Market uncertainty is causing some hedge fund managers to stay on the sidelines (see WSJ article). Steven Cohen, John Paulson, and Israel Englander have move much of their funds into cash. In addition to general market uncertainty, many hedge funds are also worried about stricter regulatory requirements and short selling limits, the rules of which appear to be changing nearly every day. While it is not unusual for managers to not trade when they feel they do not currently understand the market, it is also not unusual for them to begin trading quickly once conditions improve and market dynamics are more clear. Unfortunately, even once the markets start to enter steadier waters, navigating the regulatory environment will no doubt continue to be a challenge going forward as the debate continues in earnest on how to prevent similar problems in the future. Funds may find that hedging such risk is just as important as guarding oneself against market risk.
Money continues to flow into gold assets and gold ETFs (see Time Online article). The SPDR Gold Trust has expanded its holdings by 26 percent since the Lehman Brothers failure. South Africa has temporarily run out of krugerrands, and the US Mint has also temporarily suspended sales of American Buffalo bullion coins (American Eagle coins were already halted in August). Maybe this is a contrarian sign. The market action today certainly is promising.
There was an interesting article at the AllAboutAlpha blog a few weeks ago that discusses a recent working paper that considers a new method for measuring the systematic risk to the financial system that results from the level of hedge fund leverage. The report considers both funding leverage and instrument leverage (i.e., leverage to increase returns directly, such as buying on margin, compared to leverage that results from the product itself, such as buying an option contract). Of interest is that the study uses techniques from hedge fund replication research in order to determine the level of leverage a fund was using. Fascinating stuff for someone interested in developing hedge fund replication models. Nonetheless, given the recent issues with marketing to model when data is limited, the models developed will no doubt need to be improved a little before the Bank for International Settlements incorporates it into the next version of the Basel accord.
A combination of falling crude oil prices and falling US and world equity markets has caused stocks over the last four days to lose almost a quarter of their value in Dubai and 17 percent in Saudi Arabian markets, just less than a week after there was an expectation that these markets were immune from the financial problems in the West (see Washington Post article). Some stress that the problems in the Gulf are more structural, with the lack of transparency and information resulting in the markets being impacted more by unsubstantiated rumors and panic selling. Nonetheless, the level of exposure is still believed to be significant. Losses from sovereign wealth fund investing in the US and elsewhere are yet to be disclosed, but are expected to be significant, causing many funds and their capital to sit on the sidelines as the credit crisis to unfold.
It appears that one potential opportunity has presented itself as a result of the ongoing credit crisis. Many larger investors investors who qualify for hedge fund investment, but who have previously been shut out due to their fund of choice being closed, may now have their opening (see Reuters article). Mass redemption are causing funds that previously closed their doors to open them back up. Of course, for many hedge funds this would still require you to have up to half a million dollars, and also nerves of steel given the daily developments in the market. While at a loss, hedge funds on average are still "only" down 9.41 percent, compared to the 30 percent drop in the DJIA over the same time frame. Yet a loss is a loss. Of course, even if you feel that the market has bottomed and decide to park your money in a hedge fund, the fund may not put your funds to work right away given that money is still being kept on the sidelines in order to deal with future redemption. Furthermore, while long-term investors should be rewarded, there is always a worry that hedge funds that continue to see larger losses and redemption may also force them to close-up shop and start new if current performance takes them too far away from any internal high water marks that are necessary to once again start taking performance fees. While the dawn does come after the darkest part of the day, it may unfortunately still be too soon to know how late it is in the evening.
The Financial Services Authority (FSA) in the UK is planning to conduct a "significant reappraisal" on how banks use securitization to free-up capital (see Financial Times article) given that mortgage bonds and other asset-backed securities are becoming more complicated than originally believed. This is important for US investors given that the FSA is the leading voice on the Basel Committee. Adjustment beyond current Basel II regulations and guidelines are already being discussed with regard to raising bank capital requirements. The problem is that as new products are developed, it is difficult to know exactly what risk are being created for all counterparties. Since the risk is often managed at the point of origination, or sold off, there has at times been less interest in formally quantifying the risk, leaving counterparties on the other side with a product that is less understood than others in terms of market and credit risk exposure.
