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Thursday, September 25, 2008

About Those Hedge Funds

The current market turmoil has, to say the least, created significant problems for hedge funds They often make use of short selling which, under current regulations, is severely restricted. As a consequence the financial times reports :

Hedge funds charging hefty fees for sophisticated trading strategies aimed at outperforming the wider market have collectively parked $100bn in simple money market funds typically used by investors seeking safe rather than spectacular returns.

Citigroup estimates that hedge funds have now placed $600bn in cash, and that $100bn of this is held in money market funds,

normally seen as some of the safest places to invest cash.

However, last week, those money funds became embroiled in the wider financial crisis to the point that the US Treasury was forced to offer a blanket guarantee on them as part of its attempts to prevent the spillover of the financial crisis into the $3,400bn sector.

The extreme measures taken by the Treasury followed mounting fears that retail investors in the sector could be starting to panic and might withdraw funds on a large scale.

But some analysts say the extent of hedge fund investment in money market funds shows how scarce attractive investment opportunities and safe havens have become.

In other words investors are paying a fee of 2% +20% of profits and the investment managers are partking the cash in money market funds yielding around 2$.

The WSJ noted the difficulty if not impossibilty for some funds to implement their strategies


Hedge Funds Wrestle With Short-Sale Ban

The short-selling ban is taking the "hedge" out of hedge funds.

The Securities and Exchange Commission has banned short sales of roughly 950 financial-related stocks until Oct. 2, a list that ranges from Goldman Sachs Group Inc. to International Business Machines Corp., which was added Wednesday.

With their hands tied on those stocks and the algorithms that do much of their trading running into technical hitches, many quantitative and other "market-neutral" hedge funds are significantly reducing trading activity, according to people on Wall Street. Once major buyers and sellers on the stock market, these funds may have to reinvent their models in the event the rule is stretched beyond the Oct. 2 deadline.

Such an extension is expected. The top executive at New York Stock Exchange parent NYSE Euronext said Wednesday he believes the emergency short-selling ban on the U.S.-listed financial stocks will be extended....

That would be continued bad news for most hedge funds. "There are very, very few short-only funds on Wall Street, so the ban mainly removed long/short funds from the market," said Dan Mathisson, head of the algorithmic-trading unit at Credit Suisse Group. "If they can't put on their short positions, they can't put on their long positions, either."

Market-neutral funds offset the risk of random market swings that they take when buying stocks by short selling, or selling borrowed stock, in an equivalent dollar amount of other shares. That way, as long as they choose their stocks well, they will make money whether the market goes up or down.

Many of these funds are "quantitative," and use mathematical models to identify relative strength and weakness in the market. Often, automated "algorithmic" trading programs keep their portfolios balanced between the long and the short side. Removing a large chunk of the "shortable" universe upsets that cosmic balance.

Wednesday, September 24, 2008

As I Expected

On Septemeber 22 I pointed out that the new short selling rules would create mega problems for the hottest new product from the mutual fund industry : 130/30 and other long short funds.

Wall Street Journal
SEPTEMBER 24, 2008

Short-Sale Ban Is Hitting Mutual Funds

Some Managers Say They Aim to Avoid Big Cash Amounts

A new ban on short sales of financial stocks is hitting many mutual funds and exchange-traded funds that make bets against these shares.
Mutual funds that bill themselves as "market neutral," "long-short" or "bear" funds often short stocks, which typically means they sell borrowed shares in the hope of buying them back later at a lower price. The Securities and Exchange Commission late last week issued a temporary ban on new financial-stock short sales in a bid to maintain orderly markets.

Many fund managers are still assessing how they will be affected by the ban, which is in effect through Oct. 2. Some say they will avoid accepting large amounts of new cash from investors or adding to conventional financial-stock "long" positions during the term of the ban. Among the funds most affected are ETFs that don't even short stocks themselves but use swaps and other complex financial instruments to make bets against financials.

Fund companies in recent years have rushed to roll out new funds that mimic hedge funds' strategies, including short selling. Investment research firm Morningstar Inc. now tracks 64 long-short funds, which typically blend short positions with traditional outright stock purchases, and 41 bear-market funds, which are designed to perform well when stocks fall.

