Long PM Health/Short Tums

What do you get when you cross good, thematic long-term investors and stock pickers with quarterly or annual redemptions? Perverse decision-making and style drift. Or a portfolio manager with an ulcer. There is a fundamental mis-alignment of motives in the hedge fund business, and my guess is that it will push truly excellent investors into one of two camps:

1. Becoming "institutional," substantially growing assets, running an overly diversified portfolio in order to dampen volatility by pandering to institutional risk-aversion, and generating mediocre returns in the process; or
2. Becoming disenchanted with the focus on quarterly performance and forcing out most outside investors or imposing a super long-term lock-up which will likely have a similar effect.

I've spoken to several friends in the fundamental long/short business who are good, really good, and they all get stressed out and irritated by quarterly performance measurement because this is not their investment horizon. Many of the value-oriented funds I know will hold investments for years - whose value naturally oscillates due to both company-specific and market forces - but ultimately the thesis plays out over time. Their approach is more akin to Warren Buffet than it is Jim Simons, and turnover as a rule is quite low. Just look at Berkshire's stock price; it whipsaws around regardless of the rate at which book value compounds over time. Market sentiment, sector rotation and macroeconomic factors have dramatic effects upon stock prices over short time periods, which may have little to do with the intrinsic value of a business. Quarterly reporting and redemption horizons that are mismatched with investment holding periods exacerbate the problem and lead managers to consider portfolio management decisions that are suboptimal for maximizing long-term returns. Two excellent managers I can think of off the top of my head, David Tepper and John Zwaanstra, run very concentrated, volatile portfolios with dramatic swings in performance year-to-year. And their investors understand this and are willing to take the roller coaster ride. But they are rarities indeed.

So why has this pervasive asymmetry existed? Because hedge fund managers ask for it. If a manager wants a quarterly payout, they have to live by quarterly reporting and performance measurement. Period. And if they complain that their investment horizon is long-term and that they shouldn't be judged on short-term results, then they shouldn't get paid that way, either. In a perfect world, managers would collect fees to run the business and attract and retain talent (management fees), but would have both performance fees paid and lock-ups match their investment horizon. So, if a manager had a three-year investment horizon on their thematic portfolio, they should get paid on positions in the book on a rolling three year cycle. This would result in a true melding of the hedge fund and private equity models, where performance fees are paid upon realization, not on period mark-to-market values, and capital is committed for long time periods. The same thing can be said for quantitative managers: stat arbs and other high-frequency strategies with short-term signal horizons should get paid out quarterly - but they should have redemptions quarterly as well. This is akin to the CTA business, and quite frankly it makes a lot of sense.

I believe this is a sensible, rational, and fair way to align manager and investor interests and to let the long-term fundamental manager do what they do best - invest, not trade. People would once again get paid for alpha generation and not simply asset gathering, and portfolio managers would probably have far fewer ulcers. Long portfolio manager health, short Tums.

Where is the Hedge Fund Industry Going, 2 Years Later?

In one of my first posts I made some projections concerning the future of the hedge fund industry:

1. The number of hedge funds, higher or lower? - Answer: LOWER
2. The "shape of the hedge fund industry?" - Answer: BARBELL
3. Will fund-of-funds continue to be relevant? - Answer: YES, BUT LESS SO OVER TIME

A recent commenter asked the following: Roger, have your view changed since your original post? I think it is high time I revisited my earlier predictions to see if anything has, in fact, changed my views.

Number of hedge funds

My bottom line on this issue back in July 2006 was:

All of this points to an industry which will grow smaller by number of constituents but be made up of the super-big and the super-small, each geared towards a specific pocket of investors.

To be honest, I don't see things any differently. The big have clearly gotten bigger, whether you are talking about Fortress, Och-Ziff, Lone Pine or Citadel. Large, sophisticated investors have placed increasing value on the institutionalization of the largest players, offering stability of management, infrastructure, reporting, risk management and a control environment worthy of larger investment dollars. Part of this trend has slowed the small fund launches, notwithstanding the rise of the seeder programs. There has also been a continued trend towards multi-strategy funds, giving the managers the ability to allocate capital to those strategies best suited to current market conditions. Also, there has been a shake-out over the past two years, driving the marginal players out as the smart money has either gravitated towards the large, established players or the high-profile new fund launches by successful portfolio managers. I think it is increasingly hard to sustain a single-strategy effort in the face of competitive pressures from the multi-strategy behemoths. So net net, I still see the number of hedge funds as being on a slight downtrend before it plateaus. And I believe the market is getting more efficient at picking the great from the good, creating a healthy, purging cycle that will also force consolidation across the hedge fund universe.

Shape of the hedge fund industry

My view two years ago:

...you have a group of large, global players populating the upper end of the spectrum with a churning, roiling lower end where some simply die off while others make it happen and jump to the big leagues after putting up serious numbers over a 2-3 year period. At the  end of the day, you end up with an industry that has the characteristic shape of a barbell.

I am more confident in my view today than I was in July 2006. The "great squeeze" of the middle that was happening  two years ago is alive and well today. The big have gotten bigger. The middle have either made the jump to the big leagues or are in an increasingly tenuous position. And the small is an amalgam of new starts, falling stars and a small group of single-strategy managers with laser focus who are happy with their business. And as the costs of entry I'd argue have gone up, not down, this serves to reinforce the barbell shape of the industry. Why have costs gone up? Even in the face of rapidly declining technology costs, the infrastructure necessary to run institutional money has gone up, up, up, in terms of people, systems and the time it takes to administer such an organization. Further, as the largest firms move into every market and asset class, it has created an arms race that makes it increasingly difficult for smaller funds to compete. I believe this is an inexorable trend that shows no signs of abating.

The relevance of fund-of-funds

Roger, circa mid-2006:

While I believe there will always be a group of institutions that will simply want the added protection of having a professional fund-of-funds manager when they report back to their boards, this group will, without question, shrink over time and place ever greater downward pressure on fees for providing these services.

This is an interesting one. I'd say that I got the theme right but the timing wrong. Why? Four words: Amaranth. Sowood. Bear Stearns. If there is anything that can shake the confidence of an institutional investor it is a colossal blow-up, and these are just three of the many we have witnessed since my original post. And the big beneficiary of this waning confidence in one's due diligence ability? Fund-of-funds. These institutional investors still need to generate returns, and they're not running away from the asset class. But many would rather pay away some fees and get the imprimatur of a top fund-of-funds than go it alone and risk personal and professional ruin. I'm not saying this is rational, but it is what it is. Plenty of fund-of-funds got smoked in these three high-profile explosions, but the mere perception of greater stability and security offered by fund-of-funds is enough to make the marginally-confident institutional investor sign up. But as a trend, I believe that alternative asset allocations will continue to rise, and that many will reach a cross-over point between hiring a fund-of-funds and building an in-house due diligence and risk management team. Eventually, both economics and control will dictate the construction of these in-house efforts, leaving fund-of-funds to a more marginal role in the investment landscape. That said, in light of the jittery markets and high-profile instances of hedge fund failures, this trend will take longer to play out than I had originally anticipated.

I guess two out of three ain't bad.

Internal Hedge Fund Platforms: Get the Model Right or GET OUT!

Trashing in-house hedge fund platforms is currently all the rage. And why not? They had a bad year, no? This from today's Institutional Investor's emii.com:

Poor performance by in-house hedge funds launched by investment banks and the like may lead some big Wall Street names to exit the field, Dow Jones reports. While many a top hedge fund enjoyed returns that outperformed the standard indices, a number of in-house HF offerings by the likes of Goldman Sachs, Bear Stearns and Barclays have not.

And there were several pieces in the past week that were in this same vein. Bottom line - this is not new news. Most banks have gotten this business wrong for quite some time, in pursuit of its promise of great riches. And last year's weak performance does not begin to illustrate the core problems of most internal hedge fund platforms. Recently stories are trying to sell longer-term business model issues as near-term news. Sorry to disappoint, but these writers don't really get what's going on. Fortunately, I do.