One person close to the issue was quoted as saying that securitization of ordinary loans turned out to be "considerably more complicated than originally thought." Yes, but in many cases it was not that they were more risky than previously calculated, but that the risk was never really calculated or considered in the first place. As risk was sold off and transferred, there was often an assumption that someone else was bearing the risk. In the end, the risk was not only larger than some predicted, but it was not transferred to others as expected. Contagion in the system was not hedged away as expected.
While new regulation is a given, hopefully some type of clearing house for credit derivatives and related products will also be considered to help price these assets, which will in turn will allow the markets to observe the level of risk that is currently being reflected in market prices. Regulation that encourages such transparency would be a good and necessary first step. On the other hand, if new regulation is just another way to require extra regulatory capital without really developing a mechanism for understanding the risk of the assets in question, we will once again be back where we started - not fully understanding the risk will result in companies continuing to be under-capitalized and at risk, or forced to set aside too much capital for the current levels of risk exposure. Such an outcome will simply prevent the efficient flow of capital that is necessary to spur economic growth without really addressing the problem of knowing the true levels of risk and exposure.
September may in fact be the cruelest month of all, at least for hedge funds - now even worse than the previous "comeuppance month" just this last July (see previous post). Popular funds, such as Greenlight Capital and Maverick Capital had especially difficult months (see WSJ srticle and figure below), driving year-to-date losses beyond 15 percent and more.
Source: WSJJust recently many were asking the question: "Where are the big hedge fund failures?" (see previous post). At that time, many hedge funds, while down, were still doing better than the broader market (see previous post). Some of the funds that were struggling were hoping to see recovery before waiting periods on redemption notices were finally met. Unfortunately, the September sell-off has only made it more likely that investors will go forward with their plans and begin pulling money out of funds (see recent post).
As a result of potential mass withdraws, there is an expectation that as investors pull money out of funds, the larger funds are the ones that are most likely to survive. This belief is felt in part since large funds have more institutional clients, such as pension funds and endowments, which are less likely to reallocate funds to another manager, especially after putting so much money into hedge funds over the last few years. This could have a profound impact on the structure of the hedge fund industry given that three-fourths of the nearly 10,000 estimated hedge funds have less than $500 million in assets under management (according to data from Hedge Fund Research).
Yet, smaller funds have their advantages as well. While being more nimble with their portfolio as the market changes, they also have the ability to form a more personal relationships with their high net worth clients. In fact, a recent survey found that while an overwhelming 81 percent of wealthy investors were looking to change their advisor, only 29 percent of investors with smaller firms were looking to withdraw funds (see previous post). When all is said and done, clients need to put their money somewhere, and trusting it with someone they know, and someone who can hold their hand during difficult times, may help some successful small managers weather the current market sell-off.
It is quite possible that both large funds (due to experience, reputation and stability) and small funds (due to being more nimble and personable) may survive, as more mid-range funds (between $500 million and $1 billion) find it difficult to be flexible enough with their portfolios, or maintain the necessary personal relationships. Like election voters this fall, those in the middle may find themselves choosing between experience and stability versus flexibility and change. Of course, just as with elections, such choices are not always as easy or as clear-cut and obvious as they seem. The hedge fund landscape will no doubt change, but it may end up looking less different than anticipated. Furthermore, while looking structurally similar, the hedge fund industry, with its innovation, flexibility, and capital, may also end up doing more to help solve the current difficulties regardless of whether one believes they were the root cause of the problem (see Financial Times article).
As a follow-up to yesterday's post, many of the hedge funds that are being forced to liquidate positions due to redemptions and deleveraging are seeing an opportunity to take advantage of the mass selling (see Financial Times article). Hedge funds will often be holding many of the same securities, either due to using similar strategies, or simply from chasing the same hot securities. As hedge funds begin unloading these positions, selling pressure will naturally cause lower prices and additional selling in a kind of longer-term reverse short squeeze as the number of redemption notices increases. In a effort to profit from the selling, many of the same funds that are being forced to liquidate are now shorting other securities they don't currently own, but believe other funds are being forced to sell. This cannibalistic activity has been especially troublesome to some of the more popular and well known funds, such as at Ospraie, whose positions are more well-known than small, less capitalized funds. The larger funds are also natural targets given that it often takes a while for them to fully unwind their positions, providing better shorting opportunities. With the TARP bailout bill signed into law, and any benefits of the bill potentially priced into the market, we may be in store for more selling until the prey stop being preyed upon.
