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

The UNC Chapel Hill Board of Trustees announced that their endowment lost about $320 million (see Charlotte Observer article). A big loss indeed, but when you consider that the endowment is currently worth about $2.5 billion, the approximately 13 percent loss is not too bad when compared to the broader market - albeit some funds are more conservative and are geared towards protecting the capital at all cost (something worth considering once again for everyone). On the other hand, the fund appears to have underperformed other endowments - the top 30 university endowments (each over $1 billion in AUM) have lost on average about 9.8 percent. Then again, "just down 10-13 percent" is usually followed by "we need to cut spending and raise tuition," which is not what anyone wants to hear or say right now. Just ask students, faculty, and of course, parents.

Option trading in the United States has decreased 23 percent compared to October (see Bloomberg article). During market moves, it would normally seem to make sense that market moves might cause increased option activity as investors look to protect their equity investments, but rapid sell-offs (and subsequent rallies) have resulted in higher volatility, driving option premiums higher. While higher option premiums may be prohibiting some traders from being able to efficiently use options for hedging, the root cause may be with the equity trading itself. Regardless of its impact on option premiums, the increased trading has reduced the number of equity trades for those who typically hedge such positions, thereby reducing the need for hedging with options. As hedge funds get smaller, their impact on trading (currently about one-third of all trading) will also decrease, reducing volume, and putting further pressure on liquidity. As traders search for a market bottom, they may be misleading themselves. We could simply be looking at a type of mean reversion to a pre-hedge-fund-explosion market with regard to asset prices and trading volumes. Current levels may be less about bottom building, and more about new market norms. Of course, this means reversion from the mean could take us into seemingly scary territory in the near future as the market recalibrates to a new post-irrational-exuberance world.

There is an interesting Business Week article regarding the increased use of FHA-backed loans that are being used to continue lending to borrowers who once again may be unable and unlikely to pay back their loans. Inside Mortgage Finance (a research / newsletter firm) estimates that bad FHA-backed loans could end up costing taxpayers more than $100 billion over the next five years. As subprime loans have dried up, the FHA loans have become the only source of lending for many at-risk borrowers. Congress and the current administration have been encouraging lenders to apply for FHA guaranteed loans in order to access the current FHA loan reservoir, but the banks and loan quality are not being monitored, allowing the funds to be loaned to the very same borrowers that had trouble paying before, and which of course began the chain reaction of defaults we are now witnessing. To make matters worse, the government guarantees are creating incentives for banks to buy the FHA loans and securitize them, in what may become another bad dream realized. Hopefully the markets will wake up and be spared in a year or so when the new "FHA-insurance Armageddon" is suppose to hit - but past history is not encouraging.

Changing rules, even when the change may ultimately be good, can be disruptive. As a result of the change in the TARP from buying troubled assets to injecting capital directly into companies, the credit markets have once again reversed course (see Financial Times article). The fact that now there are no buyers for some toxic assets has the value of some mortgage-related securities falling to new lows. Jay Mueller, portfolio manager from Wells Capital Management, said it best:

“Now those markets will go back to being completely illiquid as there will be no price discovery process started by the Tarp. It is tremendously difficult to trade when the rules of the game change.”

Now that the government has realized that it cannot justify and support non-market prices, the banks and other holders of toxic debt will have no choice but to further discount and account for reduced asset values. For the rest of us, this just means more volatility, lower asset values, and a market that continues to suffer under its own weight. At this point, "building a bottom" may be the best we can hope for in the near term.

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

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

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

Given the recent "black swan" events in the market, quant funds that have relied on longer-term trading strategies have suffered (see Reuters article). As a result, many quants are now focusing on higher-frequency strategies that are executed quickly, both to get into and out of positions. No doubt that such an increase in programmed algorithmic trading is contributing to already elevated levels of market volatility. Ironically, many traditional quant funds operate more efficiently in stable market environments, causing such funds to suffer under the recent higher levels of volatility.

The change in trading duration is needed in part since many of the longer-term strategies are no longer valid given the changing market landscape, which due to company failures and shifting regulations, seems to be changing nearly everyday. Modelers using intelligent trading systems, especially supervised systems like neural networks that require extensive historical data in order to learn market patterns, are finding it a challenge to train their systems given the changing market dynamics and subsequent lack of relevant data. The tracking errors have also been significant enough to cause many funds to scale back their use of leverage, putting further pressure on quant funds that rely on borrowed money to juice returns.

