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Thursday

Financial stress test

Hedge funds haven't had a real stress test since 1998. Then, as now, there were "experts" who said short selling didn't work anymore! Speculators marketing themselves as "hedge funds" had also been playing positive carry and riding the stock and credit bull markets despite neither being a legitimate skill-based strategy. The problems had also been brewing for ages but the "efficient" market failed to immediately factor them in thereby giving plenty of time for those with expertise to make money or protect client capital.

There were also the usual predictions of the end of the hedge fund "fad" when in fact it strengthened the industry and emphasized the need to diversify investors' portfolios properly. The SAME market phenomena and manic behavior has repeated many times throughout history. Some investors have learnt very little from the lessons of the Long-Term Capital Management crisis or the earlier credit-induced panic of 1907. Knickerbocker Trust would have been called a "hedge fund" if it were around today. Is the "correction" over or could the markets be setting up for the "panic of 2007"? The volatility is NOT finished. Get long vol and T-bills and short stocks and credit. You can thank me later.

As in 1998 some funds used massive leverage and useless models that had no relation to actual markets to invest in overpriced credit products - subprime Russian debt then, subprime CDOs now - while shorting liquidity, shorting the Japanese Yen and shorting optionality. Clearly not all subprime CDO buyers were aware they were effectively writing embedded put options. Both times VaR provided misleading information on the REAL value-at-risk being taken. With debate still raging on where to mark all this margin and distressed "collateral" I wonder how many vacations have been cancelled this month. Interesting how often these things happen in the summer "doldrums".

Many risk assets fell recently; stock markets, high yield bonds, high yield loans and high yield currencies. Many real estate and private equity holdings also fell but their price won't be known until someone bothers to value them correctly. Asset allocation doesn't help much when correlations across risky securities tend to +1. The mythical "LBO put" also evaporated; there is no floor on the market. Maybe the "Greenspan put" will belatedly vanish too; it would be sad if Ben Bernanke is pressured to bail out the beta bandits. Credit and equity are two sides of the same coin yet some still seem to treat them as if they were unconnected. A portfolio of assets is not sufficiently diversified to be sure of making money in turbulent times. Strategies that do NOT rely on easy conditions are a MANDATORY portfolio component.

Limited losses are acceptable but meltdowns are not. Every strategy, every fund AND every asset has negative months sometimes. Skill, risk management, short selling and portfolio nimbleness are what determine if the loss can be kept low. It is why strategy and manager diversification is even more important than asset allocation. SMALL losses are inevitable but a wide spread of bets, hedging and knowing your risks AHEAD of time are what prevents BIG losses. Illiquidity and other non-linear exposures combined with leverage is asking for trouble. Why did so many believe in the free lunch of high yields at low yield risk?

Hedge fund pioneer Alfred Winslow Jones considered the purpose of his equity hedge fund was to guard against a stock market drop. He got it right over 50 years ago yet the semantic abuse continues. Hopefully recent market events will bring renewed attention to Jones' definition. A credit hedge fund's purpose is to guard against a credit market drop. Period. If a proposed "alternative" strategy is not set up to do just that what is the point in investing in it? I've been doing strategy evaluation and due diligence for a long time yet still encounter many "hedge funds" with scant risk management, reluctance to be net short and dependent on optimistic assumptions. If you want optimists go with the long only crowd.

Many passive index and long only funds are underwater for the century yet again. Curious how the media goes crazy when an endowment or pension fund loses millions in a hedge fund but not when they drop billions in traditional funds. "Alternative" ASSETS don't help if they fall just like traditional assets but are able disguise this price volatility and market dependence through delayed mark to market. We are also getting an overdue shake-out of "hedge funds" that were NOT managing strategies that diversified a portfolio. Risk-managed funds are the way to be more confident of protecting capital whatever the conditions. Hedge fund critics will cite summer 2007 to show they were right all along yet the truth is the subprime-induced meltdown PROVES the case for real hedge funds and diversifying by STRATEGY not only by ASSET.

Credit modeling and risk measurement are NOT rocket science. It is much more complex than that. Rockets have more predictable trajectories. CDO waterfalls can be like real waterfalls - take one step over the edge and there is a good chance you'll drop all the way to the bottom. Debt spreads are basically options premiums; if you buy a risky bond or loan you are in essence writing a put. Such a strategy is short volatility and hazardous if the premium does not compensate for the intrinsic default probability. As with many options selling strategies, taking in premium works fine UNTIL you get blown away by a fat-tailed move. It is with good reason that the ONLY thing I try to do with explicit or implicit optionality is to own it, NEVER short it. Bear markets are better than bull markets in that you make money much quicker. That is why I like buying "value" volatility. Unlimited upside with a known downside and guaranteed to produce lots of alpha in kurtotic markets.