In a surprising turn of events (for some), the market sold off Monday on news that the TARP bill failed, and again today on the news that the bill passed, even with the ban on financial stocks still in place and extended for another few weeks (see WSJ article here). How could this happen? Isn't the short-selling ban suppose to put a floor on the market? Of course not, but the current sell-off of the market at a time when a ban on short selling exists for over 1,000 stocks illustrates in part how current portfolio positions are still being reduced.
So who is doing the selling? It is probably coming a little bit from everywhere, but the hedge funds in particular appear to be taking every market rally as an opportunity to sell into strength. Recent news highlights how hedge funds are experiencing a decade-worst level of performance (see WSJ article), with September possibly being one of the worst months on record for many funds, with losses expected to be between 5-9 percent on average. Such poor performance is also causing an increase in withdraws. In particular, fund-of-funds (FoF), which invest in individual hedge funds in order to diversify risk, are helping to facilitate the hedge fund redemption as some investors are withdrawing up to 20 percent of assets under management (see WSJ article). On average, FoF were down 6.4 percent in August, even worse than the already terrible 4.9 percent loss experience by individual hedge funds. The problem is significant given that FoF account for about 40 percent of the $2 trillion hedge fund market. Many FoF also make it easy to withdraw money, as opposed to most hedge funds that have longer lockups and notification periods. To compound the problem, many hedge funds also became over-weighted in energy and commodity stocks just as the market was topping this summer, and are continuing to unwind these positions. Redemption notices put in near the end of the summer are also now meeting their time restrictions and being executed. Many funds had hoped to see a recovery before any redemption requests came due, but many investors are not having second thoughts, and are going forth with withdraws. The wave of selling may continue for a while, regardless of any short-selling ban.
Even with the downturn in the residential housing market, and credit issues that continue to make front page news, as of the end of September REITs have generated total returns including dividends of about 1.8 percent year-to-date (see Investment News article). During the same time the S&P 500 was down 19.3 percent, the Nasdaq was down 21.1 percent, and the DJIA was down 18.2 percent.The REITs that are outperforming include the self-storage REITs, which are up 33.8%, health care REITs, which have risen 18.5 percent, and apartment REITs, which are up 17.4 percent. Not surprisingly, the worst-performing REITs are those tied to mortgages, with returns down 31 percent. Other poor performers include the lodging REITs, down 26.7 percent, and the industrial REITs, down 25.4 percent. The wide range in returns continues to illustrate that not all REITs are created equal, in part due to their varying levels of exposure to the current credit issues that are gripping the market.
In fact, if you still find the US market a little too uncertain, looking outside the US may prove beneficial. The Canadian real estate market appears to not have the same level of exposure to the recent US housing-related problems due to their real estate market having a more stringent regulatory structure (see Seeking Alpha article). Unfortunately, many of the REITs in this market have already had a nice run after being oversold last year, and may provide less current opportunity (see past Trader's Narrative blog post for a listing of Canadian REITs). On the other side of the globe, Northern Trust has recently launched a new Japanese REIT, although it is also not clear if the timing is right given possible credit exposure in the Japanese markets, along with the low liquidity and volatility of the product (see Seeking Alpha articles here and here). Nonetheless, many Japanese REITs do have exposure to commercial real estate, as opposed to residential real estate, making them currently more attractive. Analysts are also speculating that the market has finally reached rock bottom in Japan and is therefore due for a correction, although many have been making this call for a while now.
