traded volatility products such ETPs tend to exhibit weaker negative correlation, as our quant analysis shows. The study in fact shows that there low correlation of long volatility etfs with S+P 500 index in the past year of benign volatility. The median correlation for long exposure ETFs was 0.24.

Apart from understanding the variables for implied volatility calculations, FPM monitors outstanding options on the VIX as auguring volatility price-action. For instance outstanding positions on the VIX rose to 9.01 mn on 16th October, the most ever according to Bloomberg data.

Our study also found that CBOE Holdings Inc (owner of Vix) said in September that it intends to expand trading hours for VIX futures to 24 hours from 8, five days a week, starting in 2013. We can expect increased liquidity in volatility trading, which may equally dampen or exacerbate volatility spikes depending on the degree of herding in particular views on asset class direction.

The ability to manage volatility similar to that of US equity markets is developing with domestic futures and option exchanges globally. For example, futures on volatility gauges for the Nikkei 225 Stock Average and Hang Seng Index started in February of this year.

Other benchmarks such as HFRX Global Volatility Index may also get monetised expanding scope of diversified volatility management.
The main factors other than being long or short of the stated volatility index:

Ø      Two volatility ETFs are approaching thier meaningful 3-years track record – the first of 17 in the universe incepted in Jan’09 (VXX)
Ø      The oldest volatility ETF (VXX) is also the largest with $1.6 bn+ in assets at Mid-November. The smallest one has ~$1.8 mn in assets (IVOP)
Ø      Volatility as an asset category is classified under alternative investments by prominent ETF vendor  ETFdb (with Hedge Funds and Long-Short ETPs)
Ø      ProShares VIX Short-Term Futures ETF (VIXY) is the only ETF approach in the space, others are notably Exchanged Traded Notes ETNs.
Ø      Only 5 of the 17 volatility ETFs (VXX, XIV, TVIX, UVXY and VIXY) characterised daily average volumes over 1 mn shares traded; solid volumes indicates tight bid ask spreads
Ø      Another not small consideration in ETF allocation are the ever present management fees, which is relatively the lowest of various fund sectors, for basic index replicating performance.

We noticed that being short or long volatility is an event-based trade. Often described as ride to the sound of the trumpet, and then take profit when there! We identified ‘3 P+L  periods / option-settlement-rollovers’, Feb, Apr-May and Aug-Oct, were profit/loss taking months for institutional ETF players, depending on which side of the long/short volatility net position. Typically volatility may be expected to surge in October, as investors try to exit losing positions before the end of the year.

The short-term long volatility ETFs experienced their worst monthly price-basis drawdown in Feb’12 losing between -31.5% and -55.8% (bear in mind that this ETF class is only approaching its 3rd year of existence). The short-term derivatives investing inverse volatility ETFs (essentially puts on S+P 500) experienced their worst monthly drawdown in Apr’12 ranging between -2.3% and -25.5%. FPM SWITCH RECOMMENDATION the ‘XXV’ and the VOGUE STAR PERFORMER ETF ‘XIV’ experienced a modest monthly -2.3% and the worst drawdown of -25.5% respectively. The medium-term long volatility ETFs took worst monthly loss in Aug’12 averaging -17.1% with outlier performance of -31.7% from VelocityShares Daily 2x VIX Medium-Term ETN (TVIZ), due to its 2X leverage. 

At this stage we also present a Long/Short VIX ETN. A discovery from FPM analysis of statistics, that finally recognises a hedged volatility tracker.

Another of the creative combinations of the exchange-traded structure and volatility is the UBS E-TRACS Daily Long-Short VIX ETN (XVIX), a product designed to exploit the steepness on the short end of the VIX futures curve. XVIX is linked to an index that maintains a 100% long position in the S&P 500 VIX Mid-Term Futures Index Excess Return with a short 50% in the S&P 500 VIX Short-Term Futures Index Excess Return (an inverse-ETF position). The result is a product that offers non-correlated exposure but hedges out exposure to the short-term index, making it a potentially interesting for investors looking to achieve exposure to volatility over a longer time period. During Wednesday’s session, XVIX lost about 1%, a result to be expected then the gain on the short-term futures index was more than twice as large as the change in the mid-term index…” [Source: Michael Johnston of ETFdb on March 21, 2011]

FPM adduces that most ETFs, at least in the S&P 500 option volatility space, experienced the biggest drawdown synchronised with clearing months for futures and options settlements calendar. Participants took money off the table / or switched trades in the volatility space, based on ambiguous or benign economic and regulatory event-drivers. Catalyst-drivers for the markets and wider economic sentiment are orchestrated by authorities in ostentatiously retaliatory stance for financial crisis and aftermath. Before the Lehman collapse the markets were crying foul of buyout-centric momentum-driven trading disrupting company fundamental valuations. And now the macro fundamentals are driven by global statutory agents. The point being that presiding investor sentiment on the prevailing macro policy issues also caused profit / loss taking in volatility ETFs.

