Multi-Strategy Credit in an Adverse Environment

The wetlands of market efficiency

Originally published in the October 2015 issue

Pretty much 90% of my net worth is in their hedge funds as is true for all the other partners. As an undergraduate I studied math and I had some aptitude for it. The original title for the talk was: Credit opportunities in an adverse environment. For the past four years this has been a challenging environment for investors looking for yield for almost five years now.

Yield-starved markets
We believe credit investors have been taking on too much risk for too little reward. Upon reflection however, I decided my original title was insufficiently specific. After all, it is not at all mysterious what is the cause of low yields investors face. Since 2008 at least, financial markets around the world have been driven by government policy even more than what is usually the case. Yields have been low because governments have been taking extraordinary measures to keep them low.

Perceived risks, and I emphasise perceived, have been low because governments have taken the extraordinary measures to maintain that perception. All this has made life challenging for investors seeking yield, the same government interventions that limit some opportunities almost always create others. When governments intervene in markets, it inevitably alters their structure and changes in market structure and also tends to change the relative value of certain securities with reference to others.

Market structure matters for the evolution of price. If you change a market structure, you have to change the relative pricings or you’re verylikely to change the relative pricings for each of the components.

ETFs and market structure
For many decades there were basically two ways for people who had an interest in gold in the US, generally derogatorily referred to as ‘gold bugs’, to invest. They could buy gold mining shares or they could buy gold itself, and gold itself is a little messier – has to be stored, has to be insured, if you want to sell it again you might have to have it assayed, etc. So buying gold mining shares was perhaps a better proxy, a better way for people to express, or at least a more popular way, for people to express their interest in gold.

About a decade ago, along came exchange-traded ETFs, an entity that traded like a stock but represented the actual direct ownership of gold, whereas the gold mining shares have all sorts of other things attached to them, subject to operating difficulties, labour strikes and disruptions, environmental regulation. So somewhat predictably we could think that the introduction of gold ETFs probably increased the price of gold as it make it easier for people to own gold and less expensive, while at the same time decreasing the relative attractiveness of gold mining shares.

Gold mining shares as a result are in a different place today than where they would have been had that structure not changed. In our view gold mining shares are something of an orphan, they don’t get very much attention, but just suppose we find a gold mining company with a new patented process for smelting ore, for extracting the gold out of the stuff that it comes with. We think it is very exciting technology. For some grades of ore it will reduce the cost by 10%, for others maybe 50%. We’d like to own a piece of this technology, we’d like to own that patented new process. How do we do it, how could we do it? Well, the technology is wrapped in a gold mining company, so in order to buy that exciting patented new process presumably of value and very possibly missed by the market, ignored by the market of people looking at gold mining shares and manufacturing processes.

To own that we have to own the mining shares which means in large part we would own gold too. So we have an opinion about the technology, the process, the value but we have no particular knowledge or now particular desire to own gold. So what would we do? We could buy the shares in the gold mining company and sell short, gold itself or probably an ETF for gold. In the real world we probably wouldn’t do it that way but you get the idea. Take the bundle, get rid of the thing you don’t want.

What does hedging mean?
In American English, there’s an expression ‘hedging one’s bets’ which usually has the connotation of blurring or obscuring or muddling one’s position, hemming and hawing, not having a strong idea. We actually think of hedging differently as in this context, it’s not about luring a bet, it’s not about equivocating, it’s about expressing the conviction we have, strengthening the bet we want – the vote on this company’s technology. At Whitebox we operate according to 10 principles, which we believe very strongly in. You will probably all be relieved I’m not going to talk about all 10 but just the first three.

Whitebox’s principles
The first and foundational principle is this: source of investment returns is the efficient reduction of risk. Here we’ve said risk but we really mean uncertainty. Our first rule of an investment is to reduce risk or uncertainty so as to increase our chances of making a profit. We can never eliminate the uncertainty entirely but in some cases we can reduce it substantially. It’s very hard to predict how all of these factors will interact to the determine prices so we don’twant to invest in all of the factors, we want to invest in that one factor we believe we understand. We call that factor the driver of the trade.

This brings us to our second principle: know the drivers of your investment, maximise exposure to the mispricing which is just another word for the driver, and minimise exposure to everything else. Why is this so important? Because the biggest mistake most investors make is by accidentally buying the wrong thing. Maybe your brother-in-law told you about the great mining technology and you really want to invest in it, so you buy the gold mining shares thinking you are going to become rich as that technology proves out.

Then you find out what you really bought was mostly a pile of gold, and if gold goes down, instead of making money you lose. In my experience, investors most often lose money not on bad ideas but on good ideas. They lose money because their good idea is overwhelmed by other uncertainties for which they did not control.

