No Smoke Without Fire!

 

FPM's Bells and Whistles!

No Smoke Without Fire: Of Reputation Risk

Q. How can an investment firm be really worried about reputation risk and at the same time cavorting with a web of securities fraud affiliate?

A. Because ‘institutionalisation’ has created ‘big fish’ with manageable concern about the fall-out from ‘smaller fish’ troubles...

Fund Portfolio Management (“FPM”) have been observing the financial news about the vehemently committed affiliation of publicly listed Blackstone Group (“BlackStone”) and the web of securities fraud surrounding hedge fund heavyweight SAC Capital Advisors (“SAC”) and its billionaire eponymous founder Steven A. Cohen. Forbes recently ranked Mr Cohen as the 117th richest man in the world with net worth of some $9 bn.

Blackstone formed in 1985 specializing in private equity, with current asset under management (“AuM”) of $218 bn, as at end-March 2013. “Blackstone is sensitive to reputation”, was recited like a mantra to the author of this research during a due diligence meeting in 2007. With any sense of responsibility to its investors, the market reputation of SAC or related headline risks should have sent Blackstone scuttling for the exit doors and severing links long ago. At time of writing, with extended SAC redemption date approaching on June 3, Blackstone is astonishingly still invested with its client’s capital in SAC.

SAC Capital Advisors started out as opportunistic long / short equity and is now multi-strategy hedge fund formed in 1992 and with current AuM of approximately $15 bn. More than half of the assets belong to Mr Cohen and SAC employees. For investors who’ve had their head in the sand, SAC has been on the back-foot about insider trading other securities fraud cases for six years. The recent arrest of SAC’s most senior fund manager Michael Steinberg by FBI agents, has escalated the court proceedings with trial date set for November. To date nine current or former SAC employees have been charged by the US investments regulator the Securities and Exchange Commission (“SEC”), with convictions, jail sentences, fines, forfeitures and in one case the largest insider trading settlement of $602 mn. Mr Cohen has been portrayed as at the centre of this web of securities fraud but as yet only implicated and still uncharged.

As hedge funds are a people business, with ‘key man’ concerns, the character and moral compass of the principal at SAC is the categorical imperative to reputation. Even far back as 1986 Mr Cohen was investigated but not charged for insider trading. See the exclusive ‘Litany of Litigation’ compiled in the full research.  More than a quarter of a century later the US investment services regulator, the SEC and other government agencies are still targeting him in securities fraud. For this FPM alternative independent restricted research entitled ‘No Smoke without Fire’, we draw affirmative conclusions about Mr Cohen’s part in a long history in a web of securities fraud.

By Blackstone publicly allying itself to controversial capital-outsourcing vehicles such as SAC and other convicted insider-trading funds in the past, such as Diamondback Capital and Harbinger Capital – the inflicted reputation or headline risk could conceivably be more than a minor due diligence embarrassment. In fact FPM have recommended a downward stock price target for Blackstone (BX). Blackstone, via its Hedge Fund Solutions group / BAAM (founded 1990, AuM $48 bn as of 31 March 2013) is reportedly the largest or one of the largest ‘outside-money’ investor in SAC with $550 mn allocated.

Reputation damage, like forest wildfires, once started can quickly spread, given the right conditions.  Adverse reputation can indeed cause material damage to the hedge fund and its investors, litigated-stock investors (class action law suites from insider-traded stockholders) and the AI industry reputation again tarnished. In the end, FPM foresees SAC forced to close doors to external money. For SAC’s last mid-February redemption window, notices were submitted for $1.7 bn of asset withdrawals. FPM doubts SAC offset those ‘guilt by association’ redemptions through inward subscriptions, while ensnared in battle with federal regulators of the US.

