Margin debt at NYSE member companies fell 37.6% for the year through November, down to $201.48 billion (see WSJ article). This is no doubt that some of this reduction came from forced margin call selling over the last few months. While rampant speculation may not reenter the markets anytime some, the reduction of speculative investments, along with past hedge and mutual fund redemption selling, is helping to clear out the excess in the market, allowing it to find a bottom and begin building a base. January is often used as a bellwether for things to come in the markets, and the market action on the first trading day was encouraging - yet one day does not make a market. Nonetheless, January will certainly continue to generate interest as the confluence of a new year, a new president, a new congress, a new stimulus bill, and an unfolding credit crisis continue to intertwine in what will continue to generate some interesting times, not to mention opportunities in the market.
The Yale University Endowment is looking for opportunities in the credit markets and distressed debt, including bank loans, investment-grade debt, and lower-grade bonds (see Bloomberg article). David Swensen, the Yale endowment investment chief, believes that distressed corporate securities will produce "equity-like" returns. He also mentions in the article how corporate governance helped the Yale endowment steer clear of the Madoff investment mess, and believes that others need to take a similar direct and transparent approach to investing. Of interest is Swensen's views on Funds-of-Funds. The Yale Investment chief states that "the reason I don't like funds of funds is that they facilitate the flow of ignorant capital." Of course, the same could be said for most mutual fund investments, and Swensen states as much, stressing that most investors should stick with passive investments like index funds since attempts to outperform the market are usually unsuccessful for retail investors. Yale recently announced that its endowment had fallen 25 percent since June (see previous post), not unlike the 22 percent loss at the Harvard endowment (see previous post). Nonetheless, even with some of the luster off the past outstanding returns from both endowments, each fund is still outperforming the general market - although, with an increasing amount of capital in alternative investments, and an equally shrinking amount in equities, comparing against traditional benchmarks such as the S&P 500 is becoming less reliable.
Recently it was reported that the Harvard Endowment had fallen at least 22 percent and was on its way to possibly a 30 percent loss once alternative investments are considered (see previous blog post). Now, the WSJ is reporting that the Yale Endowment has fallen 25 percent since the end of June when the endowment was valued at $10.1 billion (see WSJ article). Of interest is how marketable securities in the endowment "only" fell 13 percent, giving Yale a problem similar to Harvard - decreasing alternative investments, such as real estate and private equity, have caused the overall losses to be more severe than expected. As with Harvard, the diversification and increased use of alternative investments has helped Yale weather the downturn in the equities markets, but at the cost of decreased liquidity. The subsequent fall of less traded real estate and private equity markets has introduced a form of liquidity risk that was either unexpected, uncovered, deemed unimportant, or some combination of the three.
Fortunately, such endowments do not have the same problems with redemption requests that hedge funds experience, and can therefore possibly hold assets longer, waiting for more liquid markets. On the other hand, the academic endowments do rely on their investments for funding scholarships and supporting the general operating budget, among other things. At Yale, the endowment supports 44 percent of the $2.7 billion annual budget, or nearly $1.2 billion per year. With a decline of twice this amount in the endowment, belts at Yale will definitely needed to be tightened given that a guaranteed 16 percent return on the remaining approximately $7.5 billion would be needed in order to pay current expenses and still keep the principal in place. Of course, this just got more difficult now that the market is on its back, not to mention that the only sure bet in town - Bernie Madoff and his "guaranteed return" hedge fund - are out of business. Difficult times indeed.
It turns out that the Madoff hedge fund losses will cause the Credit Suisse / Tremont Hedge Fund index to post a 4.15 percent loss for November, quite a bit larger than the preliminary data that was showing a monthly decline of 0.7 percent (see WSJ article). As this fraud unfolds and the details become more transparent, there is likely to be even more losses and levels of exposure and negligence uncovered.
