The Favourable Outlook for Investment

A US perspective and rationale

GUY HASELMANN, PRINCIPAL, GREGOIRE CAPITAL

Investors, like traders, need to constantly assess and reassess market conditions in the context of their goals. This reassessment has never been more important or necessary than after the historic events of the past 18 months in the economic and financial markets.

No doubt, dramatic market events have left investors tentative and confused. The transition into the present, and substantially different, financial landscape is ripe with great uncertainties, and so investors are finding it difficult to appraise current investment opportunities. Many realise incredible investment opportunities have arisen (which often happens coming out of crises), but they also recognise that there are great risks.

While the systemic risks, which reached their pinnacle in late 2008, have been well advertised, opportunities presented by the current investment landscape have receivedless attention. In this light, it is helpful for investors to not just gain understanding of the new financial paradigm, but to more completely understand the chaos of 2008. In doing so, investors will gain greater comfort and confidence in their investment decisions in 2009 and beyond. This perspective reviews:

• the economic events of 2008.
• the current economic and investment landscape;
• how capital markets and hedge funds are changing and adapting to new financial realities; and
• what the prognosis is for hedge funds for the future.

Understanding the markets of 2008
Few investors, hedge funds included, successfully navigated the systemic market meltdown of 2008. There are many reasons for this, but, in essence, the markets became fractured. The result was not just a global equity market crash, but a global credit instrument crash as well. A perfect storm of events hit at the same time which resulted in a financial and banking system teetering on the brink of collapse; this, in turn, led to completely dysfunctional capital markets.

Credit dried up after Lehman Brothers failed, because all market participants were forced to question whether lending and borrowing to any counterparty was truly safe. Solvency concerns magnified as fear swelled from hidden off-balance sheet transactions, fuelling further mistrust. Capital recoiled in massive amounts forcing most investment banks to become bank holding companies. In this way they could benefit from the full support of the Federal Reserve and avoid attack from predatory speculators, who were correct in thinking that they could be next.

In early 2008, Bear Stearns became the first casualty and a prelude to the meltdown that was to follow in September. Around the same time Lehman failed, Merrill Lynch was taken over by Bank of America, and Goldman Sachs and Morgan Stanley became commercial banks. Such moves meant that investment bank leverage had to come down from 40 times capital to approximately seven times to meet the regulatory capital standard requirements of commercial banks under Basel II rules (more on this later).

In addition, during this period the largest savings and loan company, Washington Mutual (WaMu), and the largest mortgage originator, Countrywide Financial, had to be taken over, causing even more positions to be sold.

As Wall Street was directly in the midst of these dramatic changes, the government changed the rules of capital market investing. The SEC banned short selling, seriously damaging many common investment and hedge fund strategies. Stock trading volumes were instantly halved significantly impairing liquidity.

In addition, the Federal Deposit Insurance Corp., or FDIC, made a mistake inits handling of the assets securing the WaMu senior bonds. When the FDIC confiscated WaMu’s assets, to help facilitate a takeover of the company by JP Morgan, they elicited substantial uncertainty and turmoil as market participants were forced to question their priority position within the hierarchy of the capital structure. This merger was seen to be necessary because a WaMu failure, with its $320 billion of assets, would have wiped out the $37 billion in the FDIC insurance fund, conceivably generating unimaginable systemic risk. These unfortunate government decisions had critical unintended consequences. It is vital to understand that implementing these various changes and instilling greater uncertainties to the rules of investing made risk valuation impossible, and thus, compelled hedge funds to liquidate their positions. This combination of hedge fund liquidation, at the same time as all the investment banks on Wall Street were deleveraging, created a “get out at any cost” market environment. Stated simply, there was no place to hide.

Systemic instability was further compounded by the cyclicality of bank regulation, whereby banks (under Basel II agreements) are not required to build up enough capital in good times and are obliged to increase capital in a downturn.

Such regulatory requirements accentuate boom and bust cycles. This cyclicality was further exacerbated by mark-to-market accounting rules.

The present economic environment
A lack of visibility in the broader economy and thus corporate earnings, combined with elevated levels of political, financial, and global event risk, has wrought a wide range of opinions, forecasts, and potential economic outcomes. Even the few with strong conviction will be the first to admit that there is a high probability their opinion will end up being wrong.