Most pure quants and trend followers had a bad year in 2007. They got whipsawed, statistically durable relationships broke down and they generally got hurt. Luminaries as bright as Jim Simons, Cliff Asness and the Goldman and BGI quant groups got hurt, and they were by no means alone. Whether the teams in this area were internal or external, the markets brought harsh reality to the lot. And let's talk about hedge funds investing in structured mortgage paper. Unless you were shorting like a Paulsen you were getting murdered. Again, it didn't matter whether your were internal or external. Someone ripped your face off, pushed you in front of the mirror and you screamed for the last five months of the year. This is just the way it was.

So Goldman (quant), Bear (mortgages and mis-management) and Barclay's (quant) suffered the same as off-platform funds, so this this whole line of argument is a bunch of garbage (pronounced gar-baaaaage). It makes for a good story, but this isn't the real story. The REAL story is why most on-platform funds suffer from adverse selection, where the best of the best either start their own hedge funds or get a sizable book at an established hedge fund, while the remainder trade in-house. Here are some of the issues:

• Compensation
• Autonomy
• Stability of investment capital
• Compounding of capital
• Branding
• Ego

Compensation is an easy one. Most in-house operations don't pay nearly as well as hedge funds do. Because it is just not the bank culture to pay like hedge funds. If you want to be successful running an in-house platform you need to pay a much more competitive wage. And if you have truly great traders, it is worth it. And the more liquid the portfolios they run (and therefore attract a lower amount of regulatory capital), the better the deal for all parties involved. I could talk about this for days but this is the gig. Pay fair, create a separate culture for the in-house group versus the traders in the broker/dealer and get on with it. Or don't even try.

Autonomy is what it is. Some top traders just want their own show. And they have to go; because if you contort yourself to keep them they will kill the culture and damage the platform. However, if what they really want is to do their thing and be left alone then agree to clear parameters for book size, portfolio construction and risk parameters. And stay on it. But a little light mentoring and strong risk oversight can give the bank the security and comfort it needs while giving the trading team the perceived autonomy it wants. Again, a culturally challenging thing to do but absolutely necessary for building and running a successful in-house operation.

The biggest fear traders have is getting their capital yanked away from them and precisely the wrong time (or at any time, for that matter). If you run and hedge fund with some locked-up capital, you don't deal with this risk. This is a tricky point, because as head of an in-house platform you want to balance favorable capital treatment (which generally connotes the ability to liquidate positions at a moments notice) with giving the trader a measure of comfort (that you won't arbitrarily make them cut the book). Given these opposing needs, a pretty big measure of trust needs to exist between the trader and trading management, because the manager can't get the security they really want without killing the capital treatment (which the bank won't accept). It is what it is. The answer to this one isn't perfect.

Compounding of capital is an interesting point. When you run a hedge fund that starts the year at 100 and you generate 20% gains, you begin the next year at 120. In a bank where you are trading prop capital outside of a fund structure (i.e., in a managed account with the assets held on the bank's balance sheet), that 20 gets swept out and the trader begins year 2 at 100. Over time, the loss of the value of compounding can be stunning. Once an on-platform team begins trading client capital, this issue is ameliorated through a melding of manager and client capital which both benefit from compounding. But when a trader is running purely prop funds, they generally lose the benefit of compounding. Just something to be aware of when negotiating a deal.

Branding means more to some than to others, especially once client capital is being managed. The trader generally wants to own their brand and to have portability, which I think they need to have if you want to attract and retain (for a period) the true rock stars. Inevitably the rock stars are going to want to set up their own fund, and the strong in-house platform should be supportive of that move subject to terms in the agreement that provide a package of benefits to the bank, i.e., capacity guarantees, fee discounts, distribution agreements, etc. If a bank tries to hard to keep the intangible assets (the brand, the track record, the models) all to itself, it will lose out on the best teams out there. Because the best will want to be in-house at the right time and for the right reasons, and if they feel like they are being held up they simply won't do it, or will be resentful and cost the bank in other ways down the road.

Ego really relates to branding as well as portability. Many platforms don't anticipate teams being able to leave in a pre-agreed manner, and end up fighting bitterly with the team when the time comes for them to externalize. This just dumb. Put it all on the table upfront, let the team keep the brand, track record, and models should they leave, with the proviso that the bank gets the benefits mentioned above. it become a win-win, where only the best teams are able to spin-out because of strong performance and investor demand, which creates enormous value for the bank through their capacity option, discounted fees and distribution rights. This is the natural evolution of things. Don't fight it.

In sum, the in-house platform isn't dead. It has been dead for most for a long, long time. It is precious few firms that have ever done it well, but those that have created tremendous value for shareholders, traders and fund investors.

Alternative Asset Managers and Down Market Cycles: What to Expect

The equity market has been a roller coaster, characterized by bone-jarring volatility and single-stock blow-ups that are enough to make even the most steely-eyed hedge fund manager cringe. And private equity firms have seen arbitrage spreads explode, fueled by the knock-on effects of broken credit markets and concerns over whether the PE firms or the banks will walk away from agreed-to transactions. But these are merely observations. The real question is, how will a persistent down market impact the returns of the hedge fund and private equity industries? My handicapping: most participants will suffer and suffer badly. Why? In summary:

• The net long exposure of most hedge funds will weigh on returns. Historically it has been difficult for most hedge funds to add significant alpha on the short side, the side which may well be the key driver of returns for quite some time.

• The excess capital across the private equity industry and sharply wider financing spreads will hurt new deal returns. An unfriendly equity market will make for a limited IPO calendar, eliminating an exit that has proved so fruitful for many of the largest PE firms and their investors over the past three years.

Bridgewater Associates had a very interesting report yesterday that addressed this very issue. Here are some of their thoughts as it relates to the hedge fund industry:

For the most part, hedge funds have gotten through the credit crunch relatively unscathed. For example, the average hedge fund generated a return of 12.5% last year and 2.5% in the fourth quarter. And private equity funds generated an average return of 11%. The main reason that these two groups held up as well as they did is because the equity market has not fallen nearly as much as the bond markets (i.e., spreads), and the majority of the risk allocation of these funds is in the equity market. And because their performance held up, they have not been forced into much asset liquidation to speak of. But stock market action is beginning to pressure the hedge funds and private equity players.

Hedge funds used to be a lot more hedged than they are today. Today, just about anyone who wants higher fees based on total return calls themselves a hedge fund, even if they are just a buyer of assets. And the fat cash flow yields in global stocks have also attracted a number of hedge funds into net long equity positions. As a result, hedge funds are now heavily long the equity market. Based on fund by fund holdings data we estimate that hedge funds are net long about $150 to $200 billion in U.S. equities (foreign equities are not included in this figure).

********************
Hedge funds are also highly leveraged. Losses raise a fund’s leverage ratio, which requires asset liquidations to bring the leverage ratio back to normal.

Let's see, big net long equity exposure + high leverage + down markets = not good. Clearly we are both taking an industry-wide view of things, but I think it is important to have a grip on the thematic issues in order to gauge possible broad-based effects. Earlier this week I wrote a post that identified industry-specific knowledge, liquidity and value-orientation as being key components for success in volatile markets. Let me add a long time horizon to that list. One of the big issues plaguing many hedge funds is a focus on managing to monthly and quarterly numbers. In real life, this is no way to run a business. Some of the greatest investments of all-time have looked really crappy at the beginning and the thesis has played out over time. If you've got the time, which means either long lock-ups, stable and mature investors, eye-popping long-term performance or both.

