Critics of hedge funds often argue that industry growth has had two negative side-effects: firstly, that less-skilled managers have been attracted to the sector and second, that the number of alpha-generating opportunities has not kept pace with asset inflows.  Assuming these are true, then it could be argued that recent industry shrinkage may lead to new opportunities.  In our monthly guest contribution from a member of the Chartered Alternative Investment Analyst (CAIA) Association, Tommaso Sanzin of Hermes BPK Partners suggests that recent headwinds have ushered in a new phase in the “hedge fund industry life cycle”.  Sanzin is Partner and Head of Quantitative Research and Risk Analysis at Hermes BPK and was previously head of quantitative research at Pioneer Alternative Investment Management in London.  Hermes BPK is a boutique fund of funds majority-owned by British pension manager Hermes.

Alternative Viewpoints: Manager Capacity vs. Market Capacity: The fund of hedge fund conundrum

Special to AllAboutAlpha.com by: Tommaso Sanzin, CAIA, Partner & Head of Quantitative Research and Risk Analysis, Hermes BPK

In December, the National Bureau of Economic Research (NBER) announced that the U.S. economy entered the recession in December 2007, declaring the longest contraction since 1982. At the same time, early November reports estimated that the fund of hedge funds industry returned  negative 19% YTD, making it the worst and the longest drawdown on record, according to Chicago’s Hedge Fund Research (HFR). There is no doubt funds of funds are possibly facing the strongest headwind ever, as prices depreciate, liquidity conditions worsen and a tsunami of redemptions hits managers.

Clear and Present Danger

“Flow risk” can be defined as the risk that a manager experiences significant redemptions mostly due to industry-wide issues or a specific category of investors, rather than due to issues related to the manager itself. Among the current threats, this risk is probably the toughest to navigate. It can be exogenous to the portfolio and usually results in massive deleveraging that  impacts most managers, regardless of their performance or size, since both longs and shorts are indiscriminately squeezed and/or liquidated. This may seem obvious in the current environment but the summer ‘07 quantitative long/short managers debacle highlighted how a deleveraging event can hit hedge funds even if they run “neutral” portfolios and the equity market closes the month up (recall August 2007).

Liquidity or Objectives Mismatch?

The above mentioned flow risk is caused by a general liquidity mismatch between assets and liabilities caused by a deeper mismatch between clients and hedge fund managers objectives. The industry has always been broadly split into high net worth individuals and institutional long-term investors, with fund of hedge funds typically viewed as institutional investors. The issue has been that funds of funds raised money mostly through platforms or structured vehicles whose investors were predominantly private clients. These clients had a shorter term view than the funds of funds themselves and definitively had a much shorter one than the underlying managers (especially with regards to the less liquid strategies). Not only did they have different investment horizons but also different investment objectives. Private clients were looking for “optionality” in returns (equity like returns during bull and bond like returns during bear) while institutions generally aimed for low volatility and contained correlation against other asset classes. All this resulted in a conflict of objectives, which was very difficult to manage by funds of funds, thus creating the foundation for the current liquidity crisis.

Hedge Fund Evolution

Life below the ubiquitous “high water mark” has never been easy. Having said that, hedge fund survivors have always enjoyed periods of renaissance right after each previous crisis. It is likely that the overstretched bull environment attracted less skilled (on average) players in a very crowded (and thin) opportunity set, leading into the current crash which very few have been able to forecast. The good news is that market capacity is improving day by day and a new range of opportunities has arisen from the present dislocation. The winners will prove their skill and are likely to enjoy the panacea of rich trades and very little competition.

Where does the new set of opportunities lie?

Even with outflows threatening to wipe out 1/3 (or more) of the industry (according to various press reports), there are some hedge fund allocators working hard to identify where the next set of opportunities will arise. I remember that once, during a sailing competition, my coach said: “Once you touch the bottom, you can only do better…or start digging”. By the end of that competition, my yacht club was in last place.  As he had predicted, we simply couldn’t do any worse.  Later that year, however, our team clawed our way back to a silver medal at the national championship. Like that sailing team, it is likely that we shall all wake up in a brave new world full of opportunities.

As an example, distressed debt is one particular opportunity that I believe will be the next wave to ride..  Why?…

• Investment Grade (IG) and High Yield (HY) spreads went through the roof;
• All but one high yield sector is trading at distressed levels;
• Leveraged loans and mortgage pools underwent a dramatic transformation as a result of excessive liquidity conditions;
• Massive dislocations took place in IG and HY capital structures, cash and derivatives market.

If the default rates eventually met spreads in 2009, the supply of new distressed debt should subside somewhat relative to demand, which probably would be good news for distressed investors. Furthermore I expect an unprecedented supply of juicy fallen angels’ paper, which typically yields higher alpha and lower tail risk than any other distressed security.

There is little question that a gale force headwind blew the hedge fund sector off-course in 2008.  But as any sailor will tell you, headwind - like any wind - can power a boat forward as long as the sails are trimmed right.