Completing our micro event-driven 'regs-news' for volatility ETFs we edited together our ‘Prescient People News Annual’ of ‘proper’ macro and market policy issues (as distinct from ‘news noise’), as below:

Volatility from a Macro Perspective

Re-emergence of macro economic concerns, through escalation in state and national debt defaults – by whatever label and however well stage-managed the propaganda and behind-the-scenes debt restructuring progresses amid the de-leveraging cycle. We refer you to Ray Dalio’s “D-Process” as an expert’s long-term macro view. Currently, the synthetic economic confidence efforts (QE, TALP, TALF, Tax-holidays etc) and general lifeline provided by global central banks is keeping the global economic ship on a steady / even keel i.e. mitigated risks scenario. Remember it’s not that long ago were there concerns about global bank solvency. A once profligate wealthy sector is now transferring its credit-boom-bust losses to future taxpayers! FPM knows that even a hedge position can have a downside – if confidence and economic activity is not restored in balance!

On this Chicago-school of monetarist policy path, a scenario of Europe or other nation or bloc-state running-out of money and/or stopping-the-printing-press via geopolitical pressures like populous uprising, could make recent solvency issues of financial institutions and the housing sector seem a mere trifle. Statutory monetary expansion to quell systemic credit market risks of 2008 has exponentially ballooned national and fiscal balance sheets / debts. For example, US Total Public Debt Outstanding is US$ 16.3 trillion!   The souring of these government / state debts, currently and seemingly only affecting irresponsible fiscal management fringe countries and municipal states, blowing up i.e. credit default risks, is not an incorrigible reality. viz. Greece et al / ‘PIIGS’ and California  See below for more on “Volatility in a Macro Perspective”.

We can see from VIX chart below that since the frenzied life-time high level of 80 in Oct 27 and Nov 20 following Lehman bust in Sept’08, equity market swings have been less volatile, none more so than in 2012, at pixel time. CBOE Volatility Index or VIX is now around a five-year low, reflecting a steadied-ship which is the global economy proxy of S&P 500 constituent options’ implied volatilities!
For the record, before the Lehman bust, the VIX level rose to a five-year high of 32.24 on Mar 17, 2008 the day after the Federal Reserve rescued Bear Stearns. The VIX fell for four straight years through 2006 and slid to a 14-year low of 9.89 in January 2007, a month before the first reports of subprime losses. Previous highwater mark for VIX was 45.74 in Oct 1998, when the collapse of Long-Term Capital Management LP destabilized financial markets worldwide. Then of course cliff-fall in market sentiment sent fear gauge to 80 levels in Autumn 2008. Can anyone see the lull-before-the storm playing out again in similar yet shorter via volatility trading?

Source: Yahoo.com and FPM

The “plaster-policy-fix recovery” in housing and financials from maelstroms of the past is an opened Pandora’s box. This author remembers how the developing nations defended a run on their sovereign currency during the hot-money capital flight. For example, the Thai Bhat’s devaluation was the catalyst for the Asian financial crisis in 1997-98. Only after hardy-denials of the insurmountable problems did the national authorities capitulate and accept realities of bubbles. Just as we now have ‘troika’ restructuring nearly-out-of-control European fiscal and national debts, Thailand then also had the IMF satraps pushing and shoving national prestige into accepting the capital malfeasance facing it and the region. In a similar fashion, those liberal marketeers not living in ostrich paradise definitely envisage other indebted European nation following the way of Greece et al, leading to the final capitulation of the European exchange rate mechanism. 