I happened to be at the Greenlight Limited Partners Annual Dinner last night, and David Einhorn did his usual impressive presentation of 2007 results with an overview of trends, risks and opportunities today and in the future. The great thing about David is that he is very honest, very humble and very, very focused on sticking to his long-term value mission. In quest of high IRR value-based ideas, wherever they be found, even if they take a long time to play out. He gave examples of positions that have been in the book for five years, making lots of money for investors on an IRR basis but only after the market finally bought into the Greenlight thesis. Several other funds I respect a great deal roll this way, including Rob Medway and Yale Fergang's Royal Capital and Seth Klarman's Baupost Group. It is funds like these that can withstand the pain, and which also have the skills and experience to manage an active short book as part of a true "hedge" fund portfolio.

Bridgewater also had some cautionary words for the private equity industry:

Private equity also looks vulnerable... One element that we showed was the recent deterioration in the yield on private equity deals, driven by too much money chasing too few good deals. This contrasts with the fat yields that existed a few years ago. Those fat yields contributed to the recent high returns on private equity (2007 private equity returns were 11% according to Cambridge Associates and the average return over the past three years was 20% per year). The recent skinny yields, combined with public equity market weakness, are a bad sign for future private equity returns.

I heartily agree. This is an area I've written about quite a bit, both about the glut of capital saturating the high end of the industry and new types of structures (like KKR's investment in Sun Microsystems) that might become the vehicles for deploying capital. Until credit market capitulation is complete, bank balance sheets have been rebuilt (through a combination of external fund-raising via SWFs and other deep-pocketed investors and internal fund-raising through a Fed-induced steepening of the yield curve) and investors have coughed up and marked-to-market all that seemingly low-risk paper trading at 20 in their books, it will be hard to see how debt capital formation will support the scale of private equity transactions we've witnessed in the 2005-07 period. So where does all that private equity go? Either to far less levered deals generating far lower IRRs than in recent years, or into PIPEs and other types of minority stakes that offer downside protection but with modest upside and 10-12% IRRs instead of the 25%+ IRRs we've become accustomed to. In short, it is hard to see the halcyon days for the private equity industry in the near term.

So in the final analysis I think we all need to dial down our expectations. Structural issues will continue to depress hedge fund and private equity returns until the credit cycle and its impact on global equity markets plays itself out. It won't be pretty but we'll all get through it. And some will thrive. Those who have the breadth of skills, the capital and the long-term orientation to take advantage of others less fortunate.

Is Old Lane Old News?

Now that it appears that Vik has nosed into the lead in the great Citigroup CEO race, what of Old Lane? When it came out that Citigroup was buying the new Old firm back in April, I had hypothesized that they were essentially paying an $800 million executive recruitment fee. Sure, there was spin that Citigroup's alternatives business was going to broadly distribute the Old Lane product across its broker network, and use it as lever for growing its alternatives franchise. But I wasn't buying. Who would pay such a sum, call it 15-20% of assets, for a new hedge fund firm with just ok returns? No rational financial institution, IMHO. I know, I know, we are talking about Citigroup here. I felt that promises of an Old Lane product push was a bunch of smoke to get at Vik and John Havens, two quality managers with bulge bracket Wall Street cred.

Fast forward to today. Was I right? Are quants grumpy? Has anybody heard of a sub-prime mortgage? Of course I was right. Citigroup looks to be getting their new CEO (Pandit), a top guy who may run investment banking or some other super senior job (Havens), Old Lane's performance is weak and the product isn't being pushed by anybody. Assets are reportedly around $4 billion, less than the $4.5 billion when the deal was announced. Ho hum. Old Lane is truly old news. So what does the rich Old Lane price tag look like now? Just like I said nine months ago - the biggest headhunter fee on record. Vik did an amazing deal for which he should get the props - getting paid to find himself. Now if only I could do that deal...

The Pressures of Scale in the Hedge Fund Industry

The hedge fund industry is rapidly becoming an amalgam of "haves" and "have nots," with the larger, more established, "institutional" funds getting larger with the small and mid-size funds more or less bumping up against an AUM ceiling. Of course there are exceptions, but this is the general trend I've been witnessing for the past year or so. In fact, I wrote about this in one of my first posts as a blogger, titled Where is the Hedge Fund Industry Going, 7/17/2006:

As noted above, it seems that the "middle class" is getting squeezed and will have to make a decision - to "go global" or "go local." To be truly multi-strategy and have access to the best investment ideas across the spectrum,  a firm really needs representation in New York, London and Hong Kong, at a minimum. This is not cheap. A close friend of mine, who happens to be a very successful  long/short hedge fund manager running about $1.2 billion, recently told me that he feels at a competitive disadvantage to some of his peers who are running $3 billion and more. Why? Because they have the resources to set up offices in these locales (without presumably placing pressure on team compensation in the process) and gaining better access to information and ideas in these regions, and he feels somewhat strapped, especially in a tough market like this one. I couldn't believe I was hearing this from a friend running over a billion dollars, but times really have changed. So, if a guy running a billion is feeling pinched, how large do you need to be? $3 billion? $5 billion?

It seems that the high end will be defined by those with the resources to support and sustain a global multi-strategy platform, with a world-class infrastructure to support the operation. So what about going local, staying pure to your initial style and demonstrating superior alpha generation across a manageable asset base? I think this is a viable and rewarding strategy for someone who either runs their firm as a lifestyle business, or is setting the stage to build a track record sufficiently attractive to garner the assets necessary to make the jump from local to global. This will serve to create a dynamic where you have a group of large, global players populating the upper end of the spectrum with a churning, roiling lower end where some simply die off while others make it happen and jump to the big leagues after putting up serious numbers over a 2-3 year period. At the  end of the day, you end up with an industry that has the characteristic shape of a barbell.

Just as I was thinking about discussions I've had recently with several friends at hedge funds large and small, I read about Perella, Weinberg's acquisition of Xerion, a $400 million AUM special situations fund. And if you read the comments from Xerion's founder, it appears that he and I arrived at the same conclusion as it relates to the pressures of scale.  From the Wall Street Journal 10/02/2007:

Behind the trend is the growing realization by those who run smaller hedge funds like Xerion that their job has gotten much harder. The firm has scored gains of 30% so far this year betting against financial companies and subprime debt, and by making wagers on so-called special situations, such as shares of early-stage commodity producers, according to one investor. Xerion, which was formed in January 2006, was up about 12% last year.

But its founder, Daniel Arbess, said so much money is flowing to larger funds that it makes it harder for smaller firms to raise cash. The 100 largest hedge funds control about 70% of the money in the hedge-fund world, up from less than 50% at the end of 2003. That leaves thousands of smaller players scrambling for the rest.

"We don't need to sell out now," Mr. Arbess says. "But the hedge-fund industry is becoming winner-take-all, with the vast majority of capital going to the largest, most institutionalized firms."

Daniel is right. He could keep right on growing incrementally, but not getting the big allocations necessary to bring him to the next level any time soon. And then the question becomes: is it important to get to the next level to be competitive? My friends who run the $1.2 billion long/short fund found their budget too tight given their goals, namely to source and due diligence ideas globally and to build a local presence in the key global financial hubs. So their rush to scale is not driven by more management fees to pad their wallets - they are spending virtually all of their management fees on running and growing their business; it is to have the fee stream necessary to support multiple offices and to build a bench of top talent that can operate a global platform. This is not growth for growth's sake but growth for the sake of incremental alpha generation. Other funds might not feel the same way, such as a geographically concentrated small-cap hedge fund whose capacity really maxes out in the $300-$500 million range. This can be a nice, profitable business run by a small team - as long as performance is strong. But if performance wanes, poof! Not such a nice business any more.

The WSJ story goes on to describe some of the perils of growth, where the motivations aren't quite as straight-forward and returns-based as those of my friends:

Still, some investors are concerned that the rush to establish large, "multiple-strategy" hedge-fund firms that embrace different investments might not work out. They cite Amaranth Advisors, a multiple-strategy fund that collapsed last year after heavy energy-trading losses. They worry that some of the hedge-fund managers selling out are simply cashing in while the money continues to flow.