- T. Sanzin, December 2008

(Editor’s addendum: Related news items: John Paulson looking to buy distressed debt: report [Reuters, Dec. 31], Yale’s Swensen Sees ‘Extraordinary’ Opportunity to Snap Up Debt [Bloomberg, Jan. 2] )

The opinions expressed in this guest posting are those of the author and not necessarily those of AllAboutAlpha.com.

Peter Douglas, CAIA, the founder of Singapore-based hedge fund consultancy and money management firm GFIA, is a well known and often-quoted figure in the alternative investment industry.  Regular readers may recall our conversation with him in his Singapore offices last fall (see post).  But Douglas also has another claim to fame.  As the Asia-based director of the Chartered Alternative Investment Analyst (CAIA) designation, he is a pioneer-cohort charterholder, and was the first CAIA in Singapore.  So we are pleased to bring you Douglas’ latest comments on the hedge fund industry as part of our monthly column featuring the ruminations of a CAIA charterholder, “Alternative Viewpoints”.

Today, Douglas pulls out his crystal ball to look at the future of the hedge fund industry.  He says that a dearth of alpha-seeking capital will usher in a “golden age” for alternative investing.  He also foresees larger hedge funds regulated as investment banks, and most large multi-strategy funds morphing or fading.  He says that as boutiques flourish, diversification across funds will become easier and price differentiation will finally take hold.  In addition, predicts Douglas, leverage will fall out of favour, operational expertise will become even more critical, and regulatory arbitrage will remain alive and well.

Alternative Viewpoints: What Next for the Hedge Fund Industry?

Special to AllAboutAlpha.com by: Peter Douglas, CAIA, Founder, GFIA pte.

The future will (not ‘may’) hold many surprises, and some could make a huge difference to our world view.  However, here are our thoughts on how the hedge fund world may pan out over the next 2-3 years.

In summary, the hedge fund world will (i) see higher returns (ii) see strong new manager formation (iii) be dominated by small boutique managers (iv) have relatively few very large funds.

Returns will be higher, possibly much higher, than they were 2006-2008

Of (very roughly, erring on the conservative side) US$2tn of hedge fund assets, and >US$4tn of investment bank trading assets, at the beginning of this year, we will, by the beginning of 2009, have lost perhaps 1/3 of the hedge fund assets and 3/4 of the world’s banks’ prop trading assets.  Assuming (and this is perforce guesswork) that aggregate leverage in the hedge fund ecosystem falls from 3x to 1.5x, and that ditto in the prop desks drops from 20x to 10x, that means that US$86tn of alpha-seeking capital will become US$12tn, an almost 90% implosion.  This is conservative. At a recent conference, we heard Paul Marshall, of Marshall Wace, estimate that half of all hedge fund capital, and 80% of investment bank trading capital, would evaporate.

(Goldman Sachs’ reduced their overall leverage from 24x to 16x, still, to our mind, an extraordinary number. We’re assuming that the majority of the new owners of investment banks will not be as confident of their new-found treasure’s ability to manage risk and will run significantly lower leverage. Professional trading units outside banking, such as Cargill, typically run at around 10x and we feel this is a realistic estimate.)

This accords with our view of the number of stocks in Asia with institutional levels of liquidity.  (From a Singapore base, we naturally see more data points from Asia than the ‘developed’ markets.) In the summer of 2007, this was perhaps 500.  Now, it’s more like 50, across the whole region.  In brief, alpha-seeking capital has shrunk by an order of magnitude.  As liquidity across the financial system continues to ebb, we believe that we may still not be at the low point.

Other discretionary flows into risk assets will also slow, as individuals and trustee-directed investments will lose their enthusiasm for market-related investments, further constricting liquidity.

Without market liquidity, arbitrage opportunities will be wider for longer, and markets will generally offer far more persistent opportunities.  Whether the opportunity is simply a hugely undervalued equity, or a mispricing in a complex derivative relationship, inefficiencies will be larger and more persistent - creating supernormal returns for investors with the skills to find and execute.

With a lack of general appetite for equity market risk, indexed or quasi-indexed returns will be meager, making the relative attraction of alpha returns much stronger.

We will, at some point in the next 6-12 months, enter a golden age much like that of the 1990’s, for hedge fund returns - indeed, returns from all but simple benchmark investing will be high.  We prophecy that the broad hedge fund return indices will annualize at 20% from 2009-2011.

The >US$5bn funds will be the new investment banks, and no longer relevant as hedge funds

We’ve pointed this out before, but hedge funds have been far better risk managers than any other investor group.  In 2007, aggregate hedge fund profits to investors were roughly equal to bank write-offs.  So far in 2008, although hedge funds have had a disastrous year, it’s been only half as disastrous as that for mutual funds, and exponentially less disastrous than for the owners of the banks (the other main risk-takers in financial markets).  Clearly this is where risk capital should and will be concentrated.  We can only suppose why this should be… but our supposition is that risk is best managed in discrete pools, by experienced professionals, remaining close to their specific experience, and with their own wealth at stake.  That mandates a boutique approach.

