The Alternative Investment Management Association (AIMA), an international trade body for the hedge fund industry, is reporting that an absolute majority of all assets under management by hedge funds and funds-of-funds are held by institutional investors. In addition, a third of those assets from institutional investors now come from pension funds. While the AIMA has some interest in promoting hedge funds and other alternative investments, the breakdown does highlight how a growing number of institutional investors, including pension funds, university endowments, and foundations that are invested in alternative investments, with the numbers growing each year. While there is certainly reason for individual investors and those on "main street" to be upset with some of what has been happening on Wall Street, using a blanket approach of penalizing all of Wall Street could have unintended consequences for individual pensions and those charitable and cultural activities often sponsored by endowments. Saying that "what is good for wall street is no longer good for main street," to paraphrase some in Washington, could be bad for the average citizen if actions begin to match the rhetoric.

Harvard University, buffered by its huge endowment, has long enjoyed AAA credit. But now, as a result of some past interest rate swaps positions that have went against them, Harvard is now finding itself paying a higher interest rate on recently floated bonds (see Bloomberg article). In fact, Harvard's main rival, Princeton University, was able to obtain better terms recently, as much as 50 bps or more on some debt going out 10 to 30 years. As a result, if Harvard's recent December sale of $1.5 billion in debt had yielded rates similar to what Princeton would have received, the savings for Harvard would have been on the order of $150 million.

It appears that the problem stemmed from the purchase of interest-rate swaps that were being used to protect the school against rates increasing in the future. Unfortunately for Harvard, rates fell, causing Harvard to look for more cash in the bond markets just as credit dried up. At one point the value of the swaps had fallen enough that they were worth a negative $570 million to the endowment. To add insult to injury, the losses required Harvard to post additional collateral, just as the market was falling and its portfolio was losing additional value. The $1.5 billion sale of debt was believed to have been done in part to allow Harvard to get out of the interest rate swap position. Unfortunately, the sale had to be made right at the time when the credit markets were freezing up, resulting in the higher cost for floating the debt. As they say, when markets are crashing, correlations have a tendency to go to one. This is surly something they will no doubt be teaching at Harvard. Liquidity risk is probably another.

Approximately two-thirds of fund managers recently polled by HSBC are overweight in Chinese equities, higher than the 50 percent that were long Chinese equities in Q4 of 2008 (see Asian Investor article). The companies polled were 12 funds with some of the largest assets under management, including (in alphabetical order) AllianceBernstein, Allianz Global Investors, Baring Asset Management, Deutsche Asset Management, Fidelity Investment Management, Franklin Templeton Investments, HSBC Global Asset Management, INVESCO Asset Management, Investec Asset Management, JF Asset Management, Schroders Investment Management, and Societe Generale. Of the funds increasing exposure in Asia, some mention their belief that the stimulus plans of China and Singapore will help support demand and growth in each country. One fund manager also mentioned that the construction and basic materials sectors will serve as a guide for the impact of the Asian fiscal packages, since each will benefit early from planned spending in infrastructure, and should lead to trickle-down effects to consumers. Others are not so sure about the trickle-down effects to Chinese consumers, and also mentioned that while having China rebound will be necessary to help spur global growth, such a rebound may be a few quarters away, at best. Still, most agree that the stage is set given that China appears to have put in place an actual stimulus plan - something the markets in the United States are still questioning domestically.

According to a recent WSJ article, in the wake of the recent Madoff and Stanford scandals, hedge fund investors have been requesting their money back at an increased pace over the last few months. Morgan Stanley analysts are forecasting that assets under management could fall by another 30 percent before the year is over. This follows an already 20 percent decrease at the end of 2008, reducing total hedge fund AUM to below $1 trillion. The withdraws are getting large enough that some funds are now left with only illiquid assets, most of which have to be sold at depressed prices. Increased selling has certainly help pressure the market recently, and will likely continue to do so if the hedge fund redemption forecasts from Morgan Stanley are correct. Having the DJIA fall to 6,000 and the S&P 500 fall to 700 would certainly seem more likely under such intense and systematic selling.

Jim Chanos, the famous short-seller who runs the hedge fund firm Kynikos Associates, was up 25 percent last year betting against equities. Nonetheless, he still found running a successful short fund challenging due to increased client withdraws (see Reuters article). Even with outstanding performance in a down market, investors still withdrew 20 percent of his funds assets. While some withdraws are normal, the percent was probably higher in part due to redemption gates put in place with other funds. After all, if you received margin calls, you have to get the funds from somewhere. As jokingly mentioned by Chanos, "we were like an ATM machine." Fortunately for Chanos and his investors, the Kynikos ATM was being replenished with cash. Given the current market, investors and depositors with some national and regional banks can only hope they are as fortunate.

