As reported in a recent WSJ article, small hedge funds (those with less than $1 billion in assets under management) are struggling to not only beat the market, but also stay in existence. The impact is seen below in a chart from the WSJ article, by way of Hedge Fund Research, Inc.

Source: Hedge Fund Research, Inc., Wall Street Journal
At the end of 2007, 87% of all hedge fund money was in funds with $1 billion or more assets under management, and 60% was in funds with at least $5 billion in assets. Furthermore, while the number of hedge funds has grown to over 8,000 from only a few hundred just 10 years ago, only 1,152 new funds were launched in 2007. While 1,152 is still a large number, this figure is down 50% from the 2005 peak. When you also consider all the funds that were either merged or went out of business, the net number of new funds was even lower at 589.

The shift towards larger funds appears to be occurring for a number of reasons. For one, smaller firms are having difficulty borrowing funds, making strategies that utilize leverage much more difficult to employ. Some lower cost mutual funds are also beginning to act like hedge funds using various replication strategies, thereby giving investors other options. Institutions and pension funds, which are increasingly looking for alternative investment opportunities, are also choosing to allocate capital to larger hedge funds, which many believe are safer, given their larger capitalization and risk management (i.e., hedging) practices. The more flexible smaller funds have at times generated higher returns, but given the current market environment, larger funds with better risk management have made up for their lack of flexibility. Given that some smaller funds can spend up to $1 million or more a month for staff salaries and expenses, along with the reality that it may be a while before some hit their high water marks and can begin capturing 20% or more of profits, it is becoming more difficult for these funds to contend with current cash burn rates. As a result, don't be surprised if more smaller funds either change strategies, close down, or merge with the larger funds as the credit problems continue to unwind, and new capital continues to get allocated to hot markets, such as commodities and energy.

Recently there was an interesting article at Spiegel Online regarding the faces of commodity speculation, as told by a farmer, baker, banker, and hedge fund manager. The use of the futures market by both the farmer and baker (hedging against falling and rising prices, respectively) are well known, as is the interest by both investment bankers and hedge funds, but the perspectives offered by the participants are interesting nonetheless.

While the article highlights only four individuals/institutions, and is somewhat anecdotal, it does offer a few observations. For instance, the following quote from the farmer is telling: "Farmers who don't have supply contracts at the moment are now calling the shots." This particular farmer, who had not yet signed a contract, is planning to sell only half of his crop to the cooperative at the end of July at the current price. He then plans to store another 50% until at least October in silos in the hope that prices will rise further. He admits that farming is becoming more speculative and that he is willing to take the risk. Quiet a turn of events and roles.

The baker on the other hand is worried about speculation and the associated risk, and is still worried that his raw material costs will be too high. As prices have increased, he is being forced to pass cost increases on to his customers, and is worried that the markets he must now operate in are too unpredictable. Since the EU has abolished intervention prices - which had helped to regulate the market he operates in, prices are now set at the CME, which he worries is being driven by speculators.

The investment banker is, not unexpectedly, trying to take advantage of the market by offering new products, such as certificates whose value rises or falls along with the price of food commodity contracts on the CME. Of interest from the investment banker is the quote of how they want to "provide each private investor with a toolkit he can use as if he were a hedge fund manager worth millions." This brings back memories of people quitting their day jobs in the late 1990s to trade stocks online at home, only to see the market correct violently. As has been pointed out by others numerous times before, when the average investor begins talking about securities and markets that he or she never talked about before (day trading tech stocks before, commodities and futures this time around), it is usually the sign that a top in the market is near.

Finally, a hedge fund manager was interviewed and pointed out that he no longer trades crude oil futures (ironically, since they are too speculative), but continues to watch them closely, since at the moment "... oil futures are the measuring stick for everything." Whether trading in oil futures or not, the fund manager needs to know how high crude oil might go given that its price has such a strong impact on the stocks he trades. Many other traders have also expressed how crude oil is affecting nearly every other asset, and how crude oil itself is becoming the new global currency. Right now that currency is in an uptrend, but volatile, and worrying market participants of a correction.

As reported at Arab News, and commented on at Bloomberg, United Nations Secretary General Ban Ki-moon is saying that Saudi Arabian King Abdullah "... acknowledged that the current oil prices are abnormally high due to speculative factors and he is willing to do what he can to control it.”

Video Source: Clip Syndicate Bloomberg
Saudi Arabia had previously offered to increase production in June by 300,000 barrels, and may now increase production by 500,000 barrels in July. Given that Saudi Arabia is one of the few countries that has idle capacity and can actually raise production, this could certainly help in the short-term.

