Hedge funds increased their stakes in financial stocks during the second quarter according to the Goldman Sachs Hedge Fund Trend Monitor (WSJ). Specifically, ownership in financials increased 55% from Q1 to Q2, growing to $70 billion - representing 3.7% of the sector's market capitalization. Bank of America (BAC) and JPMorgan (JPM) were some of the more popular financial holdings within hedge funds, with Regions Financial (RF) and Citigroup (C) also becoming new long positions for some funds. While the net short position of financials also rose slightly, 8% to $63 billion, the large increase in long exposure has resulted in hedge funds being net long the financials by the end of Q2 (WSJ). Although hedge fund redemption request have decreased, reducing the need for forced selling, it is unclear if hedge funds on average will maintain their net long positions in financials after the nice run these stocks have made since the March market lows.

On average, hedge funds were up 2.44% July and 11.89% for the first seven months of the year according to data from HedgeFund.net (see hedgeweek article). This was the best seven month performance data since 1999, driven in part by the rising equity markets and near record performance in directional fixed income. Convertible arbitrage returned 6% in July and is the best strategy year to date, while managed futures have lagged equity-based strategies. Nonetheless, even with the current out-performance, 54% of funds are still below January 2008 levels.

Hedge fund firm AQR Capital Management has launched a set of indexes designed to capture the returns of stocks that have positive momentum (see WSJ article). In addition, the firm launched three no-load mutual funds that will track the new momentum indexes. The AQR Momentum Fund, AQR Small Cap Momentum Fund, and AQR International Momentum Fund will track the AQR Momentum, Small Cap Momentum, and International Momentum indexes, respectively.

The new AQR indexes are constructed using the top one-third of stocks that have outperformed other stocks in their grouping over the last 12 months, with the stock weightings based on market capitalization. The large-cap index examines the 1,000 largest U.S. market cap stocks, while the small-cap index will examine the next largest 2,000. The indexes are rebalanced quarterly. The designers of the funds hope that investors will use them to represent the growth portion of their portfolio since momentum-based portfolios tend to do well when value strategies are not in favor. Pure growth strategies also tend to under-perform momentum strategies over time according to a principal at AQR. Nonetheless, each momentum strategy needs to be somewhat specific, making it difficult to do a direct momentum for growth substitution, but could still prove useful for those looking for diversification with their momentum investing.

Hedge funds posted their first inflows in nine months (see BarclayHedge article, free registration required). Based on a survey of over 1,200 hedge funds, it is estimated that the hedge fund industry gained $1.4 billion in May, or 0.1% of total assets. Nonetheless, funds-of-funds and CTAs are still experiencing outflows. Fund-of-funds, which did not do as good a job as expected picking hedge funds in order to justify their extra layer of fees, lost $5.2 billion, or 1.0% of assets in May. This makes their twelfth straight monthly outflow. Below is the hedge fund asset flow data by strategy for May 2009 (source: BarclayHedge, see article, free registration required). Next to fund-of-funds and managed futures, event driven strategies saw the biggest outflows. Equity long-short, fixed income, and multi-strategies saw the biggest inflows.

Now that the Obama Administration has released its proposed Financial Regulatory Reform: A New Foundation for updating the regulatory structure of the financial system (pdf file of reform, WSJ article), the public debate will begin in earnest regarding the details and proposals in the document. Ironically, while the public seems open to new financial regulation, the release of the document is coming at a time when some citizens are starting to worry about growing deficits and government intervention (see WSJ/NBC poll article), with almost seven in 10 people surveyed saying that they had concerns about federal interventions into the economy. Nonetheless, finding ways to limit risk and prevent another credit crisis through added regulation of banks and hedge funds still rings a populist tone, and is likely to continue to receive support.

Like many others, I feel that there are aspects of the new regulations that seem appropriate and make sense, with others that seem counterproductive. As for those that concern me, I agree with some who point out that it seems odd that the Fed is going to be given greater power (and responsibility) to fix some of the very problems it may have caused or contributed to (see Larry Kudlow article). I also worry that the new proposed Consumer Financial Protection Agency could end up just adding new and potentially unnecessary regulations and red-tape paperwork, along with producing counterproductive limits on rates and fees that will do less to protect individual consumers and more to reduce the availability of needed products that are offered to such individuals. Such restrictions, if not properly crafted, are likely to reduce the earnings of financial services companies, and even worse, limit their ability to effectively manage risk (through fee and rate changes).

