Jeremy Grantham of GMO in a recent letter writes about a number of interesting points:

1. Bernanke missing the housing bubble and its bursting, the potentially disastrous implications interactions between lower house prices and new financial instruments (MBS, CDOs), and international distribution of the associated risk.
2. Other Teflon Men: Larry Summers, encouraging deregulation and lighter regulation and not sounding warning signals to the 2006 – 2007 bubble years. Tim Geithner, et al, for various failings relating to regulation and policy.
3. Misguided and reckless mortgage borrowers and the efforts to bail them out while prudent borrowers and home buyers receive no help.
4. Reckless homebuilders for overbuilding and subsidizing reckless homebuyers.
5. Over spenders and under savers.
6. Banks too big to fail, and a policy of making them bigger in the rescue attempt.
7. Over bonused finance types. Goldman Sachs is singled out.
8. Overpaid CEOs.
9. Investors in overleveraged and wounded corporations.
10. The auto industry.
11. The world’s most over-vehicled country.
12. Stock options. An old gripe about the asymmetric payoffs and the adverse selection created in management (agent) behaviour.
13. Greenspan. For promoting deregulation, for keeping rates too low for too long.

And 6 months ago, Grantham predicted a sharp liquidity driven, fundamentals confounding rally. The logic is quite compelling.

Then he moves to prescriptions for redesigning the US financial system.

1. Regulators were too cosy with financial enterprise.
2. The overly large and overly complex financial system, well beyond the control and understanding of regulators.
3. Separate bank principal and agency businesses. Grantham points to the conflict of interest between representing clients and trading against them; Goldman is cited as an example. Some proprietary activities should be allowed, in particular genuine hedging of the main activities. Imposing leverage limits is suggested.
4. Prevent banks from getting or staying too big to fail. Break up the large banks into more manageable size.
5. Better public oversight and leadership.

He summarizes:

1. Yes, this was a profound failure of our financial system.
2. The public leadership was inadequate, especially in dealing with unexpected events that often, like the housing bubble breaking, should have been expected.
3. Of course, we should make a more determined effort to do a more effective job of leadership selection. But excellence in leadership will often be elusive.
4. Equally obvious, we could make a hundred improvements to the lifeboats. Most would be modest beneficial improvements, but in the long run they would be almost completely irrelevant and, worse, they might kid us into thinking we were doing something useful!
5. But all of the above points fail to recognize the main problem: the system has become too big and complicated for even much-improved leaders to handle. Why should we be confident that we will find such improved leaders? For, even in an administration directed to “change,” Obama and his advisors fell back on the same cast of characters who allowed, even facilitated, the development of the current crisis. Reappointing Bernanke! What a wasted opportunity to get a “son of Volker” type. (Or should that be “grandson of Volker?”)
6. The size of the financial system continues to grow and shows every sign of being out of control. As it grows, it becomes a bigger drain on the rest of the economy and slows it down.
7. The only long-term hope of avoiding major recurrent crises is to make our financial system simpler, the units small enough that they can be allowed to fail, and, above all, to remove the intrinsically conflicted and dangerously risk-seeking hedge fund heart from the banking system. The rest is window dressing and wishful thinking.
8. The concept of rational expectations – the belief in the natural efficiency of capitalism – is wrong, and is the root cause of our problems. Hyman Minsky, on the other hand, was right; he argued that the natural outcome of ordinary people interacting is to make occasional financial crises “well nigh inevitable.” Crises are desperately hard to avoid. We must give ourselves a chance by making the job of dealing with them much, much easier.
9. All in all we are likely to have learned little, or rather to act, through lack of character, as if we have learned nothing. In doing so we are probably condemning ourselves to another serious financial crisis in the not too- distant future.

Grantham has tremendous insight. His diagnosis of the evolution of the bubble and the precipitation of the credit crisis is accurate. The solutions for avoiding or mitigating further disasters, however, is a matter of opinion, and quite frankly of taste. There are many ways to skin a cat, pluck a black swan.

Grantham’s solution would work, but it would leave moral hazard unaddressed. The approach I favour is further deregulation, with a difference. Reregulation is a better word.