Secondly, the businesses-formerly-known-as-investment-banks will be very tightly constrained, not just by penal regulations, but also by their new owners, the commercial banks or sovereign entities.  While hedge fund regulation is clearly going to tighten, the hedge funds may be better placed to work round whatever’s put in their way.  The regulatory arbitrage between implementing a strategy within an investment bank, and within a hedge fund, will be strongly in the hedge funds’ favour.  The U.K. F.S.A. chief executive recently said:

“Hedge fund managers in general are weathering the market turmoil pretty well in the circumstances, certainly versus other components of the financial services industry.”

However, while a few months’ ago, we would have argued that hedge funds will be regulated fairly lightly compared with investment banks, we’re having doubts.  The industry’s larger players are increasingly being found guilty by their investors of having abandoned their fiduciary responsibilities, in favour of entrepreneurial zeal.  While 18% of hedge fund capital has been subject to gates or other restrictions on redemptions, this is concentrated within about 5% of funds by number.  In other words, it’s the big boys who are alienating investors.  The building crescendo of complaint from investors will I’m sure reach regulatory ears.

We think there’s an argument for regulating very large funds pari passu with investment banks, while leaving the boutiques largely unregulated.  We have a comparable situation in Singapore, where large institutional managers are generally subject to full investment management regulation, comparable with that mandated by the SEC or FSA, while smaller specialists can opt to be exempted.  This has worked remarkably well in balancing the growth of a dynamic indigenous industry, with the needs of very large allocators and their preferred managers.

Thirdly, running large amounts of money will be very difficult in a world of shrunken and much less liquid securities markets.  Much of the trend to multistrategy funds has been an attempt to create the scale that institutional investors would like to see (our humble opinion has been that ‘multistrategy’ has always been far less an investment strategy than a business model - and it’s always been the most difficult strategy to recommend to clients).  Alpha is never scaleable at the best of times and we believe the optimum size for almost all strategies has decreased very substantially of late.

We believe that the current very-large hedge funds will see the most dramatic changes.  Some will fragment into their constituent parts, some will become investment banks and be regulated as such, and some will disappear having committed suicide by gating their investors.

One effect of this is likely to be that a few remaining mega-funds will typically compete for similar returns, finding their scale a handicap.  They will also be among the few able to run heavily leveraged strategies, meaning that this universe is where the system-shaking implosions will happen next…  but not yet!

Strong growth in new boutiques and strategies

There is, and will be, attrition of hedge funds.  While there will be consolidation of funds of funds, which have an asset aggregating business model and therefore clear scale advantages, hedge funds won’t generally consolidate. Diseconomies of scale, and the extreme individuality of hedge fund professionals mean that hedge funds evaporate, not merge. Furthermore, the prospect of a year or two scrabbling back to high watermarks and therefore performance bonuses, will loosen the ties of many investment people to their current firms.  In addition, the overall contraction of the financial services industry will result in a widespread freeing of talent.

There will be increasing numbers of Ronin on the streets - skilled warriors answering to no master - easing dramatically the key constraint to growth of the industry, namely finding experienced people.  While some will attach themselves to the relative security of large funds, many will try their hands at starting their own shops, however tough fund-raising may be for a while.  We started GFIA in the depth of the Asian crisis, and can attest first hand that it’s far easier to start a business in a recession, with little competition for resources as diverse as research talent and airplane tickets, than in a booming economy.

We will a return to the early noughties, with plenty of highly skilled professionals starting firms with few staff and few assets, producing very attractive returns for a few years before gradually attracting assets from initially-shy investors.  This is exactly the experience post the Asian crisis, which left a lot of excellent but dislocated talent looking for a home for their skills.  The period 1998-2002 was the genesis of the boom in Asian hedge funds, which really happened from 2003-2006 before leveling off.  We will see a rerun of this movie starting in 2009, but this time it’ll be global not regional.

The way the investment world will change, with the current huge dislocations opening new arbitrages, and new ways to access the opportunities available, will facilitate plenty of good new pitchbooks.  The revised realities of working in a world with few mega-buck opportunities in investment (or any other sort of…) banking, with a backdrop of a vicious developed-economy recession, will make it relatively attractive for very good people to manage a few 10s of US$m in a strategy.

Conversations with law firms and prime brokers confirm this is in motion.  While prime brokers see a lot of wannabes alongside the likely starters, the law firms (who cost money!) only usually work on high-likelihood propositions.  And they’re seeing a strong pipeline of new funds for 1Q and 2Q 09.  While as an allocator, we’ll find it hard to allocate to any PM that didn’t have p&l responsibility through 2008, we’re sure we’ll be kept busy reviewing the propositions.

