Interesting post over at the AllAboutAlpha site that is worth the read. The post discusses how even if a hedge fund has stop reporting returns, this does not imply that the fund is dead and closing up shop after blowing-up in the recent market downturn. As it turns out, only about a fifth of the funds (according to the study) stop reporting because they are liquidating. Others simply have stopped taking on new investors, or have other reasons for not reporting returns. Of interest in the article is how the researchers studied fund-of-funds to estimate (guess) what the returns are of those funds that have stopped reporting (given that their performance is still showing up in the fund-of-funds that do report). Not surprising, while the "dead" funds that no longer report returns did perform worse than those that did report, the level of losses were close to -3%, and not in the category of "blown-up." While many funds may still go under (in part due to it now taking too long to reach high water marks after significant losses), the reports of the death of hedge funds may be greatly exaggerated.

A Financial Times blog post at Alphaville reports how 63 percent of respondents believe that the hedge fund deleveraging process is about half over (see Bloomberg article as well). To date, leverage has fallen to 142 percent of AUM, down from 175 percent in 2006 and 2007. A majority of respondents also believe that redemption requests are at least half over, with the process finishing up early next year, probably in the first quarter. Of interest is how cash now represents approximately 31 percent of total assets, compared to just 7 percent over the last few years. As we have discussed before (see previous post), there is an expectation that once the market turns, and redemption request slow down or stall, the amount of capital that could be deployed back into the market could spark a significant rally. Empirical estimates have between $650 and $700 billion withdrawn from hedge funds, and another $325 to $350 billion from mutual funds (see DowJones Financial News Online article). This amount of funds represents about 6.5-7 percent of the capitalization of the US equity market. Even just a small portion of such capital hitting the market could produce a relief rally that would be jaw-dropping.

A recent Financial Times article highlights that 15 percent of asset management houses, pension funds, and private banks have invested in hedge fund replication strategies (the survey had only 97 respondents). Given the low number of companies offering products, the interest and use indicates that some firms are engaged in internal model development. As further encouragement for the field, 55 percent say they would be willing to consider investing in replication strategies, while only 30 percent were against such investment (of course, that could change as the strategies become more developed). On the down side, a significant minority of respondents also felt that hedge fund returns could not be replicated, were not transparent enough, used unproved technology, or simply gave poor returns. Many appear to be waiting for better products, even though there is a significant fee reduction when using replication strategies. Considering that the hedge fund industry is currently unpopular and an easy punching bag, not to mention being down for the year, the results are encouraging for those doing replication research and indicate some interest for the development of more robust models going forward.

Shelf registrations are increasing, but it has little to do with tapping into future higher prices or a new found optimism in the market (see WSJ article). Back in 2005, the SEC put a "shelf life" expiration date of three years on all shelf offerings. The initial set of filings after the ruling are now set to expire on December 1st of this year, causing many companies to refile, even if they are not expecting to access the equity capital markets at a time when prices are depressed. Nonetheless, since shelf deals can be accessed at any time, it is smart to re-register so that capital can be accessed in the future when it make does make sense. When the market is rallying, it is not unusual for companies to float equity that may be selling at inflated prices. On the other hand, accessing capital in a down market when value is low is probably more of an indication of trouble, making it less likely that companies will sell stock off the shelf in the next few months, even if re-registering opens up the window for them.

While the Citigroup news is certainly generating much of the financial news this morning (and for good reason), three more banks have also recently failed, bring the total to twenty-two (see WSJ article). Two of the recent bank failures were California thrifts, while the third was located in Georgia. Of the three recent failures, Downey Savings & Loan of Newport Beach was the largest, and the third largest bank failure this year, coming in at $12.87 billion - still less than the $307 billion failure of Washington Mutual.

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.