The SEC's ban has become even more complex for funds in recent days as the original no-short-sale list of nearly 800 companies has expanded rapidly. Among the stocks that joined the list Monday are Ford Motor Co., General Motors Corp. and General Electric Co. "Trying to keep up with that list is a pretty challenging feat," says Barry James, co-manager of James Market Neutral Fund. "We don't like having more and more [stocks] taken away from us."

Some managers with significant financial short positions say they will avoid taking in much new cash for now. Ric Dillon, chief executive and chief investment officer of Diamond Hill Investment Group, says he would have to turn away any substantial new investment in his Diamond Hill Financial Long-Short Fund during the term of the ban, since he would be able to put that money to work only on the long side. Mr. Dillon calls the SEC's action "misguided" and says his own publicly traded company asked to be removed from the no-short-sale list. "What you've done by eliminating the short sellers is eliminated information content," Mr. Dillon says. "That's bad for markets."

This leaves the investors in what is now a long only financial services fund with an annual management fee of 2,56%, The long only Vanguard financial services exchange traded fund has a management fee of .25%.

More broadly diversified fund managers say they will continue taking in new money but will avoid the financial sector for now because they don't want to upset their balance of longs and shorts. Kurt Borgwardt, manager of the American Century Long-Short Market Neutral Fund, says he would put any significant new cash to work in nonfinancial sectors because he likes to keep his long and short positions within each sector roughly equal……

Many fund managers are concerned the short-sale ban could be broadened to include even more stocks or extended to a longer period. "Hopefully it's not the beginning of something larger," says John Boich, portfolio manager at Security Global Investors. "If it is, then you're talking about a wholesale change in how alternative strategies are managed

Tuesday, September 23, 2008

Some Thoughts On The New Financial Landscape

The prospect of a govt bailout of financial institutions of $700 billion entails a massive increase in the federal deficit. Since the government must print money to pay for this increasing the amount of outstanding govt bonds it seems likely to be inflationary.

While this is not specific investment advice I would note that the following asset classes generally do well in such an environment

treasury inflation protected bonds (TIPs)
non dollar denominated assets particularly bonds

and that long term dollar denominated bonds perform poorly

Monday, September 22, 2008

What Do They Do Now ?

It was only on Septemeber 1 that I wrote about the latest "hot product" from the mutual fund industry, the 130/30 fund which combines long positions (100) with short positions up to 30% of the value of the longs thus allowing the fund to produce "alpha" and profit in up and down markets.

Well under current conditions with a list of around 900 (and it seems growing) stocks that cannot be sold short the strategy is difficult if not impossible to implement.

Have the fund companies announced anything about how they are responding to this major impediment to their strategy ?...not that I could find.

Tuesday, September 9, 2008

There are no geniuses/past performance doesn’t guarantee future results department

It seems like the surest kiss of death for an active fund manager is to be proclaimed by the financial press as a genius hot fund manager. The latest seems to be Kenneth Heebner, whose high flying CGM Focus fund has turned in eye popping results including an 80% return in 2007. Not surprisingly the returns were generated with highly concentrated positions and leverage (the fund can go short stocks).
For those familiar with how these stories usually pan out, the results of the past two months should not come as a shock. CGM Focus fund managed by Ken Heebner has fallen 21.33% since the Fortune Magazine May 23,2008 cover article proclaiming him America’s hottest investor. That is almost 3x the 7.27% decline for the s+p 500 over the same period .

ome excerpts from the article
America's hottest investor

Never mind the rocky market. After a string of supersmart calls, mutual fund manager Ken Heebner is putting up the best numbers of his sterling career