The idea of requiring companies to retain 5% of all structured product offerings also has me concerned, even though this specific proposal seems to be generating some of the most support, at least initially. Recently I wrote that I have worries about forcing companies to retain a stake in each securitized product they develop since I believe it could actually make companies more risky (since they cannot off-load and manage all their risk, see previous post). Furthermore, while I agree that forcing companies to have some "skin-in-the-game" would make it less likely that they would offer risky products, it also makes it more likely, in my opinion, that they would offer less structured products. While this may be a desired outcome for some, the impact of this would be less liquidity and available credit at a time when the country can least afford it.

Another area that is generating support involves the idea of controlling systemic risk. I too believe that this is a good idea in theory, but am unclear exactly how this would be measured and acted upon. As recently reported in the WSJ (see article), one potential area to start with is leverage. As the chart below illustrates, financial sector borrowing increased steadily between 2004-2007, before dropping in 2008 as companies began unwinding leveraged positions. It is now well known that banks, hedge funds, and average citizens were carrying too much debt, thereby helping to increase systemic risk, and trigger the credit crunch.

Source: WSJ, Fed data
Yale economist John Geanakoplos, who has studied leverage in the economy, believes that regulators need to gather daily data from all market participants and then publish aggregate data. The feeling is that if market participants knew that leverage values were getting to extreme levels, they would be more likely to begin backing-off their own debt and leverage levels in anticipation of eventual market corrections, or restrictions imposed by regulators. Focusing at least in part on debt and leverage seems to make sense.

Unfortunately, measuring system-wide daily leverage changes at banks and hedge funds may be difficult at best, and suspect at worst. Yet, maybe the focus does not need to be on the three person hedge funds that are investing $10-50 million in capital. Getting comprehensive data which includes smaller players may not be necessary. Risk manager Richard Bookstaber - whose book "A Demon of Our Own Design" is recommended reading - believes that focusing on just the largest financial firms and hedge funds would cover roughly 80% of the risk, allowing you to see systemic trends.

At this point it is unclear if such trending information on leverage levels would be enough. Other related areas that could also cause potential cascading effects, such as specific derivative use (i.e., CDS) and counter-party risk, should also be examine - although regulating that which has not yet been developed is obviously difficult. Nonetheless, looking for new ways to measure leverage might be a good place to start for spotting worrisome trends. Such a signal could allow investors, funds, and the Fed (or other regulator) to take action. Of course, what action they take is another area of debate, and potential new area of concern.

Morgan Stanley is attempting to lure hedge fund clients back to its prime brokerage (see WSJ article). As a carrot, Morgan is planning to announce that hedge fund clients will be allowed to hold some of their assets in the MS Trust National Association, instead of being held in the brokerage units of the firm (for a small fee, of course). This could be significant given that many hedge funds are worried about their assets being held in a brokerage unit after the collapse of Lehman Brothers. Of interest is that assets held in the trust will not be federally insured, like deposits, but will still nonetheless probably be considered safer given their separation from the brokerage operations. It will be interesting to see if in the months to come whether or not more financial firms follow suit. In the mean time, it is one more indication (among others, see second WSJ article) that the hedge fund industry is starting to get back to normal. You can decide whether that is good or bad.

In a recent Bloomberg article, it was mentioned by the Credit Suisse Group that the Federal Reserve could consider selling options to primary dealers in order to help them ease imbalances in derivative positions that are amplifying swings in interest rates (see Bloomberg article). This sounds interesting, given that a similar strategy was used in 2000 in the form of liquidity options to help head-off potential Y2K funding problems. In addition to options, investors could also use swaps, swaptions, and Treasuries to help hedge interest rate risk.

Of course, such a hedge position may not be possible for others if the new regulation being proposed by the Obama Administration is put in place (see the Washington Post article). One aspect of the new proposed regulatory framework would require firms to retain a stake in each securitized product that is developed. Furthermore,

"The plan also would prohibit firms from hedging that risk, meaning that they could not make an offsetting investment"

While I understand the reasons for proposing such a restriction - the hope that it will cause investment banks to develop less risky, less leveraged, and less opaque products, thereby preventing another 2008 credit meltdown - it seems this could be achieved in a less restrictive, yet more focused way. Forcing companies to keep a piece of the structured security (and subsequent risk) on their books appears counterproductive when it makes more sense to allow and encourage companies to hedge this risk, even if it means passing the risk onto another investor such as a hedge fund willing to take on the risk (and reward). Forcing companies to keep risk on their books will only repeat some of the same problems that various investment banks faced in 2008 when they were unable to sell and shed structured product risk once the credit crunch unfolded.