In March, US District Judge Victor Marrero had ethically questioned the record $602 mn settlement being a satisfactory verdict in the long-running litigation of Matthew Martoma and CR Intrinsic of SAC by stating:

"There is something counterintuitive and incongruous in a party agreeing to settle a case for $600 million—that might cost $1 million to defend and litigate—if it truly did nothing wrong…" Judge Marrero, April 2013

Given that majority of securities fraud proceedings have not delivered a culpability or innocent verdict in ridiculously numerous lawsuit complaints related to financial services, Judge Marrero broadly raises question of standards in US legislature…

For the full 25-page research FPM covers a multiplicity of aspects: FPM articulates the long relationship between Blackstone and SAC in ‘reputation risk’ terms and securities fraud within a wider paradoxical context of institutionalization of alternative investments (“AI”). The implications drawn from our research are for immediate action concerning Blackstone and SAC, but also for consideration of long-term AI issues; not just issues of securities fraud and its regulation but asset class performance from convergence of alpha and long-only beta strategies. 

The full FPM research incorporating urgent action recommendations regarding Blackstone Group and SAC Capital Advisors is available on sponsor request.

“No Smoke Without Fire!” substantiates the likelihood of Steven Cohen evading the authorities in an orderly fashion and the negative implication on investor confidence 

To ignore FPM findings is to be dismissive of the numerous independent consultancy warnings about Madoff and his now infamous ponzi scheme.

FPM predicts an imminent hedge fund scandal and fallout from SAC Capital’s trading irregularities and 5-year regulatory investigations.

FPM’s research is an importunate reminder that Galleon Group founder’s 11-year incarceration for securities fraud is merely a ‘scapegoat’ and only the tip of the iceberg.

FPM seeks to liaise with Blackstone and SAC Capital as a matter of confidential courtesy before disseminating the timely research to investors and media.

 ‘You are failing to understand the facts of the case,’ the priest said. ‘The verdict does not come all at once, the proceedings gradually merge into the verdict.’

(“The Trial” Franz Kafka)

Managers of the Alternative Universe

FPM is discerning trends and themes in the fund managers metamorphic landscape. Especially vigilant of established themes as well as emerging ones . Established trends are both at once an issue of concern and an exploitable transaction opportunity for investors and rain-makers alike. The commercial premise of this article arbitrages between Established Alternative Managers (EAMs) and Fledgling Emerging Managers (FEMs).

The process of institutionalization of alternative investment managers, namely, hedge funds, private equity et al is mired in paradoxes and oxymoron. How can a once boutique nimble investment management team producing above-beta absolute returns become an unwieldy behemoth and still produce alpha? In philosophical terms:

"You cannot step into the same river twice: you will not be the same person and it will not be the same water" Heraclitus 500 BC 

These large institutional asset managers whether Ken Griffin of Citadel or Clifford Asness of AQR started as small partnerships with an edge. To FPM that’s what the ‘edge’ in hedge funds should mean! Whether it was their innate talents (almost autistic character traits of principals, such as card-counting and astute gambling skills), and / or the ability to identify, exploit and strike at big opportunistic game, allowed these once hungry-and-angry origin whizz kids to become masters of the universe while compounding 20-30% annualized returns.

The increasing amount of evidence to support FPM’s thesis of the paradox of institutionalization is mounting. We are aware of some giants from the pantheon of hedge funds returning outside investors’ money and reverting to family office status. George Soros and Stanley Druckenmiller are two prominent examples from 2011 ahead of adherence to new SEC rules on registration in March 2012; there are many others. This operational reversion to origins is obviously de-institutionalization. Though managers may cite change as being for regulatory purposes, i.e. to evade the watchful burden of increasing scrutiny from financial watchdogs, it is clear that the financial landscape since the financial crisis of 2007-08 has changed for the venerable old timers mentioned and the like.

However, some heretofore secretive asset managers have not so much thrown in the institutionalization towel as elected to join the process (which we at FPM previously highlighted as the ‘Convergence Story’). To perspicacious FPM principals this evinced ‘asset gathering’ strategic impetus rather than ‘absolute return performance’ efforts. Our due diligence in the past has distinguished between ‘asset gatherers’ and ‘performance harvester’ or ‘alpha generation’ operations. The former tend to have numerically less and even relatively lower paid investment professionals. Asset gatherers are characterized by bigger marketing department budgets, perhaps wielding big hitters in its sales force and / or using specialist brokerage / distribution outlets. By implication the star marketer would also be a partner.