The best mutual fund manager around - a.k.a. Ken Heebner of Capital Growth Management - looks restless. He is sitting in a conference room at Goldman Sachs's Boston office, listening to a young analyst pontificate about all the trends he thinks will sweep the markets in coming years. Oil demand outpacing supply. The rapid growth of agriculture. The increased sway of sovereign wealth funds. And on and on.
Heebner couldn't care less. His flagship fund, CGM Focus (CGMFX), has already made a killing on energy and agriculture, and Heebner has no patience for the pet theories of this or any other analyst (or economist or strategist). "I want information, not opinions," Heebner will later tell me. Then, just as the meeting is looking like a washout, Goldman analyst Marc Fox lets something slip that starts Heebner's brain whirling.
Fox mentions that sovereign wealth funds are diversifying out of bonds and bank bailouts and into broad portfolios of common stocks. Coming from Goldman, the world's top trading house, this is valuable information. Heebner is one of the few fund managers who routinely engages in short-selling, and the prospect of a couple of trillion dollars flooding the equity markets should be enough to give any short-seller pause.
Immediately Heebner is peppering Fox with questions about where all this sovereign dough is going, wondering, for instance, whether Goldman is now recommending "short-busting" strategies to its worldwide clientele. (Short-busting involves trying to drive up the prices of stocks that a lot of investors have sold short.) "All I can say," Fox replies, looking a tad overwhelmed, "is you're multiple steps ahead of me."
Fox shouldn't feel too bad: Heebner is multiple steps ahead of everyone these days. At an age when most of his contemporaries have either retired or given up the daily grind of running publicly traded funds, the 67-year-old Heebner is putting up the best numbers of an already exemplary 30-year career. He's Barry Bonds without the steroids. "He's a rock star - he's Bono," quips his Irish-born (and U2-loving) analyst Catherine Columb. Given that U2 hasn't put out a good album since Joshua Tree - sorry, Catherine - Bono should feel flattered. (Of course, it's doubtful that Heebner, who by his own admission spends most of his waking hours thinking about the markets, could pick either Bonds or Bono out of a lineup.)
Just how good has Heebner been? We may well be witnessing the most dazzling run of stock picking in mutual fund history. Since May 1998, Focus has an average annualized return of 24%, the best ten-year record of any U.S. mutual fund, compared with only 4% for Standard & Poor's 500. Focus, which has $7.4 billion in assets, is already up 15% in 2008 (as of May 19), but it is 2007 that will be remembered as Heebner's pièce de résistance. Fueled by big bets on energy, fertilizer, and metals, Focus soared 80% last year, vs. 5% for the S&P 500. "I told Ken it was like he was walking between the raindrops," says CGM president Bob Kemp, who oversees sales and marketing at the firm, of the year Heebner had in 2007. "It amazes even us." Last year marked the fourth time since 2000 that the fund returned 45% or better. And it's not as if Heebner has needed the big years to make up for a lot of losses: Launched in late 1997, Focus has had only one money-losing calendar year (2002).
Peter Lynch's 14-year tenure at Fidelity Magellan has long been the gold standard for mutual fund excellence. During Lynch's best ten years - August 1977 to August 1987 - Magellan recorded an average annual return of 36%, according to fund tracker Morningstar. It's a remarkable achievement, but even Lynch acknowledges that he was backed by a strong tailwind. The S&P 500 returned 19% a year over the same period. In other words, Lynch beat the market by 17 percentage points a year during his heyday. Ken Heebner has beaten the market by 20 points a year during his heyday…
And Focus isn't the only Heebner-managed fund that's excelling. CGM Realty (a sector fund), CGM Mutual (a balanced fund that owns stocks and bonds), and CGM Capital Development (closed to new investors since 1969 and soon to be merged into Focus) have been standouts too. Realty boasts a 22% annualized return for the past ten years, sixth-best in the mutual fund universe, according to Morningstar. It's also the only fund in its category that's been bucking the real estate slump. Realty's one-year total return: 34%, vs. 6% for its nearest rival.
A true contrarian
Even more remarkable than the raw numbers is how Heebner has earned them. Heebner is a true contrarian, who says he's most confident as an investor "when everyone else thinks I'm nuts." He works long hours trying to identify emerging trends in the economy. When he finds a promising one, he'll go all in, making huge bets on the stocks poised to benefit. Asked how long it takes him to identify those stocks, Heebner answers, "About ten minutes. I've been at this a long time." It's an investing style that will never be taught in business schools and is definitely not something any amateur should try at home. But Heebner, blessed with uncanny instincts, has managed to see around just about every corner in a market that has befuddled just about everyone else.