While forcing these companies to keep some of the structured securities on their books could make it more likely that they would offer less risky products, is this what we really want? One of the benefits of securitization is its ability to free-up capital for more productive uses. While this process certainly got out of control and was misused in some instances, placing a blanket restriction on what can be sold also places similar restrictions on risk reduction and the flow of capital into more productive hands - something we cannot afford to restrict, especially at this time. Here is hoping that the current proposal is just that, a proposal, and that any final legislation will consider the unintended consequences and be more focused on the specific problem that needs to be addressed - uncontrolled risk taking.

Hedge funds had a nice May, up 5.2 percent on average. While the recent market rally no doubt helped, hedge funds also appear to be benefiting from less competition (see Economist article), with approximately 1,500 funds liquidating last year. This follows a similar trend observed in the late 1990s when less competition for trading opportunities helped those funds that survived after the LTCM failure.

But as reported in the article, not everything is rosy. After poor performance in 2008, many investors are requiring a more fair fee structure, one that is either closer to 1-10 (instead of 2-20), or that phases in fees over a longer period, after the fund has outperformed a benchmark - with the benchmark closer to the general market, and not simply zero, or a non-negative return. Investors also seem to be asking for more managed accounts where they can see where their money is being invested, and can also withdraw it quicker (and without gate restrictions). If that was not challenging enough, one cannot forget the added government regulation is coming down the pike. Possibly the biggest loser will be the funds-of-funds, which tack on an extra level of fees for the expertise of picking the best funds. Their failure to outperform enough to compensate for the extra fees, along with the benefits of cheaper hedge fund replication clones (see previous posts here, here, here, and here), are also making their services less cost effective.

According to the recent TIM (Trade Ideas Monitor) report, over the last five trading days, institutional brokers are continuing to becoming more bearish (see note below, previous post, or the youDevise website for additional information on the TIM report). For the five trading days ending June 4, the number of short ideas as a percentage of new ideas sent to investment managers increased 41.35%, compared to 35.88% just a week ago. The TIM reflects which direction brokers are expecting a stock to move over the next 1-3 weeks. The TIM Long-Short Index, measuring the total number of long ideas compared to the total number of short ideas sent to clients, decreased 35.4%, further highlighting negativity and bearishness from brokers. As for individual securities, Palm (PALM), Freeport McMoran (FCX), and Petroleo Brasileiro (PBR) were the stocks most recommended as shorts by institutional brokers.

Note: The Trade Idea Monitor (TIM) is an application for measuring "ideas from authors (mainly brokers) to recipients (mainly buy-side clients)" (see youDevise website). It is used by institutional brokers to send long and short equity and ETF trade ideas to clients. The TIM Report is based on the number of real-time equity trading ideas sent to over 4,300 equity sales people, sales traders, and analysts at over 300 institutional brokerage firms to more than 100 hedge funds, quant funds, and investment managers.

In the CNBC video below, Bill McIntosh, editor of the Hedge Fund Journal, outlines the state of the hedge fund industry, with a focus on those strategies that have been doing well since the market correction last year. Equity-based strategies, arbitrage, and long-only emerging markets have been doing the best (see Hedge Funds Review article for more on emerging market funds). Not surprising, funds investing in banking and energy stock have been doing well. Defensive funds have underperformed, even though they have at least been able to preserve capital as advertised. The increased optimism is also causing most hedge funds to remove gates and lockups that were put in place late last year.

Source: CNBC Video
As reported at both Reuters (see article) and Bloomberg (see article), and discussed in a previous post, redemption request have decreased, and there is an expectation that investors will add $50 billion into hedge funds this year in an effort to catch the current wave, and hopefully recoup some losses suffered last year. Whether this is a bullish or contrarian indicator remains to be seen. Given the recent market moves, along with inflation and debt worries (see previous post), there are concerns of near term bearishness (see previous post). Yet, if "panic buying" starts occurring from the nearly $3.8 trillion currently sitting in retail and institutional money market funds (see Huffington Post article), a nice summer rally may still be in the cards.

As for the hedges, it will be interesting to see if the smaller funds can regain their out-performance status over larger funds, after falling behind last year (see Hedge Funds Review article). Even with their flexibility, this may be difficult given the trend for skittish investors to now require a track record of accomplishments, which is sometimes easier for the larger funds to provide (see Financial Times article). Of course, if the market continues to rally, greed may starting winning out over fear of loss (possibly replaced by the fear of missing out), regardless of the managers style or size.