For instance, the once esoteric Farallon Capital Management is marketing itself with a nine-page Institutional Investor article under the financial news service EuroMoney publications. Using the back-story of its illustrious founder Thomas Meyer stepping down at fifty-five years of age, and successor Andrew Spokes being announced as the chief. This is a process of institutionalisation via branding. In corporate lifecycle terms it is a precursor to eventual floatation and other business exit strategies. Perhaps a chance for founders to pocket or release some self-vested equity capital in 10 years or so. In February 2007, Fortress Investment Group became the first U.S. hedge fund to go public. Other one-stop alternatives managers also saw the exit door like Blackstone (BX), Och Ziff et al. Some EAMs had the exit door firmly shut in their face by the ensuing financial crisis which they strangely could not foretell from their capital markets tea leaves, though they were managing multi-billion dollars of institutional money under the premise of economic and financial savvy - Doh!

Of the many ‘pulled’ IPO alternative managers, the potent example I cite is quantitative algorithm guru Clifford Asness’s AQR Capital. His fames needs little introduction to hedge fund aficionados, and needless to say the firm is a heavyweight and managing in excess of US$50 bn at end 2012. FPM foster pioneer strategies and managers as they tend to display their real depths of spirited enterprise. Mr Asness is not only a Ph.D professor who led the group that developed statistical models in 1989 which eventually formed the Global Alpha at Goldman Sacs, but is an advocate against exorbitant fees prevailing in AI. We have tracked that he has been spearheading the charge on high fees at least since 2010. Fee reduction is a necessary feature of the convergence story between mutual fund, hedge funds, exchange traded funds et al. Whatever Mr Asness’s motives, even if not altruistic, he seemingly is admitting that his own technology-based alpha is not especially genius! Perhaps partly the rationale for AQR’s unsuccessful planned cash-out of 10% stake as early as July 2007. We commend his fee integrity (yet as a made-billionaire backstabbing late hedge fund entrants as barriers – You’re ‘Avin Laugh!). In his own words about the state of the fees from a recent conference speech:

"Most hedge fund strategies are more about very competent implementation and fair fees and terms [institutionalization] than they are about 'genius’… Hedge funds generally offer a nice portfolio (gross of fees!) of passive beta, alpha, and a middle ground we call hedge fund beta or style premia; but unfortunately, managers like to charge fees as if it's all alpha” 

At FPM we view the ‘branded institutionalization’ of the alternative investments (AI) industry trend with diligent skepticism. Concerned that a) founding principals with the innovative investment technology wits are operationally and executively not at the helm henceforth and b) merely seeing institutionalization as a stepping-stone opportunity for retirement and/or cashing out from the global institutional operations they painstakingly established and developed. In private equity investor partnering parlance ‘divorce and separation’ is the end. FPM’s reservation on this trend cogitates on the idiom that institutions are now content to invest in the golden egg but not the goose that laid it! Hence why there is naturally a lot of noise about backing fledgling emerging managers in the burgeoning alternative space.

Other than institutionalization features relating to key man, fees, cashing-out, and regulation there are other salient aspects of transparency and reputation. These cannot be irrelevant or ignored concepts, especially now in neural/viral wired-up multi-media cyber globe. Whistle blowers, disgruntled staff, disillusioned investors, anti-capitalism activist, email trails etcetera all become source of unofficial non-public information.  The prevailing reputation of a manager with small asset under management (AuM) is all important to its preservation. Otherwise even any alleged fraud can change its fortunes quite quickly, for the better or worse. Therefore with partnership self-interest they are less inclined to risk their good repute with fraud or other corporate misdemeanor mischief or downright shenanigans. Managers consciously protect and preserve the firm in positive light to the privy circle of co-participants in the ‘edge’ investment game. Degree of transparency to regulators, or institutional publicity in media is often minimal in niche partnership family-office type investment operations. Indeed investment regulation limited whom unregistered investment vehicles could market itself to (‘qualified investors’ only), and to whom the manager had obligatory reporting duties.