Recovery rates on leveraged loans (often used to fund leveraged buyouts) have been less than 25 percent, compared to historical average recovery rates greater than 80 percent (see WSJ article).

Source: WSJ article image, Moody's Investor Service data

Given the recession and recent credit problems in the market, increased defaults are to be expected from companies with high debt and falling revenues, yet there appears to be more to the story. As is typically the case when a company defaults, those at the bottom of the debt food-chain, such as those holding senior unsecured bonds and subordinated debt, are the first to lose everything, compared to leveraged loans and senior secured bonds. What is unique in the current market is that a large majority of recent leveraged financing for acquisitions was done with loans, rather than unsecured bonds. As a result, the debt food-chain has contracted, such that the normal buffer of junk bond subordinated debt that is usually in place to absorb the initial losses is smaller than normal, or in some cases non-existent. Recent data from Moody's finds that 60 percent of all issuers in the US that have rated loans, along with over 30 percent with speculative-grade issuers, have a loan-only capital structure. With such a flat structure, losses go straight to the top of the debt food-chain, thereby explaining the lower recovery rates for leveraged loans. This is certainly not good for the large bank lenders of leveraged loans, but may be even worse for the junior lenders that hold subordinated second-lien and mezzanine loans (see Reuters article). A recent Fitch report finds that the recovery rates of such subordinated holdings are expected to remain in the 0 to 10 percent range. It appears we can expect more shakeout in the credit markets, which will continue to put pressure on the banks.

A new study by Mark Kritzman, president and CEO of Windham Capital Management, found that standard index funds - those with their lower fees and expenses (including transaction costs, taxes, management fees, and performance fees) - gave better returns than actively managed mutual funds and hedge funds (see New York Times article).

For his study, which is similar to past studies, Kritzman calculated the average return over a 20-year period, net of all expenses, of three types of investment, including a stock index fund with an annual return of 10 percent, an actively managed mutual fund with an annual return of 13.5 percent, and a hedge fund with an annual return of 19 percent. He used volatility, turnover rates, transaction fees, management fees, and performance fees that were based on industry averages.

His finding pointed to the problem with high expenses. The actively managed mutual fund and hedge fund each had total expenses of more than 3.5 and 9 percentage points a year, respectively. As a result, in order to break even with the index fund net of all expenses, the actively managed fund would have needed to outperform the index fund by 4.3 percentage points a year before expenses. For the hedge funds, it was even worse, with each fund needing to outperform index funds by 10 points a year. While similar studies have been done in the past, the current finding are just yet another reason that the 2-20 hedge fund model may see more resistance going forward. Managers will no doubt be asked more than ever to verify their ability to capture alpha.

In a recently published research paper in the Journal of Applied Corporate Finance, Tim Adam (from the MIT Sloan School of Management) and Chitru Fernando (from the University of Oklahoma Michael F. Price College of Business) report in their research paper "Can Companies Use Hedging Programs to Profit from the Market? Evidence from Gold Producers" that during the 10 year period of 1989-1999, the gold derivatives market was characterized by a positive risk premium that resulted in short forward positions generating positive cash flows. The authors found that the gold mining companies that hedged their production during this time realized an average cash flow gain of $11 million, or $24 per ounce of hedged gold per year, compared on average to an annual net income of only $3.5 million without hedging. Of interest is that as a result of the positive risk premium that resulted from a positive spread between the forward price and the realized future spot price, short derivatives positions did not result in significant losses, even when the price of gold increased. In summary, hedging helped increase profits.

Also of interest in the article was the finding that there was also a significant level of volatility in corporate hedge ratios, implying that some managers were incorporating market timing into their hedging strategies (no surprise, as hedgers will sometimes begin to speculate). The authors found that attempts to time the market by "selective hedging" were futile and unprofitable, even causing the company to consistently lag the markets as they attempted with little success to successfully adjust their hedge ratios in response to expectations regarding market direction.

In summary, hedging helped profits, but the benefits were from hedging, and not from the risk managers ability to predict price moves as they set their hedge ratios. Therefore, one can expect, at least for the gold mining companies, that while earnings and profits may remain volatile, those investors holding longer-term investments should see higher returns from companies that successfully implement and execute a defined hedging program that do not try to engage in market timing. While it is difficult to know when any company that you are investing in begins to move from hedging to market timing, at least knowing that a company is hedging will give you the potential for higher returns as long as you can weather a few up or down moves that may temporarily reduce profit margins.