While some quant funds could potentially go out of business given current losses, there is no doubt that many other quant traders are seeing this as an opportunity to create new algorithms not yet adopted by the larger quantitative trading community. I image the next great algorithms and trading strategies - which we will not hear about for a few years - are begin developed and deployed as we speak. If there is one thing many quants like more than money, it is a good challenge. The market has certainly provided the challenge, along with some unique opportunities.

First State Investments' Media Works fund has acquired the copyrights to more than 26,000 songs, earning a royalty fee every time they are played commercially (see Financial Times article). Using leverage up to 50 percent, the fund expects to generate minimum returns of 15 percent or more, net of fees, including a dividend of 8-10 percent. The fund has already raised $130 million from institutional investors and private wealth managers. One benefit of the fund is that it is uncorrelated to other asset classes and believed to be largely immune to current problems in the economy. Better yet, since royalties are relatively consistent, the generated cash flow is easier to predict, making it easier to value and generate a net present value. At least now you can encourage others to listen to some music as a distraction from the markets, and make money in the process.

A recent survey of asset managers, institutions, and high net worth investors at the Global Alternative Management Fund of Funds conference found that 36 percent of those questioned felt that technical analysis-based trading strategies are likely to outperform in 2009 and 2010 (see Reuters article). This tends to mimic a prevalent view in the market that investing based on fundamentals will be difficult going forward. Changing regulations, compressed multiples, and unknown forward earnings are making fundamental investing suspect and difficult at best. Double digit percent moves on very little or no material changes in fundamentals are also causing investors to now pay more attention to volume, price action, patterns, and support / resistance lines in an effort to predict the size and reversals of potential stock moves. Given that technical analysis can often be a self-fulfilling prophesy, the added attention to technical indicators and patterns may actually make it more likely for such signals to be realized, at least in the short-term. As with many technical indicators, there does not always need to be a theoretical mathematical justification, but simply a heuristic and common sense expectation of what each indicator implies and is likely to predict. In the short-term, such a belief may be all the market has and needs. Hedge funds will no doubt exploit this momentum going forward.

There is an interesting post at the Bespoke Investment Group blog. Apparently, the entire TARP application is only six pages long, with the first four pages describing eligibility and confidentiality. The actual application is just two pages. Of the two main pages, page one is just for your name and contact information. Page two does ask for some details on financial information, but not much - basically how much do you have, and how much do you need. I wish my home loan was that easy. Then again, maybe that was part of the problem - some home loans were that easy. Certainly not encouraging. Will there eventually be a TARP for the TARP?

Initial results show that the Credit Suisse / Tremont Hedge Fund Index was down 5 percent in October (see MarketWatch article) - final numbers will be released on November 17th. Not surprising, fixed income arbitrage suffered some of the worst monthly losses, losing 17.75 percent. Emerging markets were close behind with 15.36 percent in losses. Fixed income managers have suffered as a result of loses in mortgage-backed securities and corporate bonds, each of which have fallen in price due to a combination of decreasing credit quality, forced selling, and decreased liquidity. Managed futures and short bias funds are both up for the month, and year-to-date. Convertible arbitrage is down the most year-to-date, losing 19.45 percent (which while bad is still better than the broader market losses).

A recent WSJ article reports how Harvard's president is telling campus administrators, faculty, and students that the university will need to consider budget cuts and other steps because of hits to university investments caused by the global economic crisis. It was only a few months ago that reporters and bloggers (myself included - see previous post) were discussing how Harvard was reducing its weighting in domestic equities and was investing more in alternative investments, including private equity and hedge funds. Other funds were even beginning to mimic the asset allocation of the Harvard endowment (see previous post). While specific areas and loss amounts were not mentioned, one would have to believe that hedge fund losses are having a negative impact on the Harvard endowment. In what may be typical for most universities, but somewhat shocking for Harvard, President Faust is quoted as saying: "we need to be prepared to absorb unprecedented endowment losses and plan for a period of greater financial constraints." You never want to hear the words "unprecedented" and "losses" in the same sentence. Moody's is even projecting a 30 percent decrease in the value of the endowment. Pretty amazing given how just this summer Harvard was being cast as a model for the use of alternative investments for achieving a global diversified endowment. In the end, the Harvard endowment will probably still fare better than most, but the recent news shows that even the benchmark for university endowments may need to patch a few cracks in the ivory tower.