Nonetheless, even with the news of increased production, crude oil prices were still up sharply this morning in futures trading. While the crude oil markets are volatile and seem to have a mind of their own, the current news may be a reflection of a few realities. First, there is only limited idle capacity that can be brought to market. If the world were to suffer another shock, given a political or weather-related oil field or pipeline shut-down, it may be difficult for the markets to make-up reduced capacity in short-order, quickly putting pressure on prices. Second, the increased crude oil that is being placed on the market is not the light sweet crude that is demanded and driving price.

Of course, prices may also be reacting to recent calls by analysts, CEOs, and speculators, such as the one made by the CEO of Gazprom (see Bloomberg article), forecasting $250 a barrel for crude oil in the "foreseeable future." The call is more of a worst case scenario, and certainly is not unbiased, but does reflect the current mood of the crude oil market. T. Boone Pickens recently called for crude oil to reach $150 a barrel over the summer (when it was around $120), only to see the price spike higher. Recent calls such as this bring back images of the dot.com bubble in the late 1990s. During this rush, all things technology and Internet-related were doubling on a regular basis, with many stocks reaching new analyst annual forecasts in a matter of weeks. A $100 stock that was forecast to reach $180 over the next year often found its market price close to the new $180 target in just a few trading days. While I am still a skeptic as to how much speculators and not supply and demand are driving the crude oil market, calls such as the one recently made by the Gazprom CEO are not helping to stabilize the market, and are certainly enticing some momentum traders to take positions and enter the market.

2nd Notice: Given that the weekend link summaries are a little dated, in the future I will just post the shorter summaries as I write them in an effort to make them a little more timely.

After a short hibernation, the Microsoft-Yahoo saga is back in the news (for the time being I am taking the ! off the Yahoo name given that the excitement is now gone). Per the Wall Street Journal, Microsoft and Yahoo have decided to give up their plan courtship, but of course, each leaves open the right to form some type of partnership in the future. Yahoo then went right out and got engaged to Google (which it can back out of with a change in leadership - i.e., Yahoo decides later it really prefers Microsoft).

To be honest, it is all a little boring anymore. Like many merger agreements and talks, value usually gets destroyed instead of created. This certainly seems true for Microsoft, given that Yahoo is now partnering with their main rival Google. For their troubles, Microsoft left with nothing but a bruised ego and a stronger main competitor. Microsoft stock did pop on the news, as investors were glad that the distraction was gone, at least for now. Eventually they will realize they lost this part of the Internet, and will begin scratching their heads and wondering what to do next - as well as praying that the Xbox 360 numbers are better than expected, and that Vista is not really that bad. Sigh.

Of course, Yahoo really did not fair much better. For a company that built itself on search, they have essentially farmed-out the business to their main competitor. Exactly how this is good in the long-run is difficult to understand. But as Yahoo CEO Jerry Yang mention, this will bring $800 million in annual revenue through improved monetization. No mention was made of loss of market share. Sigh.

And of course, there are the billionaires - Icahn, Pickens, and Cuban. Cuban will not get his board seat, and Icahn and Pickens, well, they will not get richer - at least not yet. I am sure they will be fine. As for the other Yahoo investors, some of which were invested through funds, well, they did not fair as well. Each may have a wait a while before seeing Yahoo at the proposed $35 a share price. Sigh.

Any winners? The same winner before everything was put into motion - Google. Without really doing too much it was able to chop a leg out from under and weaken the behemoth Microsoft, who while inept in search and the Internet, still has a lot of money to throw around. At the same time it took its next closest competitor and put a leash on it. Not bad for six months of press releases and the extension of a previous beta test agreement with a competitor.

In the end, nothing much has changed. Microsoft continues to trip over itself when it comes to the Internet, Yahoo continues to destroy value, the billionaires are still rich, small investors still absorb the lost capital, and Google continues to dominate search. Myself? I just feel a little hung-over.

Given all the bad news written about the U.S. economy, in particular energy and food prices, credit problems, financial failures, higher unemployment, and the housing crisis, it would be nice to finally hear some good news. As reported in a Financial Times article, the good news came in the form of the Rand Corporation announcing that the U.S. remains the dominant global player in science and technology. Among all industrialized nations, the Rand study finds that the U.S. still accounts for 40% of global spending on scientific R&D and 38% of patented inventions. A total of 75% of the world’s leading universities are in the United States. A total of 70% of the world’s Nobel prize winners also work in the U.S.

Of course, everything is not rosy, as expected. Policymakers worry that lower standards and decreased spending on research could hurt the economy and threaten national security. The Rand Corporation also warns that more college educated scientists and engineers now graduate in the European Union and China every year, compared to the U.S. As a member of academia who has taught in both engineering and finance departments, the increase of domestic students choosing to enter the work force after graduation as opposed to entering graduate school has been apparent for years. Unfortunately, at this point it is hard to see how the trend can be reversed quickly, even with our continued good standing regarding undergraduate and graduate science, engineering, and technology education. The difficult part is convincing domestic students that the hard work they put in now will pay dividends in the future. Unless we continue to support investment in all kinds of technology (be it biological, energy, computer/electronic, etc.), and give companies the business environment they need to continue to innovate and attract the best and the brightest, this may continue to be a hard sell. But if we can continue to do the right things, and provide the proper environment, there is reason to be optimistic.