The behavioural finance aspect of the “collective institutional market psyche” is an interesting aspect of understanding the reduced equity volatility in 2012. In the context of the cycle in this double-dip financial crisis, sometimes we get so inundated and eventually fatigued by, or simply get used to scandalous corruptive news that we hardly register them, never mind taking uproarious action. The Libor-fixing revelation hardly caused a tremor, as reaction in the global equity markets this year, though its rate setting effects trillions of referenced debt assets! Incidentally this indicates the markets’ predilection and state of readiness for a crisis. Hedges were at the ready and Libor-news-risk volatility safely mitigated for now.
A certain period of inveterate state in society and / or institutions can stifle conscientious objective thinking, breeding hubris and complacency maybe dare we suggest stagnation-economy. Such as those of the disenchanted or disengaged economic workforce, who are and were once productive units in cooperative societies. Those who are long-term unemployed or in the conditioned-‘Black-Economies of the World’ could reassert themselves gainfully. In some developing countries women are now being considered to join workforce – Wow! To increase economic activity or perhaps a liberalisation of the alter-ego of economics - no less! Of the inveterate state of societies’ conscientiousness or interest in self-governing facts, we are lazy or unspoken majority! When time framed status-quo societys’ behaviour and expression changes, suddenly and unexpectedly then panic arises and the diligence becomes collective mass fear-flight to switch asset holdings. They are dynamics of the fast world we domesticate. 

Litigation surrounding Libor and related-banks should cause mainstay financial institutions’ equity to stay in the mire of regulatory and litigious uncertainties for longer. This to us means that the conventional banking business model is in a state of slow flux. One might say ‘alternating’ flux! Allocation buckets for financial investments is switching to Emerging Alternative Asset Managers. (email me for FPM’s fund manager transactions ‘FMT’ efforts)

Equally as interesting to consider that equity trading volume and general market direction has been at range-bound levels, has contributed to lower volatility. At the end of the first week of this month December, the YTD daily average volume is about 6.48 bn shares changing hands on the New York Stock Exchange, the Nasdaq and NYSE MKT. At end-1H12 trading volume was again light, with about 15.72 bn shares traded on aforementioned bourses, well below 2011 daily average of 7.84 bn.

Other Volatility Plays:

There are so many ways to play volatility, and volatility systems typically perform best when “everyone else is confused” and / or when “excessive fear or greed among investors exist” or “it would require something to happen that is unknown today”!
Other than ETFs there are other portfolio vehicles and investing strategies to understand and profit from this volatility asset class. That is, up and down swings can be a defining material investment, if principals / managers are “swinging” in their investment outlook and approach.

Listed below are 4 Low-Volatility ETFs to Hedge Portfolios, as reported by Zacks.com:
PowerShares S&P 500 Low Volatility (SPLV) - SPLV tracks the S&P 500 Low Volatility Index, which consists of 100 stocks from the S&P 500 Index with the lowest realized volatility over the past 12 months. Est.May’11 with current AuM ~US$ 2.6 bn.
iShares MSCI USA Min Volatility (USMV) - USMV seeks to replicate the MSCI USA Minimum Volatility Index, which is comprised of U.S. securities in the top 85% market cap that have lower absolute volatility. Est.Oct’11 with current AuM ~US$ 465 mn.
iShares MSCI All Country World Minimum Volatility Index Fund (ACWV) - It tracks MSCI All Country World Minimum Volatility Index. Est.Oct’11 with AuM ~US$ 639 mn
iShares MSCI Emerging Market Minimum Volatility Index (EEMV) EEMV is an ideal choice for the investors looking to participate in the emerging markets growth while limiting their portfolio volatility. Est.Oct’11 with AuM ~£603 mn.

Index Replicators like ETFs produce average performance i.e. sector beta returns. However, alpha stars in hedge funds with the right redemption / exit terms are the ones perform best. If

The HSI Volatility Index (VHSI), a measure of Hang Seng Index (VNKY) option prices, is also possible volatility play on wider markets; other than of course thr widely accepted volatility benchmark of the S&P 500 companies.
As is the HFRX global volatility index which gained 7% this year to Oct’12, outpacing the 4.8% advance of its broader measure of hedge funds.

