In the Great Global Macro Experiment, The Next Bubble to Burst is...
I am going to introduce a paradigm shift in the content that I introduce to the blog. As reporters and institutional investors who have contacted me can attest, I have been very secretive and stand-offish in terms of what I do for a living. The reason is that I was in the process of launching a hedge fund, and my lawyers were quite explicit in telling me that I am in no way to promote the fund through the blog. You see, I think I'm pretty good at this investment stuff, and I needed access to more capital to fully exploit the next step in my investment thesis. So, what better route than to open a fund up to investors who can appreciate my investment style, and take advantage of that 20:1 leverage offered so freely. Well, one of the reasons I have had such a strong investment record is that I am able to smell bubbles. Unfortunately, I smelled this fund bubble coming but I thought I could sidestep it. I seem to have been wrong, but didn't realize it until after I spent an upper middle income family's salary on fund formation. With a raft of adverse legislation, tightening operating environment and increased regulation, this bubblicious industry just ain't what it used to be.
So, I have decided to simply go it alone through my single family office. What does this mean? Well, for one, I can now be much more explicit with what I do in my postings to the blog since I cannot be seen as selling investment management products - which I both do not do and do not want to do. I want to make that clear from the outset, again! I will start being more communicative right now by releasing my own proprietary account investment results and comparing them with the blog's research model, hedge funds, and the US broad market. Here's a sneak preview to bait you into reading this rather lengthy article behind my decision:
I will reveal a lot more in the future, as well as how to compare newsletters, investment advisors, funds, pundits and blow hards on a true risk adjusted reward basis (watch out Cramer!) in my next post or two. But first, a public service announcement...
Hedge funds haven't been performing that well anyway
Hedge funds have experienced historically record losses, record client redemptions, record volatility, and record closures. Sounds like the bubble is burst. There are a few fundamental reasons for theses occurrences (other than there being just too many of them (7,000+ as of last year):
Leveraged loans and high yield securities posted their worst monthly performance on record as prices tumbled to new lows and volatility spikes after Lehman filed for bankruptcy: The Standard & Poor's/LSTA Leveraged Loan Index returned a negative 6.15 percent in September, almost double the previous record loss of 3.35 percent set in July 2007. Leveraged loan prices tumbled 8.57 cents in September to a record low of 79.8 cents on the dollar as financial companies failed and hedge fund managers sold assets anticipating client withdrawals. The selling of assets into falling market always exacerbates the collapse in price precipitating more selling, which leads to a further collapse in price which precipitates more selling. Rinse, lather, repeat. The leveraged loan debacle is covered in explicit detail in The Asset Securitization Crisis Part 27: The Butterfly Effect.
Perfect Storm for Hedge Funds: Short-selling was banned literally overnight, the actual collapse or near collapse of ALL of Wall Street's major broker dealers, a literal freeze in the credit markets and unprecedented volatility not only reduces the possibility for funds to borrow money and hedge through exchanges, they're stuck with forced delivering and increased regulation at the same time they are experiencing their own "run on the bank" as September came to a close, marking the end of the fiscal year for many funds. Forced redemptions in volatile and/or illiquid markets lead to fire sales which lead to lower prices that precipitate forced redemptions which leads to... Rinse, lather, repeat! What also bites is that hedge funds are net sellers of credit protection via CDS in the $62 trillion credit derivatives environment (see The Next Shoe to Drop: Credit Default Swaps (CDS) and Counterparty Risk - Beware what lies beneath! and Reggie Middleton says the CDS market represents a "Clear and Present Danger"!) and were called to perform on their obligations wrt Lehman, WaMu, Kaupthing, etc. The Lehman credit sellers got a dismal recovery rate of 8.75 cents on the dollar, meaning that they have to cough up roughly $320 billion in cash to make whole their credit protection contracts. I hope they have the spare change lying around.
NYT: In the month of July, hedge funds experienced nearly $12 billion in outflows. September 30 was the deadline when many funds are scheduled to accept withdrawal requests for the end of the year. To pay back investors, some funds may be forced to dump investments at a time when the markets are already shaky thus fuelling a vicious circle--> some hedge funds are reported to block withdrawals.
Attari/Ruckes: Redemption feature causes fundamental maturity mismatch with borrowing short term and lending/investing long-term and illiquid e.g. in leveraged loans--> when redemptions increase, hedge funds have no other choice than liquidate assets thus fuelling a negative spiral. Evidence from leveraged loan market shows that this is unravelling is underway. Rating agencies start to downgrade collateralized fund obligations (C.F.O.) which are the hedge fund equivalent of mortgage-backed securities: securities backed by hedge funds. Some have a 7-year lock-up period. While few in number, C.F.O.'s represent a broad swath of the $2 trillion industry.