As recently discussed at bullbeartrader.com, and followed-up today with another article from Bloomberg, heavy rain is causing corn prices to reach record levels. Prices have essentially risen for 6 straight days after Bloomberg first reported how heavy rains would cut the corn crop estimates. Global inventories are forecast to fall to a 24-year low as prices head higher for the fourth straight year. As reported in the recent article:

Corn's yield potential falls unless plants have emerged from the ground before the end of May in most of the Midwest. Corn planted in wet, cool soils develops shallow roots, increasing the threat of damage from hot, dry weather in July and August. About 60 percent of the corn crop in the U.S., the largest exporter of the grain, was in good or excellent condition as of June 8, down from 63 percent a week earlier, and 77 percent a year earlier, the USDA said June 9 in a report. An estimated 89 percent of the corn crop had emerged from the ground as of June 8, compared with 98 percent a year ago and the five-year average of 89 percent, the USDA said.

As the U.S. summer heat begins to increase in July and August, there is an expectation that the USDA will cut its crop estimates even further. Wheat (up 48%), rice (up 62%), and soybeans (up 64%) have also all been rising over the last year.

The Financial News is reporting how the current methodologies for non-exchange dark pools may be resulting in volumes being reported higher than they should be. Guidelines exist for reporting volume, but there is not a standard way for calculating them. Currently, both the buyer and seller volume are being counted, resulting in a form of double counting. This has been standard practice, but now smart-order routing is causing many sellside brokers and independent pools to count routed volume as well. For instance, by using smart-order routing, an order sent to a dark pool could be matched in the pool, or routed to another dark pool, causing volume to be counted two or three times. When it is match in the second dark pool, it is counted once again, possibly even two more times.

Double counting is often used as a standard practice, many times for no other reason than for marketing purposes in order to show the liquidity offered by a particular dark pool. Nonetheless, not everyone is following the same rules-of-thumb, making it difficult to compare dark pools, and more importantly, get a good read on the real level of trading volume. Some brokerages, such as Merrill Lynch, are choosing to not publish volume data given the industry-wide inconsistencies. To correct the problems, some are reporting both "volume" and "pass through." While using "pass through" to measure routing volume would seem to be an easy fix, it is not quite as simple as it seems given that some pass through trades are "not matched," some or "not eligible for matching," and some are just "touched."

To complicate matters, the exchanges are not free and clear when it comes to dark pools. While the exchanges have seen some trade volume move to the dark pools, and the non-exchange dark pools have generated criticism for their secretive nature, the exchanges are also involved in similar activities. In fact, exchange dark pools not only exist, but have been increasing as the exchanges try to fend off threats from non-exchange dark pools. Approximately 10-20% of consolidated volume occurs on Bats Trading, Nasdaq OMX, and the NYSE Arca exchange-based dark pools. As mentioned by Brian Hyndman, senior vice-president of Nasdaq transaction services: "We have the ability to break our non-displayed liquidity from our displayed liquidity. We are the largest exchange in terms of volume in the US and the largest for non-displayed volume." Such a badge of courage may make Nasdaq investors happy in the short-term, but may also cause problems in the future as regulators begin to look into dark pools and their affects on liquidity and price discovery. Given the recent talk of speculation in the commodities markets, in particular the crude oil markets, any discussion of lack of price discovery, even in a different non-commodity market such as the equity exchanges, may generate un-welcomed attention. The uncovering of increased dark pool activity may be something that not only results in embarrassment, but also causes investors to increase selling volume and execute their own method of price discovery.

The Financial Times and Reuters are reporting that Icap, the interdealer brokerage, is launching a new survey-based reporting of one and three month unsecured bank funding cost. The poll will be released at 10 AM New York time. The move is yet another attempt to find solutions and/or provide alternatives to Libor - which has come into question recently and has been something we have talked about extensively (last article), including proposed alternatives.

The 10 AM reporting for the Icap value will occur when the eurodollar deposit market is the most active. Only rates, and not contributing banks, will be reported - thereby reducing signaling effects. Currently, more than two dozen institutions are involved in reporting for Icap. The British Bankers Association (BBA) is already meeting to discuss alternatives and ways to return confidence to Libor reporting. Moves like the one recently made my Icap will certainly help speed up the process.

