Global Stock Markets Are In A Funk

As a current turning point, there are both obscure and vivid examples of the market clearing of bad loans (referred to by degrees as delinquent, non-performing, forbearance, distressed etcetera) as reaching its conclusion.

Stop Press: Due to the Splash Crash Precipated by Dow Jones Index Average's -4.3% Crash Yesterday... This article is a digression from other piece I was completing "Credit Markets @Optimistic Workout Inflexion Point"

The microeconomic aspects of the bubble economies of 2003-2007 are and were being fixed at the expense of macroeconomic monetarist expansion policy, kick-started by Alan Greenspan. This in some cases leaves countries overly indebted and exposed to short-selling attacks. Led by feral bond vigilantes and crowding bond traders, using bond-shorting and –leveraging devices like credit default swaps (CDSs), can bring vulnerable corporations and even countries to their knees. Similar to housing monolines and CDOs being shorted through CDS during the housing asset devaluation by MichaelBurry, John Paulson et al. 

Coincidentally, while global stock markets are in a funk (@time of writing the Dow was closed after plummeting -4.31% for the day!), the remedy now has to be tough love. So that means NO QE3! Monetary policy predecessors served only to create bubble in commodity asset plays while aiming to restore confidence in a widely acknowledged and prolonged de-leveraging cycle. Quantitative easing et al has arguably produced a soft-landing since 2007, but unless non-monetary self-preservation policies are in place, monetary-plaster-fixes are not the intrinsic value solutions. Economic soft-landing via monetary policy fix for a problem created by money-gamers politicking is only a pyrrhic victory. An oft used analogy criticising Friedman-type Monetarism (versus say Keynesian Fiscal) is of giving uncontrolled heroine to an addict to help him out of addiction. In some instances and under certain circumstances this has worked as a remedy, so social and drug workers inform us.

If I was President of the US, my policy response now is a threefold intrinsic value solution:

1)      The shock-treatment of increasing Federal rates by 25bps. Yes initially painful, but as dust settles inflation is introduced into the system; and as Barton Biggs commented: reducing debt by devaluing it through inflation is less painful than capital destruction. 

2)      Dampening capital markets’ clear over-exuberance by restricting naked shorts of sovereign and strategic-interest corporate bonds for foreseeable future

3)      Introducing a fiscal expansion programme (rather than a monetary one) of rebuilding housing sector by initiating and funding programmes to improve existing housing-stocks’ energy efficiency (I seriously don’t believe climate change is solely a phantom problem). 

So here I have conjoined monetarist, fiscal and regulatory fixes to stop befuddling through this deleveraging cycle (which is expected to last 10 years according to economists Reinhart and Rogoff, who penned “This Time Is Different: Eight Centuries of Financial Folly”).

Hedge Fund Performance Since July 2007

Studying the last four years of hedge fund performance ending-June 2011, we at FPM are able to notice strategic investment trends, as depicted by various hedge fund strategies and their dynamic risk metrics.

Click to view chart

 In Numbers: All Hedge Fund Strategies:  

Table 1: CLICK (and zoom) to view full Table

(or email FPM to receive Word format version: Kristian)    

Performance Observations:   

Based on above chart and  table we can identify many investing trends. In the table the green and yellow highlights reflects best and worst performance metric under consideration.

• The top compounded performance of Relative Value Fixed Income Asset Backed  strategies, gaining 40% over 4-Years to end-June 2011, might be unexpected and warrants analysis. Structured credit isn’t toxic after all! (See FPM's Credit Markets @Workout Inflexion Point).

• Emerging Markets Russia / Eastern Europe Index cumulatively lost 19% versus 12% loss for the S&P 500, deserves scrutiny over use of hedge fund label - more likely “a beta masquerade”. Latin America-focused emerging markets hedge funds did better, up 22%.

• Macro hedge funds (especially Systematic Diversified) offered the best protection against the worst of the credit crisis, down 0.6% in the worst 12-month period. The aforementioned proxy on Russia/Eastern Europe Index lost 88% between Mar’08 and Feb’09.