There has been a lot of discussion lately regarding the surge in volatile late-day trading that has occurred since the summer sell-off and fall credit-crisis began to unfold. In November alone, an average of 26.2 percent of trading volume in S&P 500 stocks took place in the final hour of trading, with 17.1 percent of the trading occurring in the final 30 minutes (see WSJ article). Furthermore, for eight of the ten worst days for the S&P 500 since September 1st of this year, 29 percent or more of the move took place in the final hour of trading, with three instances in which over half of the market decline occurred during the last hour. Much of the blame for the late day sell-offs has been assigned to hedge fund redemption selling, or simply nervous traders unwilling to hold positions overnight. A possible new culprit may be ETFs, in particular, leveraged ETFs.
Leveraged ETFs, now numbering over 100 in total (see lists here and here), have recently become popular since they allow market participants to take 2X and 3X positions on popular stock and sector indexes. Many of the leverage ETFs utilize swaps and options to achieve their leverage ratios. Not surprising, when the linked index or sector falls, corresponding stocks in the ETF have to be sold at a two to three times greater rate, increasing the moves in the indexes. In fact, the trend has become so predictable that many proprietary trading desks actively trade the levered ETFs toward the end of trading days with large moves, knowing that increased buying or selling is on its way. While the VIX has been coming down over the last few weeks, it is still at elevated levels, indicating that the next big daily move up or down is likely to be capped off with an equally impressive last hour move, generated in part by momentum investors taking a position in leveraged ETFs. For once, the market (myself included) has someone else to blame besides the hedge funds for late day trading volatility.
US financial institutions reported an increase in Level 3 assets in Q3 to $610 billion (see Financial Times article). This amounted to an increase of 15.5 percent from Q2 as low liquidity has made it difficult to sell MBS and CDO assets. Classifying assets to Level 3 also gives the banks more control over how valuations are modeled and set. As banks begin reporting Q4 results, many analysts expect the number of writedowns of these assets to increase, especially given the recent announcement that the Treasury plans to use TARP money for capital injections directly into financial companies, as opposed to the original purchase of illiquid assets.
There is an interesting article in the WSJ about Bill Miller, and the fall of his once lauded Legg Mason Value Trust fund. After continuing to dip into the value market, buying many beaten down financial companies, the fund has fallen from $4.3 billion AUM from over $16.5 billion just a year ago. The fund that was consistently one of the top performers over the years is now among the worse for one-, three-, five-, and ten-year periods based on Morningstar's rankings.
The IEA is forecasting a contraction in world oil demand, the first in 25 years (see WSJ article). Spare production capacity is at a six year high among OPEC members. Specifically for the US, consumption is expected to fall off 6.3% this year, and another 1.4% in 2009. China is expected to fall 3.5% in 2009 after increasing oil consumption 5.3% in 2008.
Charge-off rates among credit-card issuers are expected to rise more than expected in Q4, after rising more than 6% in Q3 (see WSJ article). Roll rates, which indicate that customers will go from late to not paying, was up 20%. The roll rate for American Express increased to 47% in Q3 from 35% during the same time last year. Capital One increased to 34% from 28% over the last year. Given that unemployment is a leading indicator of credit card defaults, the numbers are not all that surprising.
Defensive stock Proctor and Gamble lowered its sales outlook for the current quarter, stating that organic sales growth will fall short of the previous 4-6% growth targets given just a few months ago (see WSJ article). The stock is down nearly 20% for the year, but still fairing better than the broader market.
A number of firms are beginning to become more active in using clawback provisions (see WSJ article). The clawback rules are being put in place to allow firms to take back money paid to traders and others whose trading positions blow-up at a later time. Such provisions are believe to help keep employees from entering into positions or strategies that may be too risky, but which may provide a large initial return and subsequent nice bonus. The worry of course is that such rules may cause some traders to become too careful, essentially shying away from necessary and manageable risk. There is also a worry that good traders may move on to other firms with less restrictive provisions.