As reported from Reuters, the CEO of Potash has recently stated that he believes that the next five years could be "the greatest period of growth" for the company in its history. He goes on to say: "We have a lot of pricing power. We're nowhere near peak pricing." Given recent fertilizer price increases, demand, and stock price activity, this certainly seems like a bold statement. As seen in the daily and weekly charts below (from stockcharts.com), the price activity for Potash has been outstanding. The weekly chart shows a nearly perfect 45 degree line uptrend for both the weekly price and its 50 and 200 week averages.



Charts like this are both exciting and scary. While the chart looks good technically, logic tells us that what goes up must surly come down - or at least take a breather. While not apparent on the weekly chart, the daily chart does show some consolidation before moving back up, albeit somewhat volatile. If the stock can hold above the $210-215 level, then investors may have a little more confidence that the uptrend will continue. Recent comments from the Potash CEO should certainly help provide some short-term buying interest in the stock. If he is correct, and fertilizer prices truly are going up and demand does stay strong, than Potash and its competitors (Mosaic and Agrium) should continue to outperform.

As reported in Bloomberg and elsewhere, a group of 17 banks have come together to create a clearinghouse system to move credit default swap (CDS) trades and cover a failure by one of the market-makers. While the amount of potential CDS loss is closer to $2 trillion, and not the entire $62 trillion in notional value that often gets reported, the possible market exposure is still significant and should be addressed. Just a little over a week ago we discussed the CDS counterparty risk issue in an article that mentioned how regulators and the Fed were looking for ways to limit the exposure from a counterparty failing to meet its obligations.

Of concern is not so much the failure of one bank or counterparty, but the possible systematic risk that would be felt by the entire financial system. The new system will allow the market to trade against the central counterparty, mitigating the consequences of failure by a major institution. In addition to systematic risk, the system should also help prevent a Bear Stearns-type of failure since there will be less need to make a run on a specific institution.

Other benefits of the clearinghouse will be increased liquidity and transparency. Providing a clearinghouse will encourage more swap trading, and larger volume will allow for a more efficient market and more reliable mark-to-market process. This will make it easier for investors to have a better idea of the true exposure that a company is taking, allowing for a better valuation and more efficient stock price. Currently, it is difficult for companies to even know what their credit risk exposure is given that the CDS market is thin and delayed, not to mention opaque at best. The new center counterparty system is a good step towards helping to shine light on the CDS market by reducing credit risk, and allowing for more real-time price discovery.

Unfortunately, it will not be enough to suffer losses from just regular credit default swaps (CDS) and collateralized debt obligations (CDO). As reported in the WSJ, additional pain from synthetic CDO losses may be just around the corner. Synthetic CDOs have been around for a while, but have become popular in the last few years as a way for insurance companies, banks, and funds to invest in a diversified portfolio of companies without directly purchasing the bonds of the companies. While many of the problems with CDOs linked to mortgage debt have been uncovered and are currently being felt, problems with CDOs linked to regular corporate debt are now raising the interest of rating agencies.

Unlike normal CDOs, synthetic CDOs do not contain actual bonds or debt. In order to provide the normal income stream generated by CDOs, synthetic CDOs provide income by selling insurance against debt default. Each synthetic CDO typically has numerous companies with good to high "investment-grade" credit ratings. Like a normal CDO, different tranches, or levels of risk and return are sold. The tranche structure allows some investors to receive higher returns (while taking higher risk), while making it possible for others to take much less risk, but also receive lower returns. Again, much like a normal CDO, it is possible to create a higher investment grade asset (tranche) out of lower quality securities. Additional details regarding collateralized debt obligations can be found here.

Insurance companies typically purchase the higher rated senior and mezzanine tranches, while hedge funds, looking for higher return, yet willing to bear or hedge the additional risk, typically invest in the lower-rated or unrated equity tranches. As with any CDO, in order to increase the returns of the equity tranche, the banks that created the CDOs can simply include lower-grade (higher return) debt. As the credit crunch progressed, more of these lower-grade companies have defaulted on their debt, causing the CDO losses to move up to the higher tranches. Given the synthetic nature of the CDO, rating companies are now being forced to develop new methodologies that will allow them to examine synthetic CDOs.

New downgrades will surely result from this closer examination, forcing additional selling of already distressed securities, putting further pressure on the markets. Combined with higher energy costs, this should prove to be a challenging time for some companies and investors, as well as the market in general. The old saying, "may you live in interesting times," will certainly get tested as we move into the dog days of summer.

Video Source: Clip Syndicate Bloomberg
Richmond Federal Reserve Bank president Jeffery Lacker is warning about consequences from the decision of the Fed to lend to securities dealers. Of concern is how investment banks are not subject to the same level of regulation and oversight as are commercial banks. Paraphrasing, Lacker points out that the effect of the recent credit extension on the incentives of financial market participants might induce greater risk-taking, and that this increased risk-taking could give rise to more frequent crises - the classic case of moral hazard.