Inevitably, of course, a few of the new mini-boutiques will achieve scale, and the cycle will turn again…  But we feel that the next few years will be remarkable for the crop of new, small, skill-driven boutiques that appear.  It will be very exciting for investors.

Leverage will be used in fewer strategies

Only the very large funds will be able to convince their bankers to make significant leverage available.  But in any case, referring back to our earlier comments, you won’t need leverage to find good alpha returns.

This is likely to provide a conundrum, however.  In a generally unleveraged world, markets are likely to be substantially less leveraged than of late.  Large firms may well have access to leverage, but in relatively illiquid and volatile markets, will they be able to deploy that leverage well?  We expect that some will, and some won’t, and that the inherent riskiness of larger funds will, if anything, increase.

Systemic risk may reappear, but concentrated in the mega-funds, while mitigated in the smaller funds.  This is a further reason why the very large hedge funds will increasingly be regulated like investment banks - it’s because that’s where the risk will be concentrated.  Smaller boutique houses will be fragmented and largely unleveraged, and will operate with considerably more freedom.  It’ll be easy to argue that large funds should be regulated like investment banks.

Diversification will become easier

Their will be clearly be a period of good beta returns from dramatic market swings, as investors grapple with the likely direction of the new world order.  While simple ETF-like exposure is likely to be a rollercoaster, good directional equity managers with stock-picking skills will make good returns.

(From 1929 to 1934 there were 5 dramatic bear market rallies, 2 of which were >100%, before the Dow finally bottomed, with a peak-to-trough fall of almost 90%.)

Buy, hold, work-out and sell distressed strategies will make money.  So will arbitrage specialists whether they be event driven, market neutral, or any other convergence strategy.

But in the absence of blanket leverage floating all boats, it’ll become much easier to identify the specific characteristics of various sources of return, and it’ll become significantly easier to achieve effective diversification again, reviving the fortunes of the fund of funds industry again (albeit, see below, likely within a fragmenting range of business models).

Differentiation of fees

Investors will be in control, given the new scarcity of investment capital.  2 & 20 may be the sticker price, tho’ some new funds may go for a more conciliatory 1 & 20, but the effective pricing of investment strategies is likely to disperse dramatically, through the use of separate accounts, co-investment rights, and advisory contracts, as well as through simple fee rebates.

Differentiation of liquidity terms

Recent experience has shown that there cannot be one-size-fits-all liquidity terms.  Long term institutional investors want limited liquidity to protect themselves from other investors.

Intermediating investors (such as FoFs) legitimately need frequent liquidity to be able to adjust their exposures.  The two don’t mix.

Within the proviso that of course fund liquidity must match underlying asset liquidity, hedge funds will increasingly polarize between the two investor groups, defined by their liquidity needs.

The classic upward mobility of successful hedge funds, graduating investor profiles from agency to principal investors, may be constrained, as funds are defined either as “intermediary” or “proprietary/fiduciary” in nature.

Operational infrastructure will be more fragmented and expensive, and therefore operational expertise will be critical

Hedge funds will continue to appoint multiple prime brokers as a need-to-have rather than a nice-to-have; they will diversify their counterparties as much as possible; manage their cash more proactively; and quite possibly disaggregate many of the current package of prime broking services.  Investors will require this even if hedge funds don’t see it.  The de minimis internal infrastructure within hedge funds, needed to manage this increase in professional relationships, will increase, even for very small firms.

As the current prime broking model morphs, prime brokers will charge in more visible ways for their services; service providers generally will act for a larger number of smaller players with a corresponding impact on their cost base…  frictional costs will rise.

Good hedge fund ops managers will, even in the near-term shrinking environment, be bid-only.

Strong geographical movement to less politicized jurisdictions

The current financial crisis has galvanized policymakers to think and act globally, and regulatory agencies will be under pressure to homogenize regulations.  However, there will remain underlying philosophical differences, as well as different models of political and regulatory interaction.  In particular, we envisage that the main continuum of regulatory policy will be along the axis “politicized - non-politicized”.

Jurisdictions where regulatory policy is relatively free of political interference, and hence regulatory environments driven by pragmatism and effectiveness rather than dogma and populism, will see measurable increases in business.

Regulatory arbitrage will continue to exist, but be driven as much by perceived regulatory policy as by current compliance cost.  There’ll be further arbitrage between those managers serving investors with little need to deal with regulated entities (who will inevitably find ways to structure themselves to avoid burdensome regulation), and those managers serving investors that do need regulated counterparties, who are likely to maintain a far more costly compliance overhead.

- P. Douglas, November 2008

The opinions expressed in this guest posting are those of the author and not necessarily those of AllAboutAlpha.com.

The Fall issue of the Journal of Alternative Investments contains a great 75 page section on hedge fund replication.  Articles cover the latest developments in the two major techniques used to approximate hedge fund returns (factor and distributional replication), performance characteristics of actual hedge fund replication programs, and practical hurdles to implementing these programs.