The SEC is reminding financial services firms that they don't have to use fire sale prices when evaluating hard to price assets (see Reuters article). In making the clarification, the SEC reaffirmed that management's internal assumptions can be used to measure fair value when relevant market evidence is not available, and that "distressed or forced liquidation sales are not orderly transactions." Now, instead of relying on fire sale prices, companies can go back to marking-to-model, even when the inputs to models that are based on observable factors are no longer being observed. The greater use of assumptions for valuation has caused a former SEC accountant to state that the SEC directive could be titled "pick a number, any number" in how it gives banks too much leeway in choosing numbers for valuation. Other opponents also feel such steps just reduced the transparency of the real risk facing institutions. While the move may in fact make the real risks less transparent, I am not sure the existing method as used, at least in the current environment where problem assets are nearly impossible to price, is helping the situation. I suspect that at least in the short-term investors are not going to be underestimating the risks that financial institutions are facing just because mark-to-market rules are a little less transparent. At least the new interpretation, and possible additional changes being considered in Congress and elsewhere, should help with liquidity problems while other steps are being taken to help open up and stabilize the credit markets.
It looks like the market sell-off is causing wealthy investors to start getting a little nervous (see a recent Wealth Report blog post). A new survey by Prince and Associates has found that 81 percent of investors with over $1 million of assets available for investment plan to take some of their assets away from their current advisor, with 86 percent recommending that other investors do the same. Just 2 percent plan to recommend their firm to others. The larger brokerages and banks appear to be taking the lion's share of the blame, with 90 percent of clients with large brand firms planning to move money away from their current advisor, with 70 percent moving all assets. Only 29 percent of investors with smaller firms (with more personalized service) plan to withdraw funds. Of course, this always begs the question: "What do you then do with the money?" More than likely it will just move to another advisor, although smaller firms may see a net increase in accounts and funds. The movement of money often corresponds with the movement of advisors (see an On Wall Street article). Ironically, it is often during times like this when most small (and large) investors realize that they actually need help. In the late 1990s, when investors felt they could just throw a dart at the stock tables, many felt they were a market genius, or at least believed they did not need to pay for genius advice. After the crash, both portfolios and attitudes quickly changed. I suspect we will see a similar interest in professional money management given the recent market corrections and volatility, even as the deck chairs are shifting.
According to research by Bespoke Investment Group (see article), 78.8% of the stocks in the S&P 500 were trading more than one standard deviation below their 50-day moving average. On a net basis, 78.2 of the stocks in the index were oversold. In the last 18 years there have only been 36 other days where more than 75% of the stock in the S&P 500 were oversold on a net basis. Nonetheless, this does not indicate that the stock market is ready to reverse long-term given that on many of these occasions any reversals were short-lived (less than one year), and were at times followed by further declines.
There is an interesting article by Felix Salmon over at the Market Movers blog on how risk aversion is changing among retail investors. It used to be that when someone was risk adverse, they wanted to make sure that their principal was protected, even if that meant giving up return. Now risk adverse investors are more worried about losing everything. Even if a nice product is offered that protects principal, it could be viewed as risky if the bank or institution offering it has the chance of going bankrupt. Riskier products, such as various types of index funds, might now be preferred. Even though they to can go down in value, and have been, the chances of them going to zero is smaller, so investors feel safer. I guess this is comparable to the current demand for gold coins. Even if gold goes down in value, investors still have something in their hand beyond just a worthless stock certificate or bank statement.
There is an interesting article by John Berry in Bloomberg that highlights how the US government may be able to profit from what will amount to one giant carry trade. Specifically, the government will need to get the proposed $700 billion bailout funds by selling a range of US Treasuries with yields in the range of 3-4 percent. As we have seen recently, investors are eagerly trying to purchase Treasuries, so the market should be able to absorb the supply without increasing yields to any large degree. Furthermore, even if the trouble assets that are being purchased take haircuts of 50 percent or more, yields should still be in the range of 10 percent or more. The spread on an investment of $700 billion could then generate income up to $40-60 billion annually. Of course, this is all just speculation given that no one really knows yet what assets will be bought, or what price will be paid, but the potential for profiting in a "carry-trade" manner does exist. Optimists go on to state that not only would it generate some positive income, but such income could be used to reduce the budget deficit. Carry-trade profits? Maybe. Using profits to pay down the deficit and debt? Not so sure. As they say, stay tuned.
Update: Nothing like speaking too soon. The Paulson plan went down to defeat this afternoon. I don't imagine this is over.