Institutional brokers are becoming more bearish on equities over the last five trading days according to the Trade Ideas Monitor (TIM, see Hedge Funds Review article). The TIM is an application for measuring "ideas from authors (mainly brokers) to recipients (mainly buy-side clients)." (see youDevise website). Short ideas as a percentage of all new ideas sent to investment managers through TIM increased from 28.55 percent to 35.88 percent over the last five days. During the same five day period, the TIM Long-Short Index decreased 28.6% from 2.50 to 1.79, signaling more negativity on the market as a lower index reading implies that brokers are more bearish. The TIM Long-Short index measures the total number of long ideas sent to clients, compared to the total number of short ideas, with the ideas focused on market moves covering on average the next 1-3 weeks. This seems to correlate with some of the recent sentiment from technical analysts who predict that the markets may experience a short-term sell-off as they consolidate around key technical levels, even though the upward trend still appears to be in place.

As insurance companies, banks, and endowments continue to scale back hedge fund investments, a new survey from Barclays finds that pension plans and wealthy families may be increasing their investments. Such investors have about 14 percent of their assets in cash, with almost 80 percent of this group planning to allocated money to hedge funds during 2009 (see Bloomberg article). With pension plans having around $437 billion in assets, and wealthy families controlling another $72 billion, potential investments could result in over $50 billion being added to hedge funds this year. While $50 billion is not anyway near current Government spending levels, it is certainly enough to generate its own form of market stimulus, adding additional buying pressure as the major indexes continue to flirt with key levels.

Even though on average hedge funds had a down year last year, they still outperformed the broader market and many other asset classes. As a result of this out-performance, the money allocated to hedge funds had become one of the larger positions within many investment portfolios, causing portfolio managers with defined asset weighting to reduced exposure to their hedge fund investments in order to get portfolio allocations back in-line. Now, as a result of broader market and other asset classes rallying over the last few months, the allocation to hedge funds is smaller than required, reducing redemption requests which began increasing last fall (see the NY Times article). With fewer redemption requests, hedge funds can quit hording cash (in anticipation of new withdraws), and instead start putting capital to work in the market. As mentioned by the authors of the NY Times article, given their high fees, new regulations, and negative press, it may take some time before new money makes it way into hedge funds at the same pace managers saw just a few years ago. Nonetheless, the reduced selling alone could be enough to start increasing returns and attracting new interest among investors. This alone could be good for all investors, regardless of their individual exposure to hedge funds and other alternative investments.

Just as the media and regulators continue to discuss the use of alternative investments and the active trading of hedge funds in contributing to the downfall of the economy and the stock market, many private investors are seeing each as a way to help protect themselves from recent market uncertainty (see New York Times article). While a more conservative trading mentality has been the norm for high net worth investors, many are now questioning its usefulness in the current market environment. Many investors who in the past have relied on a simple mix of stocks, bonds, and cash, and now turning to managed futures, financial futures, hedge funds, funds-of-funds, mutual hedge funds, currencies, commodities, and other avenues for gaining exposure to alternative investments.

Maybe even more interesting is how these same investors are becoming aggressive in moving away from a strict buy-and-hold approach, and instead are looking to take advantage of short-term trading opportunities - a move that indicates in part that such investors are not only opportunistic, but also worried about placing longer-term bets on the markets. As mentioned by Paul Speargas, senior client at WMS Partners:

“The buy-and-hold strategy, which was almost universally accepted by the investment and academic community over the past several decades, is no longer the sole investment strategy to be employed in order to deliver solid investment returns. A thoughtful balance between long-term investing and short-to-intermediate term trades is likely the recipe for investment success in the volatile years ahead.”

Given the interest by clients to still utilize hedge funds, commodities, futures, and alternative investments, not to mention the desire of the Fed and Treasury to have investors step-up and provide capital to purchase distressed assets, it might be good to pause and reflect before slapping or over-regulating the trading hands that are still willing to check the temperature of the investment waters.

Even while equities were rallying over the last few months, some well-known hedge funds were increasing their exposure to gold (see WSJ article). Some of those buying gold, gold futures, and shares of gold producing companies include Greenlight Capital, Paulson and Company, Eton Park Capital Management, and Blue Ridge Capital Holdings, among others. Yet, instead of providing a hedge against a market correction, the move appears to be motivated more by a worry of excess spending and borrowing by the government, resulting in an eventual spike in inflation, and rally in gold prices. While the recent market run has scared some away from the trade, many others are staying long, and even adding to positions, with current gold-related hedge fund investments coming in on average around 5 percent of assets. With gold still holding above $900 an ounce, there is some worry that a crowded trade will keep the shiny metal from moving much higher in the short-term. Nonetheless, for those with a longer investment horizon, there is still an expectation that the excessive printing of money will eventually cause the chickens to come home to roost, validating those who continue to stay long gold.