the above seems a strange definition because if anything Heebner seems to be the ultimate momentum player according to morningstar his CGM focus fund which can go both long and short has 58% of its long positions in energy, 38% in materials, Its short positions are heavilty concentrated in the financial sector)

Friday, September 5, 2008

Don"T Try This With Your Own Money

In an his “common sense column” James Stewart writes about the strong investment performance of the Harvard (and Yale ) endowments. Interestingly, he draws conclusions for individual investors that are quite different that those expressed in recent books by the managers of those endowments,

Harvard's Endowment Offers
An Education in Asset Allocation
September 3, 2008; Page D2
It's back-to-school week, so let's do some homework by studying the success of Harvard University's endowment.
Harvard Management Co., which runs the endowment, generated a return of between 7% and 9% for fiscal 2008, according to people familiar with the returns and cited by The Wall Street Journal in August. That's consistent with an estimate of 9% for the first 10 months of the fiscal year, which ended June 30, reported the Harvard Crimson in July. Given that the S&P 500-stock index fell about 15% during the same 12-month period, and that Harvard's returns were well above the rate of inflation, I'd award that performance an "A."
How did Harvard do it? The key is diversification, and not just by investing in a variety of stocks and bonds. Harvard invests in 11 noncash asset classes, only one of which is U.S. stocks. Like Yale and other large endowments, it counts on one or more of those to shine even when others are weak, achieving better long-term results than could be attained with fewer asset classes. It looks as though Harvard's 33% allocation to real assets, which include commodities and real estate, salvaged performance in what was otherwise a treacherous year.
(both endowments also include allocations to inflation protected bonds which they categorize as real assets)
Individual investors can emulate the principles, if not the exact returns, of Harvard's approach. True, Harvard's vast wealth -- $38 billion as of April -- gives it access to the best managers, the most sought-after private-equity and hedge funds, natural-resource partnerships that are closed to most, and even the ability to eliminate middlemen and fees and buy direct. (At one time Harvard was even the world's largest owner of timberland.) But you too can achieve similar -- maybe even better -- results by embracing a variety of asset classes.

(In fact David Swensen, the Yale Endowments manager in his book : UUnconventional Succes explicitly notes that individual should avoid the above assets, specifically because of the preferred access that the Yale Endowment has to these asset classes)

Like Harvard's, my results last year were strongly enhanced by the allocation I made to real assets, a result of more closely aligning my portfolio allocation with that of Harvard's and Yale's. That's why I recommended and bought stocks like BHP Billiton, Rio Tinto and Cia. Vale do Rio Doce, which are both commodity producers and foreign. As of June 30, the stocks were near their peaks after a spectacular multiyear run.

(There is often a significant divergence between stocks of commodity firms and the commodities themselves (the route chosen by Harvard and Yale), although direct investment in commodities is now easily accessible to individual investors through etfs and exchange traded notes (etns) Much of the recent runup for BHP and Rio Tinto has been because of a merger between the companies, not necessarily the move in the commodities markets)

Harvard hasn't yet released the official results for fiscal 2008, but its 2008 asset-allocation strategy is on its Web site. Despite the subprime, real-estate and credit crises, Harvard is staying the course, with even larger commitments to foreign equities and commodities than in 2007. U.S. equities constitute 12% of the portfolio; developed foreign equities are 12% and emerging market equities are 10%. Total foreign equities account for 22% of the portfolio, up from 19% in 2007, compared with 12% domestic. Real assets, including commodities, are 33%, up from 31%. Fixed income dropped to 9% from 13%.