Since this note's premise explores why size matters in investments. Investment flexibility and alignment of interests are other considerations when deciding to park with large managers. For instance, on investment position sizing, the principals of the partnership may decide that a high conviction risk-on trade is permissible. Institutional policy tends to be compliant with oversight regulatory bodies. Bodies which monitor and dictate risk parameters to larger registered money managers. An essential feature of alternative investment mandates is the scope of flexibility in investment asset and strategies, within given private placement memorandum. This flexibility is further watered-down in larger institutions as key man / principals may delegate investment risk decisions to vested investment committees.

“Blackstone Alternative Asset Management (BAAM) is the world’s largest discretionary allocator to hedge funds, with $46 billion in assets under management as of December 31, 2012.” Source: blackstone.com

For example, BAAM started out as family size operations:  In 1990, Blackstone created fund of hedge funds business to manage the internal assets and that of its senior managers of the then mainly private equity core business.

FPM’s due diligence identifies institutional managers by the degree of the managers’ alignment with its clients / investors, essentially by a ratio measuring principals’ and internal capital to that of the fund or firm AuM: 

"Most importantly, our interests are always closely aligned with our clients' with over $1.3 billion of the firm's and employees’ assets invested alongside those of our clients." Source: blackstone.com

So US$1.3 bn of “firm’s and employees” assets of a total US$46 bn in AuM is the extent of alignment of BAAM fund of hedge funds business to its clients. This is much much lower ratio than at the turn of millennium, when alternative investments and industry bellwether Blackstone Group came into institutional prominence, at the height of the DotCom bubble. BAAM acknowledges its own asset  gathering impetus on the Blackstone website “Over Ten Years of Asset Growth”. To FPM’s long memory BAAM’s current ratio of mutual investment interest is poor evidence of economic alignment between a firm and its clients. Further, asset growth is not the same as asset performance.

Often profitable niche business is kept close to one’s chest and a privy few as a closely guarded money-making secret. How many professional investors understood or had ‘the edge’ in exploitatively spotting the US housing bubble through the sub-prime market in 2007-09, and then were also able to make an ‘absolute’ killing? Certainly only handful of investors, from reading the Gregory Zuckerman book “The Greatest Trade Ever” concentrating on Paulson and Co.

Damaging reputation to a manager with large asset-base can lead to assets walking out of the door, which can be successfully public-relations-managed as an operable hemorrhage, given time. This mega asset base providing a substantial buffer / margin against sudden multi-million liquidity shocks is the implicit explanation as to “why big hedge fund gets bigger”.  In the same scenario smaller AuM hedge fund firms founder. Large institutional investors tending to pile into the perceived relative safe-haven of hedge funds and other alternatives are sacrificing absolute performance for cash preservation mandate. Understandable that strong absolute return performance is incompatible with cash preservation, but here’s the bewilderment. Even accomplished pension or proprietary capital administrators allocating to hedge funds are overlooking ‘alpha generation’ while allocating in an ‘all-about-alpha asset class!’ Further, these savings administrators believe they have to pay “2/20” fees for core low volatility portfolio cash preservation mandate. Why don’t they invest directly in cash bonds! It’s the same mockery and folly as an airline marketing its premium first class seats as plane-crash-risk-proof. All the seats are the same in the aero plane and subject to the systematic risk of it going down (unless the first class seats are re-enforced with steel bars like that cockpit of fast-car drivers or fitted with parachute ejection seats).