Others say the push to purchase hedge funds and offer more strategies to clients is simply a way to increase management fees, rather than a means to deliver top-notch returns.

As large firms buy up hedge funds and bolt them together to form multiple-strategy funds, many could prove unable to appropriately allocate capital and manage the risk of these varied investments, says Gregory Curtis, chairman of Greycourt & Co., a Pittsburgh firm with $10 billion in assets that invests in hedge funds for wealthy individuals. He says that even successful hedge-fund managers usually know little about allocating money among different strategies -- or how to manage all the risk.

I find these arguments pretty weak when it comes to well-managed firms, and right on when it comes to hype-machines that are great at asset gathering but lousy at investing. But at the end of the day there will always be good and bad funds, and it is incumbent upon potential investors to say "Hey, these returns aren't sustainable. They were concentrated in a few trades and their risk management culture is marginal." It is so easy to follow the herd and get caught up in the group-think - which inevitably leads to pain. And we've seen this time and time again.

But I think Xerion's move is rational and a sign of the times. If good small and mid-size firms want to achieve scale they might be best served selling out, and getting a smaller share of a much larger pie:

Mr. Arbess, who will become a partner at Perella, said that selling out to the larger firm will help cut Xerion's trading costs, give it better client service and technology -- and enable it to raise more money. Since large institutions such as pension plans generally want to invest at least $50 million in a fund, and don't want to hold more than 10% of assets, it makes them less likely to shift money to a mid-size firm like Xerion. That adds to the attraction of selling out to Perella, Mr. Arbess says. Perella will put $100 million into Xerion's funds as part of the agreement.

Rock on, guys. You are on the leading edge of an inexorable wave that will ripple throughout the industry for the next 24-36 months.

Single-Manager Platforms: Opportunities and Challenges

I've spent a lot of time thinking about single-manager platforms, their optimal structure and operation. I ran a big one while at Deutsche Bank called DB Advisors. Goldman Sachs recently announced the building of a similar platform in its asset management division. Most Wall Street firms have some kind of single-manager platform as I define it, and these operations are frequently characterized by:

• Legal, operating and risk management environments that are separate from the broker-dealer;

• Teams that are initially seeded with proprietary capital, but after establishing strong track records often are marketed and attract client capital as well;

• Managers who are paid better than position traders in broker-dealer Sales & Trading operations, but not as well as external hedge fund managers;

• Managers who are often either quant-driven or socially challenged, and either lack the desire or ability to run an independent hedge fund operation on their own;

• Teams that are paid off of a percentage of net profits (realized and unrealized gains less direct and indirect costs of running the business) on an annual basis and begin each year at -0-, meaning they generally don't get the benefit of compounding capital over time;  and

• Top talent from the broker-dealer clamoring to get in, sometimes causing tension between the best broker-dealer traders and senior management.

These groups can be fantastically profitable ways of deploying firm trading capital while creating valuable third-party product for distribution. This is the good news. The bad news is that these businesses are hard to run and, by their nature, are subject to massive volatility due to internal and external factors. Consider these three real-world scenarios:

1. Say that one day you wake up and your top performing manager has grown some personality and wants to leave. Well, what do you do?
2. Imagine that the market gets crushed (as it did in August) and that hedge fund returns across most strategies are poor. This results in huge mark-to-market losses for the firm and potentially a whole lot of pissed off asset management clients. Then what?
3. What about the very real possibility of some marquee traders in S&T getting angry about their comp because they are getting 10-12% of net on smaller capital amounts than their pals on the single-manager platform getting 15% on both proprietary and client capital. How do you preserve firm talent without either cherry-picking top S&T talent and putting them on the platform or paying them off the curve relative to the colleagues with whom they sit, collaborate and trade?

There are no easy answers to any of these questions, but they are questions that need to be considered if a firm is to be successful in building and operating a successful single-manager platform. Given these headaches, is it worth it? Quite simply, the answer is yes subject to a few important caveats:

Management needs the right mind-set when establishing these businesses. This means:

• Setting aside a pool of risk capital upon which it is willing to accept hedge fund-like levels of volatility in stressed environments. Because the worst thing you can do is set up a business, communicate a vision, a mission and a risk tolerance, and get cold feet right when your traders and clients need you to suck it up, keep cool and stay in the game.

• Establishing a strong, holistic risk management culture. A firm running one of these platforms will have a lot of prop capital at risk and position-level detail across all of its books. This information needs to be aggregated, analyzed and disseminated in an accurate, fluid manner, and used for managerial decision-making when viewed in context with the firm's aggregate risk position.

• Accepting the fact that successful teams will eventually want to leave and providing a mechanism for creating a win-win between firm and team. This could mean the firm getting an option on a share of the newly-established GP, guaranteed capacity, reduced fees, continued prime brokerage business, etc. In exchange, a team will get to keep its name, its audited track record, and receive assistance in moving parts of its book to other prime brokers and in setting up the new business.

• Creating open communication and understanding among business leaders in the single-manager operation and S&T. This will be required to handle situations where top traders want to move from the broker-dealer to the single-manager operation. This will inevitably come up and create discomfort among all parties, and this situation needs to be anticipated with rules of engagement defined beforehand to guard against fractious, destructive behaviors.

There are so many interconnected factors to be considered when building and operating a single-manager platform that a book could be written on the topic. But I have hopefully provided an interested party with a primer on the key issues that need to be considered.

Sowood, So Long. And Not Short Enough.

Sowood, simply the next in the parade of likely credit hedge fund blow-ups. Exactly how many funds will be laid low by the current credit markets ugliness? I'd hazard a guess that the final count will be in the low hundreds. I keep asking myself why, WHY this is happening, and it always comes back to THE common thread separating the truly successful hedge funds with long track records from road-kill: strong risk management practices. This seems like straight-forward common sense, right? Well, apparently not. I know as much as all of you do, but what I can infer from Sowood's situation is the following:

• They were long lower-rated credit instruments, either pure credit or credit spreads;
• The likely hedged the long positions by shorting equities and/or high-grade credit instruments;
• They likely employed leverage to amplify the bet; and
• Their book wasn't very well diversified by strategy, even if it was across a range of credits.

The net result: lower grade credits eroded, higher grade credits eroded as well, and the drop in equities didn't begin to offset the decline in credit values. And leverage only increased the adverse result of the trade. Now, consider that Sowood was a Day 1 $2 billion launch by Harvard Management rock-star Jeff Larsen. This is not some greenhorn tossing around huge institutional dollars without having any inkling of what they should be doing. This was JEFF LARSEN. Of the super-successful Harvard Endowment? Right - you know the one. Don't you think Mr. Larsen knew better than to place so many concentrated and statistically-related bets such that, if all hell broke loose, he'd drop 50% of his NAV in a month? I'd think so. But then, I'd be wrong.

I guess if it can happen to LTCM and its brain trust it can happen to anyone. But didn't Mr. Larsen learn from LTCM? Or, more recently, Amaranth? What is driving these types of behaviors? Unhappy with a few years of mediocre returns and trying to shoot the lights out? I'd bet a lot of money that Sowood's true NAV didn't drop 50% in a month - it actually dropped a lot less. Why? Because it really began dropping well before last month, it is simply that positions weren't marked to true liquidation value but marked-to-model. I will almost guarantee you that this high-profile blow-up will cause many to revisit this issue - and fast. This kind of practice causes artificial stability in both position values and fund NAV, and generally provides a false picture of risk as well as possibly resulting in excess manager compensation. Autocorrelation - the smoothing of returns - is a big no-no, and if there is some basis in fact that banks aren't causing gradual mark-downs in counterparty collateral because it would hurt their own proprietary positions, we've got a big, big problem. And this is what I'm afraid we may have.

Anyway, at times like these I hear the refrain from Queen "Ba da ba, ba, ba, another one bites the dust." And I'm sure I'll be hearing it a lot more in the coming months.