As the current administration continues to scold hedge fund "speculators" and blame them for potentially forcing Chrysler into bankruptcy for not accepting a deep discount on their debt (before they finally relented), those same firms may now hold more keys to the success of some of the programs being pushed by the same folks doing the scolding (see Bloomberg article). While smaller in numbers and size than just one year ago, hedge funds are still in many instances those with the most capital and risk tolerance to participate in programs such as the TALF and PPIP. Yet, while hedge funds like making money, they hate losing it even more, especially when those losses are driven in part by the rules of the game being changed. Given the recent move to ignore and subordinate more senior debt to a status lower than other parties, hedge funds may be more cautious with future investments opportunities.

Such program participation may soon get another test as hedge funds weight their options as GM goes through its own restructuring. Holders of GM bonds have just a few weeks to decide if they want to swap their debt for a 10 percent equity stake in the company - while the government and the United Auto Workers union-run health care funds get 50 and 39 percent, respectively. While not only getting the short end of the stick, those debt holders who also hold CDS contracts would most likely favor a bankruptcy filing (see Financial Times article). Estimates have investors holding $34 billion in CDS on GM, with profits on the order of $2.4 billion if GM were to default. In what is not much of a surprise, current CDS prices are indicating that a bankruptcy filing is likely. The complicated and extensive lines of debt and derivatives will make both a GM bankruptcy, and any strong arm tactics, much more difficult to execute. Given less of an incentive to participate in the next restructuring, hedge funds may find others offering a little more cooperation, and maybe even a seat at the table going forward. At some point, you cannot keep slapping the hand that may save you.

In the wake of some hedge funds pulling back risk, participants at a recent Investing Summit in Asia feel that private equity, boutique firms, institutions, and sovereign wealth funds will begin buying distressed debt (see FinanceAsia.com article). Many of these firms are expected to enter the secondary market for distressed assets given the opportunity to buy them at large discounts. Nonetheless, participants at the conference worried that all the "distress" was not currently in these assets, and that there was no reason to rush into buying them. Ed Altman, Professor of Finance with the NYU Stern School of Business, agrees, and predicts that the assets and the bargains will be available for another 6-12 months.

The Worlds' Largest Hedge Fund (yes, that one, the one owned by you and I, the U.S. taxpayer) may now be adding additional securities to its portfolio. According to a recent Bloomberg article, the Fed is considering expanding the Term Asset-Backed Securities Loan Facility (TALF) to include loans for the purchase of Commercial Mortgage Backed Securities (CMBS). As you may recall, the TALF was developed to provide low-cost Federal Reverse loans that would be used to buy securities backed by consumer debt - essentially using taxpayer money to provide debt to help other taxpayers purchase the debt of still other taxpayers that took out too much debt [Yes, I know, using debt to solve a problem caused by too much debt does not really make sense, but I digress]. Anyway, since the TALF has previously been used to purchase securities tied to automotive debt and credit cards by offering three-year loans, why not try it now using five-year loans for commercial real estate? After all, it has been so successful for the auto and credit card industries (GM, Chrysler, and a White House Presidential scolding of credit card executives, notwithstanding - tongue in cheek, of course).

All kidding aside, it is hoped that such loans will create buying pressure for CBMS, thereby decreasing yields - many of which are near junk levels, making it unprofitable for banks to make new loans at such high yields. The down fall, of course, is that with such loans having a five instead of three year maturity, it will be even harder for the Fed to timely withdraw money from the system in later years, just when inflation is likely to creep back with a vengeance as the economy begins to hopefully recover. While maybe too late, at some point we are going to have to ask, are we preventing collapse and saving entire industries, or are we simply, and needlessly, juicing the system in order to save a few select companies, all the while unnaturally speeding-up the recovery? If the later, we may want to start planning for the hangover now.

In the video below, Jim Cramer makes the case that hedge funds, and others for that matter, should consider going long select names given the recent positive (or less negative) macroeconomic data.

The Alternative Investment Management Association (AIMA), an international trade body for the hedge fund industry, is reporting that an absolute majority of all assets under management by hedge funds and funds-of-funds are held by institutional investors. In addition, a third of those assets from institutional investors now come from pension funds. While the AIMA has some interest in promoting hedge funds and other alternative investments, the breakdown does highlight how a growing number of institutional investors, including pension funds, university endowments, and foundations that are invested in alternative investments, with the numbers growing each year. While there is certainly reason for individual investors and those on "main street" to be upset with some of what has been happening on Wall Street, using a blanket approach of penalizing all of Wall Street could have unintended consequences for individual pensions and those charitable and cultural activities often sponsored by endowments. Saying that "what is good for wall street is no longer good for main street," to paraphrase some in Washington, could be bad for the average citizen if actions begin to match the rhetoric.