• Of Equity Hedged strategies, Short Biased Index  as expected had the least correlation to the general market as proxied by S&P 500 and also the Hedge Fund Composite Index.

• FPM’s forward looking analysis suggests directional strategies may benefit most from on-going debt-overhang workout, reform and confidence-restoration trends (e.g. the Russian / Eastern Europe sub index has bounced back 47% over 2-years to end June’11).

• Due to the effects of currency fluctuations, the hedge fund weighted composite index performance, based in Swiss Francs (CHF), is half that of the US-dollar composite index.  The appreciation of the Swiss currency to the US dollar diminishes dollar-based returns.    

 The four-year window of observation was chosen as it coincides with when the FPM author last practised in institutional investments, allocating treasury money to hedge funds.

During this sojourn, as a self-starter initiative, K Kristian Siva is designing and developing the Fund Portfolio Management (FPM) programme for Alternative Investments enterprise implementation. 

The Media's "Straw-Man Fallacies" about Madoff and Rajaratnam

The Straw Man Fallacies  is a list of falsehoods in logic and rhetoric.

It’s not a coincidence that during financial crises there is often continuous and focused attention in the popular and specialist financial media about white-collar corporate crimes. Press articles about the leaks, allegations, investigation, charges, court proceedings and even about lengthy jury deliberations. Such articles' overall purpose is to seed the suggestion that retribution against corporate misdoings is in process. The publications’ other subtext purpose might seemingly be that “crime does not pay!” etcetera. We are reminded that institutional media can often be less about informative, didiactic or anecdotal stories / news, and more about hidden agenda-driven entreaties. 

During the last downturn, dubbed “TMT-bubble” between 2000-2003, we heard much about Enron, Paarmalat and other frauds; yet the lessons were evidently not learnt.  In 2007-2009 the global capital markets nearly collapsed with imminent global systemic financial failure. An all important, global commercial paper market for short-term funding, used widely in the economy by corporations and financial services, literally ground to a sytemic halt. The real assets were different from the dotcom era bubble, this time it was housing and the financial sector bubbles. The similarity was the prevalence of the notorious structured products from securitization tied to housing and off-balance sheet liabilities. 

The media attention on one or handful of cases and /or figures being made a scapegoat serves only to propagate a distorted, exaggerated or misrepresented premise. Hitler’s contrivance was that, “All effective propaganda has to limit itself only to a very few points and to use them like slogans.” Relating my article’s headline point to one of the many Straw-man fallacies, the best fit was with the fallacy of “Biased Sample”. Also Known as, Loaded Sample, Biased Statistics, Prejudiced Statistics, Loaded Statistics, Biased Generalization, Biased Induction.

Clearly, the mass air-time and clolumn-space focusing on the long-running insider trading court case against Raj Rajaratnam, of Galleon hedge fund, and the notorious Bernard Madoff, using the Ponzi scheme fraud, is intended to convey justice prevailing. However it detracts attention from the persistent and on-going white collar mischief in financial markets (or for that matter any professions, for example, UK parliament member’s expense scandal unfolding in 2010). Also, such decoy-news takes focus away from regulatory battles taking place between hardliners and laissez-faire believers.   

Also, diverting attention “to a very few points” of reference like Madoff and Rajaratnam helps deflect stark negligence or sheer incompetence of those charged with looking after the fort i.e. executive management, quasi regulators and other authoritative oversight entities. Not quite the holistic picture is presented.

So why does the Financial Times newspaper visit Madoff in prison? Not that Gillian Tett the FT's well regarded journalist is undiscerning, but more that she is compartmentalised in her thinking and publications by an age-old institutional media machinery, designed to serve the community which it represents – in this case the financial services versus all others. Media savvy, in using investor relations, public relations, lobbyists etcetera, are the key function in diseminating straw man fallacies about a position. 

To give statistical evidence to my point  about “iceberg theory of financial crimes” and media’s role, I cite these: Since the beginning of 2007 there have been 70 fraudulent cases in hedge funds alone, including Madoff, as shown in HedgeTracker Hall of Fraud listing). That’s almost 20 cases of fraud a year in hedge funds (HedgeTracker data ends with last fraud listed in June 2010, with Luis Felipe Perez’s Lucky Star Diamonds, operating yet another Ponzi scheme).