1. Education. In school, we are taught apart from maths, science, language and arts, the basic necessary functions of cooking, sewing, metal work, woodwork. Has anyone thought to educate people in basic management of household finances? Balance sheet management, cash flow management are basic elements of survival. More people know how to ride a bicycle than manage their own finances. The decision to be reckless or prudent should be a decision, not a non-decision based in ignorance. I do not advocate prudence, only that the individual is provided with the tools of their own success and demise.
2. The role of government and regulation should be pared down. A government should only provide goods and services that the free market is unable or unwilling to provide. It should also encourage the functioning of an efficient free market as far as possible. Where there is no market and government has to intervene, government should work to its own obsolescence.
3. Central banks and governments need to stop providing a safety net. Central banks need to stop providing a signal to the market about inflation expectations and interest rate policy. Reflating the economy post a bubble creates disastrous moral hazard. The removal of safety nets deals with the reckless mortgage borrowers, mortgage lenders, reckless bank prop desks, reckless credit providers, overpaid bankers and CEOs, overgrown banks, overgrown banking system, overcomplex financial systems. The only way to get economic agents to think carefully, act prudently, is to simply remove the safety net. No more bailouts, no signal on inflation expectations, no leader on interest rates, no lender of last resort. How careful will we be in all our financial decisions.
4. Promote standards of public disclosure and transparency for financial institutions in lieu of restrictive regulation. Provide the market with the information to self regulate. Even here, don’t force it. Full disclosure about compliance to standards is sufficient.

And that’s it: a new world order where we are each and every one of us responsible for our own financial well being. Lets see if this answers the issues Grantham raises:

1. Central banker myopic: Central banker rendered less relevant.
2. Teflon Men and the de-regulation bandwagon: Get what they wish. Light on regulation, heavy on disclosure.
3. Reckless borrowers: Would be properly educated. Would lose their homes if reckless, just the same as before. Would blame everyone around them, just as before. But this will change in 1 generation since the lack of protection would constitute a true shift in paradigm.
4. Overspenders and Undersavers: What is the definition of over spending and under saving? Education about financial management should address this. A household has the right to be reckless as long as they know they are being reckless and decide to be so intentionally, knowing there is no safety net.
5. Reckless homebuilders: Will fall in line with the new credit underwriting standards in a world with no lender of last resort.
6. Without a safety net, a lender of last resort, banks would shrink to fit. Investors and creditors and depositors would self regulate the size and complexity.
7. Overpaid bankers: An educated investor base will self regulate.
8. Overpaid CEOs: Ditto.
9. Investors in crap: Ditto.
10. The auto industry: Investors in crap. Ditto.
11. Over vehicled Country: Can’t help you there. China is getting there.
12. Stock options: Market ex lender of last resort will police.
13. Greenspan Put: He was the lender of last resort.

Hedge Fund Performance 2009 09

Hedge funds as represented by the HFRI returned 17.01% year to date. In the same time period, the MSCI World returned 38.08% YTD. Global Bonds measured by the Barclays Global Bond Index (the old Lehman Agg) gained 8.14%, and the CRB Index (Commodities) gained 17.71%. Adding more granularity to the numbers, the volatility of the HFRI was 10.05%, the MSCI 34%, the Barclays Global Bond 5.5% and the CRB 30%.

Convertible arbitrage led the pack with a 53% YTD gain. Its not clear what the arbitrage is. Rising equity markets, tightening credit spreads and renewed issuance are driving long only performance to an extent that sidelines the need to hedge. And with the numbers, its not clear how much hedging is going on. Recent performance, 1 month and 3 month has been consistently robust.

Emerging market funds also performed well with a 34% YTD return. Given the performance of Asia and LatAm, its not surprising that these funds have done well. An accidental net long bias would quickly have turned into a windfall profit.

Equity hedge has done well as well returning 21% YTD. Volatility has been quite high, evidence of a net long bias in aggregate as some managers chased rising markets. Equity market neutral strategies’ performance was instructive. YTD they have gained a paltry 1.5% with a volatility of 3.8%. This year’s equity market volatility, the decline in the first 2.5 months followed by the strong rebound has been characterised by liquidity, central bank policy, macro economic recovery, market psychology, and a reversal of risk aversion. So, of the non market neutral managers, how much alpha have they been generating? How much alpha could they possibly generate under the circumstances? When will it become a stock pickers market again?

Distressed debt strategies returned 21%. It is not clear if this return is due to the specific execution of the strategy or if it is a collateral consequence of spread tightening and rising equity markets on a predominantly long biased strategy. The volume of workouts is still slow compared to the acceleration in defaults. There is risk of volatility in this strategy and certainly ample opportunity for later entry points.

