There is an interesting post at the A VC blog on a new type of investment approach, called Covestor Investment Management (CV.IM). [Hat tip to all the Twitter tweets that pointed to the link]. The post describes the CV.IM as:

"The world’s first retail Multi Managed account or MMA. With an MMA you can invest directly alongside professional and retail investors, managing their own money in their own account. It is a new category of Investment product that gives you access to expert managers like a hedge fund with the security and transparency of a managed account."

Basically, the system is designed such that you would have your own account, but could then choose from a number of investment managers that you want to follow. The investment managers could be in the financial industry, or more likely just an average investor like you, but possibly with more experience, and with a track record or strategy to your liking. If you choose to follow the investment manager, funds in your account are used to mimic the trades of the manager. In return, the investment manager could get some compensation for sharing his/her data, although they can also continue to share their investment ideas for free.

It seems that such a structure could have some advantages. First, the fee structure is certainly less than a mutual fund or hedge fund for following the free managers, and also much less for even those charging a following fee (listed as $120 per person per manager). The system could also end up offering a number of investment options and strategy choices for free. For aspiring investment managers, there is also the opportunity to "prove yourself" and your strategy, and make a little money in the process.

Nonetheless, there are a number of questions. While the company does have a system in place to report performance, it is not clear how much data is available, or how accurate it will be if trading data/history is introduced for new managers. It is also unclear whether or not the managers could somehow game the system, or receive an unfair advantage by front-running the followers. One of the founders did respond in the post comments section that there will be minimum liquidity restrictions to prevent some abuse, but the managers could still have an initial advantage over new followers. The minimum daily trading volumes of 10,000 shares and $50 million in market cap also seem a little low. It is also worth noting that the managers will most likely be timing their buying and selling based on what is most beneficial to them, and not necessarily your current situation, causing you to possibly incur a commission and/or tax event at an inopportune time. Such a structure could also lose the ability to take advantage of scale with regard to transactions, unless a large number of investors are already following a particular manager (scale advantages are still possible given that most of the funds will be with only a few brokers - so far TD Ameritrade and Interactive Brokers). Nonetheless, new followers would most likely have to pay higher per share fees.

Although there are still numerous questions to be answered, the idea sounds intriguing, and is certainly worth pursuing more. Check out the Covestor website to learn more.

While hedge fund returns have been taking a beating lately, the talk of the demise of hedge funds is probably a little over done and premature. While there has been $72.5 billion in outflows, this represents less than 4 percent of the average mid-year industry volumes (see Wealth Bulletin article). Also, while the industry has seen a number of funds close up shop, the numbers have "only" decreased from 7,601 to 7,299. As discussed in this blog a number of weeks ago (see previous post), the fallout seems to be impacting smaller funds more that larger, more established funds. In fact, many of the larger funds - which are either more diversified or have a star manager - are seen as being able to take advantage of the shifting resources and capital.

Even with fewer funds failing than originally expected (yes, these are just preliminary numbers), funds that stay in business will still find that they cannot operate as usual. For starters, funds will need to better match redemption rules with strategy. Some funds are illiquid by design based on the strategy being used. While trying to lock up funds until returns are realized (as with private equity) is probably not feasible, funds will need to better insure that redemption request rules take strategy into consideration. The use of leverage will also no doubt be reduced for many funds, which will also affect returns going forward. Finally, the popular 2-20 fee structure will also come under assault. Not only does the existing compensation structure seem excessive given recent performance (and future lower returns in the wake of lower leverage), fee concessions will be necessary as an incentive for agreeing to longer lock-up periods. In the end, expectations on both sides may need to be scaled down a little.

Hedge Fund Research's Global Hedge Fund Index was down 3.04 percent in November, after a drop of 9.26 percent in October (see FIN Alternatives article). That brings the index down 22.3% YTD through November. Continued poor performance has increased redemption requests, causing an increasing number of hedge funds to block investors from redeeming shares (see NY Times article). The increased addition of illiquid investments over the years (such as real estate and private equity) has caused many funds to start considering a new model that would require longer lock-up times for lower fees. High-water marks, which would force some under-performing funds to earn back 25 percent or more before taking profit fees, will cause additional funds to close, although others insist they will take the high road and not close until they are profitable again.