Performance of hedge funds as an asset class, as indicated by a benchmark index average, fared only marginally and negligibly better than equity market index, such as the S&P 500, over the recent systematic financial crisis. Then as stock markets recovered from an approximately 50% drawdown, hedge funds underperformed (and some threw in the towel unable to reach high water mark and thus earn performance fees). In the long-run the convergence story depicts falling alpha and alignment of hedge fund performance with market, asset, or strategy index. Achieving index returns by hedge fund portfolio managers (like conservative FoFs) in absolute return investments is a misnomer or sheer debauchery of AI. Similar to to turning a thoroughbred racing horse or stallion  into a rocking-horse! The tilt in favour of hedge funds comes from alternative managers being able to acknowledge gross of fees…

[ For a complete business proposal based on this note please email FPM with link]

Investment Sector Outlook for 2013: “Credit is a Lover on the Re-bound?”

FPM considers the macro speculation that policy makers’ credit cycle stimulus is in musical terms at a moderata end in 2013. The high flying segments of the credit asset class are behaviourally like a spurned or unreciprocated lover on the rebound to the next ‘pick-me-up’ lover. FPM’s analogy is that eventually this new quickly formed, on the bounce love-affair is checked. And in the end not lasting or enduring, as it was a hastily formed affair from hurt ego and pride following a more secure stable relationship or courting. We feel the stellar ‘dead-cat bounce’ from credit-bubble bursting in 2007-08 should unwind. Especially so in mortgage credits and leveraged loans. Not forgetting that these segments of credit were in greater proportion the underlying constituents of structured products dubbed ‘toxic’ CDOs, CLOs et al. The credit collapse should eventually be precipitated by the un-leashing of inflation expectations. Turning off credit stimulus is the first step. This view rhymes with some professionals predicting a strong equity market rally. Also, in this article we review our credit opinions expressed in September 2011 in “Credit Markets @Optimistic Workout Inflexion Point”. The hedge funds we recommended in that article, such as the Chenavari ABS Toro and the CQS ABS funds FPM put on “Review / Redemption” rating.

Our view is based on policy-lead from the US Federal Reserve and understanding of cyclicality in capital markets. The Fed’s minutes of its recent Federal Open Market Committee’s (FOMC) December 11-12 meetings hinted at reversal of policy by some of its members. Particularly toward halting the policy of monthly purchases of US$45 bn in Treasuries and US$30 bn in mortgage related securities.  Minute extracts:

“Several others [of the FOMC members] thought it would probably be appropriate to slow or to stop purchases well before the end of 2013… citing concerns about financial stability or the size of the balance sheet, which has grown from $869 billion in 2007 to over $2 trillion.”

In hindsight, policy makers or establishmentarianism turning off the bankers’ credit tap has been inevitable, or put another way long-time coming. Especially when considering the subsequent bargaining in ‘fiscal-cliff’ discussions at end-December 2012: whether to continue Bush-era tax holidays for all except US$400,000+ earners. In budgeting terms, something often has to give, or philosophically “be sacrificed”. FPM are aware that until final budget and national debt discussions are concluded in late February /early March there might yet be other compromises in American austerity drives. Set your calendar alarms to March 1^st announcements on this.

After all, how long can the prime-and-pump machine churn-on towards inducing improved confidence and sentiment in economic activities and capital markets. The Great Depression could not be one if it was over in five year! Despite reserve-currencies ‘printing-money’ and the associated moral hazards in an increasingly interconnected global economy, concerted economic policy response has been credit expansion.  Inflation could still well be a scenario for debt devaluation. Inflations has been abated/ repressed or even manipulated in reserve-countries. Statistically, inflation is failing to measure a relevant representative basket of goods and services. Multiple academia and statistical research have distortedly indoctrinated professionals and public that ‘perceived inflation’ was higher than ‘actual’ reported cost of living because the basket constituents that were rising were repeat purchase items like food and other living day essentials. So price of cars or other durable goods and services deflating would be less noticeable, yet these heavily-weighted goods in the inflation basket more influence the ‘actual’ inflation. So like manipulation in LIBOR, we may understand that inflation measurement baskets are not representative to most of the population, who do not buy new cars repeatedly! Admittedly there are other prevalent inflation-mitigation factors than simply a pacifying behavioural finance explanation for biased inflation data. For example, China and other developing countries are globally exporting deflation through the activation of lower cost-base economy and globalisation trends in general.