Tougher Lending Terms for Hedge Funds? Free Market Regulation in Action

The Financial Times had a front page story today titled Tougher terms for hedge funds, discussing the impact of credit market uncertainty on the willingness of investment banks to provide leverage:

Investment banks are responding to rising credit concerns by imposing tougher lending terms on hedge funds, in a move that threatens to exacerbate investor unease in the financial markets.

Prime brokerage departments at several investment banks have raised their margin requirements for certain hedge fund clients as they seek to insure themselves against the possibility of new hedge fund collapses as a result of the recent market turmoil.

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The move could raise pressure on parts of the hedge fund sector, since it comes at a time when performance at some groups has slumped as a result of market swings. The average hedge fund, across all strategies, returned 0.8 per cent in June, down from 2.3 per cent in May, according to Credit Suisse Tremont.

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The stricter approach to lending to hedge funds by investment banks comes as markets continue to suffer as a result of concerns about the state of the US credit markets.

There are several messages one can extract from this story:

1. The Bear Stearns debacle has put prime brokers behind the 8-ball;
2. Credit-driven strategies are hurting, and are dragging down the returns of composite indexes;
3. Hedge fund leverage will be harder to come by for the foreseeable future;
4. Prime brokers are able to manage their policies, practices and exposures based upon market conditions; and
5. Regulation via the free market is effective.

I'd say 2-5 are right and 1 is wrong. Prime brokers aren't behind the 8-ball, they're on the ball. Most of the people I know at the leading prime brokers have lived through ugliness before, and are pretty experienced as it relates to non-normal market risks. And while competitive market forces may drive down pricing and hurt the risk/reward balance for prime brokers in hot markets, my sense is that sufficiently conservative controls exist around the risk side of the equation such that they will do just fine in most market dislocations. They've taken their lumps in the past and have learned from their mistakes. In fact, almost all leading investment bank risk management infrastructures, policies and controls have been strengthened dramatically over the past decade. So I am pretty sure that 1 is untrue.

2-5 are factually correct. Credit-driven strategies (at least most long strategies) are hurting, and it appears that their is more blood to be shed on the Street. Prime brokers are reining in lending practices, so portfolios for both credit and non-credit strategies alike may well be more difficult to finance. Clearly prime brokers have the flexibility to deliver bad news to their clients and make lending more restrictive, as this is happening all across the globe. And this is the very essence of market regulation, provided courtesy of the free markets, no government involvement required.

Prime brokers are in business to make money, not make friends, and if this means pissing off some friends by tightening lending standards to protect current and prospective P&L, so be it. And this is highly rational. And it's not as if they needed the SEC, Congress, the OCC or anyone else to tell them how to do it. They know just what to do as rational market actors. I hope Commissioner Cox and those in Congress are tracking this story. Because this is the way it should work. Mr. Market driving decision-making. And, as is almost always the case, leading to the right answer.

Goldman Sachs: Taking a Page from the DB Advisors Playbook

Yesterday in Dailyii.com and today in greater detail in the New York Times, it was reported that a chunk of Goldman Sachs' Principal Strategies Group is moving from the securities business to the asset management business to build a hedge fund operation. This means that traders and teams that were previously running only the firm's capital will be part of fund structures that will trade both firm and client capital. Interesting. Very, very interesting. This something I know a little bit about, having run a group called DB Advisors which was, in essence, exactly the same business. We ran about $4 billion of prop risk and $2 billion of client capital as part of a Registered Investment Advisor that was wholly-owned by Deutsche Bank. This structure can be great or it can fail miserably, and few have gotten it right. Based upon my reading of how Goldman is doing it, they are getting the big things right (no surprise). That said, running a successful operation of this type involves walking a very fine line, the reasons for which I'll share with you. But first, for background I'll pull a few extracts from the NYT article to give you context for my comments.

Now Raanan A. Agus, 39, head of that (Principal Strategies) desk, is starting a hedge fund, but with a twist. His fund will be inside Goldman Sachs itself.

In a first for Goldman, Mr. Agus will move part of his principal strategies team — the formal name for the equity proprietary desk, which had been known as the risk arbitrage desk — to the bank’s asset management division to start a hedge fund that some insiders speculate could reach $10 billion.

The fund, which does not have a name yet, will receive money from Goldman and raise money from its private clients and outside investors, according to people with knowledge of the fund.

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The decision to move Mr. Agus highlights the importance of hedge funds for investment banks because of the potential revenue they can generate and as an option the banks can market to their wealthy clients. Inside the securities division of Goldman Sachs, Mr. Agus puts up the firm’s own capital.

With Mr. Agus’s shift into the asset management division, he and his team can gather money from Goldman Sachs, its clients and outside investors, offering Goldman three benefits: a fund for its clients to invest in, a stream of fees from the funds and the ability for Goldman to put more money at risk — through the hedge fund, and in principal strategies.

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This will allow Goldman to try and make money in both places: the securities division with the remaining principal strategies group and in asset management with the new hedge fund (two of the bank’s internal hedge funds, Goldman Sachs principal strategies and its special situations group, account 12 to 15 percent of the firm’s revenues, according to one person briefed on the firm’s results).

So, the punch line: Goldman is taking one of the prizes of its securities division (and, in fact, the entire firm), Principal Strategies, and handing it over to the asset management division. This could only happen in a place where politics take a back seat to business rationale, and, quite frankly, I am not aware of too many shops like this. This "playing well together" concept might be the single greatest asset Goldman has over other firms, and it is grossly undervalued by the market. Goldman's people are great, sure. But there are lots of great people at other firms as well. In my opinion what distinguishes the firm from its peers are two key things: (1) a culture of teamwork, and; (2) excellence in risk management. Goldman is, at its core, a hedge fund with an advisory, underwriting and asset management fee component, and the only way this works is because the firm is so good at taking and managing prudent risks and leveraging relationships and insights across its business lines. Anyway, it is this distinguishing feature that gives it a shot to make this new venture work.

This all sounds really good. So what's the issue? Well, these platforms have some inherent issues that need to be considered when building them out. If Mr. Agus and his pals took their team outside, they'd get 2/20 and plenty of Day 1 assets to manage. They'd also get to build a brand just like Mr. Singh, Mr. Mindich and Mr. Steyer have, which has value in and of itself if, say, you want to go public someday. So, why accept an internal deal where, by definition, they will not be getting the full 2/20 and will not be readily thought of as an independent, branded entity? Three key reasons:

1. Reduced management and administrative headaches. Setting up a robust, multi-billion hedge fund platform takes time, effort and money. But more importantly, it is a major distraction to what a top trader/investor wants to be doing - making money. And then there is the ongoing management, compliance, record keeping, vendor management, etc. It is no walk in the park, let me tell you. So by setting up this business within Goldman, much of this burden will be offloaded to its prime brokerage unit and other internal teams. While setting up a platform like this even in a well-oiled machine like Goldman isn't easy, it is far easier than doing it de novo as a new independent hedge fund.
2. Enhanced asset gathering power. A person with a reputation and a track record like Mr. Agus would certainly be able to raise $1-$2 billion+ upon launch. But again, this takes time and effort. By staying in-house and having the full Goldman asset gathering operation at your disposal, not only is the process easier but the sheer amount of assets raised will likely be far greater. It is a pretty compelling pitch to say "Top trader performance with world-class controls and infrastructure from Goldman." Don't you think this message would resonate with institutional investors? I know it will. We used the same rap at DB Advisors and it is both true and represents a powerful selling point.
3. Flexibility and portabiity. Though I am not privvy to Mr. Agus' deal, I'd be willing to be A LOT of money that his contract contemplates things such as taking his audited track record should he want to set up an independent fund outside of Goldman; taking his brand; and taking his team. In exchange, I am virtually certain that Goldman is getting guaranteed fund capacity; possibly preferential fees; either an implicit or guaranteed share of their prime brokerage business; serving as the asset gathering conduit for the independent fund; and maybe an option on a share of the GP. And you know what, this makes sense and is fair. We did some of these things at DB Advisors because they were fair and worked for both the manager and for the bank.