Market efficiency
Classical economists say markets are efficient and almost always get prices more nearly correct than any investor can on average or over time. In financial markets the idea is called the ‘efficient market hypothesis’. To understand this, think about as large body of water on a calm day. Being liquid, the water is all at the same level, the surface is smooth. This is how classical economists view markets under normal circumstances or what they would call say equilibrium.

Even classical economists admit that market equilibrium is disturbed from time to time, so imagine a big fish leaping up from the water and diving back in. The fish makes a splash. Surface equilibrium is momentarily disturbed but because the pool of water is an extremely simple structure and quite large compared to the fish, the water smooths out almost immediately and equilibrium is restored. All the water returns to the same level, all prices are again in line or efficient.

To us, markets look very different; markets are not a simple pool of water, they are more like a complex wetland. In the wetland there are streams, there are swampy areas, there are little waterfalls, there are places that are dry when the water is low, and submerged when the water is high. In the wetlands just as the classical economist’s pool of water, there is a strong tendency for all water to settle at the same level. The water wants to be at the same level. In this complex wetland, however, it is not always easy for the water to level out by flowing from one spot to another.

For instance, when the stream of water is disturbed, perhaps by a storm, some water can be trapped below or above. It could be in a puddle from which it could not easily escape or escape only slowly, or dammed behind a wall of mud. As a result of the storm, in some places in the wetlands there is too much liquidity, in other places there is not enough liquidity. Eventually, this situation would probably correct itself through natural processes such as erosion, but natural processes can take a long time and the dry places on our wetland may need water right now.

This creates an opportunity for investors who pay attention to market structure. We can intervene and hasten the process of getting the water back to where it needs to go. We can get in there, we can dig tunnels. We can build water wheels. We can in fact direct capital from high ground to low ground, from where it is wet to where it is dry.

Gaps in capital markets
How can we bring this back to the real world? Go back to our gold mining company for a moment, the one with the great patented technology. The company wants to apply this great new technology as widely as possible and let’s say their business strategy is not to set it up and process other people’s ore but to try and acquire other companies to have more ore to process.

Our advance company needs capital. Unfortunately, because of Dodd Frank and other changes in the contour of the wetlands, banks are either not going to be interested in applying capital in new technology of uncertain value or they will be so slow and so arduous that the opportunity may dry up, so to who do our miners turn? Perhaps venture capital but venture capital firms will have told their investors that they are only interested in social media and phone technology, again, not available.

Increasingly, companies such as our gold miner will turn to hedge funds and other independent investors. A firm like Whitebox might make a short-term bridge loan to the advanced gold miner so it can buy old-fashioned gold miners now. We can provide this money because we are in the business of addressing unusual situations. We are in the business of adapting to changes in market structure. The bank is not in the business of addressing unusual situation. The bank, especially after 2008, is in the business of following general rules. The bank must be governed by rules because it is large, communication across the firm is difficult, and also because the banks have come to be in many ways public utilities.

We are much less driven by rules. We are more driven by principles, principles that help us to adapt to changing circumstances, in particular the changing structures of markets. These large-scale changes bring me to our third principle and the last one I will mention.

Regulatory impacts on market structure
The third principle says: right or wrong, the market always has a message. Listen carefully. By this we mean that in reaction to some large event or policy change, market prices may begin to express an explicit idea or a message. Sometimes the implied idea will be just right, exactly in touch with reality. Sometimes the idea will be confused and wrong. Very often, new strong market messages are the result of government policy.

To go back to the title of my talk today, what is the message the markets are sending? Where have the structure and rules of markets been affected? What opportunities have been created and what risks? First, market structure has been entirely changed by government. Dodd Frank and Basel III have radically changed who is allowed to do what in financial markets, with banks generally doing less, and that has created some opportunities for hedge funds and other independent investors to do more. For instance, banks are increasingly restricted from trading securities on their own behalf, so-called proprietary trading. These banks used to help smooth out financial markets. They provided liquidity to dry markets and withdrew liquidity in over bond markets. Of course, the banks did this to make money. Still, it was an important service. Increasingly, hedge funds are playing that role and it can be a profitable one. We also find that with banks, there is less capital in general, more dedication to smoothing markets, and prices have become more extreme.

I don’t think this is very good for markets any more than a major disturbance in our wetland could be good for the creatures living there. Nevertheless, hedge funds can play a role in addressing this problem and we can make money by collecting the greater spread between the buyer’s price and the seller’s price.

Moving to a larger issue, government policy since 2008 may look complex but can be summed up very simply. Increasingly, governments have been shifting assets, often quite dubious assets, off the balance sheets of private investors on to that of the governments or agencies under their control. Public, or effectively public debt, has been rising dramatically compared to privately issued debt, and all debt held by the public, publically held debt, is increasing relative to the amount of debt held privately.