As the market chaos of last year recedes, a dramatically different investment horizon is emerging. While markets are operating in a more orderly manner, they are not yet efficient or back to normal activity levels. Though improving, liquidity remains challenging, credit is tight and market dislocations are evident everywhere. Vast numbers of securities are still trading far away from their fundamental values.

Near-zero interest rates and massive liquidity injections through newly created government initiatives have provided some relief for borrowers, while high fiscal deficits are helping to partially fill the void of weak final demand. However, only little traction has taken hold, because it is unlikely that such actions can prevent the continuation of balance sheet deleveraging by banks and individuals which is serving to keep the economy snared in a deep recession. As a result, balance sheet adjustments are acting as a powerful economic drag and an overpowering offset to expansionary monetary and fiscal policies. Such a trend will likely take several years to reverse.

Consumers account for 70% of US GDP. With household debt level as a percentage of disposable income at an all-time high, economic growth will have to come from another source; perhaps government spending, export growth or inventory re-stocking. Sustainable growth from any of these sources is highly unlikely. During such periods, global economic growth stays sluggish and is now further impacted by the combination of credit squeezes and rising unemployment. The domestic savings rate will surely have to rise. Even the most optimistic forecasts for GDP growth top out at a paltry 2% over the next several years. Bill Gross at PIMCO has labelled this “the new normal”.

The current investment landscape
Various securities are still changing hands merely because forced sellers are liquidating assets and handing them off to opportunistic buyers. As a means of generating alpha, all hedge funds try to some extent to exploit such opportunities. Since hedge funds are in the business of taking market risk, they should be in an ideal position to source and capitalise on the activities of these distressed sellers. Attractive purchasing levels means, in theory, that hedge funds can earn outsize returns with less or no leverage and have higher than normal probability of success with appealing risk versus reward ratios. If history is a guide, hedge fund performance is strong in the period following a financial crisis. Coming out of the crises of 1990, 1994, 1998, and 2002, the HFN Hedge Fund Aggregate Average returned 29.39%, 25.33%, 30.20% and 21.19% respectively.

The current economic headwinds of disinflation and below-trend growth are limiting the prognosis for solid returns from long-only stock and bond investments. Stocks may not have sufficient earnings growth to generate sustainable rallies, while bonds may generate low returns due to low official interest rates. However, those fixed income investors willing to increase their risk profile to more risky issuers, via moving down the capital structure, should perform better. On the other hand, a move to high yield bonds could be dangerous as many of those securities are called junk bonds for a reason. Repayment risk is a real concern when it comes to high yield bonds, especially in the current environment where the economy may be worsening or possibly stabilising, but where default rates continue to rise. Over the past several years, the private equity industry orchestrated highly leveraged transactions leaving behind thinly capitalised issuers struggling to survive, further complicating the investment risk. Additionally, the opportunity cost for investors planning to hold such bonds to maturity are exceptionally high at present, making locked-in capital less attractive.

Hedge fund managers who are allowed to go long and short are less limited and locked in, and thus, in a more advantageous position. Buy and hold strategies should underperform hedge fund managers who trade more actively, and who can capitalise on trendless (yet volatile) markets. In general, hedge fund managers and investors who perform best will be those who can tactically change their exposures nimbly and opportunistically as news is disseminated and broader market clarity rises.

Inflation versus deflation
Numerous investors feel an important choice has befallen them between preparing for inflation or for deflation; in each case, the implications for financial assets differ widely. Several recent news articles, and a few well-known hedge fund managers, have argued that inflation will likely be the result of the Fed’s zero interest rate and quantitative easing policies, although this is disputed by some academic research. On the other hand, some believe that the 1930s or the Japan experience are better precedents arguing for an extended period of no growth and outright deflation.

Both hyperinflation and deflation are unambiguously awful. Deflation is more difficult for the Fed to combat, which is why the government has intervened in such an extreme manner. Conversely, if inflation were to become a problem, the Fed has better and more numerous tools to quickly shrink the money supply to deal with it. One likely possibility is that both camps are wrong and overly worried. The economy could merely be entering an extended period of slow growth with mild disinflation. Regardless of which outcome prevails, the outlook for buy and hold strategies seems dubious with the current economic underpinnings.

Tactical thinking/strategy focus
A hedge fund can be described as a fund that can take both long and short positions, use arbitrage and leverage, buy and sell undervalued securities, trade options, bonds, or invest in almost any opportunity in any market where it foresees impressive gains at reduced risk. With such in mind, it could be argued that the current environment may be ideal for returning hedge fund investments back to their original value proposition. Therefore, traditional hedge fund strategies, such as long/short equity, long/short credit, relative value, and event driven, look attractive now, as they capitalise on hedging strategies, elevated volatility, and a dynamically changing marketplace.