As of the end of last week, approximately 100 hedge funds have placed restrictions on withdraws, in what is becoming a financial roach motel where investors can check in, but they cannot check out (see Bloomberg article). The increased use of gates has even spread to some of the previous stars of the industry, such as Fortress Investment Group, Tudor Investment Corp., and D.E. Shaw & Company (see WSJ article). Furthermore, the problems are even worse for those funds investing in emerging markets, which continue to under-perform and are down an additional 1.41% on average in November (see Bloomberg article).

Finally, even with new gating restrictions, some hedge funds are also being forced to renegotiate borrowing terms with their prime brokerage lenders as losses and redemption requests increase (see Financial Times article). Many prime brokers are also seeing this as an opportunity to drop clients or renegotiate terms that were originally in favor of the large hedge funds who previously had bargaining power. No doubt many large investors with liquidity will be able to throw their weight around in a similar way as they begin renegotiating lower fee structures in return for longer lockup periods.

According to information from the Preqin Global Institutional Review (by way of an Albourne Village post), institutional investors plan to continue allocating capital to hedge funds. A total of 46.6 percent still have a positive long-term view of hedge funds, while 67.8 percent have an unfilled long-term target allocation to hedge funds. A total of 75 percent reported that while hedge fund returns had fallen short of original expectations, 53 percent were satisfied with returns (compared to the market in general, I assume). Of interest in the post was the comment that while institutional investors were delaying making new investments with hedge funds, few were redeeming their original investments. Whether this means redemption requests will slow down, or whether the speculation about redemption requests driving the recent sell-offs were overblown (by many, including myself), is unknown.

Interesting article about John Paulson and some other hedge fund winners this year (see Bloomberg article). The article is long, but worth the read. There is some variety in the strategies and approaches, but funds betting against subprime and housing did the best, not surprisingly. Even a quant fund did well.

It looks like the commodity crash is taking its toll on salaries and bonuses. The top paid metal and energy traders may "only" earn $1-1.5 million in salary and bonus this year, down from $5-8 million in 2007 (see Bloomberg article). Difficult times indeed. I guess there will be no more $1,000 ice cream sundaes and pizza for a while (see blog post).

According to Treasury Secretary Paulson, there is a need for a new regulatory system that will look "at the entire financial system." See Financial Week article. "Entire" in this case applies to countries, in addition to asset classes. So the plan is to have each country overseeing the regulation of another country's financial system - this should produce some interest debate.

Man Group says that banks, and not hedge funds, are more levered, and as a result are the main cause of asset price declines (see Reuters article). Man also puts hedge fund leverage at about one-third its levels in 2007. Expect future returns to also show similar trends.

Interesting post over at the AllAboutAlpha site that is worth the read. The post discusses how even if a hedge fund has stop reporting returns, this does not imply that the fund is dead and closing up shop after blowing-up in the recent market downturn. As it turns out, only about a fifth of the funds (according to the study) stop reporting because they are liquidating. Others simply have stopped taking on new investors, or have other reasons for not reporting returns. Of interest in the article is how the researchers studied fund-of-funds to estimate (guess) what the returns are of those funds that have stopped reporting (given that their performance is still showing up in the fund-of-funds that do report). Not surprising, while the "dead" funds that no longer report returns did perform worse than those that did report, the level of losses were close to -3%, and not in the category of "blown-up." While many funds may still go under (in part due to it now taking too long to reach high water marks after significant losses), the reports of the death of hedge funds may be greatly exaggerated.

A Financial Times blog post at Alphaville reports how 63 percent of respondents believe that the hedge fund deleveraging process is about half over (see Bloomberg article as well). To date, leverage has fallen to 142 percent of AUM, down from 175 percent in 2006 and 2007. A majority of respondents also believe that redemption requests are at least half over, with the process finishing up early next year, probably in the first quarter. Of interest is how cash now represents approximately 31 percent of total assets, compared to just 7 percent over the last few years. As we have discussed before (see previous post), there is an expectation that once the market turns, and redemption request slow down or stall, the amount of capital that could be deployed back into the market could spark a significant rally. Empirical estimates have between $650 and $700 billion withdrawn from hedge funds, and another $325 to $350 billion from mutual funds (see DowJones Financial News Online article). This amount of funds represents about 6.5-7 percent of the capitalization of the US equity market. Even just a small portion of such capital hitting the market could produce a relief rally that would be jaw-dropping.