Robert Eisenbeis from Cumberland Advisors points out that some of the Fed officials may be having "buyers remorse" with regard to going down the path of opening-up securities lending to investment bank. As a result, some are starting to discuss potential problems in public, possibly in an attempt to begin sending a message to the market that this is not something that the investment banks can always rely on. Many economist have pointed out that once the Fed bailed out Bear Stearns and opened up the discount window, they let the cat out of the bag and will have a difficult time getting it back in. As other investment banks run into trouble, they will no doubt be expecting similar treatment, including cheap borrowing and a market for illiquid assets.

Eisenbeis mentions possible ways to begin correcting the perception, including preventing investment banks from being prime dealers - in effect preventing them from being a conduit for implementing Federal Reserve policy. The Fed could also force the investment banks to change their charter, allowing the Fed more flexibility to take necessary actions to secure the assets available for borrowing. Nonetheless, any changes will be difficult. Since it is unlikely that the Fed will make any formal declarations, the market will no doubt have to wait until the next potential failure before it will know for sure what actions the Federal Reserve is willing to take. Hopefully this will not come sooner than later.

Given that the weekend link summaries are a little dated, in the future I will just post the shorter summaries as I write them in an effort to make them a little more timely.

Video Source: Clip Syndicate Bloomberg
Rainfall has been over 3 times the normal amount in the Midwest the last few weeks, with more rain on the way. The heavy rains are affecting corn and soybean yields, with just 74% of corn emerged from the ground, and only 32% of soybeans emerged. Farmers are now at a point of needing to make a decision of whether to take the Government subsidized crop insurance and keep the ground idle, or plant and take the risks of lower yields, which could be potentially as low as 75% of normal yield levels. As much as 500,000 to 3 million acres may become idle. Analysts are already cutting corn crop yields by 4 bushels per acre. As ethanol production continues to increase, expect corn prices to rise, with consumers feeling the effects at both the pump and in the grocery store.

Companies to watch that may be impacted include Archer Daniels Midland (ADM) and Bugne (BG). Others that are likely to continue to benefit from rising demand for food commodities include fertilizer companies such as Mosaic (MOS), Potash (POT), and Agrium (AGU), chemical and seed companies such as Dow Chemical (DOW) and Monsanto (MON), and agricultural machinery makers such as Deere (DE). On the direct downside are the users of corn, especially the restaurants and food producers with lower margins and less pricing power, such as Darden (DRI) and Tyson Foods (TSN).

Cambridge Energy Research Associates is estimating that the Tupi-area fields in Brazil will cost between $200-$240 billion to develop. As reported in Bloomberg, labor and equipment costs are rising as oil prices increase. Recently, deepwater rigs have received rents of $600,000 a day. As a result of the huge project, Brazil and Petroleo Brasileiro SA will need international partners with lots of capital. Nonetheless, the effort and cost might be worth it given that the offshore fields are expected to hold up to 50 billion barrels, or $6 trillion of petroleum at today's prices. If estimates are correct, the wells could help to make Brazil a top 10 oil producer.

As discussed before, Petrobras has already leased approximately 80% of the deepest-drilling offshore rigs. Astonishingly, the company also plans to hire 14,000 engineers, geologist, and drillers to help with the project. They are also buying new rigs and production platforms. As periphery plays in the short-term, this is certainly good news for the drilling contractors, such as Transocean (RIG), Nobel (NE), and Nabors (NBR). For longer-term investment, some capital-intensive E&P oil companies such as Exxon Mobil (XOM) should do well, although these companies may require direct involvement to see any benefit.

As discussed in a recent Bloomberg article, the spread between the 3-month Libor and the overnight index swap (OIS) rate, traded forward 3 months, is greater than similar expiring spreads. This recent movement in the spread is signaling that traders are concerned that banks will have difficulties obtaining cash to fund existing assets, as well as putting into question their ability to shore-up their balance sheets. In general, an increasing spread signals that funds are becoming less available. The recent activity appears to be driven more by traders leaving the short-term, closer to expire positions early over worries about Libor and its reliability.

The spread has averaged about 11 basis points over the last 10 years, but has ranged between 24 bps to 90 bps this year, and has gotten as high as 106 bps last December. The activity in the swaps market is worrisome, indicating that derivative traders do not feel that the sell-off of financial companies in March was the low, and that the worst is not behind us. Recent problems/concerns with Lehman Brothers, Wachovia, and UBS, as well as the recent sell-offs in Goldman Sachs, Merrill Lynch, JP Morgan, and Citigroup are also highlighting concerns with the financial companies. As usual, this is not good news for the economy and the market as a whole as it needs a strong financial system to keep greasing the gears of expansion. It may be a long summer until the credit markets start showing a little more confidence.