The latest, but not the last, leverage and illiquidity blow up is Sowood Capital. Interesting how "market-independent" Sowood turned out to be dependent on credit beta just like Amaranth was on energy beta. Being concentrated in one area and charging hedge fund fees for simply gearing up investments in credit spreads is absurd. What they were doing was more complicated but simplifying the scheme: suppose you raise $100 from investors and borrow another $900 from leverage providers (really cheap in yen!). Then place the entire $1,000 into higher yielding assets and short something low yield. A year later you've "made" over 10% after fees but with no skill, no alpha and no justification in calling your product a hedge fund. Sowood wasn't a hedge fund; effectively it just took in inadequate credit risk premiums and hoped for the best.

Citadel, which actually is a hedge fund, bought out some of those positions because it is "hedged" and like anyone sensible keeps capital available for good opportunities. Other real hedge funds like Tudor and Caxton apparently had a rough month, giving back a minute fraction of their cumulative capital gains over the last two decades. It is much easier to pilot a speed boat than an oil tanker. Both were among the best speed boats in the 80s and 90s but have become oil tankers in recent years. It is very difficult to reconfigure large portfolios and take aversive action when a regime change hits the market which is why staying in liquid areas and closing strategies to new money is important. Paul Tudor Jones and Bruce Kovner are probably good enough to figure out ways to make the money back. Ken Griffin had a difficult 2005 during the CB arb meltdown but seems fine for now.

Jeremy Grantham, the permabear "G" of GMO, thinks 5,000 hedge funds will eventually disappear. There will certainly be more clueless credit spread speculators shutting down soon. But after that I would hope we lose 80% of good and bad hedge funds to attrition like in any other entrepreneurial business sector. Some will close down because they were outstanding but more will go because they weren't. Managers with genuine ability will thrive and alpha is a redistribution game. We've seen plenty of alpha transport in recent weeks as the skilled made money out of the unskilled. That's real "portable alpha"; other funds' negative alpha becomes your positive alpha. If anything a crisis just increases the money-making opportunities. Creative destruction and business Darwinism is healthy for any industry. The dotcom implosion didn't hurt internet growth and shaking out the beta bundlers won't hurt hedge fund industry growth either.

I am a permabull as far as innovation and people continuing to figure out ways to invest money safely is concerned. I certainly prefer manager risk than market risk. It is easier to find good managers than good markets. Markets don't hedge. It is so long since we had a proper shakeout to show who has been swimming naked in an outgoing tide. Ideally we have entered an extended period of flat to negative asset returns which is the ideal environment to detect genuine alpha-generating ability. Whatever the market does and whether Grantham proves correct, 5 years from now the hedge fund industry will be MUCH larger than today and there will be many more "start-ups" to replace all those "close-downs". Hedge funds are no more a fad than the internet.

Markets are a leading indicator not a lagging. At least the economy is "strong" according to economists who always seem to be able to succinctly explain the past. It is true the economy WAS strong but that does not mean it WILL be strong. Seems hard to believe that global risk aversion, reduced loan availability, higher borrowing rates for weaker credits, scepticism of ratings and less private equity deal flow will NOT have an effect on the liquidity driven world economy. The market always tends to "know" a lot more than economists. Equity traders also know a lot more than equity analysts. Credit markets know more than credit models.

As previously blogged I've been long implied volatility and short various credits for months but it is probably time to book those profits. Still short of FIG and BX but no need to cover those since they offer negative plays on private equity industry problems. The implications of tighter credit and stricter loan covenants for private equity are not yet discounted. Seven "analysts" issued "buy" ratings on BX today so clearly there is a lot more downside! If those sales-side cheerleaders were required to put at least 5% of their net worth into BX at the $31 IPO price I might start paying attention to their "opinions". But doing the opposite to what underwriter equity analysts say is usually quite reliable. Yet another example of bad stock, good company but that is hardly a rarity.

I wonder if those "research" reports noted the moral hazard of going public when your rivals remain mostly private. There was no way to short big private equity before 2007 but there is now. Quite kind for Fortress and Blackstone to provide global investors with the ONLY short sell plays on private equity. Even if those firms themselves are good, their public currency allows anyone to implement negative views on the industry. Merger arb used to be "buy the acquiree, short the acquirer". Reverse merger arb worked like a dream recently as spreads widened but normal merger arb might look favorable now strategic buyers probably have the upper hand. With KKR possibly wavering on its IPO, BX and FIG are out there in the cold as proxies for possible private equity problems.

The risk-adjusted performance of real hedge funds has been vastly superior to long only public AND private equity and they offer essential strategy diversification. While I realize many people far smarter than me are skeptical of hedge funds, my analysis of hedge fund performance leaves NO room for doubt that proper hedge funds offer important value to a portfolio. Even if some lose money and a rare few blow up, the spread of returns and strategies is the key value proposition. Asset allocation is less important than strategy allocation and hedge funds are strategies NOT assets. A stress test is great for showing who is good and who is not.

Risk and failure are necessary in a functioning financial system and during such crises there is ALWAYS opportunity. It has been a long time since tough trading conditions and while many products had been making money easily this year, the numbers show which funds have been generating alpha and hedging out that beta. As experienced in 1998, financial contagion is likely not yet contained. There is plenty more money still to be made out of the situation if you are nimble enough to capitalize on it. The credit market dislocation PROVES the case for quality hedge funds in REDUCING portfolio risk.

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