HedgeWorld’s Alternative Reality

You’re going to read, hear and see a lot in the next few days about how this is the one-year anniversary of the credit crisis. NPR’s Morning Edition had a special report this morning, for instance.

With Michael Phelps having been elected president of the world by a vote of the obsequious mainstream media, oil falling and the dollar rallying, it’s hard to remember there are any economic problems at all. We can thank Fannie Mae and Freddie Mac and Lehman Brothers for reminding us that the credit markets are still sick.

As if the message weren’t coming through clearly already, Kenneth Rogoff, former chief economist for the International Monetary Fund, said at a conference in Singapore that at least one major U.S. bank or investment bank is poised to fail later this year.

“The worst is yet to come in the U.S.,” Rogoff, a Harvard University professor of economics, said in an interview in Singapore today. “The financial sector needs to shrink; I don’t think simply having a couple of medium-sized banks and a couple of small banks going under is going to do the job.”

Well. That’s encouraging. Say, what’s the medal count these days?

Anyway, as you’re reading, listening and watching all this about subprime’s anniversary (note: paper is the traditional gift when celebrating a first anniversary), I’d like to take a moment to remind you that we did it first.

Here for your viewing pleasure is StreetInsider.com’s look at JANA Partners’ latest 13F filing with the Securities and Exchange Commission. It covers the quarter ended June 30. You really have to love regulatory filings to compile this kind of information, and it’s nice that someone does.

StreetInsider also has the skinny on the latest 13Fs from the likes of Steven A. Cohen, John Paulson and others.

Given the time lag between the end of the reporting period and the filings, this information is mostly voyeuristic. But it just goes to show how valuable it can be to take raw data and provide even a surface-level analysis.

There are a lot of dark monitors and empty chairs at HedgeWorld this morning. Many people whom I like very much and who have made my life brighter these last years are gone, sacrificed on the cold altar of profit and loss.

Jacob Bunge
Martin de Sa’Pinto
Christopher Faille
Bill McIntosh
Chidem Kurdas
Maggie Shea
Emma Trincal
Michael Fischer
Andrew Morken
Judy Miszner
Steve Moy
Marc Yellin
Danielle Milazzo
Tracy Becker
Johann Wong

And of course the ringleader, Kristin Fox.

I’m still here, which is very odd for me. I am, as of now, HedgeWorld’s editorial ambassador of sorts. I am charged with carrying the flag into battle. At first glance, there is no longer an army here. And although that’s not entirely true—Thomson Reuters does have hedge fund coverage, which we will continue to run on the site—there is no hiding the fact that there is considerably less firepower at HedgeWorld from both institutional memory and analysis standpoints.

I find myself in the conflicted position of grieving the loss of my friends and at the same time fulfilling our commitments to HedgeWorld’s readership, which is to offer the most and highest quality news possible about hedge funds. Proof of the latter will come starting today.

In terms of the former, however, one of the nicest tributes I’ve seen comes courtesy of our friends over at the excellent blog All About Alpha. The Alpha Male has put together a retrospective of HedgeWorld’s home page through the years. It’s so funny to see those old pages, those classic colors, the old HedgeWorld logo, which I always liked.

Thanks, Alpha Male, for the retrospective.

But more importantly thanks to my colleagues for your hard work, your dedication, your friendship and for many years of memories. Regardless of the shape HedgeWorld takes online in the future, the spirit that made it great will live on in all of you.

It’s a case of doing well while doing the right thing. Judging by data presented to the Plan Sponsor & Minority Manager Annual Consortium in June, pensions that hire women and minority investment managers are making shrewd business decisions. 

 Of some dozen pensions surveyed for the Consortium, 50% said they have emerging manager programs. They define “emerging manager” by assets under management, ownership by minority people or women, or other criteria.

 A key finding came from Kenneth Heinz, president of Hedge Fund Research Inc. At the Consortium he presented data for a diversity index of partly or wholly minority-owned hedge fund businesses.  The strategy mix was different for this group compared to other hedge funds.

When he corrected for the difference in strategy mix, he found significantly higher returns for the diversity index compared to the regular hedge fund universe.

Many public pensions have channeled significant resources to this area. Tessa Hebb of the Labor and Work-life Program at Harvard Law School says in a report that the California State Teachers Retirement System uses diversity as a strategy across the entire portfolio, seeking higher returns through this approach.

The New York Common Retirement Fund has invested $1 billion with emerging managers in private equity and $600 million with those plying their trade in public equity markets.

Greater diversity is one of the most important strategic initiatives, according to New York State Comptroller Thomas DiNapoli’s message to the consortium. Of course, diversifying your portfolio to reduce the risk has been conventional investment wisdom for decades. Adding women and minorities just widens range—it should come as no surprise if it improves performance.  