Of Volatility Hedge Funds: we initially examined sector specialists from the smaller Asian universe. Our findings suggest there was a creative-destruction bias, at least in long-biased volatility hedge funds. Artradis Fund Management in Singapore ran two volatility funds accounting for most of its US$ 4.5 bn in assets in early 2009, propelling it to Asia’s third-largest hedge-fund group. It reportedly made US$ 2.7 bn for investors as markets seesawed in 2007 and 2008. Artradis closed in March 2011 after its funds lost US$ 700 mn in 2009 and 2010. Artradis comprised former colleagues of Asia-office of Fortress Investment Group who had started the Fortress Convex Asia.

Another example of transactional creative-destruction in hedge funds is the Sharp Peak Vega Feeder Fund, which invested in OTC equity derivatives including volatility swaps, lost 12% in the first half of this year and 18% since it started in Oct’11. The Hong Kong-based manager has now shuttered shop. Another Hong Kong-based manager, DragonBack Capital, which managed as much as US $600 mn at its height of fortunes in 2008, also closed in Aug’10.

To get material proportion in the advance of volatility trading trends we compare scale of Euro-Asia Volatility Markets. Asia-based volatility funds tracked by Eurekahedge Pte managed US$ 212 mn of assets as of June, less than one-tenth of the mid-2008 peak. In comparison, Newedge’s index of hedge fund volatility sample of 10-fund constituents alone managed a combined US$ 4.6 bn approximately.

On an encouraging note of “letting your work be your fight…”, Stephen Diggle of the failed Artradis FM and of ex-Fortress team, had started Vulpes Long Asian Volatility and Arbitrage Fund with mostly his own money, a couple of months after in May 2011: “…He’s betting on price swings for government debt, currencies and commodities.”

FPM seeks to engage Vulpes Investment Management with salutation of: “…let your peace be a victory.” [Ki Action Point]

Closer to home we are closely following the fortunes of Maple Leaf Capital in London. Passing their tenth anniversary of operations earlier in May. Congratulations Men! Maple Leaf was founded by Michael Wexler and George Castrounis, specialising in volatility trading and arbitrage across equity, commodity, currency, and fixed income markets.

FPM is engaging them and others on a sector marketing diligence mission for in-depth coverage and peer study. Peers which we will follow-up on include JD Capital with similar operations establishment date in 2001, with a strategic prominent FoFs backer FRM Capital. Also JD Capitals Tempo Volatility Fund is part of the 10 constituents of the NewEdge Volatilty Index.

Finishing on an anecdotal note we extracted these two statements from our web-trawl research, one ironic and the other validation of volatility assets:

``You're either going to be buying at the bar tonight or crying! There's enormous opportunity if you're an options player because the volatility is there and if you hedge it right, you don't care if it's up or down. But if you don't do it properly, you can lose a lot of money… The [S&P 500] index may have its most volatile year since 2002. ''
Howard Silverblatt, an analyst at S&P in New York, commenting days before Lehman’s blowup.

``They make money when others don't. They act like insurance in one's portfolio.'' Antonio Munoz, CEO of EIM Management USA, a unit of EIM Group of Switzerland, commenting on volatility funds it has held since 2002.

On behalf of FPM I wish my friends and colleagues and web-trawlers the best of season’s festivities and holidays.… let our peace be an all deserving victory.

[@pixel time Ed deeply watching and then breaking-off from movie “The Abyss”, Tomorrow evening looking forward to hanging out with my special fasionista connections’ family in airy Cornwall.]

‘Seasons Sentiments & Cya in 2013! xk’

Friday, 23 November 2012

Next Stop For Capital Markets via Biggest ETFs (5-Year Performance)

Double-Click to Enlarge Chart
Last Updated: 24th Nov '12

We at FPM, with proprietary analytical tools, felt consolidated in our process of ultimate "enterprising execution" that less narrative and more active visuals are better. So we analysed the wide universe of ETFs to gauge the investment climate. The above ETFs performance chart shows medium term trends in select asset classes for the past 5 year to end-October 2012.

We're lending our hedge fund metrics analysis to measuring ETF performance over the past years to montth-end October '12. The basis for converging hedge funds and ETF analysis are to do with the fact that a) many hedge funds are increasingly using ETFs to express their directional / hedge views on macro variables and, b) FPM strongly believes the terms for passively-managed / index-following ETFs are compelling for any multi-manager portfolio. Low fees and greater liquidity, than say hedge funds, gives an easy access to directional 'kicker' allocation.