What is probably most unnerving about such provisions is that it implies that the companies utilizing such a provision really have no idea what their risk levels are, or how to go about managing such risk. With risk management policies in place, especially those that elevate risk management functions within a firm and properly reward both traders and risk managers that at least attempt to manage and price such risk, a company should be able to better understand the risk they are taking and prevent traders from entering positions with excessive risk. If a properly analyzed trade later blows-up because of unforeseen events, then it could be argued that it is just the cost of doing business. Sure, if traders circumvent risk management procedures put in place at the firms, or are negligent in obtaining the necessary data or developing the best possible model, then by all means penalize them, regardless of whether the trade worked out or not. But as long as the traders and risk analysts accessed the risk based on the available data and models, and have their work approved by the risk managers, then it seems counterproductive to penalize traders for events outside their control. Sure, you will recover some bonuses, but you will lose much more in terms of talent, reputation, and lost capital. Recovering a rogue traders bonus may be too little too late and of little value, other than helping to pay the bankruptcy lawyers.
Even hedge funds that are doing well are seeing withdraws (see Reuters article). Why sell a good fund? As it turns out, the main sellers could be those that operate fund-of-funds. As a result of other funds (holdings) being down, redemption request at FoF are causing selling across the board, dragging down performing funds as well.
There is an interesting article from Cam Hui at SeekingAlpha discussing the need for hedge funds to return to basics, and for investors to rethink their expectations. Of interest from the article is the quote: "Hedge fund investors found out what they had wasn’t a contract with a hedge fund manager, but a call option on a management contract. When the incentive fees dried up, the manager packed up and went away." This gives me an idea. How about selling an option on ......, never mind.
Rumors of a Goldman / Citi merger have changed to a Goldman / Morgan Stanley merger (see Here Is The City News article). Still waiting for the Goldman / Yahoo / Microsoft rumor to surface.
I was just kidding about the 10 million. I did not want a bonus afterall (see Clusterstock article). Merrill and/or Thain doing damage control.
Fleckenstein, a regular guest on Fast Money, is calling it quits, or at least closing his short-only portfolio (see FINalternatives article). He is planning to open a new fund (not a hedge fund) that would be available to retail investors (ie., everyone). In a blog post, Fleckenstein states "I now (sic) longer want to run a short-only hedge fund, as it is very stressful, nerve-wracking and generally not very much fund (sic)." Then again, the money was nice .........
There is an interesting New York Magazine article on Jim Chanos. Even though he seems to be on CNBC just about every time you turn around, the article provides a little more detail on his background, and provides some insight into his approach. Interesting read.
While hedge fund returns have been taking a beating lately, the talk of the demise of hedge funds is probably a little over done and premature. While there has been $72.5 billion in outflows, this represents less than 4 percent of the average mid-year industry volumes (see Wealth Bulletin article). Also, while the industry has seen a number of funds close up shop, the numbers have "only" decreased from 7,601 to 7,299. As discussed in this blog a number of weeks ago (see previous post), the fallout seems to be impacting smaller funds more that larger, more established funds. In fact, many of the larger funds - which are either more diversified or have a star manager - are seen as being able to take advantage of the shifting resources and capital.
Even with fewer funds failing than originally expected (yes, these are just preliminary numbers), funds that stay in business will still find that they cannot operate as usual. For starters, funds will need to better match redemption rules with strategy. Some funds are illiquid by design based on the strategy being used. While trying to lock up funds until returns are realized (as with private equity) is probably not feasible, funds will need to better insure that redemption request rules take strategy into consideration. The use of leverage will also no doubt be reduced for many funds, which will also affect returns going forward. Finally, the popular 2-20 fee structure will also come under assault. Not only does the existing compensation structure seem excessive given recent performance (and future lower returns in the wake of lower leverage), fee concessions will be necessary as an incentive for agreeing to longer lock-up periods. In the end, expectations on both sides may need to be scaled down a little.