Selling by hedge funds is still putting pressure on the market (see WSJ article). As we have discussed over the last month (see posts here and here), many redemption requests by hedge fund investors are now meeting their waiting periods, causing many funds to sell assets in order to raise cash. As quoted by Gregory Horn, president of Persimmon Capital Management:

"In mid-October, redemption levels were in the 5% range but all of a sudden now it's cranking up to as high as 25% for some funds."

Certainly not good news for hedge funds, but maybe even worse news for the market. With continued forced selling, it is unlikely the market will quit trying to find a bottom. Hedge funds will continue to sell every rally, increasing volatility. As long as the VIX continues to spike and stay at elevated levels, and we continue to see the "punch-in-the-stomach" late day sell-offs after nice rallies (both of which I suspect are indications of further hedge funds selling), we will continue to be in a volatile holding pattern between 850 and 1,000 on the S&P. Unfortunately, it is difficult to know exactly when the selling will quit, as the selling and redemption requests are tied together in what is becoming a volatile catch-22 pattern that is feeding upon itself. The other day I heard an analysts say it was "too late to sell, but too soon to buy." Until hedge fund investors believe the former, it is unlikely any investors will quit believing the latter.

Trend following managed futures funds have outperformed hedge funds this year, gaining 8.9 percent year-to-date (see WSJ article). Hedge funds have lost almost 19 percent during the same time frame. Managed futures funds often use quantitative trading algorithms to spot market trends, at which point a long or short position is quickly taken in futures or other derivatives. Managed futures underperformed between 2003 to 2007 when volatility was lower, but have since done better as volatility increased. The ability to quickly initiate an "unemotional" short selling signals has also added to recent gains. Ironically, the reduction of risk by some traders and hedge funds has resulted in less liquidity and larger price swings, both of which have allowed managed futures to outperform hedge funds who have traded in many of the same markets.

For the first time since 1993, credit card companies were unable to sell bonds backed by customer payments (see Bloomberg article). Top-rated credit card-backed securities maturing in three years are selling at spreads of 475 basis points over Libor, compared to a spread of only 50 basis points less than a year ago. Given higher unemployment, leading to potentially higher credit card use and an inability to pay, lenders are expecting higher default rates for 2009. American Express is already accessing the Fed commercial facility program, as well as cutting 10 percent of its work force. Bank of America, JPMorgan, and Citigroup all rely on the debt market to fund their credit card portfolios, and could also subsequently be impacted by higher spreads and lower liquidity.

It appears that efforts by the central bank to encourage investors to purchase corporate debt are not having much success (see CNN Money article). While it is often the case that companies are hesitant in the fourth quarter of a fiscal year to purchase debt for fear of creating problems on their balance sheets, this year the policy decisions of the Fed also appear to be having an impact. Currently, the Fed is offering a much lower borrowing rate than the market, with rates as low as 1.55 percent for three-month paper. The market is offering closer to 2.6 percent for similar debt. Until the market rates are lower, or the Fed rates become higher, it is not likely that investors will take the extra risk of buying corporate debt.

In a seemingly unrelated story, automakers are apparently unhappy with the $25 billion in loans they are set to receive for making more fuel efficient cars, with paperwork and administrative hurdles delaying the money (see Reuters article). As a result, the industry is continuing to burn through cash at a faster pace, causing GM to warn that the industry is now "near collapse," requiring further assistance. New aid is now being demanded, possibly up to another $25 billion in loans. The difference is that now these loans would come with no strings attached, with the expectation is that the companies would use the money to pay retiree health care obligations.

As the current financial crisis continues to unfold, one can expect that similar market circumstances (interest in cheaper Fed debt) and stimulus requests (taxpayers covering operating costs) will continue. At some point the response to such request will have to be no, and the results of such decision will have to be felt. Unfortunately, the longer that requests are accepted and government intervention occurs, that longer it will take to separate business from government and allow the free markets to get back to doing what they do best - rewarding with cheaper capital those companies that are managed well and properly positioned, while punishing those that aren't.