(Contrary to Stewart’s assertion Mohamed el Arian recently departed ceo of Harvard Management in his new book When Markets Collide the allocation el Erian recommends for individuals is quite different than the Harvard allocation listed above. Here is his allocation for individuals (“midpoints” are listed)

US Equity 15%
Developed Intl Equity 15%
Emerging Market Equity 12%
Private Equity 8%

Real Assets:
Real Estate 6%
Commodities 11%
Inflation Protected Bonds 5%
Infrasturcture 5%

Nominal US Bonds 5%
Nominal non US Bonds 9%

Special Opportunities 8% )
(special opportunities defined as “new longer term trends supported by a secular hypothesis or shorter term activites that materialize due to sharp dislocations and significant overshoots”)

It's relatively easy for individual investors to duplicate these categories with individual stocks, sector mutual funds and exchange-traded funds. The good news is that for anyone trying to more closely align their portfolios with the Harvard model, foreign equities and real assets have recently sold off, making valuations far more attractive for anyone buying now. China stocks alone have lost about half their value year-to-date, and Russia and India are also experiencing significant corrections. Energy and commodities also have had a sharp selloff. A year ago, nearly all these asset classes seemed richly valued, if not overvalued; now bargains are showing up.

The hardest categories for individual investors to duplicate are private equity and hedge funds, which may be just as well, given their relatively weak recent performances. But in earlier years, they were critical to Harvard's success. A number of ETFs now approximate the returns of so-called long-short hedge funds by using quantitative strategies, without the exorbitant hedge-fund
(As noted David Swensen chief investment officer of the Yale Endowment in his recent book Unconventional Success and Mohamed el Arian up until recently CEO of the Harvard Management in his book When Markets Collide give their thoughts on the appropriate allocations for individual investors

With regard to hedge funds el Arian writes:
Either take comfort from the possibility that the hedge fund managers can “market time” the beta(market) exposures in a profitable way or worry that it is virtually impossible to know what the underlying market exposure is..”
on private equity:
Having a general exposure to private equity is neither a necessary nor sufficient condition for obtaining superior investment results you need to be in the right fund at the right time. The studies also show that it is difficult for new investors to get into the right funds. Why ? Because the individual performance difference among funds is rather stickyees. Harvard allocates 11% of its portfolio to private equity and 18% to hedge funds.)

David Swensen’s allocation for individuals differs even more radically from the Yale Endowment’s allocation listed in the 2007 annual report
Yale Individual
Absolute Return 23%
Fixed Income conventional 4% 15%
Inflation Protected Bonds 15%
US Equity 11% 30%
Foreign Equity 15% 20%
Private Equity 19%
Real Assets 28% 20%

(In sum it seems neither the Yale or Harvard endowment managers think it is “easy to replicate “their portfolios although of course they advocate broad diversification for individuals’ portfolios.
So it would be hard to disagree with this point made by Stewart)

Although I've been moving in the Harvard direction for some time, I still haven't gotten to as high a weighting in either foreign stocks or real assets. But the key is diversification. So far, it's benefited my portfolio just as it has Harvard's.

Monday, September 1, 2008

New "Product" From the Mutual Fund Industry: Not a Good Idear for You

The actively managed mutual fund industry seems never to tire of new “product” which seems to be aimed at distracting investors from their long term interests by pushing them to make investing decisions based on short term developments. One of the latest” innovations” is the 130/30 fund which purports to offer investors positive returns regardless of movements in the overall stock market and…at lower risk. Not surprisingly the combination of extensive marketing and investors willingness to jump from one faddish investment vehicle to the other has led to large scale inflows into this strategy. Investment News, an industry newsletter recently reported on this development:. Article text in italics My bolds, (my comments in parentheses.)