OK, hands up all those who believe the inflation numbers churned out regularly by the eggheads at the relevant body in your home country. Were we all together in one room right now, my guess is that there would not be many hands, and that those whose hands were indeed up would feel somewhat embarrassed by them.

Maybe there is a perfectly reasonable explanation for those hands that are up, such as feeble mindedness of the owner, or an involuntary twitch. If there is anyone who really does believe government inflation numbers and is not locked in an institution of some kind, I would expect to find them in the rainy, midge-infested lands of Inverness, hunting the Loch Ness Monster, collecting car number plates or swimming in the freezing Danube on Christmas morning.

In a recent telephone conversation with HedgeWorld, commodities bull Jim Rogers was caustic about inflation numbers. “Most governments just lie about them,” he said. And at the GAIM conference in Monaco in June, political economist Marvin Zonis, professor emeritus at the University of Chicago’s graduate school of business, made a similar observation on certain emerging markets. Inflation statistics produced by some of these countries are sometimes understated “by as much as 75%”, he said. “Because, of course, the governments in developed markets would never lie to their populations about inflation,” interjected one observer, with not a little irony. Judging by the noises of approval from Mr. Zonis and the rest of the audience, he had struck a chord.

The problem with inflation numbers isn’t that they are falsified, it is that governments and others can selectively identify certain aspects of them to say pretty well anything, making consensus very difficult to achieve. Some economists are pointing to the sharp overall rises this year in the prices of oil, food and other commodities which have eroded buying power. This is the basis of their identifying inflation as a major threat, and hence their support for some degree of monetary tightening.

But looking at the same statistics Jacques Mechelany, chief investment officer at Asia-focused hedge fund firm Heritage Fund Management, said the real threat is deflation. He notes that there are four main components to inflation—housing costs, labor costs, discretionary spending and staples costs—and we can not just focus on one of these in isolation if we want to true picture of an economy’s overall health.

The problem is governments can and do use their weighting of these components to “massage” the numbers. “It is an issue that vested interests can choose to measure inflation with so many different indexes and manipulate them to present whatever picture they want,” Mr. Mechelany told HedgeWorld. However, he noted, voluntary manipulation in an environment where everyone can publish their own index is very difficult. A number of independent institutions make their own inflation calculations, he noted, but trends are similar to official numbers. Nonetheless, official inflation figures are often disputed by consumer groups, who often complain that the numbers mask what is really happening to purchasing power.

Just so. While there has been a jump in developed nations’ inflation numbers since the start of the year—the Euro area recently reporting that the index had exceeded the 4% mark for the first time in several years—this reflects little on what has happened to purchasing power. In Italy, the price of petrol and of bread have both doubled over the past year, while housing costs and labor costs appear to have remained stable. But if labor costs have remained stable, then purchasing power has decreased by 4%—that is to say, the rate of inflation—even if the statistics are accurate.

If the truth be told, the purchasing power of the average worker has been shot to pieces in recent years. In the euro area many people, politicians included, have recognized this, but tried to lay the blame at the door of the euro itself. But the erosion of purchasing power has been going on far longer than that. Do I have any evidence of this? Indeed I do.

One simple example. In 1960 my parents arrived in the United Kingdom (from India) and after four years of work (and while supporting a wife and initially one child, although the number had risen to three by 1964) managed to put down a deposit to buy a three bedroom house. He was earning what would be called an average wage. That would hardly be possible anywhere in the developed world now. But I have an example from closer to home.

Twenty years ago I left the United Kingdom for Italy for a two week holiday. A friend of mine who studied there suggested it might be a good idea for me to stay for a year, work and learn the language. I managed to find a part time job as an English teacher, and took in about a million lire a month for my troubles… about $700 at that time. It wasn’t a huge amount, but it allowed me to pay the rent, eat out five times a week, run a car (which, for a non-Italian living in Italy, now seems like a very brave thing to do)… in short, most of the things a working person would wish or need to do.

If I had wanted to blow all my meager wages on the lethal aperitif that was in vogue at the time, a fiendish cocktail of Campari, bitters and white wine (sometimes with a dash of gin) served in any of the chic bars in the center of town, I could have bought 1,250 of them with my monthly income, the drink itself costing 800 lire a shot.

Fast forward to twenty years later. The same aperitif in the same bar now costs 2 euro and 50 cents. In the meantime, the wage for the same part time teaching job has risen to about 1,300 euro. Hold on… That means that someone doing the same job as I did all those years ago would only be able to afford 560 aperitifs, less than half the number possible twenty years ago. Talk about erosion of purchasing power.

“Aha,” you might say, “but you were living in Italy. Everyone knows that ALL Italian governments lie ALL the time, so why expect them to tell the truth about something as politically sensitive as inflation?” I could not fault your logic on this. But try the test yourself and see if I’m right.