These articles have begun to attract interest from the hedge fund and broader financial communities.  One paper by Jean-Francois Bacmann, Ryan Held, Pierre Jeanneret and Stefan Scholz called “The impact of missing factors on replication quality” has caught the eye of AllAboutAlpha.com contributor Pierre Laroche, head of R&D and Innocap, a joint venture between Canada’s National Bank and BNP Paribas (related post).  Below, Laroche examines the delicate balance between adding too many factors and too few factors in a factor-replication model.

Special to AllAboutAlpha.com by: Pierre Laroche, Managing Director, R&D, Innocap Investment Management.

The issue of “missing factors” was raised soon after several major financial institutions launched their HF index replicators last year.  The use of traditional regressions by these products raised some questions about the number of factors required to fully capture the nuances of HF returns.  Specifically, the more factors one adds, the more likely those factors are to be collinear (correlated), thus lowering the regressors’ efficiency. This property of regression-based HF replicators (along with other properties such as their inability to track abrupt changes in weights) pushed financial institutions to look for more appropriate tracking models.  One such model is the “Kalman Filter” (KF).

KFs can contribute greatly to hedge fund replication models for at least two reasons:

• Their tracking algorithm explicitly takes into account that exposure to return-generating factors are dynamic (they vary through time).
• The quality of the estimated weights is impacted much less by the presence of highly correlated factors.

In other words, KFs are influenced less by using a small number of highly correlated factors.  Unfortunately, however, they do not settle the central question of the ideal number of factors to use when trying to “replicate” HF returns.

It is well known that working with too many factors increases the danger of overfit which, ceteris paribus, usually results in a lower in-sample tracking error but a higher out-of-sample tracking error.   To mitigate risk, the “optimal” subset of factors is usually just based on heuristics known as the “information criteria”.  For example, it is often suggested that HF index replication use only 4 to 6 factors - sometimes even less.

However, it is a mistake to select the number of factors solely on these guidelines because:

1. These models completely ignore the results of more than 25 years of sound empirical literature on financial markets.  The arbitrage pricing theory (APT), for Instance, suggests there are some factors that are often totally overlooked.  The interest rate slope is perhaps the best example.  It requires a long-term interest rate factor - a factor that is not generally included in the information criteria.
2. The standard list of factors for HF replication are well suited to linear regression-type replication models.  But it’s still not clear that we can extend their results to KF-based replication models.
3. Working with too few factors also has a fairly important hidden cost: model risk.  This is a lesser known, but still crucial, problem identified by econometric literature.

Let’s focus on the last point here.  To illustrate the problem of model risk (too few factors), imagine a portfolio composed of three factors whose allocations vary randomly around 0.4, 0.4 and 0.2 weightings for a long period of time.

Then imagine that these factor weightings suddenly shift to 0.25, 0.25 and 0.4 following a change in market conditions.  The following figure illustrates such a scenario (with the three factors represented by the green, red and blue lines):

Now let’s use two Kalman Filters to infer the allocations to these factors from the observed monthly returns of the portfolio.

The first filter only uses the first two factors (the ones that would have been chosen by the “information criteria”) and the second filter uses all three assets. The following table contain the out-of sample monthly tracking errors of these two models:

We see that before the market regime change, the two-factor model performs better even if we know that the third asset contributes to the portfolio return.

But after the change in market conditions, the effectiveness of the two-factor model crumbles.  In fact, its monthly out-of-sample tracking error is more than twice as large.  Across the whole period, the three-factor model performs better even if the after-change period is much shorter that the initial period.  Clearly, the third factor adds significantly to our ability to “replicate” this portfolio.

But this is not the end of the story.  As can be seen in the upper panel of the exhibit below, during the pre-change period, the fit of the two-factor model is not only very good, but the two estimated weights are remarkably stable at around 0.5 respectively (which is the anticipated result of the two-factor model since they both have a 0.4 weight in the portfolio).

After the market conditions change, however, the allocations still oscillate around 0.5, but they become extremely volatile, which results in significantly higher trading costs. The estimated weights in the three-factor model do not, however, exhibit such an erratic behaviour.  The estimated weights remain not only accurate, but they are highly stable as well (as can be seen in the lower panel of the exhibit below).

In conclusion, in line with Bacmann et al’s paper in the Journal of Alternative Investments, choosing the right set of factors is a delicate compromise between efficiency (the fewer factors the better) and the cost of discarding a factor in case market environment changes (the more factors the better).

- P. Laroche, November 2008

The opinions expressed in this guest posting are those of the author and not necessarily those of AllAboutAlpha.com.