Since 2008, a minimum of $10 trillion has been added to the balance sheets of central banks and a multipleof that to other government or quasi-government agencies or entities. Within this huge general trend there has been another trend. We can call that change the centre supporting the periphery, as so many government entities have expanded their balance sheet, the more powerful central governments have accepted progressively more legal or moral responsibility for guaranteeing the balance sheets of the periphery.

Consider China – the central bank, the central government, considered in isolation does not seem unreasonably overburdened but it appears that many provincial Chinese governments or agencies or provincial banks may be very seriously overextended. There’s now probably $2 trillion of bad debt, almost all of it held by provincial governments or entities on the periphery of China. We are seeing something of the same phenomenon in the U.S. with Puerto Rico, Illinois and New Jersey all being in much greater difficulty than the federal government. In Europe there is no doubt that the centre is stronger than the periphery, Germany is far stronger than most of the Mediterranean states.

Differentiation in government debt markets
For now, the centre is supporting the periphery. So far, markets are accepting this situation. Markets appear to believe for now that the centre will be willing and able to continue to prop up the periphery. We can see this in the relatively tight spreads in yields between bonds of the centre and the periphery. Sometimes it’s direct, sometimes not. In round numbers, all of Germany’s debt is owned by public entities, but Spain’s debt is still largely privately held, but we would infer from the narrow spread between Spanish debt and German debt that people are assuming at least that Germany or perhaps the IMF, the ECB, maybe even the US, are implicitly standing behind Spanish debt.

Once again, back to our bundle. The markets are treating almost all government debt as the same thing. The market seems to be saying that the centre will remain willing to support the periphery, and that both the centres willingness to support the periphery is infinite or nearly so, and the centre’s ability to support the periphery is infinite or nearly so. I do not believe either of these propositions are correct. I very much doubt that the centre in fact is willing to support the periphery indefinitely and infinitely and I am absolutely certain that the centre’s ability to support the periphery is limited and certainly not infinite. Eventually there will be cracks. In fact, we see some of them now, and either the centre will abandon the periphery or the centre itself will be overwhelmed. In either case, the result will be something like ripping open the bag of pencils.

Now, government debt that is now acting as a single unit will be fractured into many pieces. The value and price of these pieces will shift radically, both absolutely and in relationship to each other. Terrible storms will hit the wetland, some places will be flooded, and others parched. Investors will overreact as they always do. Risks will be great but there will also be great opportunities for investors skilled in identifying true value, and above all, rewards will go to investors skilled at isolating real value from extraneous risks as in principle number two. Often, this will require structuring investments much more complex than the relatively simple examples I gave.

One complexity that is already emerging is the changing market for municipal bonds. Very recently it was axiomatic that the safest government bond debt to own was debt-backed by the full faith and credit of the issuing government. No investor would voluntarily exchange a claim on all of the government’s taxing authority for a first claim on a limited portion of that taxing authority. But in Puerto Rico we see that already where bonds with a first claim on sales tax trade below bonds with a claim on the general, the full faith andcredit of Puerto Rico. In Puerto Rico, general obligation bonds carry higher yields than bonds secured by sales taxes alone. Why? Because in the case of Puerto Rico, investors have lost faith in the centre’s ability to support the periphery. The central government’s full faith and credit is a less sure guarantee than a specific lien on sales tax receipts.

For us as investors, the practical result set the relative value of Puerto Rico bonds to one another is changing. Beyond that however, the change in Puerto Rico and people’s willingness or need to break up the bundle will affect how people view the debt of Illinois. We believe the demands of the periphery on the centre will continue to grow and that the centre’s ability to meet those demands will continue to shrink, and we think the result will be turmoil in financial markets. We do not look forward to this turmoil or celebrate it, it will be a difficult time for the world. Many people with no hand in creating the crisis will suffer the results.

We wish the travail could be avoided, yet it will be exactly the sort of time when the world needs hedge funds with decades of experience navigating shifting complex price relationships in tumultuous markets and above all figuring out not only which exposure to own but exactly how to structure an investment so that we own the exposure we truly want.

The above is a transcript of a presentation made at the 4th FERI Hedge Funds Investment Day, held in Bad Homburg, Germany on 10 September 2015.

Andrew Redleaf is the founder and CEO of Whitebox Advisors. Mr. Redleaf was a founding partner of Deephaven Capital Management. While at Deephaven, Mr. Redleaf managed the Market Neutral Fund from 1994 to 1998. From 1980 to 1994, Mr. Redleaf was an options trader at the CBOE. Prior to his experience at the CBOE, he spent two years as an options trader with Gruntal & Company. Mr. Redleaf graduated from Yale University in three years with a BA and MA in Mathematics and was recognized as the top mathematics student of his graduating year.