Double-Click to Enlarge Statistics
This article is a  'celebration' of where we visualise poorly allocated resources will shift as exemplified in the long-only Investment Sector Funds (ISFs as I like to acronym ETFs). In the visual-nature of this article, a professional heavyweight investor's view below, which we at FPM finds curious! Just in case you haven't seen Jefferey Gundlach's proposition in the main-stream financial media entitled Gundlach Sees No Lost Decade as Biggest Bears Flirt With Stocks published by  Alexis Leondis - Sep 14, 201:

Stocks Won't Repeat Lost Decade, Gundlach Says

Whatever the pretext of the Bloomberg and DoubleLine Capital's presentation. Doubleline is the $40 bn AuM asset management firm that Gundlach founded in Los Angeles in 2009. In terms of  the article's propaganda, what is stark is that an eminent bond-shop is compellingly allocating to equities! There are myriad reasons for this perhaps. Is the representation of the article that listed equities may enjoy a prolonged rally soon and that bonds might fall out of favour?  Aside of the confidence-trick policy measures to kick-start economic continuity, we had better believe in an "earnest economic recovery and stability".

Earnest economic recovery and stability might be interpreted as consumers and corporations continuing to transact / turnover in expanding economic activity. Yet, industrialisation on an unprecedented global scale with BRIC-populus inclusion is potentially mind-blowing as a game-changing milieu!

While the  great forces of economic entities grapple for the dwindling finite earth's resources, nature is battling back via "climate revolution". FPM's supports the progressive and special Dame Vivienne Westwood, who has campaigned to stop climate change and commends  economic prudence. The damaging climate-change threat is real (viz. greater intances of extreme weather and indicatively,  insurance-linked bonds market). The policy makers, corporate executives and relevant individuals should have commensurable "active resistance" or response. It follows that economic activity therefore has to be curtailed to some extent. 

STOP PRESS: an evidence of this view is "India's capital widens ban on plastic bags" published on AFP 23rd November.

Back to the Bloomberg presentation: Gundlach's interview is either taking the heat off the credit  sector from overheating / 'bond bubble', or he really suggests equities are recovering towards a secular bull-run, at least auguring an investment climate flip-flopping between favourable to equities and bonds cyclically. From our fund manager transactions (FMT) perspective, Gundlach proposition is the same as an equity-focused hedge fund leveraging of its research into the broader capital structure asset plays and building a fixed income / credit team. The speculation is that, equity-threats are opportunities for some.

FPM's "Next Stop" Views:

+ Less bond lure as inflation-creep is simmering in dissimulated headline figures.

+ Equity rally has scope as capital structure of companies better refinanced in debt / equity ratio terms. Expecting equity returns to stop being a residual call on companies' earnings except fincos.

+ The switch away from risk-averse gold assets are likely to flow into black gold, i.e. asset flow into countries and companies realated to raw-material resources in emerging and frontier markets. Not just oil and commodities, take China, it is rich in one of the greatest resources "human capital"!

+ China and other rapidly expanding economies will inevitably catch a cold from the developed nations' consumers sneezing! So for those economies developing domestic consumption and wealth will become a priority than typical export-driven-growth model.



Monday, 12 November 2012

You're 'Avin A Laugh!

New! New! New!
In FPM digests of a more concise nature than our regular exhaustive, earnest and expansive posts, we aim to share some of our anecdotal observations. Often these musing may have serious undertone; every wit has a degree of truth, it has been said.  "You're 'avin a laugh" is the header for FPM's series of future short posts based on media release;  'YAL!' is the abbreviation leading these shorts, of which the first one is:

YAL! - Consider this syllogism: Stock picking is not either a folly or a game, but professionally viewed as an incisive active asset management expertise. Mitt Romney's stock, at least in the field of politics on Tuesday 6th November, suffered a blow-up or deal-break, as in the investment parlance! So those alternative investments illuminarie who stock-picked and publically backed M.Romney seemingly did not excercise incisive expertise! Or it was an innocent little folly with a vested agenda that had more economic upside than downside.

From either perspective these headline-assuming stock-pickers for US presidency and its assembly deserve some extent of mark-down or denigration [while they themselves and, by degrees investors, laugh all the way to the bank!]. If hedgies can short stocks, then in a similar manner they can also garner negative publicity through their publicised associations. Remember there are many donors who also choose to remain anonymous.