A recent New York Times article follows up on a previous discussion (see blog post) regarding modeling and risk management. While financial engineering and quants will continue to receive some criticism for the recent problems in the markets, along with development of generally inadequate risk management models, the NY Times article further explores whether it was the models or human failure that are to blame for the current financial situation. There is no doubt that some models, especially black box models, have created some of the problems, but we cannot really fix the problem until we know the root causes. Is it simply a matter of not having sophisticated enough modeling techniques, or are poor assumptions, inadequate data, and lack of oversight also to blame?

Research at the IMF found that quantitative methods underestimated defaults for subprime borrowers, at times often relying on computerized credit-scoring models instead of human judgment (then again, I am not sure Moody's or S&P were much better or more timely, but I digress). On the other hand, economists at the Fed concluded that risk models had correctly predicted that a drop in real estate prices of 10-20 percent would be bad for subprime mortgage-backed securities (not a surprise), but that analysts themselves assigned a very low probability of this happening. In fact, the Fed study might be at the heart of the problem - human behavior.

As mentioned in the article, asset prices depend on not only our belief, but the belief of others. In an "efficient" market the participants expect that the true (or near true) price is reflected, even if the belief of one person is far from the efficient value. Of course, it is hard to model the beliefs of the market, so often the beliefs, hopes, or profit motives of one person may come into play, with at times disastrous results. The problem is compounded when risk management models are assumed to follow some natural law, when in fact both the theory that defines the model, and the inputs provided to the models, are more stochastic in nature.

As I have argued before, we need risk models, even those based on imperfect mathematics and assumptions, but we must always take into consideration what could happen if we are wrong. If our assumptions are too optimistic or too pessimistic, what is the fallout? We should be asking ourselves how confident we are in mathematics used AND the assumptions made. Are there assumption scenarios that could bring a company to its knees? What models are best to help understand all the possible outcomes that we should be worried about? These are the questions risk managers need to continue to ask. Yet in many instances blind black box models with fixed assumptions were trusted. Unfortunately, I suspect that even with the recent problems and consequences hanging over our heads, asking which models and assumptions point to the highest profits or lowest levels of regulatory capital will once again start to be considered. After all, its just human nature. Of course, avoiding pain is also a natural human instinct. Maybe there is a lesson to be learn there as well when the next bailout is voted on.

As reported at the Deal Book blog, the total size of credit default swaps outstanding on corporate, government, and asset-backed securities is "only" $33.6 trillion, smaller than the previous estimates of +$50 trillion. The largest CDS dollar amounts were written against debt for Merrill Lynch, Goldman Sachs, Morgan Stanley, GE Capital, Countrywide, GMAC, and government debt in Turkey, Italy, Brazil, and Russia. Nonetheless, much of the notional value has been reduced through hedging. The weekly reports are being offered by the Depository Trust and Clearing Corporation, and are expected to also include trade volume and turnover in future reports. Expect more transparency going forward. A little sunlight is the best disinfectant.

Nassim Nicholas Taleb, author of the Black Swan, is using the impact of extreme events mentioned in the Black Swan to help the hedge fund he advises, Universa Investments L.P., benefit in October (see WSJ article). Separate funds in the Universa's Black Swan Protection Protocol were up between 65 percent to 115 percent in October alone. The fund has a strategy of buying far-out-of-the-money put options on stocks and stock indexes. Most of the time the fund will take small loses when nothing unusual happens, but occasionally a black swan even occurs (such as the recent 20% market decline in one month), causing the gains to be extraordinary. In addition to using deep out-of-the-money puts, the fund has a strategy of keeping more than 90% of its assets in cash or cash equivalents, and is believed to break even or only incur small losses while waiting for the next black swan event. The fund recently made huge profits buying cheap puts on the S&P 500 and AIG, with the S&P puts increasing in value over 50-fold. While profitable during times of extreme volatility changes, one has to wonder how often such changes and moves will occur. Even a previous fund that Taleb was involved with had to shut down in 2004 after lower volatility caused returns to suffer and investors to flee. But then again, a 50-fold increase in a few trades gives you time to wait for the next event. You just need to be patient, and of course, know where to look as you wait for the worst to happen. Easier said than done.