Close to half of the money flowing to hedge funds goes through funds of funds, though their share may be shrinking nearer to 40%. Smaller funds of funds face increasing pressure; a number of them closed down this year.

Others are merging or joining larger firms. The integration of George Chacko’s firm, Kite Partners, into Auda is consistent with this trend. Mr. Chacko was named Chief Investment Officer of $5 billion Auda International LP’s hedge fund investment arm. His associate Karl Neumar joined Auda Hedge as a Vice President. Kite Partners’ funds will become part of the company.

Auda chief executive Ernest Boles says Mr. Chacko’s quantitative approach will help meet client needs for specialized products and customized investments: “We wanted to add someone with a strong quantitative background.” Adding Kite’s assets makes it a win-win situation for both firms, he said.

Mr. Chacko says Kite Partners’ investments will benefit from the depth and breadth of Auda’s resources and qualitative expertise. Auda has a private equity fund of funds business in addition to the hedge fund portfolios.

Big funds of funds like Permal and Quellos are already part of large asset management companies—Legg Mason and BlackRock respectively. The alternative investment behemoth Man Group, combining funds of funds with a futures trading program, continued to grow in the past year despite market turmoil. Consolidation is clearly the winner at all levels.

There is no very good intellectual case to be made for the present state of the law on “insider trading” in the United States.

I say this because I’ve been attending (too closely) to the predicament of former hedge fund manager Ralph Cioffi. Allow me to summarize that predicament briefly: Working within the Bear Stearns fold, Mr. Cioffi founded two hedge funds with absurdly long names, both of which sought to make money in the structured credit markets. In late March 2007, according to prosecutors, Mr. Cioffi transferred approximately $2 million of the money he had personally invested in one of those funds to another hedge fund. That transfer is the basis of the insider trading charge.

Please ignore the other charges against Mr. Cioffi for the moment and focus on that one. Wouldn’t a rational response to news of that transfer be: So what? After all, the transfer didn’t mean that he no longer had, as they say, skin in the game. He still had $4 million worth of skin in that particular game!

When I talk to people about such issues, one common response is: all market participants know that the prohibition on insider trading is the rule, so they ought to respect the rule. This implies that the reason ‘inside traders’ make such unsympathetic figures isn’t because the prohibition makes any sense, it’s simply because the rule exists.

But so did the old rule against going 55 miles an hour on the highway. It, too, existed. It came about as a knee jerk reaction to the first oil shock in the early 1970s and never made a lot of sense. In time, enough people questioned its wisdom so that, on much of our highway system, the rule has since changed. Drive up to 65 without fear of the patrol car! Surely if we decide that a criminally enforced ban on insider trading (understood as including such acts as Mr. Cioffi’s) doesn’t make a lot of sense either, we can and should change that one, too!

Furthermore, it is very clear when we’re going more than 55 or 65 miles per hour. Either we have a functioning speedometer or it’s easy enough to get one. It isn’t always so clear what constitutes ‘insider trading.’

Some cases of insider trading do, it is true, imply some breach of fiduciary duty. But the law already has a name for the breach of fiduciary duty. It is … “breach of fiduciary duty.” When a particular trade by an insider fits that description; it can be treated under that heading. There is no need for a separate category of thing, an “inside trade,” which only very imperfectly overlaps with that.

The prohibition came out of the collective noggin of the judges of the second circuit in the Texas Gulf case, in 1968, on the basis of nothing better than the vague idea that buyers and sellers should be equally well informed. This is a worthless idea, and although the courts have since retreated from the extreme statements of that unfortunate start to this line of precedent, they haven’t retreated nearly far enough.

A more-or-less incidental passage within Joe Nocera’s recent book, Good Guys & Bad Guys, makes a related point. It’s in a reprinting of a story Mr. Nocera wrote for GQ in December 1992, concerning Drexel Burnham and Michael Milken. [Mr. Milken was still in prison when the column was written].

For the record, Mr. Nocera occupies a ‘moderate’ position on the spectrum of reactions to Mr. Milken: he argues that the infamous financier was guilty of some crimes, but not of the worst of those of which he has been accused, and that his sentence was excessive. But what intrigues me about this article is one incidental comment about an unnamed subordinate of Mr. Milken: “”When a Drexel salesman heard that the corporate-finance department was buying a stock – for what reason he didn’t know – and then advised a client wanting to sell that same stock that he might be better holding on to it, was that an example of insider trading? Or was it something more innocent?”

Good question. Indeed, it’s a better question than Mr. Nocera (who soon drops the query) may understand. Because there is nothing extraordinary about such an instance, and because if there is no good answer to that question, then the courts and prosecutors who punish insider trading are in effect telling traders, brokers, bond salesmen, etc. that they have to drive 55 miles per hour or below – and that they can’t use a speedometer, because none are available.