Tightening credit is hurting more than just Wall Street (see BusinessWeek article). As of September 9 of this year, 57 companies had defaulted on a total of $45.3 billion of debt, up from 22 total companies defaulting in all of 2007. For the 57 that have defaulted, 45 are not in the financial industry. Unfortunately, the trend may get worse as approximately 70 percent of non-financial companies carry a junk credit rating, with the default rate possibly rising to levels not seen since 1981. Companies that are feeling the impact of the credit crunch include automakers (in particular GM), airlines (UAL Corporation - UAUA), franchisees (such as some at McDonald's, MCD, who may not default, but are having problems getting loans for coffee bar expansions), and entertainment (Boyd Gaming - BYD, Trump Entertainment - TRMP, and Six Flags - SIX). The S&P list of "weakest links," or companies that could default in the next 12 months, is now at 162 firms and growing.
Even as Wall Street is getting its house in order, many investors are still considering the U.S. as one of the safest places for investment (see Asian Investor article). Bond and equity funds that invest in global and emerging markets had outflows of $9.5 billion last week at a time when U.S. equity funds had $10 billion in new inflows. Last week also saw U.S. money market funds gain $11 billion. This is the 11th time in 13 weeks that U.S. equity funds recorded net inflows. Of interest is that for the first time in five weeks, growth funds outperformed value funds for all capitalization levels. At a time when even U.S. money market funds have come under suspicion and had to be back-stopped, such a move by investors may seem curious. Yet, with the exception of gold, investors have been confused as to where they should put their money given that it needs to go somewhere. Recent moves indicate that at least internationally, they may be starting to make their decisions.
Credit Default Swap (CDS) dealers have reduced outstanding contracts for the first time since 2001 (see Bloomberg article). The volume of trades globally fell to $54.6 trillion from $62 trillion, according to the International Swaps and Derivatives Association. Traders are unwinding trades and protecting against losses as the U.S. credit markets continue to struggle. Currently, 17 banks handle about 90 percent of trading in credit derivatives. At the request of the Federal Reserve Bank, these individual banks have begun tearing up trades that offset each other in an effort to help reduce the day-to-day payments, paperwork, and potential errors, further reducing the amount of capital that commercial banks are required to hold against the trades on their books. It is unclear how many offsetting trades are left, and what level of counterparty exposure that will remain once the tearing up of trades completes.
In an effort to help boost its struggling stock market, the Securities Regulatory Commission in China is scheduled to sign-off on a plan that will allow short selling and margin lending (see Bloomberg article). The government is hoping that the changes will add fresh capital to the equity markets. China has also recently eliminated its tax on stock purchases and has relaxed company buyback rules. The move is in stark comparison to orders in the U.S., Europe, and Australia that have recently placed limits on short-selling. It is ironic that China, often criticized for being less open, appears to be offering free market solutions for its declining markets at the very time other economic superpowers are increasing trading restrictions within their own markets. The next year should be interesting, and telling, as countries about the globe take different approaches towards bolstering their economies and strengthening their capital markets.
Hedge fund executives are telling CNBC that Wall Street is beginning to market a new hedging product that would allow them to short stocks on the banned short sale list (see CNBC article). No doubt that this will be a new derivative-based product given that puts and other derivatives are still allowed to be sold, and that market markers are still allowed to short securities in order to hedge their own writing of derivatives. Many opponents of the new products feel they are nothing more than a loophole to the SEC order. Of course, those introducing the products stress that they will only be used for hedging purposes. Yet, it is still not clear to me how you verify this, or whether this will be just another "wink-wink" arrangement where it is assumed that everything is for hedging purposes. If the shorting product is abused and impossible to verify for hedging, then the ban on shorting financial stocks will prove to be useless, unnecessary, and itself a loophole for creating stable markets and handcuffing those who are thought to be causing the problem. In fact, does anyone else find it strange that the very firms that are protected by the short selling ban are developing products to find a way around the restrictions? Are hedge funds biting the hand that feeds them, and are financial companies just facilitating their own destruction? It all seems a little odd to me. Then again, I am still trying to understand the logic of mark-to-market accounting for illiquid assets, or why rating agencies can be so wrong and so late, yet still have the power to start the financial dominoes falling. Not a lot makes much sense right now.