In case you have not seen it, Rick Santelli, reporting for CNBC from the floor of the Chicago Board of Trade, gives his two cents regarding the recent housing bailout (CNBC video here). I would not be surprised to see future bailouts, and subsequent rants, get worse going forward. Given that housing often leads us into and out of recessions, there is no doubt that the housing problem needs to start being resolved before people will begin believing that the economy will recover. Unfortunately, there is no easy answer. Just about any of the proposed solutions that has the slightest chance of speeding up the recovery seems to reward bad behavior, while at the same time further penalizing those that acted responsibly. Do we continue bailouts, or simply let the chips of capitalism fall where they may? Santelli, as well as many others, seem to have already chosen sides.

Although the DJIA and S&P 500 were each down over 10 percent in January, the Credit Suisse / Tremont Hedge Fund Index was up 1.09 percent (also see Investment News article). The January returns were the first time the index was up since May 2008. Top strategies for the month were convertible arbitrage (returning 5.72 percent), dedicated short bias - no surprise (up 3.69 percent), multi-strategy (up 3.35 percent), and global macro (up 2.33 percent). Managed futures took the biggest hit for the month, falling 0.56 percent.

T. Boone Pickens, who as of last November had holdings in 26 energy companies within his BP Capital Management, now holds shares in nine companies as of its latest filing (see Bloomberg article). The fund fell an astonishing 97 percent during the final three months of 2008, declining from $1.29 billion to around $40 million. As for individual holdings, BP Capital reduced exposure to Occidental Petroleum, Transocean, and Suncor Energy, while selling all of its holdings in Schlumberger and Halliburton. The fund added shares of Chesapeake Energy and Peabody Energy.

Real Estate Investment Trust are designed to give investors an opportunity to invest in real estate, which over the long-term has performed pretty well as an asset class, the last year notwithstanding. Last week (2/2 - 2/6) even saw a pretty nice move in the REIT market, below the returns of the Nasdaq and S&P 500, but slightly above the DJIA.

Source: Wall Street Journal

Of course, the days of easy credit, structure real estate products freeing up capital, and rampant building may be over, most likely taking with them above average returns. Nonetheless, there may still be some opportunities in REITs as the housing mess unfolds and sorts itself out, and the Treasury department finally starts addressing the housing issue (see WSJ article regarding a proposed loan modification program - details later). Note: Citigroup and JP Morgan have agreed to a foreclosure moratorium for 90 days (see WSJ article), in anticipation that additional details of the Treasury plan will be available within the next three months.

For those considering investments in REITs, it is important to remember that not all REITs are created equal, nor are they all the same, but instead come in many flavors. Reported data for REITs is also different. Instead of sales, REITs report rental income as revenue. An advantage for REITs is that much of this income is relatively consistent given that long-term leases are often in place. Obviously, when dealing with rental income, the higher the occupancy rate, and the easier the ability to raise rates, and the higher the reported revenue. While the ability to raise rates is probably not currently in the cards for most REITs, some may begin to see an increase in occupancy rates, or at least a level of stability not seen in all markets (more on this later).

Valuation of REITs is a little more difficult, or at least different, compared to traditional equity valuation. While Book Value per Share can be used, in active markets such ratios can produce extreme values. A common approach that is often used instead begins with using Funds from Operations per Share, which includes net income, along with depreciation and amortization, minus any gains or losses from any asset sales. It is worth noting that both depreciation and interest rise significantly with increased financing, with REITs often having debt-to-equity ratios above 50 percent.

Even with a valuation approach in hand, and data one can trust, it must be remembered that not all REITs are likely to benefit in each unique market. One strategy which individual investors are utilizing in the current market is to purchase unfinished homes, often at a steep discount after builders either choose, or were forced, to move on (see SeekingAlpha article). After investing a little more money to finish the home, such properties are being rented out. Even in poor real estate markets, such as Florida and California, the rental market is doing well, and offering such rental opportunities - after all, as the thinking goes, people need to live somewhere. While individual investors may not be able to make the same large investments, there are various REITs that invest in residential rental real estate. Some of those listed in the aforementioned article include CMG Realty (CGMRX), Third Avenue Real Estate Value (TAREX), Avalon Bay Communities (AVB), Essex Property Trust (ESS), and Camden Property Trust (CPT), yet most of these REITs have their own issues and require additional due diligence.

