Hard To Invest When Your Fund Is An ATM

Jim Chanos, the famous short-seller who runs the hedge fund firm Kynikos Associates, was up 25 percent last year betting against equities. Nonetheless, he still found running a successful short fund challenging due to increased client withdraws (see Reuters article). Even with outstanding performance in a down market, investors still withdrew 20 percent of his funds assets. While some withdraws are normal, the percent was probably higher in part due to redemption gates put in place with other funds. After all, if you received margin calls, you have to get the funds from somewhere. As jokingly mentioned by Chanos, "we were like an ATM machine." Fortunately for Chanos and his investors, the Kynikos ATM was being replenished with cash. Given the current market, investors and depositors with some national and regional banks can only hope they are as fortunate.

Recovery Rates Fall For Leveraged Loans

Recovery rates on leveraged loans (often used to fund leveraged buyouts) have been less than 25 percent, compared to historical average recovery rates greater than 80 percent (see WSJ article).

Source: WSJ article image, Moody's Investor Service data

Given the recession and recent credit problems in the market, increased defaults are to be expected from companies with high debt and falling revenues, yet there appears to be more to the story. As is typically the case when a company defaults, those at the bottom of the debt food-chain, such as those holding senior unsecured bonds and subordinated debt, are the first to lose everything, compared to leveraged loans and senior secured bonds. What is unique in the current market is that a large majority of recent leveraged financing for acquisitions was done with loans, rather than unsecured bonds. As a result, the debt food-chain has contracted, such that the normal buffer of junk bond subordinated debt that is usually in place to absorb the initial losses is smaller than normal, or in some cases non-existent. Recent data from Moody's finds that 60 percent of all issuers in the US that have rated loans, along with over 30 percent with speculative-grade issuers, have a loan-only capital structure. With such a flat structure, losses go straight to the top of the debt food-chain, thereby explaining the lower recovery rates for leveraged loans. This is certainly not good for the large bank lenders of leveraged loans, but may be even worse for the junior lenders that hold subordinated second-lien and mezzanine loans (see Reuters article). A recent Fitch report finds that the recovery rates of such subordinated holdings are expected to remain in the 0 to 10 percent range. It appears we can expect more shakeout in the credit markets, which will continue to put pressure on the banks.

The Case Again for Low Expense Index Funds

A new study by Mark Kritzman, president and CEO of Windham Capital Management, found that standard index funds - those with their lower fees and expenses (including transaction costs, taxes, management fees, and performance fees) - gave better returns than actively managed mutual funds and hedge funds (see New York Times article).

For his study, which is similar to past studies, Kritzman calculated the average return over a 20-year period, net of all expenses, of three types of investment, including a stock index fund with an annual return of 10 percent, an actively managed mutual fund with an annual return of 13.5 percent, and a hedge fund with an annual return of 19 percent. He used volatility, turnover rates, transaction fees, management fees, and performance fees that were based on industry averages.

His finding pointed to the problem with high expenses. The actively managed mutual fund and hedge fund each had total expenses of more than 3.5 and 9 percentage points a year, respectively. As a result, in order to break even with the index fund net of all expenses, the actively managed fund would have needed to outperform the index fund by 4.3 percentage points a year before expenses. For the hedge funds, it was even worse, with each fund needing to outperform index funds by 10 points a year. While similar studies have been done in the past, the current finding are just yet another reason that the 2-20 hedge fund model may see more resistance going forward. Managers will no doubt be asked more than ever to verify their ability to capture alpha.