A recent Financial Times article highlights that 15 percent of asset management houses, pension funds, and private banks have invested in hedge fund replication strategies (the survey had only 97 respondents). Given the low number of companies offering products, the interest and use indicates that some firms are engaged in internal model development. As further encouragement for the field, 55 percent say they would be willing to consider investing in replication strategies, while only 30 percent were against such investment (of course, that could change as the strategies become more developed). On the down side, a significant minority of respondents also felt that hedge fund returns could not be replicated, were not transparent enough, used unproved technology, or simply gave poor returns. Many appear to be waiting for better products, even though there is a significant fee reduction when using replication strategies. Considering that the hedge fund industry is currently unpopular and an easy punching bag, not to mention being down for the year, the results are encouraging for those doing replication research and indicate some interest for the development of more robust models going forward.

An article in Pensions & Investments reports data from Hedge Fund Research showing that hedge fund industry assets fell by $156 billion in October, with $115 billion from performance-related losses, and another $41 billion from net redemptions. Investors withdrew $22 billion in October alone. Aren't redemptions, at least those above normal withdraws, due to performance-related issues? Then again, redemptions are adding to the poor performance in what is becoming a "chicken or the egg" downward spiral. I guess it does not really matter which came first at this point. We are still left with a market that has laid an egg, and investors too chicken to buy (sorry, I could not resist). The quote of the day from the article: "HFR analysts attributed the outflows to investor dissatisfaction with under performance." Yes, it is true. Markets that are cut in half have a way of generating dissatisfaction.

Just about every day we get a new prediction / forecast of where the hedge fund industry is headed. Now Citigroup is reporting that total hedge fund assets may fall to around $1 trillion by the middle of next year (see Bloomberg article). This figure would represent a decline of nearly 50 percent from peak levels. Of possibly even more interest in the report is how hedge funds are believed to have raised cash equivalent to around 40 percent of assets in anticipation of both known and unknown (but expected) redemption requests. As posted yesterday (see post), this cash could be adding to daily volatility as funds allocate it on a short-term basis while waiting for redemption requests to slow. While this may be contributing to market volatility in the short-term, there is also an expectation that once this money (forecast to approach $1 trillion) does get deployed in to longer-term investments, it could be a strong catalyst for driving the market higher. Unfortunately, many investors are following the belief that it is still "too late to sell, but too soon to buy." Once hedge funds start getting back into the market in earnest, the move could be both quick and significant enough to begin thinking it is "too late to buy." Of course, whether that happens tomorrow or late next year is just a guess at this point. Daily rallies of over 5 percent that have failed to hold have certainly not engender any extra confidence for traders or investors.

There is an interesting Forbes article that discusses the issue of whether hedge fund selling as a result of redemption notices has been contributing to market volatility (see previous posts here, here, here, and here, on the subject). The article notes that while last Saturday was the 45 day period before the end of the year that is often the one and a half month last chance opportunity to request withdraw of funds as required by some hedge funds, recent volatility cannot be blamed entirely on the forced selling of hedge funds before this date. Many funds have shorter notices, while for some the required notification period is longer. Furthermore, any volatility that was experienced may have been due more to the self-fulfilling prophecy that often follows other calendar events, such as those experienced with the January Effect, option expiration dates, and end of month/quarter trading. Instead, analysts expect that it is more likely hedge funds will systematically continue to sell as needed over the next 12 months in order to meet requests.

Of interest is that many funds have been accumulating cash, with managers eager to deploy funds into a market that some managers feel is depressed and laden with attractive values. While funds are nervous about locking up money in longer-term and possibly illiquid investments, many are also unwilling to simply sit on the cash. As a result, some are engaging in more short-term trading, both from the buy and sell sides, that ironically may be contributing to the volatility being blamed solely on redemption requests. Furthermore, there is an expectation that once redemption requests slow down to normal levels, much of this money will quickly find its way back into the market, generating a rally that could be as large as the one recently seen on the downside, albeit over a longer time frame. Of course, predicting the timing of such a move is difficult, but once previously illiquid instruments such as complex debt securities, private equity, and thinly traded companies start to increase on higher level of trading volume, the market may start seeing the beginning of hedge funds once again throwing their weight, and capital, back into the market.