A recent Reuters article highlights how 57% of U.S. venture capitalist are now investing outside the U.S., compared to 46% last year. While a contrarian might argue that this is an indication of a top in the international markets, it does give clues as to which markets are still receiving capital, and what sectors in each market are receiving attention. While the top countries for receiving new U.S. capital continue to be China and India (approximately 20%, or $9 billion of total capital flowed outside the U.S., with about $2.5 billion going to China and India, with software mentioned as one of India's strengths), money is also beginning to flow into other markets.

In addition to the usual BRIC countries (Brazil and Russia in addition to India and China), VC money is flowing into Taiwan (for semiconductors), Japan, Israel (software), Germany (alternative energy, medical devices, software), and the United Kingdom (software). U.S. companies, even when not making direct investments, are also stepping up interest in partnering with developing international companies. In particular, IBM was mention as a company looking for partners in technological innovation. It is continuing to invest in the BRIC countries, along with interest in Canada, Peru, Vietnam, Russia, and Ireland, although no specific companies were given. Warren Buffett and Berkshire Hathaway have recently been looking for opportunities in Germany and Asia.

Of course, the real story may be that since many of these countries are continuing to do well, it may be U.S. companies that increase their interest in receiving capital infusions from overseas. Investment from Middle East allies, especially in financial companies, tech, and large industrials have been commonplace for years, but investment from China and India, as well as other countries with double digit growth economies, and/or growing petrodollars, will no doubt increase. Just last month a WSJ article discussed how Brazil, originally thought the be the lightweight newcomer in the BRIC grouping, has set up a sovereign-wealth fund to invest its extra currency generated from its growing position in agriculture and natural resources, in particular its increasing crude oil exports. As the U.S. continues to figure out its energy policy, and whether we even have one, it may find itself not calling the shots anymore as it looks for ways to repatriate its exported dollars (from imported energy) back into the capital needed to continue domestic economic expansion.

As reported from ETFTrends, by way of Seeking Alpha and Yahoo, JP Morgan is launching the first 130/30 Exchange Traded Note (ETN). 130/30 funds were also briefly discussed in this blog a little less than a month ago in a Weekend Link Summary post. As designed, the offered ETN is a modified equal weighted total return index offering 130/30 exposure to large cap stocks.

The offering is certainly an attempt to capture the recent excitement with 130/30 funds, but as mentioned here and elsewhere, many are skeptical that 130/30 funds are nothing more than a traditional long / short fund. In fact, there appears to be nothing magical about the 30% short position, and there is no specific reason to short and only use this level of leverage. A general 1X0/X0 structure could be adapted to develop any long-short strategy that meets your own risk-reward objectives. Hopefully new research, both from academia and industry, will shed some light on whether the 130/30 structure, or something else, provides the best use of the short position and generates the highest risk-adjusted return.

Below are the weekly link summaries for the usual topics, with energy added. As usual, hopefully you find some interesting articles that you may have passed over.

Commodities and Energy

S&P launches new commodities and natural resources indices
Hedgeweek
* Standard & Poor's has launched two new indices, the S&P Global Natural Resource Index (with contributions from 60 large energy, agribusiness, metals, and mining companies), and the S&P PMI Commodities and Resources Index (similar sectors, but with 160 stocks for broader exposure). The indices can be invested in and are available for benchmarking. Often, but not always, this kind of activity begins to mark the top, or at least short-term peak, in a sector or market. Time will tell.

Why Cap-And-Trade Won't Work
Paul Cicio - Forbes
* An opinion article in Forbes about the problems with the proposed cap-and-trade legislation. Beyond the pros and cons of whether cap-and-trade will actually help reduce carbon emissions, of interest is the effect on clean energy. Low carbon alternatives, such as natural gas, should see an increase in price as companies look for ways around new mandates. Nuclear is another carbon-free option for power generation, but given its own regulatory issues, and the 10-20 year backlog for reactor domes and other critical components, it is likely that natural gas will be the only viable short-term alternative. If the legislation is passed, expect natural gas prices and electricity prices (natural gas plants currently set the marginal price) to increase.

Joy Global Mines Money From Commodities Boom
Melinda Peer - Forbes
* As usual, look for and consider the "consequence" or periphery plays when investing in sector booms. As for commodities, mining equipment makers Joy Global and Bucyrus International are doing well, very well. Downturns in these and other similar companies may give an early indication of changes in the commodity landscape. Often it is the pick equipment makers, and not those selling the gold, that make the most money during the rush.