Appeal of 130/30 funds swells
Advisers warned to be cautious in selecting these investments
By Jeff Benjamin
August 25, 2008
The wild popularity of 130/30 funds notwithstanding, recent analysis of the unique long-short strategy suggests that advisers would be wise to check under the hood for a closer look at the portfolio and not just jump in to the latest marketing craze.
"Some of these strategies are taking on a lot of risk for the returns they're generating," said Steve Deutsch, director of separate and collective trusts at Morningstar Inc. of Chicago.
According to Mr. Deutsch, a growing appetite for alternatives to plain-vanilla long-only investment strategies has fueled a stampede into the space by the financial services industry. A recent forecast has projected that assets in the strategy, also known as short-extension and leveraged-net-long, will swell from around $100 billion today to $2 trillion by 2010, according to research from the Tabb Group LLC of New York.
There are already 90 money management firms offering more than 200 products …... .
For financial advisers and their clients, the challenge will be sifting through the heap of new products that all claim to have mastered the balance of leverage and short selling inside a single portfolio. …
The basic strategy, which has been building momentum for almost five years, is a twist on the long-short hedge fund strategy that has been around for more than 50 years.
The idea behind a short-extension strategy is to short-sell a percentage of a portfolio and apply the same percentage to leverage on the long side, thus maintaining a 100% net long exposure.
Applied to an index such as the Standard & Poor's 500 stock index, the strategy would enable a manager to sell short those stocks he least favored while leveraging long his favorite stocks in the index.
In theory, the strategy, which can be applied to both stock and bond portfolios, is expected to outperform a designated benchmark on a risk-adjusted basis
(looked at objectively there are several reasons not to expect this strategy to deliver on its promise

• We know from long term data that active fund managers seldom succeed in beating their benchmark index when going long stocks. It seems unlikely that they would be more successful when choosing stocks to go short. In addition many managers of these 130/30 funds have little experience in shorting stocks.
• This strategy is quite likely to add risk and volatility to a portfolio. While a long position’s maximum loss is known (a stock cannot fall below zero) the loss of a short position is potentially infinite (there is not limit on how high a stock price can rise))

As the article notes:
In practice, however, the strategy demonstrates that traditional long-only money managers don't always excel at selling stocks short.
A key element of the strategy is to reduce risk, as measured by beta, in comparison with a designated benchmark.
In analyzing the returns of 40 different 130/30 strategies over the 12-month period through June 30, Mr. Deutsch found a beta range from 3.5 to a negative 1.25. A beta of 1 is considered to be subject to risk equal to that of the benchmark.
(once again in this active strategy as in traditional actively managed funds, one is betting on a “genius” manager, not only will past performance in terms of returns not indicate future performance, the same can be said for the risk measue=beta)
Mr. Deutsch found that 29 strategies were below that mark and 11 were above the benchmark beta.
(and as mentioned there is no guarantee that the funds’ risk characteristics will remain constant over time)
In analyzing the respective portfolios, he found that managers were using a wide range of strategies and in some cases taking on additional risk to increase performance.
"In some cases, investors are probably getting more risk or less return than they bargained for," Mr. Deutsch said, though he added that most investors only focus on return. (the major peril in buying actively managed funds conventional or exotic: you never really know what you own)
The fact that some money managers are now migrating toward ratios of 140/40 and even 150/50 doesn't bother Mr. de Silva, who insists that the ratios are irrelevant as long as the beta is held close to 1.TRACKING ERROR, RISK
"The ratio will vary over time, but we say, 'just focus on the tracking error and the risk and don't worry about the ratios,'" he said.
(now there’s an illogical argument, the more you increase the short ratio, the more you differ from the benchmark of the s+p 500 thus the more risk that your tracking error will increase. Of course they “focus on the tracking era” but the larger the short position the harder it is to succeed In fact in the very next paragraph below he acknowledges the additional risk:).
Risk, however, can be amplified, depending on the short-selling expertise of each money manager. "A lot of people starting these strategies don't realize that when you short something and are wrong, that position just gets larger," Mr. del Silva said.

(taking the first paragraph of his statement together with the second one, Mr. De Silva’s argument seems to be “when other people do what I do they are amplifying their risk, but when I do it all the risks are controlled and there is nothing to worry about. In other words I’m a genius, no worries. No thanks0(But interest in the product is growing as investors are attracted to the promise of the perfect investment vehicle: positive performance in down markets at less risk than the overall stock marke Meanwhile, the market continues to move in the direction of 130/30 strategies, with growing supply meeting growing demand.
We see a lot of traditional money management firms launching 130/30 strategies and we see these funds grabbing a larger share of the long-only assets already under management," said Adam Sussman, director of research at Tabb Group.
However, Mr. Deutsch is among those who worry that the strategy is becoming an investment fad tied largely to an interesting label.
"We think the 130/30 strategy is just the latest is a long line of products that have grown due primarily to competition," he said.