One key to making these structures work is to for there to be seamless communication and team play between the securities and asset management divisions, since the securities division's core competencies (risk-taking and risk management) and the asset management division's core competencies (fiduciary management, distribution and client management) are both complementary and absolutely necessary for the venture to succeed. Competing interests, politics and BS only hurt what could be a supremely profitable, value-added business.

The other big key is for the manager contracts to be sufficiently flexible to provide for hedge-fund like compensation as well as portability should the manager wish to move their team outside the firm. If the manager wishes to move outside, however, the firm gets a package of benefits that reflects the value they've helped create during the manager's tenure. And this feature is critical because without it, you won't be able to attract and retain the best managers - period. What you'll end up with is an assemblage of traders that emerge from a structure that promotes adverse selection, as no star manager will allow themselves to be trapped without a clear path to taking what they've built outside the firm. And this is very, very hard for a lot of firms to cope with, viewing traders leaving as a failure. But it is only a failure if you don't get value in return.

Ah, this brings me back to 2003-04 when I was dealing with these exact issues at DB Advisors. Goldman has the right culture and the right human capital to make this work. It is a smart move this is good for both shareholders and clients alike.

The Best Argument for De-regulation: Removing the Safety Net

I have long been a champion of light-touch regulation for hedge funds, focusing on the burden of investors to do their homework with the proviso that information provided needs to be truthful, straight-forward and timely. I have also been a proponent of letting funds fail, as I scarcely hiccuped in the wake of the $9 billion Amaranth implosion. That said, no argument I've seen for light-touch regulation is any more compelling than that I read in this weekend's Wall Street Journal penned by Allan Meltzer of Carnegie Mellon. His punch line:

Congress is about to propose new regulations for hedge funds. German Chancellor Angela Merkel has the same bad idea, meanwhile the British Financial Service Authority, currently worrying about excessive debt issued to finance acquisitions by private-equity firms, may be next in line. But whatever the perceived problem, more regulation is not the answer. It is far better to change some incentives for excessive risk-taking. The old saying is true: Capitalism without failure is like religion without sin. The answer to excessive risk-taking is "let 'em fail."

All I can say is: Amen, brother. You've got it. Think back to all the perverse behaviors that were prompted by ill-conceived market regulation. The S&L crisis. The Great Depression. The hyper-inflation of the 1970s. And now the quasi-Federally guaranteed home loan entities. And this list goes on and on. But the S&L crisis  along with Fannie Mae are probably the best analogies for the hedge fund industry. There was an implicit "safety net" that protected investors in these sectors and companies, leading to perverse risk-taking by both the entities and the financing sources backing those entities. After all, if the Federal Government is implicitly backstopping any crisis, the they are effectively underwriting a free put option, the premium of which is used to gamble on the upside. It is the same thing as hedge fund managers themselves exhibiting negatively-skewed returns with high kurtosis, which is akin to writing options and hoping they don't pay off. The net result: a steady stream of out-performance followed by a colossal bust. And at that point the managers can simply move on and try again. Just look at Brian Hunter. Who would have thought that he was employable after his little fiasco? Anyway, Mr. Meltzer goes on to say some other pretty interesting stuff that warrants mention:

Regulation will not solve the problem of risk-taking that has returned many times, under many different regulatory regimes. If there is a current problem of excessive risk-taking, it arises from financing long-term investments with short-term borrowing. This is an often-repeated problem in financial history that ends badly for many of the risk-takers, especially if the economy experiences a recession.

This is clearly what happened during the S&L crisis, where so many S&Ls held long-dated mortgage assets funded by short-term money market instruments. And when the yield curve inverted, they were toast. Or, rather, the U.S. taxpayer was toast. And Fannie Mae? Declining credit standards, but again due to the put option issued by Uncle Sam. Mr. Market is very, very smart. It will consistently go to the place that maximizes the expected value of those in power. And what about the appropriate role of financial regulators?

The responsibility of financial market regulators is to the market, not to financial firms. Sometimes risk-takers have to be allowed to fail. At the same time, announcement of policy -- and acting in accordance -- has great advantages. Financial firms can understand the rule: no bailouts, period. That will induce firms to hold more relatively safe assets and to take fewer risks. Incentives achieve what regulation cannot. They focus a manager's attention on the firm's self-interest. The Fed is responsible for aligning self-interest with the public interest.

I absolutely, positively guarantee that Mr. Meltzer is right. Financial firms will adapt. Because they will to maximize their own self-interest. And this is adaptation for the right reason, not because of some ill-conceived regulation arising from political posturing or a tussle for headlines. And, finally, the punch line:

A strategy for reducing risk is overdue. Instead of burdensome regulation, the Federal Reserve and other regulators should develop a strategy, announce it and follow it whenever the next round of failures appears. Bailouts encourage excessive risk-taking; failures encourage prudent risk taking.

I wish I had written this Op-Ed because it is so right. Arguing with its conclusions is hard to debate. Turning the market on itself, giving it clear parameters within which to operate and letting it run will both spur innovation and foster prudent risk-taking. And isn't this what we really want from our financial institutions, be they banks, investment banks, asset managers or hedge funds? I'd say so.

True Long/Short vs. 130/30: Alpha + Lower Vol vs. Beta + Higher Vol

I'm a long/short bull and a 130/30 bear. Why? Long/short investing gives managers the best opportunity to generate alpha and manage volatility without being constrained by an index. 130/30 funds, conversely, place artificial parameters around both gross and net exposure and lack the intellectual purity of their more flexible long/short cousins. There were two stories in today's Financial Times that highlighted each of my deeply-held views; this must be a gift in anticipation of my blogiversary tomorrow.

First, the power of long/short investing:

For the year to date it is one of the best-performing strategies, with a return of 9.25 per cent, according to figures from Credit Suisse Tremont. This is ahead of the 7.86 per cent average return for hedge funds across all strategies and beats the 6 per cent year-to-date return on the S&P 500 index.

Long/short managers are therefore among the few groups in the hedge fund industry, alongside event-driven and multi-strategy managers, who can make a convincing case that their often hefty performance fees are justified.

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It is a widely held belief among a broad range of investors that most port-folios should maintain a long-term weighting of between 40 and 60 per cent in equities. But a glance at historical figures shows equity long/short produces superior risk-adjusted returns in comparison with long-only equity in both bull and bear markets. The ABS study attempts to analyse the reasons for this out-performance.

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One of the potential advantages of equity long/short investing is that it provides active management. According to ABS, the differentiation between active managers such as hedge funds and semi-passive managers - including mutual funds and long-only accounts - has been one of the main factors driving hedge fund growth.

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A study last year by Martin Cremers and Antti Petajisto of Yale School of Management shows equity mutual funds that closely track an index significantly underperform those that provide more active management. Laurence Russian, principal of ABS, said this argument could be extended to hedge funds because the vast majority of equity long/short funds do not manage to an index.

Therefore, the ability of hedge funds to provide active management should result in higher risk-adjusted returns and fewer drawdowns over long time horizons, in spite of their higher fees.

Mr Russian added that flexible portfolio management is another factor allowing long/short portfolios to generate superior risk-adjusted returns. The equity long/short strategy gives investors access to both amplified alpha and flexible beta. Alpha is defined as the excess return over the benchmark as a result of stock selection after stripping out the portion of the return attributed to beta, or market exposure.

Flexible portfolio management and its advantages manifest themselves primarily in periods of negative returns or increased volatility. The ability to shift exposure and change from aggressive to defensive stocks allows fund investors to capture the upside of an upward-trending market while protecting capital in down periods.

Next, some questions arising from the proliferation of 130/30 funds:

Rodney Williams, managing director of Feri Fund Market Information, put the cat among the pigeons when he linked the hype surrounding absolute return funds in Monaco in 2004 with that building around 130/30 this time around.

