Hedge Fund Diary

November 2004

Alan Thomas
Originally published in the November 2004 issue

Oh dear!! What's this? "Some institutional investors do not fully understand the risks. Too many see hedge funds as modern-day alchemists. Regrettably, some do not understand the mutations of the base metals involved."

These words of comfort (reported by the Financial Times) came from Graeme Wheeler, treasurer of the World Bank. And the Bank's $12 bn pension fund is reported as having $1.5 bn in hedge funds; just to show their commitment.

Talking to addicts of the business at a Geneva conference on alternative investment, Mr. Wheeler laid about him in all directions. The ignorance of investors was to be found in a lack of understanding of such subjects as leveraging, valuations, liquidity, high concentrations in portfolios, together with delays over settlement when you sell.

How strange, as there are those among the global investing community who thought these were the sort of advantages that might arise from holding hedge funds. But maybe these issues will have to be addressed by the industry, as another estimate tells us that by 2006 some 50% of in-flows to hedge funds will have come from institutions as opposed to high net worth individuals.

In case you are wondering, there is also an assumption that such wealthy individuals know better than institutional fund managers what they might be doing! Ah well, that sounds alright then. Perhaps, but the punch line of all this is that emerging markets are likely to fill the gap caused by exhaustion of conventional hedge fund plays.

You know the sort of thing: out goes merger arbitrage and convertible bond arbitrage, to be replaced by Brazilian bonds, with 50% swings in volatility. I had no idea the World Bank could be so thought-provoking.

Anticipate or React?

Do you like to anticipate or react? Walter Deemer who toils in the Florida vineyards, producing his Market Strategies for institutional investors, likes to anticipate. In a recent Market letter, he explains how since the 1970s he has focused his efforts on anticipating moves in the market. His anticipatory form of market analysis has a rough time when the market misbehaves and he anticipates a downside reversal too early.

For now, he is fighting the tape as all anticipatory analysts must do. But a price has to be paid for being premature at anticipating a downside reversal.

His negative case is led by heavy outflows from bearish funds. These outflows indicate liquidations of bearish positions and more importantly heavy short covering by hedge funds. He likes to be friendly towards us and describes hedge funds as the major force in the market at present.

This theory then tells him that when a market moves in one direction it is invariably correct to do the opposite. Therefore at present hedge funds are long again and playing the upside of boring old US equities. All of this buying has of course generated upside momentum and what he now urges is that we watch for momentum to dissipate.

While Mr Deemer waits I try to persuade myself that this is not a top-building process following a cyclical bull market. I prefer to think of current US markets as having made the first major step towards a long term bull market. There is a shift away from growth to value which I persuade myself is normal at this stage. So there we are. Those who prefer to react to market trends are having a lot of fun at present. But I will keep my eye on those anticipatory indicators.

Buy 'em all!

At the bottom of the great bull market in the early 1980's I listened to Ralph Acampora talking to cynics about the coming bull market. Ralph has been a technical analyst for longer than most hedge fund managers have been studying markets. And he is never modest in holding back with his opinions.

I was delighted to read that he is bullish. In his 1980's speech, his enthusiasm overcame his normal standards of decorum. Standing in the middle of an aisle with cynics all around, he threw his chart book down the aisle and raising his voice modestly yelled: "you can buy 'em all!".

I comforted myself through the subsequent bull market, which ended only with the 1987 crash, that such a display of enthusiasm couldn't be wrong. Anyone who has a chance to listen to him at this time might let me know if he is currently behaving with decorum.

Beating the Yanks

Chris Dillow provokes me too often from the Investor's Chronicle. Until I have read him each week I worry that I am going in the wrong direction even if for good reasons. Recently he has added to my literary collection by telling me that the FTSE has been whupping Yankee ass. Why is this and can it continue?

First a surprise. UK/US relative performance is largely explicable by economic factors. A handful of macroeconomic variables can explain over nine-tenths of the variation in the level of the All-Share relative to the S&P 500, along with three-quarters of the variation in annual changes in the ratio of the two.

If you are still with me, the big variables are inflation, outquote expectations, monetary growth and retail sales. Mr. Dillow plays around with these variables and produces some entertaining thoughts. For example, a one percentage point rise in core US inflation is associated with the S&P 500 underperforming the All-Share by 6.2% a year. Since February 2004, the rise in US inflation has accounted for most of the UK out performance.

Output expectations have fallen in the US while remaining stable in the UK. US monetary growth has been weak while UK retail sales have stayed strong. For economists that's a sign that expectations of permanent income have risen, which leads to rises in share prices.

It is not all one way and the worst problem for the UK is that the All-Share now seems to be overpriced. And the conclusion is that the UK market is now 9% overvalued relative to the US. But his key fact is that moves between both markets are explicable by macro economic forces. Depending on what you want, you should keep a close watch on inflation, output, monetary growth and anything else you would like to throw in to the pot. You never know you might find a new economic indicator that will guide you when switching funds between Wall Street and London.