In terms of performance, this year looks like the worst on record: the average fund is down nearly 10 percent so far, according to Hedge Fund Research.
About 350 funds were liquidated in the first half of the year and if the trend continues, the number of closures would be up 24 percent this year from 2007.
Oct 1: There are dozens of hedge funds whose Lehman prime-brokerage accounts were frozen when the company filed for protection from creditors on Sept. 15. "One executive who used Lehman as a prime broker -- and who asked not to be named because his firm is private -- estimates that hedge funds had between $50 billion and $70 billion in Lehman prime-brokerage accounts." Moreover, hedge funds had pledged equity securities as collateral that Lehman then loaned to other investors under a practice known as rehypothecation - PWC says in that case "clients may cease to have any proprietary interest in them."
Seides (InvestorsInsight): Hedge funds are sellers of 32% of all CDS, insuring exposure of $14.5 trillion. Recent estimates indicate that the entire hedge fund market is approximately $2.5 trillion in net assets under management. Thus, hedge funds are bearing risk in excess of their ability to pay the piper if anything goes wrong--> risk might well land again with former investment banks and broker dealers (what's left of them, anyway) whose exposure to hedge funds are significant, both through their prime brokerages operations and as counterparties. As you can see, there is a risk of systemic failure here. Roubini: "one cannot rule out that some systemically important hedge fund may get into trouble with systemic consequences."
And exactly what was the hedge funds performance?
Let's take a look-see.
|Risk Summary (Since Inception
to 10/10/08 - to Sept. for select indices whose data lags the market).
Source: BarclayHedge - over 2,600 funds
|Sample Period: 16 months||Reggie Middleton Proprietary Account||S&P 500||Barclay Hedge Fund Index||Barclay Event Driven Index||Barclay Equity Long Bias Index||Barclay Equity Long/Short Index||Barclay Market Neutral Index||Barclay Equity Short Bias Index||Barclay Fund of Funds Index||Barclay Global Macro Index||Barclay Multi-Strategy Index|
|Correlation to S&P 500||-34.74%||100.00%||23.04%||60.77%||72.62%||79.05%||39.06%||-84.20%||66.66%||40.67%||67.52%|
|Jensen's alpha: 16 months||9.35%||Not App||0.20%||-0.03%||0.37%||0.12%||0.11%||0.52%||-0.12%||0.51%||0.08%|
As can be seen above, hedge funds do dampen volatility through lessened standard deviation, and provide superior relative returns. Thus on a basis relative to the broad market, they provide superior risk adjusted returns. But hey, wait a minute! Aren't hedge funds marketed as delivering superior "absolute" returns? Don't they preach diversification from the traditional asset classes via uncorrelated returns? Correlations to the US broad market index are actually very high for an alleged "alternative asset class". This means that if you think you invested in hedge funds to offset the risk of the broad market, you have another think coming! Notice how truly uncorrelated (actually negatively correlated) my investment returns have been in this down market. You can see it numerically in the table above, and graphically in the chart above that. This is what invetors should strive to achieve when pursuing alternative asset strategies. It's too bad our government is about to regulate the industry to death, or I may have been able to offer a Reggie powered hedge fund!
Also of note, although the Sharpe and Sortino ratios of the fund indices are higher than that of the S&P 500, they are still abysmal as compared to my results. They are even abysmal compared to a buy and hold strategy based on this blog's research model. If you still think that is worth 2&20, then check out the actual alpha (Jensen's) generated. No single category generated more than 100bp of alpha except for... You know, that handsome, cynical, hard edged brother that blogs a lot.
Readers interested in hedge funds may find it worthwhile to participate in the BarclayHedge Blog. If you go by, tell 'em Reggie sent ya'. Be sure to kick up a lot of dirt about how a blogger tore the pants off of EVERY index that they track, and published the research behind the performance free for a year, to boot. That's one way to make friends over there . Richard Wilson's Hedge Fund Blogger is a much less corporate (the Barclay's spot is really a corporate press kit masquerading as a blog - big financial companies just don't get new media), more interactive blog that contains a lot of info - although none of them have activated the ability to openly comment on the articles. I urge my readers to go over there and kick up some dirt as well. Might as well start some trouble. For the record, more than 30% of the BoomBustBlog readers are multi-millionaires, over 47% make more than $350k per year, and many of them influence decision making in their respesctive companies and firms. The largest demographic of the site, by far, is the financial services industry. The largest occupational tranche is entrepenuer. If BoomBustBloggers are not prime fodder for hedge funds, I don't know what is. Take the BoomBustBlog survey to find out more.
Here are some definitions for those of you who are not nerdy enough to memorize all of these financial and statistical terms:
Jensen's Alpha (From Investopedia, this is the most important measure): A risk-adjusted performance measure that represents the average return on a portfolio over and above that predicted by the capital asset pricing model (CAPM), given the portfolio's beta and the average market return. This is the portfolio's alpha. If this definition makes your head spin, don't worry: you aren't alone! This is a very technical term that has its roots in financial theory.