Name and Shame:

Anthony Scaramucci, founder of fund of funds firm SkyBridge Capital, was Obama's former Harvard Law School classmate and his supporter for the 2008 election . Recently, he's challenged the president for his administration's regulatory posturing toward Wall Street, and has switched sides. Mr Scaramucci has been holding fundraisers for Romney.

Others who've backed the political affiliations and aspirations include:

David Tepper - Appaloosa Management
John Paulson Paulson and Co.
Dan Loeb – Third Point
Cliff Asness - AQR Capital
Paul Singer - Elliott Management
Ken Griffin - Citadel Investment*
John Griffin - Blue Ridge Capital*
Julian Robertson - Tiger Management
Louis Bacon - Moore Capital,
Bruce Kovner - Caxton Associates,
Lee Ainslie - Maverick Capital
Ricky Sandler - Eminence Capital

*Verify if the 'Griffin' is a mix-up with John Griffin of Blue Ridge Capital

In FPM Research-Integrity based balance of power we like to highlight those that reportedly backed the eventual winning stock too.

Hall of Fame:

A Forbes magazine survey printed a list of the top 40 donors to the political action committees for both candidates, as the list stood at the end of September, and showed that only four hedgies gave $500,000 or more to Obama's Super PAC “Priorities Action USA”. Top donor to the left-leaning lobbying was David Shaw with $2 mn   :

James Simons - Renaissance Technologies
George Soros Soros Fund Management
DE Shaw -David Shaw
Marc Lasry - Avenue Capital

FPM's presidential stock pick was a deep out-of-the-money speculation on Ron Paul. Now that should solicit a remark like 'YAL' from the reader! That's not so bizarre, since Peter Thiel of Clarium Capital and Paypal fame also supported the Liberal outside candidate for Republican presidential nomination.

Its Friday afternoon in London in the week after the US elections and China's Party Congress. Lastly, a food for thought:
"Intellectual eminence carries with it corresponding moral responsibilities. The greater a man's talent, the greater his power to lead astray!" Bertrand Russell

Wednesday, 19 September 2012

Product Convergence or Incestuous Orgy in Alternatives - Part 2

The growth spurt in alternatives partly reflects the flow in capital to alternative managers from traditional ones, for various reasons diacussed below. Accepting plutocratic model of society, traditional manager’s time-vested and relationship-nested model of conducting a socio-politico driven economy is perhaps on the wane in its creative-destruction cycle. As an example, I am thinking of Fidelity Investment’s non-vogue long-only-securities investing since starting in 1946. Yet Fidelity is still the second largest mutual fund company in the US. In Europe, “Foreign and Colonial” a.k.a. F&C Asset Management plc, the world’s oldest manager of mutual funds, has seen its listed share price fall to a quarter of its value in 2000.   FPM believe innovation in the securities management industry with the newer mutual-fund models of Vanguard Group established in 1976, and the best of breed alternative-managers like Bridgewater, formed in 1975, are bellwethers. Additionally, lets not forget that the traditional brokers and manager’s spawned or trans-mutated into hedge funds and private equity. The ‘hedgies’ tended to be from the broking and agency or prop-trading side (secondary markets), while the corporate finance or investment bank teams did the transactions (primary markets), akin to PE-model. The closing yet untenable link between PE and hedge funds via their cross-holding ownership yet again inexorably questions Chinese walls issues. Our premise that creative-destruction via alternative assets is foreboding or to be emphatic, ill-auguring; and ultimately beneficial for FMTs.

By sampling the Carlyle Group's fund manager transactions, as one of the world's largest connected private equity investors, FPM believes their deals serve as a case study of ‘alternatives’ trends and consequences.   

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In literary terms we think The Carlyle Group’s [CG] activity represents Jacob Marley’s ghosts showing Ebenezer Scrooge things that have been in the past, are currently and will come to pass. Carlyle’s activity in asset management deals are complex if not opaque beyond the reported details. For instance, it is difficult to distinguish between their strategic and financial investment rationale for partnerships, despite rules of thumb about <20 being="being" financial="financial">30% being strategic investments.