The observation hit home in some quarters with Mark Tennant, a senior adviser at JPMorgan Securities, opining: "There are probably 10 or 12 asset managers in the world with the investment management and risk management skill-sets to manage 130/30 funds."

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The rationale for 130/30-type funds is compelling. Long-only managers can only underweight, not short, stocks they do not like. While this may be fine for large-cap stocks and low tracking error funds, it is problematic for smaller stocks and punchier funds.

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With information ratios (excess return divided by tracking error) of about 3 before fees, these portfolios have outperformed their respective long-only strategies, albeit with higher volatility. "They are doing what it says on the tin; higher volatility and higher return," says Alistair Sayer, investment director, multi-strategy equities at Henderson.

In spite of these arguments, doubts remain. Todd Ruppert, chief executive of T Rowe Price Global Investment Services, warns: "I think there's going to be a lot of blood on the tracks with 130/30 products.

"The view that 130/30 funds will generate a better information ratio presupposes that you have the skills to do it. Most long-only managers don't outperform the market, and that is where their expertise is, and now you are going to let them short."

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Watson Wyatt's Mr Baker argues that if investors have accepted the value of shorting, it is illogical to then restrict themselves to "beta 1" products, although he does accept that 130/30-type offerings can have less onerous fee structures than more traditional long/short funds. "They are hedge funds, and clients need to be aware of that," he says. "Being prepared to relax the short constraint and introduce leverage opens up a world of possibilities, but it doesn't really make sense to limit yourself to a beta of one and 160 per cent gross exposure."

Sometimes even mainstream media can hit the nail on the head. And it is nice to get some validation now and again.

It's the Liquidity, Stupid

At this point, the Bear Stearns subprime-mortgage-hedge-fund-meltdown has almost reached mythical iPhone and Blackstone status in my mind: I'm sick of reading about it. That said, there needs to be a little clarification of what the learning from the Bear Stearns situation should be. Is it the evils of derivatives? No. That subprime mortgages are bad? No. The dangers of leverage? Possibly. But there is a point - a single point - that links these and all the other explanations I've read together but that has been lost amidst the scramble to fill column inches and generate ad sales:

That liquidity, together with security selection, are the two most important variables impacting investment returns.

And in the case of many subprime mortgage securities in general and a goodly chunk of the Bear Stearns portfolios in particular, this is a key determinant of why they're getting wrecked relative to other professional investors that had positions in similar securities. If the liquidity profile of your portfolio is poor, your margin for error is very, very small. And liquidity needs to be analyzed via stress testing and scenario analysis, because a simple "there is a 1 point wide market today; these securities are pretty liquid" doesn't begin the capture the dynamics of a market shock similar to what we've encountered at the lower-rated end of the subprime mortgage spectrum.

I think it is critical to note that liquidity as a variable is closely related to risk management as a practice, which in the case of poor liqudity is severely hampered and has been on display in examples ranging from LTCM to Granite, Amaranth to Bear Stearns. So, if we are really going to focus on "root cause," IMHO the true root cause of why the Bear Stearns meltdown occurred is because of poor security and portfolio liquidity characteristics; all the other factors being thrown around are of secondary or tertiary importance.

This is also why Bear Stearns is delaying the release of a portfolio NAV until mid-July. From today's Wall Street Journal:

Investors in two Bear Stearns hedge funds will have to wait until as late as July 16 to learn how much money they have lost.

The Wall Street firm has had difficulty calculating the funds' fair value, apparently because many of the mortgage-related securities they hold are thinly traded and the market for them has been volatile.

Right. Poor liquidity, plain and simple.

Today's "Ahead of the Tape" in the Wall Street Journal titled Subprime Flu Sheds A Light on Derivatives is another example of missing the forest for the trees:

The subprime-mortgage crackup is casting a bright light on an often dark corner of Wall Street: derivatives.

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There are derivatives linked to interest rates, inflation and the weather. There are even derivatives of derivatives.

A rising concern is that many derivatives are "illiquid," or don't trade very often, making it hard to value them accurately. This can pose a problem for hedge funds, which generally need to place a value on their holdings every few months or so.

This is called being economical with the facts. First, I think the "dark corner" being referred to is pretty illuminated to be honest. Credit derivatives, structured notes, equity tranches of CMOs, CBOs, CLOs, etc. have garnered lots of column inches in the WSJ, the FT and a wide swath of the financial press. I don't think they're really such a mystery any more. And the statement that "many derivatives are illiquid," well, most are not. And the truth is that many publicly-traded common stocks are illiquid, so having a portfolio made up of illiquid equities containing no derivatives is toxic as well. So the logic here is flawed: the issue isn't derivatives, per se, it's liquidity, and liquidity is a variable in any investment. So let's focus on root cause, ok?

To be fair, the piece goes on to discuss a very important point that I've raised countless times on this blog, that from a NAV perspective, illiquid assets often get repriced infrequently, possibly leading to gaping disparities between carrying value and sale value:

The value might not always be accurate. Think of it like the housing market, where valuation can be difficult. If each house on a street of identical houses is worth $200,000, but then one sells for $150,000, you can bet that when the neighbors talk about the price of their homes, the valuations will be closer to $200,000.

The same is true for hedge-fund managers, except that they are playing with investors' money. A recent study by Paris risk-management firm Riskdata shows that roughly 30% of hedge funds that invest in illiquid securities smooth out returns with price estimates for these securities that are potentially self-serving, compared with just 3% for funds that invest in highly liquid securities such as stocks. The implication is that these funds aren't using market prices to adjust holdings' values.

In other words, a number of hedge funds have been tinkering with results, making them look less volatile. If and when these funds are ultimately forced to put an accurate price on the holdings, the outcome could be messy.

Now, maybe the author is over-dramatizing the point, but it is an important point and one that needs to be considered. The "stickiness" of illiquid asset values can lead to an overstatement of NAV (which leads to payment of higher management and performance fees) and the phenomenon called autocorrelation, neither of which is good. Now this is a point that warrants some focus and attention, particularly on the part of investors. Because investors in these funds aren't dummies and need to do their homework. There is no free lunch, and Mr. Market will be sure to penalize those who think there is. Bottom line, if you don't have the stomach for the volatility associated with large illiquid asset positions, stay away from funds whose documents permit it. Because all is rosy when things are calm, but when it gets stormy, look out.

Populist Regulatory Rhetoric? Ugh.

I feared this day would come. And it's here. No, not just the sabre-rattling and moaning about how hedge fund and private equity-types are too rich, how hedge funds are increasing investor risks and debt buyers are accepting overly-liberal terms fueling the private equity juggernaut and the like. But a newly-energized Democratic Congress starting the process of shaping the SEC dialogue around these and a host of other issues to flex their muscles. I'm trying to wake up and enjoy my coffee (jet lag, you know) and I have to click on a Wall Street Journal story titled (Entire) SEC Makes House Call - not the way to start a day:

WASHINGTON -- In the latest sign Congress is turning a skeptical eye toward Wall Street, an influential House committee is set to hear testimony from all five commissioners of the Securities and Exchange Commission today -- the first time that has happened in at least 10 years.

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With the Democrats in control of both houses of Congress, it is an opportunity for Democratic lawmakers to frame such issues as the rise of hedge funds, chief-executive pay and shareholder rights through their own prism and to sharpen the debate heading into the 2008 election.

"It's signaling power," said James Angel, associate professor of finance at Georgetown University's McDonough School of Business in Washington, of the invitation to all five commissioners.

Among the topics to be discussed at today's hearing of the House Financial Services Committee: corporate governance, the SEC's enforcement policy, shareholder lawsuits, hedge funds and a provision of the Sarbanes-Oxley Act dealing with reporting corporate earnings, according to an internal committee memo.

Congress is focusing on areas that have "populist appeal as we go into the 2008 election cycle," Mr. Angel said. He added that when populist lawmakers are looking to win votes, "when all else fails, blame the rich." One House Democratic aide said the committee will likely conduct many more examinations of the financial sector.