Also, FT’s Alphaville column reported in “Insider trading investigations, continued” :

            “…We’re now approaching 40 people charged with insider trading in the sweep of Galleon, PGR and other employees, and it’s worth pausing to reflect that these have come about via an incredibly narrow field of investigation: mostly via one expert network’s activity across one sector (tech) with relatively paltry amounts of alleged illicit profits. It’s moving from the periphery to the core, but the scope remains small.”

Just to clarify, the Galleon case has swept-up 40 people related to one “expert network”, namely Primary Global Research LLC, an independent research firm that links experts with investors seeking information in primarily technology and health-care.

Any effort to identify in list-form the number of pending Securities and Exchange Commission investigations of insider trading focused on other hedge funds and other sectors... well its an impossible task! - as SEC cannot publish these investigation due to wrongly inflicting irreparable reputational damage on parties concerned, before the verdicts. However, OnWallStreet.Com they have given some indications in "FINRA Clamps Down On Insider Trading, Expands Communication". FINRA is the acronym for Financial Industry Regulatory Authority, and their work has “resulted in more than 250 referrals for possible insider trading cases sent to the SEC ” in 2010 alone.

The reader of this article is advised to make the clear distinction between the Madoff and the Rajaratnam cases. One is outright fraud and other challenges the market-integrity under securities trading rules. Two very different segments of corporate crimes. Both offences being in financial services should not subconsciously be interpreted as all wrong-doings are caught. 

Stop press, what’s this? Hot-off the press on 25^th May 2011 from SEC website: 

SEC Adopts Rules to Establish Whistleblower Program

These SEC rules regarding whistle blowers was marginally voted in by 3-2. The new regulations required under the Dodd-Frank Act are supposed to give bounties / incentives for employees to come forward with information that helps towards cutting out securities problems. At the same time, the rules are intended to enforce internal compliance efforts to be bolstered. So it seems the authoritative oversight entities are fighting back! However, the cynicism of this author doesn’t allow too much glee, as he knows “the devil is in the detail”. 

So for who does this blog article mean “economic work creation”? – obviously for the legal profession and compliance departments, but by implication also for hedge fund due diligence staff.

The due diligence work of multi-manager / fund of hedge funds operations becomes critically crucial in determining the “moral compass” of fund management operations. Those managers who operate in unspectacular but morally modest ways are beneficiaries of intended clean-up in securities operations. Some critics of hedge funds may suggest that the “edge” in hedge funds come from unfair means. Implying that increased regulation of formerly unregulated asset managers (“shadow banking!”) might take the wind out of hedge funds, and for that matter private equity sails. The author of this insight hesitates in his assertion, since industry regulation amendments tend to come and go. Once upon a time, the first Glass-Steagall Act of 1932 came on the back of the Great Depression, and moving fast-forward in time to the start of this Millennium we saw Sarbanes-Oxley, and now the Dodd-Frank Act. 

In light of the media's iceberg-theory  presentation of frauds, insider trading and regulatory changes, those making institutionalised direct allocation to hedge funds without sufficient infrastructure, or in-depth industry relationships or longevity of game better watch out. Investors with institutional due diligence on boutique asset management operations shouldn’t just conduct tick-box exercises, but relevantly, understand what I call “process-principles” i.e. understanding the micro an macro aspects of an operation’s processes and principles, so as to be able to identify inconsistencies and irregularities in systems. Indeed the institutionalisation of hedge funds has provided many positives, among them  is the greater transparency of managers, but this may equally let in complacency .i.e. tick-box due diligence.

In conclusion, “creative-destruction in economic cycles” moves in alternating waves and trends, Madoff and Rajaratnam are just two names, like a festive sacrifice to the powers. I believe in an impending tsunami of alternative investment personalities and entities in difficulties. Notice the current trend of numerous offshoots of proprietary desks, whether originated from global investment bank desks, like Goldman Sachs luminaries, or from Julian Robertson’s “Tiger Cubs”. 