Event driven strategies returned 20% YTD but then event driven strategies encompass a host of strategies, so generalization is not useful.

Merger arbitrage underperformed with a 9.44% YTD performance albeit at volatility of 4.7%. Developed market deals have been patchy. Deal flow has slowed considerably, particularly in value. Apart from a few high profile deals, Cadbury Kraft, Marvel Disney, Liberty Direct, Sun Oracle, much of the action has been smaller and cross border, EM outbound. The deals done in the current environment carry far less uncertainty and risk. Risky deals are unlikely to come to market at all. While deal spreads have been wider than usual, there has been a dearth of hostile, complex deals where the returns usually come from. Leverage has also been scarce even for friendly deals. The result is lower returns but at lower risk.

Global macro, the favoured strategy at the end of 2008 for its resilience and performance in a difficult year (for everyone else), returned 4.2% YTD in a lacklustre performance. Especially in the context of a 5% volatility. This is not surprising in one sense but surprising in another. Investors chase returns. The first half of 2009 saw an increase in the number of potential start ups in Global Macro to catch the impending cascade of capital, which never came. It all ended up being funnelled into a few established, high profile, large scale funds. The glaringly easy trades of 2008 were no longer. It was to be expected that global macro would struggle. On the other hand, many interesting opportunities exist. Confused, prevaricating central banks, uncertain inflation expectations, confused, prevaricating Treasuries, a restructuring in the trading market for sovereign debt, particularly hard currency sov debt, is ideal for macro. So, why the poor performance at the aggregate level? Mediocrity. The good quality managers continue to take advantage of a very interesting macro environment.

Fixed income arbitrage has had a good year. 20% YTD. The drivers for their returns are very much related to the performance of global macro. Confused, prevaricating central banks, uncertain inflation expectations, confused, prevaricating Treasuries, a restructuring in the trading market for sovereign debt, particularly hard currency sov debt. The problem lies in the benchmark index methodology which is self reported and thus self classified. The macro index is contaminated with CTAs which sometimes classify themselves as Macro.

CTA’s have had a very tough year after a sometimes spectacular 2008. In 2009, they returned about 0% with nearly 10% volatility. I do not have the mathematical or statistical faculties to pretend to understand CTAs but it is rather disappointing to see a strategy so much in demand at the end of 2008 suddenly fall out of favour so quickly. I suppose in the absence of information, performance is the main determinant of investor demand.

On a risk adjusted basis, the MBS funds are hard to beat. 17.6% YTD with 5.6% volatility. Its hard to decline an invitation to feed at the trough filled by government monies.

Before we leave this, notice the difference in performance between HFRI and HFRI FOF. HFRI is an index of hedge funds while HFRI FOF is an index of funds of hedge funds. There appears to be a vast underperformance by funds of funds that cannot be simply explained by the additional layer of fees. Applying 1 and 10 fees on top of the HFRI still gets you to 14% YTD. The volatility of the funds of funds index, however, is 13% lower than that of the hedge funds index. If that is explained by cash, then the funds of funds index should still return around 12%. If we assume a much higher level of cash, say 24%, then we get to a ballpark of 10% YTD for funds of funds.

This appears to be what has happened. In the wake of the 2008 crisis, funds of funds raised more cash than they needed. They could not know how much cash they would need to meet investor redemptions and had to be conservative. 

All this together gives us an interesting picture of the hedge fund industry, the performance of strategies, the expectations and behavior of investors and funds of funds in their role as intermediaries and pooling vehicles.

Those of us faced with the reality of European hedge fund regulation will be familiar with UCITS III. You get points for knowing what UCITS actually means: Undertakings for Collective Investment in Transferable Securities, quite meaningless and proof positive of its European provenance.

In 2008, hedge funds lost money, on average some 20% of it in 2008. Traditional long only strategies lost about twice that but lets not split hairs. Some funds trafficking in illiquid investments when faced with high volumes of redemptions were forced to limit liquidity, gating or suspending redemptions in an effort to save their own businesses and or to save investors from selling off assets in a firesale. The need for liquidity and regulatory oversight thus brought UCITS firmly into the spotlight. Did Madoff really run a number of UCITS funds? Technically not. Madoff apparently never ran any funds UCITS or not.