It appears that stars of the hedge fund world, such as Cohen, Einhorn, and Signer are not having any problem raising money at a time when other funds are seeing mass redemption (see Bloomberg article). For established managers, there are a couple of intriguing reasons to raise money at this time. For one, equity prices are depressed, creating opportunity for managers with capital on hand. In addition, the recent sell-off has placed existing clients significantly under their high-water marks, meaning that it may be a while before managers can capture the normal 20% of future profits. New money, on the other hand, is starting fresh, allowing future profits to generate normal fees right away. Apparently, reputation and performance do still matter. Then again, in a down market, performance is all relative. As one person on CNBC was recently quoted as saying "small losses are the new gains." Only during a bear market, and only on Wall Street, would such a statement make any sense.

What is the hot new hedge fund strategy? Convertible Arbitrage? Distressed Debt? Emerging Markets? Event Driven? Macro? Long / Short, Risk Arbitrage? Quant? No, if a new hedge fund by a former Columbia professor is any clue, it is value (see Bloomberg article). The new company, called the Van Biema Value Partners, plans to invest in no more than 20 small Asian managers that follow value investing principles. When people start losing significant amounts of money, it is interesting how Buffett and Templeton start to appearing wise again.

As hedge fund investors find it difficult to unload their shares (often due to missing redemption deadlines, or not wanting to wait through their holding period), some are utilizing the secondary market to sell their shares (see WSJ article). Hedgebay Trading Corp., which began business in 1999, operates a secondary market to match buyers and sellers of hedge fund stakes. Initially, when hedge funds were doing well, Hedgebay would have buyers paying a premium in order to take a stake in an attractive fund that may have been closed to new investors. As the market has turned, investors are now offering their shares at a discount, with the average discount recently doubling to 3.5%. Clients include individual investors, funds of funds, pension companies, and endowments. Funds of funds in particular have been aggressively utilizing the site and have actually redeemed more money than they need out of fear that when they do need the money, the individual hedge funds will put up redemption gates. JPMorgan has estimated that there will be up to $100 billion in redemption requests from funds of funds in Q4. The secondary market has even generated new opportunities for Permal Group, which is launching a $500 million fund that buys distressed priced hedge fund stakes, with shares coming from Hedgebay and existing relationships. Just another example of how capitalism does amazing things when it is allowed to operate. Now if only some private entity can do this efficiently with credit default swaps and credit derivatives, investors might actually be able to once again sell attractive hedge fund stakes for a premium.

According to a Dow Jones Financial News article (subscription required) and data from Hedge Fund Research, equity market neutral hedge funds made 0.3 percent so far this month (to October 20th). Equity market neutral funds look to profit from the markets regardless of their direction, putting equal positions on share prices rising and falling, leaving the portfolio as a whole uncommitted to the general direction of the market. Market neutral hedge funds are also up 0.4 percent total for the year. Given that market neutral funds are one of the few funds that actually seem to employ hedging, it is often considered by some to be a pure play, or true hedge fund. Imagine that. A hedge fund that hedges, doing the best when the market is volatile. Then again, being flat is a little boring (albeit nice when the market is tanking).

Banks are continuing to ask for more collateral to back past hedge fund lending, causing more funds to liquidate their positions (see WSJ article). When added with investor redemption, bank-induced liquidation is forcing hedge funds to step-up their deleveraging. Such selling is continuing to put pressure on the market, generating more requests for bank collateral and investor redemption, in what amounts to a catch-22 that continues to spiral the market downward. Such selling has been occurring for a while, as funds have been unwinding exposure to financial and energy stocks, both of which continue to suffer as crude oil continues to drop, and the credit crisis continues to unfold. While Hedge Fund Research recently reported that the level of hedge fund market exposure has decreased by one-third over the last year, I suspect that this still may not be enough. As mentioned by Antonio Munoz-Sune, head of the U.S. for fund of funds EIM: "The combination can take anyone down." Unfortunately, it is difficult to tell where we are in the hedge fund closing and deleveraging process, with many hedge funds still appearing to use every rally as an opportunity to sell. I suspect that until we see the VIX approach more normal sub-30 levels, stop seeing the DJIA and S&P 500 Index post intra-day percent swings in the high single digits, and see crude oil stop falling in price, it is unlikely that the market will stop feeling the effects of hedge fund selling, allowing for a long-term and lasting rally. Like most bottoms, we won't know for sure that it has occurred until we see it in the rear-view mirror, but I will be watching the VIX, the price of crude oil, and the Dow Jones and S&P 500 index percent swings for clues.