The above mentioned moral hazard comes from the value of money becoming meaningless.  Capital is meant to be a finite resource in most economic models, even in an open economy.
Yet modern finance practice has advocated printing money aggressively to stave-off recessions and depressions. Castles in the air capital can be written-down to realign assets at fair value. Remember that majority of capital is ultimately quantified and recorded in global accounting and banking systems as assets and liabilities in global forex terms at any one time – excepting “fringe economy” / black-economy activities.

Writing-off of all bad debts based on bubble-valuation of certain house and financial asset prices was not an option for the banks at the onset of the financial crisis. Propping-up valuations interferes with laissez-faire market principles. Cited in ‘main stream media’ due to the strategic importance of housing and financial sectors to the wider economies (…remember even the short-term commercial paper markets froze at height of crisis due to the helm of the then capitalism masters). Even though some $600-800 bn of ‘bad vintage’ subprime was inevitably written-down signalling the catalytic economic downturn. Almost like a script from past crisis. Write-downs are no longer an option, as bank-sponsored toxic assets are now in the hands of taxpayers as collateral for government guarantees and loans. Unsecured lending is not feasible with fragile confidence in counterparty-risk. The better quality credit tranches have been hand-picked by cash-rich investors like Blackstone, Blackrock and other asset managers at fire-sale or heavy discount prices. For now it seems to be a pirate’s or vulture’s bonanza for them and their investors. FPM envisages a probable scenario in which these re-capitalised assets and their underlying debt obligations become distressed as the government credit taps is turned-off. As general interest rates tick higher so will bad debt problems.

If the ‘toxic or legacy asset’ collateral against which Governments have been lending to banks do not continue to perform in line with overall reasonable economic expectation when ‘Quantitative Easing’ stops, then another wave of write-downs and blowup-entities should follow. Fear may persist keeping capital expenditure and corporate deal making shallow. FPM certainly believes in this probability of ‘multiple-dip recession’ cycle started in 2007-08. Markets are reflecting this in sideway trending benchmarks with intermittent bull-runs, flash-crashes and dips. Economists Reinhart and Rogoff have suggested a 10-year of de-leveraging process.

Remember that allegedly towards fiscal-boosting the economy amid a bubble-de-leveraging cycle, the emergent alternative media libertarians (enabled by blogging and internet at large), have slavishly and bearishly flagged and criticised policy maker plaster-fixes. Government will no doubt have assets and liabilities in their ‘bail-out’ accounts that do not match, and therefore require further deficit-funding to keep fundamental balance sheet integrity. Together with ‘austerity’ impact and other public repression possibly causing populist uprising in mainstream European Union and American states, geopolitical risks are high on the cards. Already this is occurring in fringe states. Where protests and demonstrations occurs in UK and US, authorities have only been too quick to quosh it. Witness ‘Occupy Movements’ in London, New York and other cities.

If only vigorous and unabated expansion of fiscal and national deficits of global Governments could continue! To bring the vividness through a comparably simpler model, think of pension funding mis-match in assets and liabilities for settling retirement policies and the consequences on retirees. Many pension-dependent hopes and expectations have again been dashed in these too often de-leveraging cycles. Resulting in postponing retirement or reduced perpetuity income in effect living poorer than promised. Even if retirees were money-wise and fortunate to have multiple assets such as properties and investment portfolios they will still feel wealth destruction. Less retirement homes in the sun are being bought in affordability terms to settling for a mere sunshine holiday.

This is why we believe banks and other financial intermediaries are siphoning off / farming-out money to other institutions as investments. Hedge fund and buy-out firms are filling the void of traditional bank lending and securitisation. This shift in liabilities has hidden risks too. Consider the effect and implications of Volker rule as evidence. The global banks themselves have still to maintain sufficient ‘individual bank-tested’ reserve capital to insure against future non-performing loans and gradually correcting house and financial asset prices. Hence why traditional global banking prospects have and are in the mire (in spite of upbeat ad hoc quarterly earnings reports). Alternative financial firms are rampantly being established as the shadow banking system. If Volker is acting in a  middle-man / double-agent role between financial and government interests, then who is serving? The newly-established asset managers mentioned above and host of others are known to FPM via its Fund Manager Transactions proposals.

