Hedge Funds

Flaws of Fund Manager Regulation – the 5 points you should know… Radio Clip

“The text is not perfect but texts are never perfect.” (MEP Jean-Paul Gauzès at a press conference in Brussels, October 2010)

Follow the link below to hear a 1.5 minute radio clip of my views on the The Alternative Investment Fund Managers (AIFM) Directive – Regulatory Standards for the industry. As you can hear from the intro, it was broadcasted on “The N@ked Short Club” on Resonance FM (2m+ listeners and growing!). Follow-on comment by Sophie van Straelen, Managing Partner of Asterias – check out her blog SVS. My main concerns are highlighted below.

1. FALSE IMPRESSION OF OVERSIGHT

2. COSTLY – Increased compliance costs (+32%) – passed on to investors – higher fees lower returns – reduce European competitiveness and leave. Already hearing about delayed launches. Could boost rather than end offshore – may lead to costly changes of legal structures and domicile.

3. REDUCED INVESTOR CHOICE – restrictions on those based outside the EU

4. MAY TRIGGER PROTECTIONISM, such as the US. Contradiction to conclusion from the April G20 summit, instructed world leaders to “promote global trade and investment and reject protectionism.”

5. INDISCRIMINATE – including small AUM funds and others of no relevance to stability of financial system or ‘systematically important’ funds – contradicting EU principal of ‘proportionality’); multinationals exempt – making others uncompetitive – costs do not match benefits for certain funds

BOTTOM LINEA SIGN OF A MORE INTRUSIVE REGULATORY REGIME – start forming a plan of action ahead of 2103 implementation (not carried out by enough yet)

Worth Remembering:

The Swedish Central Bank (The Riksbank) says of short selling:

“The benefits of short selling clearly outweigh the drawbacks. Short selling allows investors with a negative view on the value of a company to take a position that reflects that view. By doing so their information will be incorporated in the prices and thus, the price formation will be more efficient.” (June 09)

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How to play the Bond Markets

“Our lives are defined by opportunities, even the ones we miss” (F. Scott Fitzgerald)

I think the above title is apt for much of life, including the investment world, and the credit crisis was one such opportunity which served to make or break many mangers out there. A “broad-based” bet on parts of the fixed income asset class was enough to extract alpha. Now things are slightly trickier…

Investing is no longer a call on the asset class alone, but rather an emphasis on specifics is coming more into play.  Spreads have narrowed, from their historically wide levels (see chart below from an excellent fellow blogger the Calafia Beach Pundit, Scott Granis, the former Chief Economist at Western Asset Management and Seeking Alpha certified) but Corporates are focused on managing and strengthening their balance sheets. Differentiation in returns can be seen between sectors and between names. Thus, the key going forward is credit selection and a focus on quality.

I remain cautious on the high yield space, concerned with the possibility of the default rate coming in higher than expected and with lower levels of credit available to struggling companies, the recovery rate disappointing on the downside. This again highlights the importance of being name specific when investing. With spreads narrowing as far as the above chart shows, the risk / reward profile of this part of the asset class is not as attractive.

INVESTMENT INSIGHT: Be name specific, focused on high-quality companies with strong balance sheets

 


A Sustainable Recovery? “What’s driving the markets and how should I invest?”

The recovery is “neither strong nor balanced and runs the risk of not being sustained,” (Olivier Blanchard, the IMF’s chief economist)

INVESTMENT INSIGHT: Closely monitor the economy/markets – look to exploit overreaction on the downside, but with protection against future market pullbacks (E.g. via managers able to short / hedge exposures quickly).


Highlights

SENTIMENT DOMINATES: Markets driven by sentiment, cash on sidelines desperate to be invested

STIMULUS TO DECREASE: Earnings growth driven by cost cutting (a limited stimulus), to fall

INVEST WITH PROTECTION: Investing but with downside protection

 

Answer

The aggressive fiscal policies we have seen and the possible stabilisation or even turnaround in some data points have given fuel to the bullish. Nevertheless, with markets rallying so far from their lows, strongly driven by sentiment and perhaps ahead of fundamentals with investors focused on good news only, the possibility of a pullback is even higher. The market is moving from pricing in stabilisation to looking for a sustainable recovery, which is very risky. Further support for the possibility of a pullback comes from the fact that the rally which took the market to its current level, from March to year end last year, was arguably a low-quality, high beta and short-covering rally driven by discretionary consumer names which should be the most negatively affected in a recessionary environment (see charts below). Notice that since this point, the World Equity Index is flat, but the sector disparity has continued to widen. Nevertheless, I am also aware that there is plenty of cash on the sidelines and many managers judged against a benchmark cannot afford to miss out on another rally.