Hedge Fund Research's Global Hedge Fund Index was down 3.04 percent in November, after a drop of 9.26 percent in October (see FIN Alternatives article). That brings the index down 22.3% YTD through November. Continued poor performance has increased redemption requests, causing an increasing number of hedge funds to block investors from redeeming shares (see NY Times article). The increased addition of illiquid investments over the years (such as real estate and private equity) has caused many funds to start considering a new model that would require longer lock-up times for lower fees. High-water marks, which would force some under-performing funds to earn back 25 percent or more before taking profit fees, will cause additional funds to close, although others insist they will take the high road and not close until they are profitable again.
As of the end of last week, approximately 100 hedge funds have placed restrictions on withdraws, in what is becoming a financial roach motel where investors can check in, but they cannot check out (see Bloomberg article). The increased use of gates has even spread to some of the previous stars of the industry, such as Fortress Investment Group, Tudor Investment Corp., and D.E. Shaw & Company (see WSJ article). Furthermore, the problems are even worse for those funds investing in emerging markets, which continue to under-perform and are down an additional 1.41% on average in November (see Bloomberg article).
Finally, even with new gating restrictions, some hedge funds are also being forced to renegotiate borrowing terms with their prime brokerage lenders as losses and redemption requests increase (see Financial Times article). Many prime brokers are also seeing this as an opportunity to drop clients or renegotiate terms that were originally in favor of the large hedge funds who previously had bargaining power. No doubt many large investors with liquidity will be able to throw their weight around in a similar way as they begin renegotiating lower fee structures in return for longer lockup periods.
Private equity investors are starting to ban together to renegotiate terms of previous commitments (see Financial Times article). In particular, endowments and foundations, which have recently increase exposure to alternative investments, are looking for ways to scale back commitments after losing money and finding it difficult to meet their operating budget without dipping too deep into existing endowment funds.
The Lehman bankruptcy has apparently went better in the US (see Financial Times article). The UK FSA is even traveling to New York to see why the US insolvency regime has worked better than in Britain in the wake of the collapse of Lehman Brothers. Problem have caused many hedge funds to move assets to the US to avoid similar problems, causing London to worry about it status as a major financial center.
A recent WSJ article is highlighting once again the losses incurred at university endowments, especially those at Harvard. The Harvard endowment is reported to have lost "at least" 22 percent in the first four months of the school's recent fiscal year. This equates to approximately an $8 billion loss for the nearly $37 billion portfolio. Unfortunately, the pain may get worse as the current value does not appear to consider real estate or private equity investments, causing the university to start planning for a total decline of 30 percent for the fiscal year. While alternative investments have helped to shelter endowments at Harvard, Yale, and elsewhere from past sell-offs in the general market, this time the recent credit crisis has affect nearly every asset class. This has made the losses on relatively illiquid assets, such as real estate and private equity, potentially quite severe as portfolios are forced to sell such assets at deep discounts. Private equity investments with Harvard are reported to only be receiving bids of 50 cents on the dollar. Diversification and investing in alternative investments has its benefits, but it can also introduce new risk to manage, such as liquidity risk. Certainly a lesson we all need to be taught, even if we have to learn it the hard way.
Surprise, surprise. A GAO audit found that more oversight is needed for the $700 billion TARP bailout package (see CNN Money article). Apparently, as a result of lack of oversight, those receiving billions in funds have not been using the money as originally intended. Not only is it amazing that this is a surprise, but it is interesting how as the amount of money increases, the level of monitoring seems to go down.
Time to bailout alternative energy (see Spiegel Online article). Cheaper crude oil is decreasing the demand for clean and efficient energy. The credit crisis is also making it difficult for new renewable energy companies to get the capital they need to expand and continue daily operations. Spain and Germany are already offering incentives, and the European Commission announced a $252 billion recovery plan that included targeted investments for carbon reduction. President-elect Obama is also expected to use some of the $700 billion stimulus package on eco-businesses.
In an effort to survive the current credit crisis, hedge funds are lengthening lockup times in order to reduce the number of redemption requests (see Bloomberg article). In return, and in an attempt to raise more capital, some of the very same hedge funds are lowering management fees from 2 to 1 percent, and further lowering performance fees from 20 to 15 percent, or even as low as 10 percent in some instances.