The continuum of evolution and adaption by the alpha-seekers, fairly or dubiously, makes it implicit that principled understanding of micro cycles in the big picture enables them to stay ahead of the game, whether by deploying media fallacies or despite them.

27^th May 2011

AuM FPM

By K K Siva

Hedge Fund Performance Through Credit Crisis

Hedge Fund Performance Analysis:

> Time is circa 3 years since the onset of the US-housing led global recession. A timely look at hedge fund performance justifies with caution the new asset class.

> Using data from the leading hedge fund index provider and Fund Portfolio Management (FPM) analysis, the HFRI Fund Weighted Composite Index gained 5% versus the S&P 500 loss of 20%, over the three years ending November 2010.

> The best performing hedge fund strategy (as highlighted by FPM's many "Green for Go" in the above Perfomance table) are Macro hedge fund strategies: returning the best compound return of 15% against other hedge fund strategies and market benchmarks, over the said period. Notice that macro funds were the leading performance in terms of 10 of the 12 analytical metrics. FPM’s sub-sectoral analysis reveals that the “Macro: Systematic Diversified Index” returned 23%, contributing to overall macro strategy outperformance (sub-sectoral analysis not shown in table - available on request only).  

>FPM’s analysis highlights in yellow the worst performances per analytical metric in the considered set of investments. Indeed “Yellow Alerts” galore for the Market Index – S&P 500; including worst drawdown / loss of 17% in October 2008 (not visible in table), time of Lehman bankruptcy. The broader FPM Level II shows that “Emerging Markets: Russia/Eastern Europe Index” was the poorest performer with 6 out 12 lowest metrics of entire hedge fund indices and S&P 500.

> Careful conclusions drawn from the performance of the asset classes (i.e. between bellwether US equities and alternative asset hedge funds) shows that hedge funds overall preserved capital, which is one their raison d'etre. Additionally, that hedge fund’s premise of dynamic asset allocation is best exemplified by macro strategies over the long-term.

> Notable is the -9% loss in the fund of hedge funds (FoHFs) sector, as displayed by the Fund of Funds Composite Index. In context, this performance is still more than 50% better than being invested in long US equities. The FoHFs loss does raise concerns about the business model’s benefits (especially if considered in a parochial absolute performance context).

>  Some investors may find it a surprising that emerging markets strategies produced lower volatility than the developed market equity benchmark the S&P 500 (16% and 22% annualised standard deviation). FPM understands that the risk-focus of the hedge fund model contributes to this lower volatility. That said, the volatility metric of emerging markets is also the highest when compared just to other hedge funds. FPM believes volatility is indeed a characteristic of general emerging market investments.

> As highlighted by “Yellow Alerts” the emerging market index suffered the worst drawdown of all the strategies over the 3 years to end November 2010. Drawdown, which is defined as consecutive months of negative returns in the investment / index, was a dismal -45%. What is not visible on performance table (only FPM’s Excel-based comments shows the drawdown periods), is that this run of negative monthly returns from emerging market focused funds occurred between June 2008 and February 2009; a notably heightened period of systemic market stress, encompassing massive subprime related write-downs and Lehman’s demise.

> Only a few considerations of hedge fund analysis were observed using the above longer-term 3-year window of performance (December 2007 to end-November 2010). Hedge funds performance viewed over the last 2 years (as in performance table below) shows some differences, what a difference a year makes! as recessionary fear abates and the credit-led crisis works out.

> Notable that Relative Value index shows more “Green for Go” metrics: for example, with Sharpe ratio of 3.89 the sector demonstrates the best return per unit of risk (volatility / standard deviation). Macro strategies, which over 3-years looked like the best performing strategy, but over this 2-years window now looks relatively lacklustre, especially with 0.66 sharpe ratio. Suggesting volatility in all investments asset classes and difficulty in tactical asset allocation.

> FPM’s Excel comment (not visible in above 2-years performance table) indicates that Relative Value strategies had their peak performance over 16 month period (between January 2009 and April 2010), where consecutive positive index returns produced a staggering  28% outpacing the Macro index showing of just +4% over the same period.