To support the rental argument, the Real Estate Channel (see article) has recently stressed how "apartments continue to be the product of choice in national investment circles," while Apartment Investment & Management announced in its latest conference call that "the multi-family investment market continues to be relatively liquid." Yet, not everything is rosy, as others feel that Apartment REITs are susceptible to the downturn, no matter how they might be positioned to other REITs (see InvestmentNews article). Other REITs, like commercial REITs, may also not do as well, and are being recommended as good shorts, even at these depressed levels (see SeekingAlpha article). Like just about everything else in the market right now - enter at your own risk. Trying to catch a bottom, especially after a relief rally and a detail-free plan from Treasury, is always risky.

The EU is looking at potential caps on the amount of leverage that banks can have on their balance sheets (see Financial Times article). What is unique, or at least of interest, is how there may be less differentiation between long-term investments and assets on shorter-term trading books. Charlie McCreevy, EU internal market commissioner, highlighted the need to considering both types of risk when he mentioned that "While the probability of default might be lower on a trading book because of the shorter time during which the assets are held, the impact of default when it happens is the same whether the asset has been held for a single day on the trading book or a whole decade on the banking book.” Commissioner McCreevy also did not hold his dislike for Value-at-Risk models, highlighting how VaR models are “very useful when they don’t matter and totally useless when they do matter”. This has certainly been a difficult year for VaR, but the question remains - What else do you use? Even if short-term trading book assets are given more attention, you still need to have an idea of your potential exposure and loss. Of course, maybe even more relevant is how the business models of some banks will need to change (either due to new regulation or pure survival needs), which will ultimately change the way such banks are valued going forward. While limits on leverage and risk may be good for the solvency of such banks, those that do survive will most likely continue to have their stock punished as investors try to get their hands around the valuation of new lower risk, and likely lower return, business models.

Per a recent SEC filing, and as reported in a WSJ article, the Harvard University Endowment appears to have cuts its holdings of public stock by about two-thirds. This is two-thirds of a position that has already been lowered over the years as a result of an increased exposure to alternative investments. About 70 stocks and publicly traded funds were recently valued at less than $600 million within a fund that was valued in total at nearly $37 billion last June - before losing a reported 30 percent of its value. While it appears that Harvard may have sold some of these assets near the bottom, they may have had little choice given that a significant portion of their portfolio is either managed by external managers and/or is illiquid, such as timber, real estate, and private equity investments (which in some cases could have additional funding obligations) - see a previous post that discusses potential liquidity risk issues at Harvard.

It looks like Morgan Stanley has found a way to reward its top employees without getting in trouble for using bailout money for bonuses. Instead of bonuses, the company will be handing out "Retention Awards" after its merger with Citigroup (see New York Magazine article). I guess the conversation will be something like: "Congratulations, since you are still employed, please accept this cash award." Something tells me that is not going to fly with Congress. Just what we need ........ another hearing.

Insiders at Bank of America (BAC) have been taking positions in the stock over the last few weeks. This includes the CEO Ken Lewis, former President John Thain, and various directors. As seen in the chart below, the stock, while still in a steep down trend, has seen an increase in volume over the last month, and has "rallied" off its recent 52-week low of $3.77 (but still down tremendously from its 52-week high of $43.60).

Source: Bigcharts.com

Ken Lewis was recently interviewed on CNBC. When asked if Bank of America will take addition TARP money beyond the $45 billion that has already been provided to the company, Lewis gave a categorical no. Yet it could be argued that BAC is technically insolvent, and that nationalization may be the next step (see John Brown article at SeekingAlpha), regardless of the CEO's view on existing and future TARP funds. Nonetheless, given the CEO's optimism (and his willingness to back it up with additional purchases), a recent upgrade, and comments this week by Treasury Secretary Geither that are expected to begin publicly addressing potential solutions for the housing and credit problems, this could turn out to be an interesting week for BAC shareholders, and may provide a window for the rest of us as to the viability and direction of the banking sector, the economy, and the market in general (stimulus bills notwithstanding).

As the market has dropped over the last six month, the lower prices have resulted in lower P/E ratios for many companies, even in the face of lower earnings (see WSJ article). While earnings could continue to fall, lower prices are currently offering value investors more opportunities than they may have had in the past as once high-flying technology, energy, health care, and bio-tech companies are now looking attractive. Many of these same stocks were sold-off as hedge funds were forced to liquidate positions in the wake of increased redemption requests. The fact that now both growth and value managers are looking at some of the same companies could produce an increase in buying pressure and stock price appreciation in the short-term for growth companies that were previously widely held.