Following on from our last thought-leader: Investment Sector Outlook for 2013: “Volatility in Vogue”, some of the above mentioned political market-interference has caused Vix-measured implied-volatility to drop to a five-year low in S&P 500 equities. And no doubt other financial and capital asset volatilities have also markedly diminished. Simply from lower economic activity caused by current and future macro economic uncertainties.  These fundamental uncertainties are referred to in financial cant as ‘sentiment and confidence’. Whether one is a consumer, investor in capital, Government employee or importer/ exporter (gdp=c+i+g+[x-m]), doubt causes catharsis or stagnation until resolve is found in endeavours to carry on economic transactions. The current economic stagnation, or euphemistically anaemic growth, is a macro fundamental fact which has been alleviated to-date by Governments, and therefore by implication future taxpayers. Though we are economically not out of the woods, policy-makers can no longer interfere with free money or ‘crowd-out’ capital investors by effectively capping interest rates. Fundamentally disrupting creative-destruction by controlling the price of capital to save Strategically Important Financial Intermediaries at the expense is taxpayer is moral obliquity and lacking sense. FPM believe policy-makers’ job is done after having successfully prevented economic freefall post-Lehmans 2008, now we feel they should let go off the economic reins and let free markets indulge in creative-destruction. FPM has less care for QE supporting banks and more will for interest rates to rise - yes it does matter whether one is a still net lender or borrower after maelstrom of the past five years.

As if to affirm direction for the economy at this forward-looking time in the Gregorian calendar, we in the UK have seen the headlines about the almost final demise of yet another long standing high-street retailer. His Masters Voice or HMV, a music and media distributor with a 90-years history and currently 230 stores employing 4,000 staff went into administration. This was after failing to secure a £300 mn credit line from its suppliers in a last ditch effort. The bank had breached its banking loan covenants in December. This circumstance surrounding its failure, not too dissimilar to the closure of the venerable Kodak company at the beginning of 2012, not only highlights flaws in its commercial raison d’etre but to us reflects a ‘zombie’ company unable to improve deteriorating asset values on balance sheet while outweighed by its liabilities. Creditor call was triggered without recourse to sufficient internal restructuring. We hope restructuring of the old business is possible in administration and emerging as a leaner brand. We had witnessed other UK high-street brands disappear, mostly new arrivals but also back in 2008 an age-old Woolworths. Behavioural finance suggests that when investors are apathetic to corporate and market foundering news over time then they are also expectant of real good news.  

So we have ultimately predicated that the credit asset class will become increasingly volatile before an eventual correction in prices from a) speculation and eventuality about the inevitable interest rate hikes and b) subsequent credit-quality concerns and defaults in the economy overall and c) triggers / catalysts in distressed credit sectors that have thus far re-bounded and propped-with-stimulus. Such as sovereign debt in European fringe countries with contagion into Spanish and French sovereign debt concerns, student loans in US, credit and consumer loans, commercial mortgages, leveraged loans.

Credit souring is as inevitable as re-bound affair not lasting. Lastly we leave you with a vogue investor’s voice on the credit cycle. Ray Dalio, founder of US$120 bn AuM Bridgewater Associates, speaking at a conference in December 2012 said “The biggest opportunity will be shorting bond markets around the world”. He also suggested that interest rates will rise in late 2013.

FOR A TELL-TALE PERFORMANCE ANALYSIS OF 20 SELECT CREDIT / BOND ETFS,

PLEASE DO CONTACT US: kristian.siva@gmail.com

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 14^th 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 2^nd 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 $37.75 unch $4,579 5,221 14.39% 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 21^st:

“…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 25^th 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 4^th month through to 7^th 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 16^th 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’