Additionally, the best sub-sectoral strategy within the total relative value universe was asset-backed fixed income.

> Complexity of constructing a hedge fund portfolio is even more entangled if one looks at the last 12 month to end-November 2010 performance, as shown in table below. 

> In the past year of modest global economic recovery and debt work-out for the credit-weaned businesses and individuals, the relative value sector seems the best strategy for selection. The strategy includes credit-focused hedge funds in asset –backed securites and convertible bonds (Click HFRI Indices Classifications to see what comprises the Total Indices).

> Comparisons of FPM’s performance metrics using HFRI indices (or even individual hedge fund NAVs) facilitate tactical asset allocation through observations in quantitative terms of hedge funds. FPM’s author, has aimed to provide basic qualitative observations from the performance table.

 

> Hedge funds as an asset class has not widely been embraced by investors (compared to say ETFs). FPM believe hedge funds are here to stay and that they will eventually converge with mutual funds, with inevitable issues to be ironed out of infant industry in institutional stages.  Yet this crisis (as previously with the 2000 technology bubble), has shown that active management and investment technology combine well for riding out difficult markets ie ones without clear secular long-trend rallies.

FPM endeavours to educate and convey aspects of hedge fund investments.

Please contact FPM’s editor Kristian Siva (ksiva@talktalk.net) for further information.

The Devil is in the Deed-Tail

Updated 21 December 2010: The tail end of June is half year mark and  brings in the tidings for the rest of the year, as does July with the 1H reporting season fully underway. Specifically “tidings’ about economics and investment markets outlook. As 'half-time' corporate and economic results are reconciled with earlier budgeted expectations, the rest-of-year's budgets can be forecast.

Taking a planned-for-event  headline: "BNY Mellon's Little joins Kedge Capital to build global multi-boutiques business", and interpreting this 2nd half strategic plan suggests decision-makers at the helm (mainly people who put their money where their mouth is!) consider that this is a good time in the business cycle to expand an existing business.
A little research into the headline suggests that multi-billionaire Ernesto Bertarelli (commercially-famed for the family biotech firm Serono and it's sale to Merck in 2007), is spearheading the venture to develop a global asset management business by buying “typically single-manager asset management business in both the long and alternative space”; Kedge Capital is the 100-personnel family office assigned with managing the wealth of the Bertarelli clan.

Professional acumen reading between the line suggests that either a) valuations of asset managers are expected to decline further, b) valuations are already near bottom or c) valuations beginning to rally. The latter observation is trader’s idea “buy on the up and sell on the down”.
[Post-publication edit: Indeed asset manager valuations are intended as a indicator of overall financial and economic health. The numerous demand and supply factors that affect valuations are both macro- and micro-issues in regard to the reference entity. If asset managers are to be acquired that signals expectations about financial asset performance and trends in money management. End-edit]

Since proverbially, the devil is in the detail: Jon Little is not expected start till later this year in November, after leaving BNY Mellon this Friday and gardening leave. Further, the headline value of this enterprise might be of greater impact than the actuality in the end (if plans do unfold at all).

So one may be able to see what this lack of immediacy on expansion plans augurs for the market and economic expectations. No great turn-around in economic upswing is in the offing; and in fact the much vaunted double-dip recession is still possible. How close were we from economic and capital markets tail-spin which was only averted / postponed after over 6 months of discussions to rescue Greece. Lehman, subprime, housing problems etc would seem insignificant to a sovereign default especially of an EU member country.

As discerning readers know, akin to taking the pulse rate, headlines augur bullish or bearish wishes / fulfillment depending on its public relations value and the confidence sentiment of the reader.

One can be led to believe that the economic and investment climate is one of the severest since the Great Depression, and even that we are emerging already from it, as has been analysed in this excellent "deduction-by-mechanism" presentation in Daniel Booth's "An overview of US monetary policy - the implications of quantitative easing Nov08".