That’s wrong.

Personally, when I use the phrase “free markets,” I don’t mean the word “free” as an adjective. I mean it as a verb. Let’s free markets.

Those nifty charts that consist of colored boxes, each representing an investment class, are worth examining now and then. They show the comparative performance of asset classes over the years at one glance, tempering the temptation to stick with the flavor-of-the-day. Countries, regions, industries, strategies all go up and all come down, given time.

There are always sectors and industries that over-perform general market indexes, says David Reilly, director of portfolio strategies at Rydex Investments. He was speaking several weeks ago in the context of Rydex introducing specialized new sector funds on the American Stock Exchange. These include inverse ETFs in energy, financials, technology and healthcare that enable people to profit from a downturn without short selling or trading options. Rydex also launched leveraged ETFs, which allow investors to magnify their exposure to chosen sectors.

The general point is that the lineup always changes. Commodities were the worst performer in 1998, the Goldman Sachs Commodity Index losing 36%. That year you could make nearly 28% just by putting money into a simple S&P 500 index fund. By then many investors did not even want to hear about commodities.

The rest is not only history but a political hot spot. Commodities were the top performer in 2007, notching up almost 33% and giving rise to charges of speculation. But the colored boxes on the scorecard are already reshuffling.

Here’s another history lesson. Hedge funds are not like commodities. Hedge funds as represented by the Tremont Index were never among the bottom performers from 1998 through 2007. Neither were they at the very top; they moved around the middle. The performance of all investments shifts over time, but some sectors and strategies jump around less than others. Just another way of saying, hedge funds as a whole are less volatile.

With so much political controversy swirling around the New York Mercantile Exchange in recent days, it is somewhat surprising that no politician has yet made an issue out of the continuing consolidation in the market for commodities exchanges: in particular, about the impending acquisition of NYMEX by the CME Group.

After all, the charge that energy speculators are to blame for much of the recent price run-up in gasoline and/or crude oil has become part of the common coin of political debate in the U.S., sometimes indeed promoted under such monikers as, “trader realism.”

NYMEX is necessarily at the center of that controversy, and CME will find itself in the same position when, as is now expected, the two complete their nuptials.

So: why hasn’t anyone on the national scene made an issue out of the merger?

In part, it may just be the the issue has too many moving parts. When the CME and CBOT merged last year, some discussion of the general trend of consolidation of derivatives exchanges did take place. That discussion involved the vertical integration of exchanges and clearinghouses, the “barriers to entry” this may create, the fungibility of products, the relationship between equity exchanges and their derivatives counterparts, and much else.

Even when a matter is of great public interest, once discussion passes a certain threshold of complexity it gets re-allocated in the public mind to a small circle of deskbound wonks.

Or it might be a general recognition that globalization has come to the point where everything has to happen on a very large scale, and that the consolidation of exchanges is an inevitability.

“Consolidation among exchange operators continues to be a viable growth strategy. The transaction will result in a more competitive exchange, offers NYMEX Holdings shareholders a financially fair consideration and is expected to be accretive to earnings for the surviving shareholders of CME Group,” is how Glass Lewis put the key point, in recommending that both sets of shareholders vote in favor of the deal at their upcoming meetings.

Still, I have the uneasy feeling that exchange consolidation could easily be portrayed, by a politician looking for a point to make, as a way of easing the least productive or rational or consumer-friendly forms of speculation out there. [I'm not making such a point, mind you, only commenting on what some hypothetical demagogue might be able to put together in this line].

My unsolicited (but inexpensive) counsel to any deal makers out there is, then, as follows: make these deals while the makin’ is good. The climate could change.

The South Carolina Retirement System Investment Commission awarded a special kind of mandate to D. E. Shaw. The hedge fund firm will invest SCRS money across a variety of strategies, including long-only, private equity and real estate.

Several aspects of this new strategic relationship are noteworthy. One, D. E. Shaw has accumulated a wide range of investment skills, a development that falls under the rubric of the institutionalization of hedge funds.

“The tremendous resources, depth of expertise and breadth of strategies of the D. E. Shaw group make a strategic relationship very attractive to us,” Bob Borden, chief investment officer of SCRS, said in a release.

“We look forward to enhancing and diversifying our investments with the D. E. Shaw group through an array of absolute return, direct capital, private equity, real estate, long-only and 130/30 opportunities,” he said.

Two, D. E. Shaw has more total assets than the pension system; $39 billion versus $29 billion. It used to be that when a hedge fund got an allocation from a pension, the larger asset number almost always belonged to the pension. No more.

The few alternative investment firms with that level of resources and breadth of expertise have formed a class of their own. They are sharply distinct from the mass of hedge funds, most of them quite small and focused on a single market. This is a vivid example of how different the top firms are from the rest.