The basic idea is that to analyze the performance of an investment manager you must look not only at the overall return of a portfolio, but also at the risk of that portfolio. For example, if there are two mutual funds that both have a 12% return, a rational investor will want the fund that is less risky. Jensen's measure is one of the ways to help determine if a portfolio is earning the proper return for its level of risk. If the value is positive, then the portfolio is earning excess returns. In other words, a positive value for Jensen's alpha means a fund manager has "beat the market" with his or her investing skills. Now, armed with this newfound knowledge, revisit the chart above.
Sharpe Ratio: A ratio developed by Nobel laureate William F. Sharpe to measure risk-adjusted performance. The Sharpe ratio is calculated by subtracting the risk-free rate - such as that of the 10-year U.S. Treasury bond - from the rate of return for a portfolio and dividing the result by the standard deviation of the portfolio returns. The Sharpe ratio tells us whether a portfolio's returns are due to smart investment decisions or a result of excess risk. This measurement is very useful because although one portfolio or fund can reap higher returns than its peers, it is only a good investment if those higher returns do not come with too much additional risk. The greater a portfolio's Sharpe ratio, the better its risk-adjusted performance has been. A variation of the Sharpe ratio is the Sortino ratio, which removes the effects of upward price movements on standard deviation to measure only return against downward price volatility.
The Sortino ratio measures the risk-adjusted return of an investment asset, portfolio or strategy. It is a modification of the Sharpe ratio but penalizes only those returns falling below a user-specified target, or required rate of return, while the Sharpe ratio penalizes both upside and downside volatility equally. It is thus a measure of risk-adjusted returns that some people find to be more relevant than the Sharpe. Thus, the ratio is the actual rate of return in excess of the investor's target rate of return, per unit of downside risk.
I know that many will probably try to excuse the hedge fund industry's performance, just as they excused the collapse of the investment banks ran by all of those smart people. I can hear the cackling now, "but no one could have foreseen devastation of this magnitude", "Who could have known?". Well, for one, I don't appreciate being called "no one."
Debunking the "Nobody could have saw this coming" mythos!
Well, if nobody could have saw this coming, where did my returns come from? I actually believe nearly everybody ensconced in the industry saw it coming and were to tunnel vision-ed to act accordingly. I am not even all that smart and I figured it out. Let's walk through this visually. Here is an opportunity to relate my proprietary results to the research that I released to the blog on a month by month basis. See the post "More on the accuracy of this blog's research" to follow the verbose postings and analysis that I used to power through each and every peak and trough on the graph below. You may persue "Actionable Research and Ideas" for research and opinion that is literally time stamped along the lines of the peaks and troughs in the chart below. If there is anything that I am not lacking in, it is documentation. Click the graph to enlarge to full size print quality.
So, no one coud have seen this coming, or guess the magnitude of the damage???!!!
I sold off my investment real estate in 2004 and 2005 (the peak in the NY Metro area was 2006).
I went short on real estate developers, builders, REITS, banks, brokers and insurers, in 2007 (see "More on the accuracy of this blog's research").
I called for massive bank failure in the first quarter of 2008, quite to the contrary of the Secretary Paulson's assertions (that's right, I've been keeping track of the credibility factor of our world leaders - see
I called the crash of the Credit Default Swap market (see The Next Shoe to Drop: Credit Default Swaps (CDS) and Counterparty Risk - Beware what lies beneath! and Reggie Middleton says the CDS market represents a "Clear and Present Danger"! ).
I called the demise or near demise of Bear Stearns, Lehman, Morgan Stanley, GGP, Ambac, MBIA, Countrywide, Washington Mutual, and the extreme overvaluation of Goldman (see More on the accuracy of this blog's research).
I called the municipal sector bust (see The Municipal bond market and the securitization crisis and The Municipal Bond Market and the Asset Securitization Crisis, pt 2)
I called the manufacturing and industrial sector crunch via leveraged loans and dried up financing markets (see The Asset Securitization Crisis Part 27: The Butterfly Effect ).
I even told my blog readers about the blood bath that would occur in global markets last week, and I posted the opinion Saturday evening. See Reggie's thoughts on financial mayhem coming into the week of October 5th, 2008. So, please spare me this "surprise of the century" bullsh1t.
Hopefully, you get the message, but I can go on. I am not stating this to toot my own horn. At least half the people in the world are smarter than I am. The point that I am trying to make is that when your government, your investment advisor, your spiritual counselor or anyone else tells you that this was impossible to see coming - you can say they are full of bovine boo-boo. I will finish this rant with a follow up describing more of what I do. It will be called, "The difference between research and advice!"