The reality-and-rhetoric-check tells me policy makers have indeed pulled the rabbit-out-of-the-hat and confidence verges "recovery" not "depression", but on closer examination of macro and micro considerations (never mind 'black-swan' geopolitical risks such as wars, austerity , and weak-links), strongly indicates an uncertain path with pitfalls especially for financial markets. For example, examine the banking and automobiles industry half-year results FT Lex: HSBC and FT Lex: Global carmakers. The Devil is indeed in the Deed-Tail. [kks/27/07]

Volker Rule Retraces & Enhances Glass-Steagall

The "Volker Rule" loaded with reforms to banking activities today was presented to the Senate Banking Committe (Volcker's Testimony to Senate Banking Committee) . It is of no great shakes!

If the rule passes and becomes enacted as legislature, as opposed to populist appeasment rhetoric, it will only wind-back and fine-tune the the Depression-era Glass-Steagall Act. This Act went a great way to dealing with systemic crisis of the day in the 1930s. This act was at the beginning of this Millennium repealed. The effect of which as we all know with great "Harry Hindsight" was to blur the lines between investment banking activity and commercial banking activity, or in the cant: the "Chinese Walls" were torn down.

The implication for fund managment firms is big: presumably they become the only game in town with legitimate proprietary trading books. Does that mean we pile into the listed active managers like Fortress, Blackstone, or UK versions like Ashmore and BlueBay at the expense of Goldmans? (Noticiable the intra-day plummet in the GS stock on the day of Volker's speech to the Senate Committee, also the daily closing price jump of $0.43 or 3.33% in Blackstone stock; GS closed up $3.81 or 2.49%). Not the worst relative value trade trading theme in the play-out of the "Volker Rule" jacanory, yours truly believes.

While GS and Morgan Stanley and few others of the US market find ways to circumvent potential loss of proprietary trading income, Volker did give with the other hand. A wind-fall opportunity for investment bank's corporate finance to underwrite and advise on mergers and divestitures of dark pool trading entities ie hedge funds and private equities. As a conseuence we can look for the next saga of this, I imagine a "too big to fail" hedge fund like LTCM or other will become prominent or come to the fore. The game just moves on, never eradicated.

Also, as sure as the "Volker Rule" in diluted-form will come to be enacted in the US, there will also need to be a global-wide initiative to shore up systemic-risk banking activities. (Recommendation: Buy listed fund managers and sell investment banks). KKSiva 2/2/2010

The Calm Before the Storm

Instead of re-cycling what is predominantly out there as views on macro and micro developments I aim to emphasise my bearish view towards March 2010.

These two website analyses are from somewhat knowledgeable bears (aside of Wall St Journal / Bloomberg headlines or mainstream hacks: 1) pragcap.com hears Felix Zulauf of Zulauf Asset Management 2) SeekingAlpha.com's Double-Dip Recession View.

The patched-up economy is just that: real unemployment is still at depression-level highs, the housing-bubble has not been allowed to burst properly, while corporations have been quick to recognise and act upon the 'recision-period', have not seen revenues increase. Corporate revenues cannot develop in a climate of consumer fear about jobs: finding one or losing one; and corporate fear about interest rates ultimately rising, but maybe sooner, and if not sooner why not?

Well, it may be that prolonged recession plays out in the real economy (skin to Japan's lost decade or similar to the Great Depression), while the Street will certainly soon expect to consolidate after state-aided momentum / herd-rally since March 2009 lows.

I felt apt at using the weather analogy: the calm in the eye-of-the-storm because of Climate Change devastations like Haiti and Japan’s fourth largest bankruptcy of flag-carrier JAL having less than a ripple in the markets. Investors are presumably de-sensitised in the World of Calamity as the Noughties ends and we enter a new decade.
Those who chose to exercise longer-term memories will realise this “patch-up” economy will only work for another 2-3 period before a Calamity is brought into focus and fear is rife – no not just new orthodoxy of shorter business-cycles; but an irreverent tinkering has been delivered to economic workings. Just like more extreme weather events (hurricanes, cyclones) and seasonal volatilities is new fact of life from the Climate Change. Again we turned a blind eye or at least we tryust the Government’s lip-service, but really no concerted effort to tackles the heart of the carbon reduction problem. Enjoy the Calm.