Also weaving an entangled web to the already complex association of cross-holdings between asset managers, is through investments in the hedge fund and/or private equity fund (i.e. via LP shares of the fund). So we are now doubled up on exposure to GP stake and LP stake. For example, as cited in Carlyle’s activity table above, the sovereign fund of Abu Dhabi’s Mubadala Development Company also committed $500 mn to an investment fund managed by Carlyle. While the US$1.85 bn of capital involved in this particular investment is not suggestive of absolute catastrophe to Mubadala, yet considering the aggregated capital investment of other petro-dollar earning countries in the Middle-East region in global financial services, the impact maybe significant wealth destruction! The prototype for which has been set since the 2008 financial crisis. The illustrious manager of Pimco’s bonds funds, Mr William Gross, stated that on a long-term basis, governments are likely to use financial repression, where the rate of inflation is higher than bond yields, to erode the value of sovereign debt over time. The late great Barton Biggs also stated in Mid-2011 that debt devaluation via inflation is less painful than capital destruction as a long-term course. (A prophetic Barton Biggs interview)
The cross-holding in financial services, which is rhetorically seen as diversification benefits (and realistically, recycling of petro-dollar revenues etc) can insidiously become risky over-concentration in a financial assets. For example, the overall leverage Company A states on its books can multiply if its cross-held affiliate Company B takes a nose-dive due to its own leverage situation. Company A’s balance sheet asset takes a knock-on hit and deleveraging may be enforced. Remember that in financial services and corporate treasuries assets usually have a charge or liability against them. By putting an asset or capital to intensive use there is less cushioning from the negative domino or chain-reaction effects created by the weakest link in the chain.

Hence why every time there is a financial crisis, after the horse has bolted, so to speak, Basel regulatory capital reserve requirements convene special discussions. And After the financial crisis which unfolded in summer 2007, regulators and bankers from 27 countries gathered yet again in September 2010 to agree on the Basel III accord.

Evidence of a cross-holding implosion scenario: by cutting financing to hedge funds and raising ‘repo haircuts’ (basically ransoming the fund-firms to put up more assets / collateral to back their borrowing / leverage) prime brokers chain-reacted in the ensuing securitised mortgage crisis of 2007.  Amid systemic crisis this credit-squeeze also caused a series of hedge fund blowups, including Carlyle Capital, an affiliate of the Carlyle Group! Also see the case of Anger at Goldman Still Simmers.

Carlyle Capital Corporation, a publicly traded fund which at the time held US$21.7 bn of securities (though it had only raised $300 mn equity through the fund IPO and listing on Amsterdam Euronext exchange!), was served with a default notice from one of its prime brokers after it failed to meet initial demands for just $60m of margin calls in March 2008. This case and FPM’s database shows how hedge fund firms and their funds can blow-up even though they have a large and powerful affiliate. Carlyle Group which had assets of US$75 bn at the time provided only a $150 mn credit line to the fund, which was the limits of its exposure.

FPM reiterates a yellow-flag warning on the prospect of "distressed domino-effect sellers" of hedge fund and manager allocations. The author suggests a growing ‘secondaries’ in alternative manager and fund stakes.  The systemic-effect concern stems from numerous potential risk scenarios according to developments in hedge funds and the tectonic shift in financial services, which FPM monitors as Accumulating Risk Trends (ARTs). Some of these ARTs we follow at FPM are listed at the foot of this article. For example, the development of buyout firms buying stakes in the managers of hedge funds or other affiliations by varying degrees of investment poses threats. The author of this FPM alert experienced first-hand the UK split-capital investment trusts implosion (British version of mutual funds with preferential and other share-classes). Eventually these regulatory body authorised trusts, which were meant to be safe, were investigated and fined for mis-selling despite their hindsight-evident concomitant risks. A fiasco that ensued once cross-holdings multiplied the effect of leverage, leading to debt covenant breaches and fund closures at the height of a general market de-leveraging cycle of 2001-2003.

In extrapolating split capital investment trust experience, FPM foresees a scenario of hedge fund cross-holdings, especially between implicitly leveraged credit management units, turning sour! A domino effect of tumbling hedge- and private equity funds valuation, through LP-share redemptions or private market value (PMV) deterioration in the buy-and-hold GP stakes, would shake the foundations of alternatives if Carlyle experienced capital-flight for “whatever!” As a reminder, the tangled web-effects of Lehman’s cross-holding and counterparty relationships are still reverberating. As with Amaranth blow-up, long-term fund investors and GP stake-holders in it would have ended by receiving little residual value. In FPM research-integrity, we do not understate that Amaranth’s demise benefited the other sides of its failed trades, in the zero sum game.