Coal seam gas seen as Asia's next hot energy play
Reuters
* Interesting article from Reuters talking about how some countries are using coalbed methane (CBM) as an energy source to power cars and electricity plants, among with things. Methane stores in Asia are estimated at 2,100 trillion cubic feet. As LNG prices continue to rise, CBM is hoped to be a viable alternative for both developing and developed countries with large coal deposits. Storage is still a problem for some counties as they retool existing plants. Coal seam gas also has a lower heating value compare to natural gas, but is able to be blended with LPG (liquefied petroleum gas). The gas does have a low sulfur and carbon content, allowing it to burn cleaner.

Derivatives

Banks launch central clearer for derivatives
Hal Weitzman - Financial Times
* To mitigate some of the risk of privately negotiated credit derivatives, 11 of the world's biggest banks announced the creation of the first central clearer for derivatives, in particular credit derivatives. The clearer will use funds contributed by traders to guarantee against counterparty default. The clearing will be run by The Clearing Corporation, a Chicago-based institution backed by the banks.

Canada's emissions-trading market open for business
Boyd Erman - Globe and Mail
* Short article about a new emission-trading market, called the Montreal Climate Exchange, from the TSX Group. The exchange will allow companies (AKA "polluters" in the article) to buy and sell carbon credits. Look for emissions trading to continue to be a big business going forward. It will be of interest to see if these markets allow for "greener" companies to develop and survive. Since carbon credits can be traded from non-polluters to polluters, a green company could sell its carbon credits to the polluters, essentially making the polluting companies subsidize part of their business. In fact, just about any business, with or without environmental intentions, could do this. I guess it depends on how the credits are distributed, but the system may leave itself open for gaming and profit opportunities.

Climate-Bond Plan by UN Official Aims to Boost Energy Investing
Alex Morales - Bloomberg
* Why should Canada have all the fun? The United Nations is considering a new climate bond that would be sold to investors in developing countries as a way to spur investment in green projects. How would they work? Mature bonds, after they have been used to finance green projects, could be exchanged for credits that allow industrial plants to emit a certain amount of carbon gases. How are they funded and priced? The amount of money generated would depend on the level of emissions-reduction targets set in the current round of UN climate talks. I guess if you need more funds, you could raise emission targets. As with the Canadian system, the effort is noble in intentions, but has the potential to kill the goose that laid the golden egg (or provides the revenues in this case), while not really solving the problem. Hopefully safeguards will be put in place to prevent abuse. In its current form it is also not clear that overall emissions will actually be reduced. Time will tell.

US and European debt markets flash new warning signals
Ambrose Evans-Pritchard - Telegraph (London)
* The cost of insuring against default on bonds of Lehman Brothers, Merrill Lynch, and others has increased in the last few weeks, as debt markets are signaling fears that the global credit problems are still here, and could be entering another phase of write-downs. Inter-bank Libor and Euribor spreads are back to near record levels, with Lehman Brothers debt credit default swaps rising from 130 to 247 in a little over one month. Merrill Lynch debt has spiked to 196. As reported by Willem Sels, a credit analyst at Dresdner Kleinwort, ".... banks are beginning to face waves of defaults on credit card, car loans, and now corporate loans. We believe we're entering Phase II. The liquidity crisis has eased a little, but the real credit losses are accelerating. The worst is yet to come." It is also felt that the increase in corporate bankruptcies is not yet being seen by the usual indicators, which tend to lag the market.

Bonds Insuring Next Hurricane Hugo Beat Subprime
Erik Holm - Bloomberg
* As hurricane season begins, investors are clamoring once again for catastrophe bonds, the market of which as tripled over the past three years to more than $13 billion. Some of these bonds yield near 15%, with the average around 11% - assuming that we don't get another Rita, Katrina, or Hugo. One attraction to the bonds is their lack of correlation with the stock and bond markets. The key here is weather or natural disasters, and not credit. Given the problems with mortgages and subprime, hurricanes and earthquakes seem like a safer alternative for some - but it is still possible to lose your entire cat bond investment if the big one does occur. What I find interesting is how the whole market is somewhat circular. Cat bonds are often offered by insurance companies as a form of reinsurance to protect themselves if a catastrophe does occur and they are forced to pay out. Who buys the bonds? We do, through pension funds, hedge funds, and less so through individual investments. We are essentially taking out insurance with the insurance companies to protect against an event happening, and then buying bonds against the event actually happening. On the other hand, insurance companies are selling us the insurance to protect us in case the event does happen, betting themselves that it won't, and then selling us bonds to protect themselves in case it does. Confused? Ah, you have to love the markets. Who are the big reinsurance companies? Swiss Re, Munich Re, and General Re (Warren Buffett's Berkshire Hathaway's reinsurance company).