MSCI World Index +73% since 2009 low. Source: Bloomberg

During the 2009 equity market rally, the MSCI World Index (white) appreciated in value by ~70% from March low to year end. US Consumer Discretionary (orange) rallied ~90% whilst Consumer Staples (yellow) rose ~41%. Source: Bloomberg

What drove this rally? Markets rallied on better-than-expected corporate earnings but

  1. analyst estimates were so low that companies were bound to beat them;
  2. they were driven by cost cutting which companies cannot continue indefinitely;
  3. there has been talk of a “new normal” with growth in earnings reaching only 3% instead of the 5% we have been used to (Bill Gross)[1]

Bill Gross cites a move to a high persistent level of unemployment as support for his view. With lower income, higher savings, rising foreclosures and a credit restraining banking system, there still remains a strong case for the Bears to cling to. Across the “Pond”, the fragility of the UK market was highlighted when the BoE unexpectedly announcing massive expansion of quantitative easing program back in May of last year.[2] Many are now focusing on the possibility of a “double dip”, questioning how governments will be able to exit from their fiscal stimulus programs without dragging a muted recovery back into recession. This is before we discuss Europe which is widely believed to make a slower exit from the crisis.

US Unemployment Rate (%) at a heightened level. Source: Bloomberg

President Obama himself was given a stern warning from investment guru Warren Buffett about the severity of the situation. “He said, ‘We went through a wrenching recession. And so we have not fully recovered. We’re about 40, 50 percent back. But we’ve still got a long way to go’,” (Obama, July 2010)[3].

The situation remains unclear. At present there is enough data out there for Bulls to find reasons to be bullish as well as enough for Bears to find support for being bearish.

 

INVESTMENT INSIGHT: Until clarity returns, continue to closely monitor the situation to look for good entry points to exploit overreacting on the downside, but with the ability to protect from future market pullbacks (E.g. via managers able to short / hedge exposures quickly).

 

A “House View”

The search for yield is becoming an ever tougher quest for investors, especially the more cautious amongst us. Arguably, the easy money has already been made within the fixed income space; cash offers little as an investment vehicle and many question what the growth drivers will be behind many developed market economies and stock markets. Thus we are left asking, where should one invest?

We also need to question the type of environment we are investing in. Government action will be highly influential as it exits from its policy of Monetary Easing. Timing will be crucial but almost impossible to get right. Too early and we risk dipping back into recession and experiencing the destructive forces of deflation; too late and the threat of rampant inflation rears its head.  The consensus is that the government will favour the latter option as the lesser of two evils. Either way, any recovery the world sees may be a volatile one and clarity may remain elusive. Concerns over debt are still acute and here in the UK the Government predicts expenditure, revenues and debt are to get worse before getting better.

Thus I highlight the importance of an active management approach to investing, where the manager has the ability to react quickly to the changing environment and provide protection on the downside. Focus is also on being selective within each asset class. Although no longer a broad-based trade, opportunities remain within fixed income, with quality paramount and the focus on being name specific. Equities are looking more interesting. Nevertheless, with the potential for corrections in the markets in the near-term, investing with long / short managers, who have a proven track record of navigating the choppy markets of the last few years successfully and who are well-positioned to exploit opportunities both on the upside and downside, is attractive.

Emphasis is on being pro-active rather than reactive and continuing to monitor the changing economic and market environments closely.

INVESTMENT INSIGHT

ACTIVE MANAGEMENT

ALLOCATE TO EQUITIES

ANTICIPATE A MARKET PULLBACK (i.e. invest via long/short managers able to protect on the downside)