GUEST CONTRIBUTION BY RONALD SOLBERG, MANAGING DIRECTOR, ARMORED WOLF LLC - The US dollar as measured against six major world currencies has appreciated approximately 19% during the last three months through end-October. In particular, the US Dollar index stands at 85, up from a recent low of 71.3. This trend reversal takes the US dollar’s valuation back to levels not seen since October, 2006 and represents nearly a 38.2% retracement from its index peak of 120 in January, 2002; by any measure a significant move and one largely unexpected by the financial markets both in terms of its timing, speed and magnitude.

What has caused this abrupt appreciation of the US dollar during the past quarter and what can we expect over the next 12-24 months? There are both fundamental and technical reasons that have been US dollar supportive in the past several months.

Fundamental Factors

First, the seven-year decline in the US dollar’s value through July 2008 improved US competitiveness and, once the J-curve effect dissipated, has led to an acceleration of export revenue.  Slower GDP growth is also allowing imports to decline. These two effects have begun to stabilize the US trade deficit in nominal terms and allowed net exports in real terms to contribute 1.1% to Q3 2008 GDP growth.  The shrinking trade deficit has also contributed to the narrowing of the current account deficit. By pumping fewer US dollars to our foreign suppliers, this narrowing is shrinking global liquidity and creating further support for the dollar.

A second fundamental reason for US dollar strength has been an improvement in US terms-of-trade: the ratio of export prices over import prices. Since the United States is a net energy importer and this cost represents a significant portion of total import expenditures, the recent decline in crude oil prices has been a boon to our terms-of-trade. The improvement in US terms-of-trade has also supported the US dollar.

Thirdly, it is suggested from viewing the highly unusual negative break-even yields for inflation-linked bonds (TIPs) that investors believe the US will suffer deflation, not inflation, for the foreseeable future. This expectation for a declining price level, as a corollary, also creates the expectation for US dollar appreciation. This is because, once the currency depreciates in real terms, there is a tendency for the currency to appreciate in nominal terms to compensate for the price-driven depreciation, especially given that the notional rise will not undermine international competiveness.

Technical Factors

Perhaps the most important driver of the US dollar’s recent appreciation is not a fundamental but a technical factor. The meltdown of prices in the commodity complex, particularly energy, has generated a very strong impulse for US dollar strength. Whilst many commodity end-users were outright cash buyers, other buyers that were investing or speculating in commodities as a newfound asset class over the past five years would typically fund their position with US dollar-denominated credit, in effect, creating a US dollar short position. Now that these commodity carry trades are being unwound, it exacerbates commodity weakness and contributes to US dollar strength.  In addition, US investments in foreign markets, particularly equities, were primarily un-hedged and large amounts of those monies are now being repatriated which holds similar bullish US dollar effects.

Dollar Strength Sustainability

How sustainable are these four fundamental and technical factors in underpinning US dollar strength?

The trade and current account deficits should continue to narrow for several more months or perhaps quarters. As the US economy falls deeper into recession, imports should begin to decline more precipitously due to declining volume. This collapse along with rising export receipts will narrow the trade deficit and continue to lend support to the US dollar.

Despite the US dollar supportive narrowing of the trade and current account deficit, the pace of improvement may begin to slow for several reasons. First, once the prices of energy and other commodities stabilize, trends in import prices will no longer help lower overall import expenditures. Furthermore, stabilized import prices will also stop contributing to improved terms-of-trade. Second, it seems that a synchronized global recession is on the horizon. If so, then exports will once again decelerate despite US dollar competitiveness. As the growth of economies representing our important export markets slows or even falls into recession, weaker export growth will result. The combined effect of these counter-veiling trends is that the incipient narrowing of the US trade deficit may be short lived.

Perhaps the key factor will be the length of the time it takes for global de-leveraging to run its course. No one knows precisely how long it will take for investors and speculators to unwind US dollar-denominated commodity and other carry trades. It could be one month or half a year. However, once complete, the strongest driver for recent US dollar strength - de-leveraging — will dissipate. At that juncture, FX traders and investors will once again re-focus their attention on the supply of US dollars being pumped into the US economy and on the global system and investors’ willingness to hold additional Greenbacks in their portfolio.

The weight of US dollar supply

It is beyond the scope of this article to itemize the growing cumulative costs of the various aspects of the bailout.  Suffice to say that the supply of US dollars is dramatically growing and measured in the trillions. To best measure this aggregate growth, lets look at the growth of the Fed’s balance sheet and the monetary base.

After remaining relatively stable for more than a year through August 2008 at around $825 billion, the monetary base has exponentially exploded. BCA[1] has recently highlighted that in the past eight weeks, the monetary base has grown 38% to $1.142 trillion, and shows no signs of slowing down. Yet these reserves injected onto the balance sheets of the banks have not been disseminated into the broader economy. This is apparent by the ratio of M2 to base money, which over the same time period since end August, has plummeted from 9.1 to 7.8 (see Charts 1 & 2). This is not surprising since most of the capital injected into banks has been used to repair and shrink the balance sheet (i.e., write-off bad assets) rather than expand it.  So fractional banking’s normal stimulatory impact through the money multiplier has by-in-large not been activated.