Goldman Sachs, still adjusting to its new role as a bank holding company, is considering online banking (see WSJ article). The move in being done in part to help increase its deposit base. While a lower-margin business, the increased deposit base will allow Goldman to have a more stable capital base during difficult market conditions, one of the main reasons for changing its status to a bank-holding company.
According to information from the Preqin Global Institutional Review (by way of an Albourne Village post), institutional investors plan to continue allocating capital to hedge funds. A total of 46.6 percent still have a positive long-term view of hedge funds, while 67.8 percent have an unfilled long-term target allocation to hedge funds. A total of 75 percent reported that while hedge fund returns had fallen short of original expectations, 53 percent were satisfied with returns (compared to the market in general, I assume). Of interest in the post was the comment that while institutional investors were delaying making new investments with hedge funds, few were redeeming their original investments. Whether this means redemption requests will slow down, or whether the speculation about redemption requests driving the recent sell-offs were overblown (by many, including myself), is unknown.
Interesting article about John Paulson and some other hedge fund winners this year (see Bloomberg article). The article is long, but worth the read. There is some variety in the strategies and approaches, but funds betting against subprime and housing did the best, not surprisingly. Even a quant fund did well.
It looks like the commodity crash is taking its toll on salaries and bonuses. The top paid metal and energy traders may "only" earn $1-1.5 million in salary and bonus this year, down from $5-8 million in 2007 (see Bloomberg article). Difficult times indeed. I guess there will be no more $1,000 ice cream sundaes and pizza for a while (see blog post).
According to Treasury Secretary Paulson, there is a need for a new regulatory system that will look "at the entire financial system." See Financial Week article. "Entire" in this case applies to countries, in addition to asset classes. So the plan is to have each country overseeing the regulation of another country's financial system - this should produce some interest debate.
Man Group says that banks, and not hedge funds, are more levered, and as a result are the main cause of asset price declines (see Reuters article). Man also puts hedge fund leverage at about one-third its levels in 2007. Expect future returns to also show similar trends.
Portable alpha strategies are providing pain for various state pension funds (see WSJ article). Even the PIMCO portable alpha fund is taking a hit. You can find additional details on portable alpha strategies here.
While hedge fund redemption requests have been strong in the US, the next wave of redemption requests may come from Asia, where many hedge funds have suffered worse performance than similar funds in the west (see The Standard, Hong Kong article). In comparison, Asian hedge funds are down 22.2 percent on average, compared to an average loss of 12.2 percent for all hedge funds. As a result, more pain could be felt for international investments.
Should Treasury go back to its original plan of buying MBS in a reverse auction? Some economist believe so (see NY Post article). Having the government receive common, instead of preferred shares, would also go a long way towards further instilling confidence in private investors - who currently see the government being unwilling to take the same risk they are being asked to take.
The option strategy of buying stock and then writing call options against it - known as buy-write - is still generating some of its highest premiums in over 20 years (see WSJ article). By using a hypothetical version of the strategy using the BMX index as a comparison, the CBOE found that a buy-write strategy would have produced an 8.1 percent gross monthly premium in November, topping the second highest recent premium of 7.1 percent generated in October just a month earlier. Since June 30, 1986 until the end of October, 2008, the strategy has generated an average annualized return of 9.2 percent, while the S&P 500 index produced a return of 8.7 percent over the same time period. While volatility will not always be as high as it is now, nor will it always generate healthy option premiums and a nice return over the S&P 500, even an average 0.5 percent extra return over more than 20 years starts to look pretty good - not to mention compounds into some significant cash.
For those a little intimidated by option strategies, keep in mind that with a buy-write strategy your obligation for the written call is covered by owning the stock (a covered call). Therefore, you don't have the same potential "infinite" loss that scares away many investors from writing options. Of course, there are downsides. Besides the fact that your long position could decrease in value, an additional downside is that your long stock position could be called away if the stock produces a significant move - causing you to potentially leave some money on the table. Nonetheless, the strategy forces a sell discipline, which for many is the most difficult part of investing. For instance, if a 3-month call has an exercise price that is 20 precent away from the current price of the long stock position, then the stock could be called away once its price rises more than 20 percent in 3 months. Certainly disappointing when the stock moves much more than 20 percent, but you still lock into 20 percent (plus the premium) in 3 months or less. Not bad in my book. In the mean time, the premium provides additional downside protection, just in case you end up not picking a winner. For those interested, some additional information on buy-write strategies can be found here, here, and here.