Consumer spending fell 1 percent last month, while the savings rate rose 2.8 to 3.6 percent (see Washington Post article). Given that consumers have less revenue streams than before - employment (still for most), but less bonuses, dividends, capital gains, and home equity cash - it makes sense that they are saving what income they are receiving, just in case job losses hit their family, or the recession deepens or becomes prolonged. While the benefits of lower energy cost are helping, memories of $4 gas are also still in the minds of consumers. This of course continues to be bad news for consumer retail, and continues to help separate the wheat from the chaff as companies such as Circuit City and Linens 'n Things can no longer take the slowdown, and subsequent lack of sales and profits. I suspect that as we continue to keep hearing about how this is going to be an extended recession and even longer recovery, consumers will do their part to insure that it is indeed long as they reduce spending and save what disposable income they have. Ironically, it may be this prudent saving that helps keep the housing and stock market ATMs that consumers have depended on short of cash for quite a while.

Just last summer as crude oil moved towards $150 a barrel, some companies were being applauded for having had the foresight to hedge their energy and fuel cost by locking into lower prices for future delivery. Unfortunately, as crude oil fell sharply from its summer highs to below $40 a barrel, some of these same companies were now finding themselves on the other side of the profit/loss equation (see WSJ article). Just recently, Delta Airlines reported a $507 million loss on its fuel hedges in Q4, while UAL reported a $370 million hedging-related loss. Southwest Airlines, known in the past for its smart use of hedging, is finding that its needs to post $300 million in collateral with its various counterparties as the price of crude oil and fuels continue to decrease. Not surprising, or maybe surprising to some, it how investors are punishing the stocks of those companies that were considered to be "prudent" in their use of hedging. What is often forgotten by both investors and management is that hedging is not speculation, or at least should not be treated as such when done correctly. A properly managed hedge should theoretically provide a predictable cost, but changes in the price structure of an industry could cause earnings to be volatile, not to mention the company stock price.

For instance, if an airline company has hedged its fuel cost based on crude oil being around $70 a barrel, the company should see some benefit compared to its un-hedged competitors as crude moves above $100 a barrel. Yet if companies in the industry have pricing power, they can pass some or all of this cost on to their consumers. Therefore, higher costs are followed by higher product prices (obviously, never exactly one-to-one, even with pricing power). For the un-hedged company, their profit margin will theoretically be the same, while the hedged company will experience increased profits due to their lower cost structure compared to their competitors. On the other hand, as crude oil prices fall into the range of $30 per barrel, the un-hedged companies could once again adjust prices, but now to reflect their lower cost (and attempt to take business from those paying higher costs who may not be able to adjust prices as quickly). Those companies that are hedged and are forced to pay the higher $70 per barrel price will experience a lower profit margin, lower earnings, and potentially a lower stock price.

So while hedging can help a company "lock-in" to a specific cost structure, if others within the same industry are not hedged, and those companies have pricing power, the hedged company can expect to see higher swings in profit margins and earnings, and subsequently a more volatile stock price. Not only does this surprise investors who were expecting a less volatile stock given that the company was hedged and should experience consistent costs, but it also generates inquiries from management as to why the risk management department suddenly turned into speculators, and more importantly why they made such a bad bet. In reality, the hedging allowed the company to control what it could (the cost), but still left it at the mercy of what it had less control over - industry pricing and investor reaction. Something to keep in mind as you invest in companies and industries that actively engage in hedging, especially in commodity markets that are volatile.

There is an old market rule of thumb that states as "January goes, so goes the year." Often the January Indicator pertains to the first five days of January, other times to the entire month. This year it may not really matter. As it turns out, this is the worst January on record for all of the major indexes, except the Nasdaq - and even the Nasdaq is nothing to write home about. The DJIA was down 8.8 percent, the S&P 500 was down 8.5 percent, the Nasdaq was down 6.2 percent, and the Russell 2000 was down 11.0 percent. The Dow Transports, which are used by some as a barometer and forecast for movement in the industrials and the broader market, was down a whopping 16.0 percent. Certainly, not an encouraging start to the new year.

On the lighter side, at least this weekend we have the Super Bowl to enjoy, along with the Super Bowl Indicator to watch - which states that "a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in the stock market for the coming year, and that a win for a team from the old NFL (NFC division) means the stock market will be up for the year." Given the market action over the last six months, even those market participants that think technical analysis is irrelevant, and indicators are just plain silly, may be saying "Go Cardinals." Yes. I know. I am grabbing for straws.

Note (update): Not that it matters, but apparently the Steelers and Cardinals are legacy teams from before the NFL’s merger with the AFL. Therefore, according to the SB indicator it should be a good year for stocks regardless of who wins the game. Of course, if you are investing based on this indicator, then maybe you should move your money to Treasuries (well, then again .....).