The last thing in the world the U.S. economy - or global economies, for that matter - need at this juncture is a bunch of politically-driven, vote-gathering rhetoric impacting investment decisions and global capital flows. One sure way to hurt the stock markets (which, by the way, impact the hot populist topics of public pensions and middle class wealth) - go after the hedge fund and private equity industries. As readers know, I am not an anti-regulation guy; I am an intelligent regulation guy. If the market is willing to reward a certain segment of society for generating a certain kind of value which benefits them, is that really a bad thing? I don't think so. But it sure makes for great political posturing. And if those in power lose sight of the unintended consequences of their actions (say, like damaging the climate for investment and innovation), that would be a bad, bad thing. And I hope this won't happen. But today's WSJ story and the upcoming SEC testimony does not give me great comfort that the next twelve months won't be full of politically-driven rhetoric at the expense of economic growth and vitality. Ugh.

Waking up to Risk Redux: Is Nassim Taleb the Regulatory Rock Star?

Systemic risk. "Fat tails." Six-sigma events. I've written about this stuff quite a bit during my time as a blogger. I've made the point that the real risk regulators should be focused on is systemic risk, not fund-specific risk. All the hoopla around hedge fund registration is, from my perspecive, a red herring. The goal of regulation should be to protect the markets, not to protect a group of institutional investors who conduct poor due diligence by hampering the flexibility and money-making ability of all hedge funds. And I've seen the leading regulatory regimes across the globe evolve to the point where they, too, are focusing on systemic risk as opposed to single-fund risk. And this is a very happy development indeed.

This point was made most recently during Anthony Ryan's speech at the Managed Funds Association conference in Chicago. Mr. Ryan is currently Treasury Assistant Secretary for Financial Markets. It is also interesting to note that I touched on this very same topic in my post on New York City last night. I am including some key points from Mr. Ryan's address; please let me apologize in advance for its length but his talk was very, very good.

...I would like to focus on the issue of systemic risk. We will never eliminate the potential for systemic risk, but we can seek to reduce the probability of it occurring and its impact. My purpose today is to sensitize all of us as to how systemic risk operates and urge all stakeholders in our capital markets to take the necessary steps to implement policies, procedures and efforts to mitigate it.

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Systemic risk can be defined as the potential that a single event, such as a financial institution's loss or failure, may trigger broad dislocation or a series of defaults that impact the financial system so significantly that the real economy is adversely affected.

Some may posit that the increasing sophistication of risk management systems coupled with other developments and efforts has placed systemic risk on the endangered species list. For supportive proof they point to the lack of extensive ripple effects upon the financial markets following some relatively recent shocks.

I'd like to elaborate why, given market conditions, I believe that subscribing to this thesis is both potentially misleading and imprudent. Let's begin with answering the question: how could a systemic risk event manifest itself? Meteorologists describe atmospheric conditions conducive to producing a perfect storm. What are the atmospherics for a perfect financial storm? While there would be several, let me name a few: easy credit and leverage, highly correlated strategies, connected and concentrated lenders, inadequate information, and underdeveloped financial market infrastructure.

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Could our capital markets practices' better play have influenced the distribution of risk events such that the tails of the distribution have shortened? It is true that the dispersion of risk is greater. The presence of so many derivatives strategies and instruments do help to hedge risk, and markets have adjusted to "tremors." At the same time, we can also observe that the capital markets, with a few periodic exceptions, are not pricing risk and future volatility anywhere near close to long-term averages.

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So, the long tails of some distributions may also be a lot fatter than people frequently assume. Besides baseball salaries, there are many other data series where the distributions are anything but normally distributed. Look at "book sales per author…populations of cities…numbers of speakers per language, damage caused by earthquakes, deaths in war, deaths from terrorist incidents…or the sizes of companies."

Could the same be true of capital markets, commodity prices, inflation rates, and economic data? If so, what are the implications? What if such events occur with much more frequency than people recognize, and what are the consequences if we do a particularly poor job in preparing for them?

One student of such distributions is Nassim Taleb. He defines an occurrence such as a systemic risk event as follows: "First, it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility. Second, it carries an extreme impact. Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable."

If we can not predict a systemic market event in advance, and we seek to reduce the impact of such an event, we must prepare.

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So the tails may be longer than people imagine, and the tails could also easily be fatter. We must therefore be humble enough to realize that a systemic event in the financial markets cannot be discounted and its impact will be significant.  Preparedness is therefore key and all stakeholders in the capital markets must contribute to the effort.

So there you have it. I believe Mr. Ryan's characterization of the challenges facing both regulators and market participants alike are spot on. And he and his colleagues are now internalizing the risks long understood by Mr. Taleb, risk managers and traders at every major financial institution: the risk of long-tail ruin is real and it occurs far more frequently than normally-distributed models would predict. Tails in the financial markets are fat - very fat - and the best we can do is to make sure the system can withstand significant and unpredicted shocks, because they will happen. And we have history as our witness.

Pricing Risk: Taking it all Into Account, and No Tears, Please

As a follow-on to my earlier post on OTC derivatives, I have just one thing to say. If you are going to swim in the shark tank, you've got to know where ALL the sharks are. Because if you miss even one, well... And this applies to more than just derivatives. Remember the VNU bond-holders fiasco, where a private equity-proposed leveraged buyout that intended to leave existing debt outstanding caused CDS spreads to blow out by 250 bps practically overnight? Sure sucked for existing bondholders, right? Well, this kind of outcome was possible given the bond covenants and, therefore, it happened. Surprise, surprise. But it shouldn't have been. It wasn't like a debt-funded VNU buyout was some three-sigma possibility. Then why did spreads blow out so much? Because bondholders didn't anticipate that they would get jammed. But it is a gentlemen's market no more, my friends. The risk existed and VNU bondholders simply didn't price it properly. Ok, but that's kind of the game, isn't it? And now we see something similar happening with the subprime mortgage meltdown. As outlined in today's Financial Times:

In the latest twist to the tale, it emerged last week that a group of US hedge funds were up in arms over the banks’ involvement in derivatives based on sub-prime mortgages. The banks both create and sell the derivatives – which offer insurance against mortgage default – and manage the mortgages. The hedge funds say they have been relaxing terms on defaulting mortgages so they will not have to pay out on the derivatives.

Leaving aside the unappealing spectacle of America’s richest – the hedge fund managers – betting on the poorest losing their homes, the question is how the banks can wind up writing insurance against risks that they themselves partly control.

There are two issues raised here. The first is around the issue of hedge funds being pissed off at the banks for being on both sides. Well guys, sorry to say but banks are going to act rationally and look at the entire picture, not each picture in isolation, and if that means taking mark-to-market losses on their mortgage portfolio to protect the value of derivatives contracts, that's exactly what they should be expected to do. It is not as if the hedge funds entering into these derivatives didn't know that banks originate and underwrite mortgages which they often package, structure, and sell, as well as write derivatives against. So given this knowledge, is it reasonable to expect that hedge funds should have priced in the possibility of banks' optimizing their own outcomes to the detriment of derivative holders? I'd say so. Everyone at the table is a shark, and to expect anything less is just silly. So please, no more tears. The best funds make money off of people and firms mispricing risks, and if every once in a while this principle comes around to bite them in the rear, it is just the cost of swimming with the sharks.

The second issue relates to how banks can write insurance against risks they themselves partially control. The answer: because they can and because hedge funds and others buy it. The banks aren't holding a gun to anybody's head. The question is, on its face, just ridiculous. There either is or is not a market for something, and in the case of banks selling mortgage derivatives, there is. So end of story.

The financial markets are tough, my friends. One should assume that homework poorly done will eventually result in one's getting smacked. There are just too many smart people with too much money looking for ways to squeeze blood from a stone. And it never ceases to amaze me just how much blood can be gotten. Again and again and again.