As we begin looking at our year-end investment portfolios, and feeling a sense of dread as we see our retirement savings down a third or more, it is useful to compare the US markets with the rest of the world. As it turns out, over the last year US investors would have been better off investing more in the US, and less overseas in the "hot" markets, such as China and Brazil (see WSJ article). Just as many investors this year realized that their global exposure was a little lite, the bottom fell out in some of the very same markets they began increasing their exposure in (not to mention drops in the US market - see graphic below from the WSJ).
After rallying nearly 10% over the last week, the DJIA is down "only" 33 percent for the year. In comparison, the Shanghai Composite (China) is down over 64 percent, while the the Bovespa (Brazil) the DAX (Germany) are down over 42 percent. The FTSE 100 (UK) is down about the same as the US DJIA. The Dow Jones World Index, which excludes the US markets, is down 49 percent in dollar terms YTD. Of course, massive sales of foreign stocks by US investors has also not helped international markets. Between July and September, US investors sold $92 billion more of foreign stocks and bonds than they bought during the same time. Therefore, if you recently failed to jump on the international diversification train this year, either because you had foresight, or were simply too confused or too lazy and never got around to it, smile - you could be even worse off this year. If you jumped on board back in 2003, you have experienced a nearly lost half-decade for many markets, but you can also smile - at least you are nearly flat. If you jumped on board in late 2007, or earlier this year, well ........, at least you have your health (and a lot of company to commiserate with).
The Microsoft-Yahoo! rumors are back in full swing. The Times Online (see article) is reporting that Microsoft is in serious talks to acquire the search business of Yahoo! for $20 billion, much less than the original $47.5 billion offered for the company this past summer. Details have Microsoft obtaining a 10-year agreement to manage the search business with a two-year call option to buy the search business for $20 billion, which would leave Yahoo! with its email, messaging, and content services businesses. It is worth noting that the BoomTown blog is reporting that the story may be "Total Fiction," based on comments from those who are reported to be involved in the deal (see post). The post also mentions how the entire market cap of Yahoo! is just $16 billion. Yet, offering a premium to shareholders, even for only the most valuable part of the company, is certainly not unheard of.
The rumors have been given some leverage with the recent announcement that Jerry Yang, the CEO of Yahoo! will be stepping down as soon as a replacement can be found. Yang was thought to be the main roadblock to a summer merger. The news that Google has decided to pull out of its advertising deal with Yahoo! also helps to clear the path for a new merger agreement (see MarketWatch article). Always one to sense an opportunity, Carl Icahn has begun purchasing more shares of Yahoo! (see WSJ article), recently adding 6.8 million shares, raising his stake to about 5.5 percent of the company. The additional $67 million is a drop in the bucket compared to the nearly $1 billion that Icahn has already lost on previous positions, but does give him more bargaining power regarding any future board members and CEO.
Whether all of this is just another case of throwing good money after bad is yet to be seen. Yahoo! stock is up a few dollars to $11.51 per share after falling to a 52-week low of $8.94 a share. While Icahn has made some money on his recent purchases (average cost of around $9.88 a share), he may once again be at the mercy of any potential deal in order to realize the original value he was hoping to receive. With a larger stake, and current CEO Yang now less of a roadblock, Icahn may finally get the deal he wants, even if it ends up costing him after all is said and done. Retail investors that skipped the first and second rounds of merger talks, but have now entered after the most recent round of speculation, may fair better. Of course, this may have less to do with Microsoft and a growing Icahn put, and more to due with a market that is attempting to build a bottom and change momentum.