Entering the crisis, credit spreads in general were at historical lows, while recently, they have traded at historical highs. Evaluating credit quality and counterparty risks has become vitally important especially after Lehman’s failure, default rate increases and asset price declines.

Regardless, wider spreads typically create more opportunities and offer traders the ability to make double digit returns with low leverage and net exposures. Therefore, managers who concentrate in long/short credit strategies should perform well, especially for those with specialised expertise.

Specific niche opportunities in credit markets are evident and have been identified by hedge funds and fund of hedge fund managers, leading to the creation of an off-shoot strategy labelled “value recovery”. The idea is to buy various types of loans, asset-backed securities, residential mortgage-backed securities, real estate and other hard assets from distressed sellers. These funds typically have longer term horizons and less liquidity.

New asset based lending (ABL) funds are also appearing. ABL funds are designed to fill the hole created from limited bank lending. The strategy focuses on short-term bridge loans. The loans are typically over-collateralised and in a first lien position. New ABL funds that do not have legacy or ‘stale’ positions are more attractive than more established funds, because existing funds typically have increasingly delinquent borrowers with securitised assets of decaying value. These types of funds typically have low volatility, but still target internal rates of return greater than 15%.

All hedge fund managers, regardless of strategy, have varying degrees of time frames for their trades and themes. Managers’ time frames have uniformly shortened recently, a tactic which should help them navigate a market environment that remains uncertain and choppy for quite some time.

Global macro hedge funds have historically been less correlated to major stock indexes than other strategies. Macro strategies involve operating opportunistically in a wide range of markets, such as interest rates, currencies, commodities and stock index futures. It is typically macro focused managers who are the most skilled risk managers, successfully navigating through volatile markets and exploiting rapidly changing environments. Macro managers are typically best at looking for systemic risks and deviations from the status quo. They often look to identify emerging trends and spot economic tensions, and then construct trades specifically designed to profit as those changes transpire. Macro managers often see opportunities where others see chaos and confusion.

Macro was one of the few strategies to have, on average, positive returns in 2008. Given the current massive shifts in capital flows due to a vastly changed economic landscape, macro focused managers should continue to be strong performers for the foreseeable future. It should be noted that hedge fund managers of all market sectors and styles have heightened their awareness of macro factors, and how those influences affect the products which they trade.

Portfolio construction
Intelligently constructing a diversified portfolio of hedge funds that incorporate several of these various strategies can have tremendous benefits. For example, a portfolio which barbells less liquid strategies like credit with highly liquid strategies like global macro can be beneficial. These strategies have historically been uncorrelated, and while both can make money as stand alone investments, combining them into a portfolio can diversify away some of their fundamental risk factors. In general, as hedge fund correlations to other asset classes have risen, it has become more important to identify and add uncorrelated sources of idiosyncratic risk. The result is a portfolio that enhances returns while lowering overall risks.

Diversification and correlations
During the liquidation chaos of 2008 asset classes became hyper-correlated and so diversification had little benefit. Most ‘hedging’ strategies were futile, because securities of all asset classes were undergoing massive liquidation. Investment banks, which are the biggest market makers, typically buy assets from market sellers.

However, during this period, they were in survival mode and frantically paring their balance sheets. They were not in a position to purchase securities for reasonable prices. In addition, as credit dried up, so did market liquidity, further exacerbating problems, particularly damaging the most distressed sellers. Luckily, markets do not become panicked often, nor do they stay dysfunctional for long periods of time. The heightened market correlations of 2008 have loosened meaningfully and orderly markets have returned in 2009. Capital markets need to, and typically do, function with a reasonable level of order to achieve diversification benefits, as is presently the case once again.

The hedge fund paradox
To some extent, hedge funds were victims of the market turmoil, rather than causative agents. Then again, forced liquidation of hedge fund positions increased the magnitude of the decline and added to hyper-correlations. Certainly, hedge funds deserve blame for not fully understanding the systemic risks embedded in their portfolios. Too many managers were more dependent on market beta to generate returns than maybe they even realised. A few even disingenuously promoted their funds as absolute return vehicles. Since some hedge funds strategies have overt and hidden betas, those should not be seen as absolute return investments.