Source: US Federal Reserve Oct 30, 2008, BCA Research

In addition to the Fed pumping money into the banking sector, the US Treasury will have gargantuan funding needs. According to Goldman Sachs[2] estimates, the US Treasury faces an unprecedented financing need in fiscal year 2009. Excluding funding requirements under the Supplemental Financing Program (SFP), they estimate 2009 FY issuance at $2 trillion compared to last year’s $1.12 trillion, which itself was already outsized.  This prospective amount is driven by an estimated budget deficit reaching $850 billion, funding TARP purchases of up to $500 billion and the rollover of maturing debt equal to $561 billion.  On top of these needs, it would not be unreasonable to expect additional SFP funding requirements of $500 billion, the amount already issued to date in FY 2008 used to recapitalize the Fed’s balance sheet.

The magnitude of such funding requirements will test the operational efficacy of the Treasury, requiring increased auction size, frequency and expanding maturity buckets on debt issuance, and will likely extend through FY 2009 and into FY 2010, prior to these pressures abating. Perhaps even more ominously, issue size will severely test market demand for such an avalanche of debt. If there is significant resistance by investors to accommodating these needs, failed auctions would require the Fed to hold new US Treasury issuance (i.e., monetization) which of course would be inflationary and foment US dollar weakness.

Lastly, our expectation is that the current account deficit, while narrowing, will not disappear.  Indeed, it will ultimately expand again once the trade deficit reverses course, which will once again increase the supply of US dollars to the rest of the world. Whilst emerging market economies have revealed their lack of immunity to the US and European slowdown, they may be the first to recover for several reasons, partly because their banks have avoided most of the toxic assets currently plaguing US and European banks. Their elevated population growth rates and migration of self-sufficient farmers into the industrialized cities looking for jobs is a secular trend that will only be deterred by the financial crisis for a short time. Within 18 months, these economies will be growing strongly and once again driving energy and commodity prices higher. This, in turn, will once again widen the US current account deficit and increase America’s reliance upon foreign savings.

Inflationary Seeds being Sown

This dramatic growth in the monetary base has not yet been inflationary since the velocity of money may have recently fallen due to the rise of deflationary expectations. Some will argue that liquidity being injected into the bank system will be drained subsequently by the Fed via open market operations. In principle, this could abate the ultimate inflationary impact of the bailout operations. However, currently this liquidity cannot be removed without collapsing the banks and worsening the recession. Since bringing bank balance sheets back to health is probably a multi-year process, this argument does not seem to stand.

We currently stand on Occam’s razor, staring into a deflationary abyss on one side and incipient inflation on the other. The Fed and US Treasury have shown their policy hand, revealing a strong preference to avert deflation. No doubt this reflects a broad political consensus that prospects of inflation are to be preferred to deflation, if those are the two choices. Claims that these massive debt levels can be financed and ultimately retired by future economic growth, taxation and lower government spending ring hollow.

Whilst the velocity of money has been quite stable in the past several years and perhaps even fallen most recently, this will not always be the case. As spring surely follows winter, it can be relied upon that velocity will accelerate in the future. Once it does, it will combine with this huge increase in the monetary base to boost liquidity and elevate price inflation.

There also remains an open question whether foreign investors will continue to be willing to accumulate additional US dollar assets. A strong argument could be made that foreign investors are already sated with US dollar debt. Foreign holdings of US Treasury and Agency debt stands around $4.1 trillion, representing approximately 36% of publicly held issuance. The concept of Bretton Woods II — wherein foreign investors were the lender of last resort extending vendor financing for their exports sold to the US (consumer) — was predicated on the stability of sustained household consumption. With the US household suffering from declining home prices, falling real wages, job loss and collapsing confidence, the American consumer will take years to recover their former spendthrift ways. With this missing critical link in the global relationship, it is suspect whether foreign governments will be willing to significantly increase their holdings of US dollar debt, if there is not the quid pro quo of increased export receipts from further US consumer spending.

Any meaningful pushback from foreign investors on buying additional US Treasury debt or US dollar denominated assets will imply either a steeper yield curve or monetization of new Treasury debt issuance. Neither outcome is desirable. A steeper yield curve implies declining Treasury bond prices and, by raising interest rates, also creates a headwind for US equities. In this scenario, it is hard to imagine a strong US dollar in the face of weakness in both US stocks and bonds.

In the second scenario, if investor demand is inadequate to absorb new issuance, then the Federal Reserve will have to hold a portion of new debt issuance by the US Treasury on their balance sheet. This is sheer monetization of the debt and highly inflationary since it is equivalent to simply printing money. Such a scenario would quickly lead to higher inflation and a weaker US dollar.