Hedge Funds

Hedgeweek Comment: Going with the flow
Hedgeweek
* There was been a lot of talk about hedge funds looking for investment in Asia, but not as much action as the talk (although some investments). It appears that now some funds are entering Asia, and not just for opportunity (which they can take advantage of stationed nearly anywhere). Instead, funds are opening in Asia to take advantage of liquidity and capital that is not as available in the west, as in the past.

Prime Brokerage Will Make $11B in ’08: Study
Christopher Glynn - HedgeFundfont>.net
* Prime brokerages are expected to receive $11 billion in hedge fund money in 2008, a 15% increase over the 2008 value. Goldman Sachs, Morgan Stanley, and JP Morgan, who own the majority of prime brokerage market share, are expected to be the biggest beneficiaries.

Private Equity

Morgan Stanley, Citigroupfont> Bankers Leave as LBOsfont> Slow
Pierre Pauldenfont> and Jonathan Keehnerfont> - Bloombergfont>
* Top bankers are leaving larger firms, such as Morgan Stanley and Citigroupfont>, as the LBOfont> market grinds to a near-halt, compared to recent years. Many banks are still trying to clear out old loans that they are unable to get off their books. Banks have traditionally made money twice, once on the deal, and once when they sell the debt to others. Many banks are now being forced to hang on to the bad debt that in the past they were able to push off on other investors. Some of this debt is now selling for less than 70 cents on the dollar, making it difficult unload without taking a huge loss.

FT REPORT - CORPORATE FINANCE 2008: Public life after private equity
Chris Hughes - Financial Times
* Interesting case study of one company, now public after it was floated on the stock market by a private equity group, is now having difficult dealing with current high energy and raw material cost after taking on previous private equity debt. Companies with high leverage can do well in boom times, but suffer more in downturns given that their fixed cost per unit begin to rise rapidly as sales decrease. The effect on the bottom line is intensified as variable cost increase, as they have for many companies highly dependent on raw materials and energy. We often hear about the slowdown and problems with private equity investors, but often forget about the companies that are now dealing with the debt issues directly.

An unlikely financier
Janet Morrisseyfont> - Investment News
* Yes, you too can start you own private equity firm. Interesting story of Malonfont> Wilkusfont>, a college dropout that started his own private equity firm, American Capital Strategies, with a focus on middle-market companies. So far the fund has delivered annual compound returns of 18%, including an average dividend yield of nearly 10%. Not bad, although last year the firm was down 22% with other financial stocks.

Quantitative Finance, Financial Engineering, and Trading

Prospectors join Canada's electronic gold rush
Melanie Wold - Financial News
* Not a specific trading strategy article, but does highlight to impact of the recent commodity boom on trading, at least in Canada. Given the rise and interest in trading in the commodity-rich country, investors are taking an increased interest in the Canadian markets. As such, market technology vendors and investors are increasing, providing numerous alternative trading systems, platforms, and trade crossing networks, causing Canadian regulators to implement institutional trade matching, settlement framework, and best practice guidelines. This looks very similar to the buildup of ECNsfont> and exchanges in the late 1990s during the U.S. technology dot-com boom. Hopefully it does not end the same way for the Canadian market.

China rebukes west’s lack of regulation
Jamil Anderlinint> - Financial Times
* Interesting perspective from Liaont> Min, the head of the China Banking Regulatory Commission, about how western governments must strengthen oversight of their financial markets. There argument is that by giving the market too much leeway, problems such as the subpriment> crisis were allowed to develop. It is believed that tight regulation has made it nearly impossible for exotic financial instruments to be developed in China. Of interest from the regulator is worries regarding the increased flow of money into their market, as a result of investors abandoning the dollar and U.S. markets (argued as being due to our regulation-lacking induced problems). This shift in funds is causing a potential asset bubble and rising inflation in the Chinese market. As a result, China is considering advocating new international laws and regulations for providing timely and accurate information during crisis. Even so, as international economies develop and mature, and the flow of money into the "new" economies slows down, I would not be surprised to see their use of derivatives increase (in order to internally reallocate capital), regardless of current perspectives.

Three ETF-of-ETFsnt> are launched
David Hoffman - Investment News
* Admit it. You knew it was going to happen. It was just a matter of time. Invescont> PowerSharesnt> Capital Management has launched three new ETFsnt> that invest in ...... what you say ..... other ETFsnt>. While providing investment advisers more choice, especially those that are not investment strategists, many advisers are not happy. Why, the ETFsnt> of ETFsnt> (ETFsnt> squared anyone - you heard it here first, I think) reduce the fees that advisers receive for recommending and selling products to investor. Why get one fee when you can get three by selling three different ETFsnt>. Even worse, some investors may realize that they don't even need an adviser, and can just invest in a diversified exchange traded pool of diversified asset classes. Then again, some investors probably will not know what that means, so the advisers job is probably safe. Now, if we only had derivatives on ETF-squares. Ah, Wall Street can dream.