The SEC is looking to force hedge funds to disclose their short-sale positions, and further plans to subpoena hedge fund records (see Bloomberg article). Why stop there? Why not just make it more difficult to even short a stock? Oh, never mind (see Reuters article). I suspect that if as much attention was paid to making sure that companies were not leveraging over 50-1 as is being given to finding coordinated short selling (which may be impossible to prove BTW, even with disclosure), that short-sellers might be getting their hat handed to them in a more natural way. By the way, if you know that a famous and successful short seller with deep pockets is taking a short position in a certain company, are you more likely to go long or short? Could extra transparency even cause more traders to jump on the pile, making things worse? Would seeing that multiple funds are short a stock make you assume the stock is being manipulated in a coordinated manner, or would it give you more reason to think the stock had issues? The law of unintended consequences may raise its ugly head once again.

As pension funds look for ways to increase return, and adjust to the changing markets, the GAO is recommending more guidance as they begin to invest more in alternative investments, such as hedge funds and private equity (see Reuters article). While there is always worry of over-stepping when Congress gets involved, the trends are real and will most likely cause more concern going forward given the lower level of transparency for alternative investments. Whether future restrictions and regulations will impose a greater cost burden on such funds is yet to be seen. Of interest, data shows mid- and large-size funds to have between 21 and 27 percent investment in hedge funds, and more than 40 percent in private equity. These trends are not unlike those seen at various academic endowments (see previous post). It would not surprise me if more individuals begin exploring these investment areas as related products start to become available to retail investors.

Ospraie Management has apparently told investors that its investment in XTO Energy contributed to its losses over the last few months (see Bloomberg article). While this is not surprising given that energy stocks have been down and have contributed to losses in numerous hedge funds, the XTO position of $128 million in shares was the largest position for the Ospraie fund, and does once again highlight the problems with having a fund be too concentrated in just a few positions. Such a concentration can cause the types of losses Ospraie incurred, including a 26.7 percent loss in just one month (see previous article and previous post).

Fund manager Dwight Anderson was quoted as once saying that: "The fact that I had a horrible quarter is a statistical probability, and we had always told people there is that possibility.'' Yes, and when you are overweight a volatile stock in a volatile industry, you can expect that statistics will line up less and less on your side. In fact, this is a common problem in a portfolio when a certain position does well. Before long a hot stock can become a major portfolio position, and one that may now be larger than your portfolio guidelines allow. Nonetheless, even though you are now overweight the position beyond allowable levels, and even though VaR measures are screaming at you, it is hard to scale back the a security that is outperforming and in a sector that is on a roll. That is until of course everything changes, and the industry or sector corrects dramatically, as we have seen with energy stocks.

Sure, these are unusual moves, but they are also precisely the types of moves you should be trying to protect yourself against. Anderson went on to say in an interview last year that: "We do everything that we can to manage the risk, and I think we're better at it today than we were a year ago.'' Apparently, everything was not enough, and everything did not include consistently updating VaR measures, or simple looking at portfolio weights. Scaling back risk is a difficult, but necessary part of any fund management, even if it involves giving up a little return in order to play another day.

As reported in a recent Asian Investor article, CQS has launched the CQS Global Volatility Fund. The fund is beginning with AUM of $160 million and has a strategy that tries to profit on equity volatility valuation anomalies within market indices and on market dislocations, including the volatility of individual global equities. Not surprisingly, the fund will rely on options and futures to take positions in the volatility-driven valuation anomalies. CQS had previously launched an Asian convertible arbitrage hedge fund in 2007 that focused on convertible bond and equity strategies in Asia, also with a global volatility bias. Whether this is yet another sign that volatility has peaked, as is often the case when new funds chase the next new thing, is yet to be seen.