In any case, in the wake of gates, suspensions, losses, regulators and investors are now looking towards more regulation. The hedge fund industry has proactively tried to head off what could be crippling regulation, first with active engagement of regulators by AIMA and the Hedge Fund Standards Board, and now with the embracing of UCITS III. Hedge fund managers have typically operated in an unregulated arena and are thus prohibited from marketing to individuals and are restricted to selling their funds to sophisticated investors such as institutional or professional investors. Naturally, hedge fund managers see UCITS as an alternative to onerous hedge fund regulation.

UCITS III, implemented in 2007, represents the third incarnation of the original UCITS directive which emerged in the mid eighties. This latest iteration is less restrictive than the original directive and allow managers the flexibility to use derivatives up to 100% of NAV for more than just efficient portfolio management and hedging purposes, the use of leverage within funds (up to 200% of assets), the creation of fund of fund structures and the ability to market the fund across international borders.

UCITS III allows previously long only portfolio managers the scope to utilise “short extensions” through the use of listed and OTC derivatives for more than simple hedging purposes. Quite how safe this is remains to be seen. It provides managers with powers hitherto out of their reach in order to introduce greater flexibility when constructing and managing portfolios. It also provides managers with powers hitherto out of their experience to introduce greater risk if misused, even and especially if unintentionally.

There are a number of important restrictions. Portfolio managers are not allowed to run net short or outright shorts. They can’t short sell stock or write uncovered call options. They have to demonstrate that they have sufficient risk controls to monitor exposure, including the OTC counterparty risk which is limited to 10% of NAV to a single counterparty. There are risk limits based on VAR and Tracking Error to some relevant benchmark.

Importantly, UCITS III provides hedge fund managers a regulated investment vehicle which may negate the need for further hedge fund regulation. This is the main attraction as regulators tighten regulation and investors are increasingly leery of unregulated investment vehicles.

Marketing and Product Positioning:

As investors fled risky investments in the wake of 2008, it has shifted bargaining power in favour of investors away from hedge fund managers. Liquidity terms are moving to be more in line with portfolio liquidity rather than the size of the ego of the manager. Liquid portfolios are matched with liquid terms and illiquid portfolios with liquidity constrained terms. Fee compression has become more of a reality.

The knee jerk reaction to all these developments, assuming that one hadn’t disenfranchised all one’s investors and had a queue of redemptions equal to 100% of NAV, has been to:

1. Keep running the hedge fund. Improve liquidity terms if possible but certainly not to run a liquidity mismatch. Consider lowering fees or redesigning fees for better alignment and less optionality. Try to raise capital for the hedge fund.

1. Offer managed accounts.

1. Launch a UCITS III fund.

1. Think the unthinkable.

Offering multiple products is not an enterprise to be taken lightly. It is one likely to be taken lightly given the DNA of the hedge fund manager who concentrates on the management of investments instead of product positioning and pricing.

Consider this; you have a product for which demand has shrunk and margins of which are likely to come under pressure. You have the capability of offering a similar product which is currently an emerging market where pricing strategy in the industry is uncertain. The marginal cost of offering the product is low as it is effectively the same product in a different wrapper, delivered to a customer base where there is considerable overlap in one area plus a previously untapped market. The new product is highly scalable and is likely to be more of a volume driven rather than margin driven business. How should you position your products to maximize profits.

The market for your existing product is or was highly inelastic. It is likely that the market has become more price elastic. How do you position the existing product? You can treat the market as highly efficient and homogenous (which it isn’t) and equate marginal cost to marginal revenue, push down pricing and try to capture market share. You can decide that the market is highly inefficient and heterogeneous (which it is in the world of skill based investing), hold up pricing, but more importantly try to move up the value chain and offer more specialized and bespoke product, avoiding the commoditization of the product, and try to equate marginal cost and marginal revenue in each sub-market for your product, effectively defining your own markets. This would include providing bespoke mandates, managed accounts, with bespoke liquidity terms and fees, targeting the professional and institutional investor. A balance between bulk pricing and bespoke mandate pricing is struck but it is struck with each client and is transparent only to each client and not to the market.

The market for the new product is likely to be inelastic as it is a new market. The natural conclusion jumped to is that the new product being offered to a wider retail audience is more price elastic. Given the general opacity in retail investment products, this is not clear. Retail products typically measure cost based on a total expense ratio. Hedge fund fees and expenses would naturally inflate this number relative to traditional UCITS funds. On the other hand, retail and mass affluent investors might be appreciative of absolute returns.

In this nascent market for UCITS III hedge funds, pricing and product positioning is still uncertain. A first mover only has an advantage if they can confront the issues and plan strategically for the eventual maturity of the market.