In general, however, hedge funds are low beta, alpha-generating vehicles that strive for positive returns in most market environments. A well constructed and professionally managed portfolio of multiple hedge funds can avoid leveraged beta and achieve the true goal of diversified alpha.

In adequately operating markets, good managers should be able to adjust their risk accordingly, handicapping the risk and reward of each idea and trade. Most hedge fund managers are sophisticated enough to adapt to changing market, liquidity and volatility conditions. Under most market conditions, flexibility and adaptability are common traits of hedge fund managers, particularly those in more liquid strategies. Such traits should particularly assist managers today, as they implement the lessons of 2008, and refocus their investment approach within the context of the new financial and regulatory paradigm that has emerged.

Pressures impacting hedge funds
Broken capital markets, regulatory gaps and well-publicised frauds have combined to place extra scrutiny on non-regulated hedge funds. It did not matter that hedge funds were not responsible for the market meltdown, or that no hedge fund needed a bailout from TARP money. Hedge funds have been targeted by regulators and politicians as a potential future source of hidden systemic risk that needs to be reeled in. The end result will lead to better implementation of best practices and structurally stronger firms.

Greater reporting requirements of institutional investors are leading to more pressure on hedge funds to improve compliance functions and transparency. These are positive pressures that will serve to further restore investor confidence. Most hedge fund managers are actually supportive of legislative efforts to promote transparency, provided their portfolio positions do not become public or lead to the undermining of proprietary information.

Unquestionably, many short-comings in the risk management tools of some hedge funds were exposed in 2008. It is almost requisite now that hedge funds build in liquidity risk assessment tools, as well as model for catastrophic scenarios of less-than-1% events. It is easy to see that the era of rising markets and easy profits are over, so hedge fund managers are recalibrating their operations and investment approaches to capitalise on the opportunities that emerge from uncertainty. Such recalibrations are healthy changes that should help hedge funds to manage risks better and lead to operationally and structurally more sound firms. Interestingly, a Deloitte research study has shown that of the last 100 hedge funds failures, 70% of the hedge funds failed because of operational risk, rather than for market risk or investment risk reasons. The study goes on to say that of that 70%, 80% could have been avoided if three factors had been in place: safe custody of fund’s assets away from the hedge fund manager; third-party independent verification of the NAV and security marks; and an independent auditor. As another case in point, self-administration used to be the norm with hedge funds and is now considered unacceptable.

Hedge funds are also now scrutinising the diversification of their investor base, so that a single redemption from too large an investor will not cause undue harm to their portfolio. In addition, managers are examining their counterparty risk from transactions, custody of assets, and their prime brokers. These actions will lower operational risks, and may have resulted from lessons learned from a few unfortunate managers in 2008.
Managers’ desire for more permanent capital is creating pressure across the industry to reduce fees. Reductions in fees get passed directly to the investor and are reflected in net returns.

Considerable brain-drain from Wall Street firms to hedge funds is occurring. Many talented traders are opting to join hedge funds, particularly because balance sheet and risk reduction combined with scrutiny on compensation is making Wall Street a significantly less appealing place to work. Hiring talented traders increases a hedge fund’s profitability outlook.

Conclusion
The investment horizon in terms of risks versus opportunities, when comparing 2008 to 2009 and beyond, could not be more different.

While the current investment landscape continues to be riddled with many land mines, there have never been greater or more numerous opportunities with which to make outsize returns. Since hedge funds are in the business of identifying and capitalising on such opportunities, they should do well. Their ability to move risk exposures up and down quickly is a valuable tool in a world where economic and geopolitical news changes with rapid fire frequency. External pressures on hedge funds from regulators and investors will ultimately result in stronger entities, operationally and structurally.

Hedge funds are flexible, entrepreneurial, highly motivated and profit orientated enterprises. As in previous crises, unlike largely static traditional managers, hedge fund managers will find ways to continually improve their processes and reinvent themselves to make money out of the current dislocations. Vastly smaller and significantly fewer investment banks have resulted in less efficient markets, which in turn, directly benefit hedge funds.

In short, the dislocations of 2008 have created the ideal conditions for smart hedge funds to be profitable, providing exciting prospects for the hedge fund industry for the foreseeable future.

ABOUT THE AUTHOR

Guy Haselmann co-manages Gregoire Capital’s portfolios. He has over 20 years of experience in proprietary trading, macro strategy, and hedge fund management. He is a graduate of the University of Delaware and received an MBA from the University of Chicago.