To really get a domino-effect or contagion from a credit hedge fund blow-up scenario, a bubble first needs to blown. Last wave of fear was triggered in subprime mortage loans, could the next economic impalement come from leveraged loans tied to buyout activity in corporations souring! So noticeable that other large private-equity firms are inevitably buying CLO funds / contracts in a bid to capitalize on a recovery in loan prices (which we at FPM benchmark with S&P/LSTA US Leveraged Loan 100 Index). Carlyle joins Blackstone Group via its credit-arm GSO Capital Partners, and a host of other managers like Deerfield Capital Corporation, in acquiring investment firms or debt funds recently. Also, in June'12, in unison with other PE managers who have opportunistically expanded into traditional and alternative assets, Kohlberg Kravis Roberts, one of the oldest PE business models, purchased an existentialism-hit fund of hedge funds player Prisma Capital Partners. For Carlyle, this trend of PE diversification by adding alternative managers was envisioned and initially developed in 2008. However this attempt to add hedge funds failed when the firm liquidated a pool hurt by investments in mortgage securities as property prices declined and credit markets froze at the onset of the financial crisis. Highlighting such waves of consolidation in alternatives and considering their impact is this premise of this note, and consultancy service that FPM is embarked on. 

A large credit hedge fund blow-up may not cause economic waves but will have ripple-effects on already dented investment portfolios at pension managers, treasuries and other pooled financial savings. Needless to remind industry main-stayers of the widespread panic from LTCM-collapse ensuing from Russian debt debacle of Autumn 1998; similarly Lehman and Bear Stearns collapse from mortgage loans should loom large in memories still! These last two were larger interweaved entities that arguably should not have been allowed to founder by the authorities. While those and MF Global’s bankruptcy reach financial media headlines there are numerous others that will not be heard-of by busy investors. Hedge funds are not only getting larger in assets managed, but also in terms of their numbers, as the sub-text premise of this note indicates. So it stands to reason that some AI managers will become behemoths and others will launch with a strategic partner/s then strive to stay afloat or destruct on stormy / rainy investment days, with or without affiliate’s help.

And as if on cue to validate FPM visionaries: STOP PRESS! Stark & Roth LLC is winding down its multistrategy hedge fund. The firm better known as Stark Investments announced this in a filing with the state authorities in 6th July ’12 Friday. Also, read about related impact of shareholders of the crisis at broker Knight Capital Group. This thought-paper blogged at end-June!

One of the earliest observation of this cross-holding, in particular via FOFs in-play-transaction trend was in 2007 when TA Associates, a significant specialist player in financial services transactions / deals bought a minority stake in K2 Advisors, which was then a UDS$5.5 bn AuM FoFs. Which had been transformed into a US$10 bn AuM firm by mid-2011. TA Associates was not only acquiring steady and diversified revenue streams but also significant client relationships. Relationships that FPM understand will help identify single-manager hedge funds to be in distress or otherwise put into play as a fund manager transactions. Other positives that FPM notes from cross-holdings, since transactions have myriad and opaque motives would be in the interest of acting as a cabal, coterie or cadre. For example, affiliated M&A arbitrage hedge funds discretely cooperating can effect board changes without breaching “ownership-percent-threshold” and triggering ‘posion pills’ (which more than 2/3rd of S&P 500 companies have as defences against hostile takeovers). 

Finally, as a self-fulfilling flow to FMTs, we consider whether Carlyle will turn their 2011 interest in K2 Advisors fund of hedge funds into a financial or strategic buy from TA Associate and K2 management. Deal terms and intangibles willing.

Accumulating Risk Trends – ARTs in Alternative Investments:

Stability of repo financing arrangements
Limits of advisor / management’s exposure for losses
Effectiveness of reassurance about undrawn credit lines
Chinese wall issues between PE and hedge fund activities
Opaqueness of leverage levels from multiple prime broker use
Heightened government and regulatory environment e.g. new whistle-blower rules
Capacity constraints on performance of larger managers and ‘style drift’
Sub-critical mass of small to midsize management firms
Degrees of manager connectivity in fraud, insider dealing and other breaches
Loan servicing and refinancing difficulties in high interest rate environment
Commodity and leveraged loan products risk – a time bomb!
Mass wealth destruction in assets e.g. bonds via higher dispersed-inflation