Conclusions

The tsunami of oncoming US Treasury debt issuance holds the real potential to crowd-out private sector issuance both here and abroad, steepen the US Treasury yield curve, put downward pressure on the real economy, undermine the US’ AAA rating, weaken the US dollar, and if the Treasury is required to resort to monetizing new debt issuance by “selling” it to the Fed due to pushback from foreign investors, it could even threaten the Bretton Woods’ US dollar reserve status and the Greenback’s role of denomination currency for commodities: a very high price to pay for a decade-long party on Wall Street.

So it seems that, despite the violent rally in the US dollar over the past three months, it may not be long lived. Much will depend on the capacity of foreign investors to offer safe harbour for new Treasury issuance and/or the likelihood of a policy mix set in Washington, DC that runs tight money and a fiscal surplus. When was the last time that occurred?

- R. Solberg, October, 2008

The opinions expressed in this guest posting are those of the author and not necessarily those of AllAboutAlpha.com

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[1] BCA Daily Insights, “The Fed: Moving Closer to Monetization” October 29, 2008

[2] GS US Daily Financial Market Comment, “The Treasury’s Financing Need: Pressing All the Buttons”, October 29, 2008

As Andrew Lo said at a major hedge fund conference in Boston last week, humans have a bad habit of confusing “very low probability” with “no probability”.  While this heuristic might help us from becoming a bunch of paranoid freaks, it can clearly be dangerous if the “low probability” event is catastrophic.  Enter catastrophe bonds.  In this month’s “Alternative Viewpoints” column, CAIA Association member Robert Koller-Vernot discusses the growth of the catastrophe bond (”cat-bond”) industry.  Koller-Vernot is a financial services and securities lawyer in Frankfurt with several years of experience in the fund management industry throughout Europe.  He also writes an interesting blog.

We think you’ll find his industry survey below (and in an expanded form available here) to be a concise and informative description of this interesting, if not a little macabre, quarter of the financial sector.  Read on to find out why Disney was a pioneer in cat bond issuance.  (For loads of references and external sources, refer to the full article.)

Special to AllAboutAlpha.com by: Robert Koller-Vernot, CAIA

Cat-Bonds are financial markets instruments that include an extra feature - an insurance element.  The main idea behind a cat-bond, as initially conceived, is to transfer risk of a natural catastrophe.

The issuer of a cat-bond issues securities that pay regular interest and return their principal at the end of their lifetime.  The normal maturity of a cat-bond is around three years.  However, the principal re-payments are conditional on certain pre-defined “triggers” (see below).  For example, in an earthquake-linked cat-bond, the trigger might be defined as a specific level of seismic activity.  If that activity occurs, then, generally, the principal will not be paid back or will be reduced at the end of the lifetime of the bond.

More…

Canadians aren’t naive.  They know why the global hedge fund community has beaten a path to their door over the past few years.  It starts with “energy…” and ends with “…and basic materials”.  While they bristle at the moniker “hewers of wood and drawers of water”, Canadians have been the beneficiaries of a global energy and basis materials boom for several years.  And as the Chairman of AIMA’s Canadian chapter, Phil Schmitt, argued last year, that’s okay with them - as long as investors stick around after the boom.

Well, the energy and basic materials boom seems to be taking a bit of breather right now.  Anyone on the HFRI hedge fund index mailing list would have noticed in today’s monthly update that the “energy/basic materials” sub-index was down over 13% in September, bringing the YTD return for this category to -21%.  So many US and European hedge fund investors are a little curious about how the Canadian hedge fund industry will fare this year.

At least one speaker at this week’s “Hedge Funds World Canada” event in Toronto was also curious.  Michael Nairne, president of family office Tacita Capital has assembled what is surely the most comprehensive quantitative analysis of these funds we have ever seen.  So if your job is to know what’s going on in the global hedge fund industry but you haven’t been up to Canada recently, you will likely find what follows to be very useful.  We have reproduced it in its original form below.

Special to AllAboutAlpha.com by: Michael Nairne, CFP, CFA, President, Tacita Capital

In order to provide insights into the Canadian hedge fund industry, Tacita Capital recently undertook a statistical analysis of the monthly returns of the Scotia Capital Canadian Hedge Fund Performance Index since its inception, the 43 month period from January 2005 through July 2008. The Equal Weighted Index (”SC Equal Weight HF”) was used as opposed to the Asset Weighted Index to minimize the impact of the results of a handful of relatively large funds. Family Offices are also interested in the opportunity set of all individual strategies, regardless of fund size.

Conclusions

The results of our analysis should be treated with caution given the limited time period, possible sample biases and the heterogeneity of hedge funds. Nevertheless, our findings provide perspective and insights on the Canadian hedge fund market.

We found that:

1. Canadian Hedge Funds during the period January 2005 through July 2008 were in the right sectors with the right directional weightings, concentrating on Materials and Energy while underweighting or even shorting other sectors. This was a great call. Time will tell whether they will be nimble enough to move ahead of future market turns. Their modest growth slant also worked to their advantage in this period. However, their concentration in small stocks hurt their performance. More bets placed in the large cap spectrum would have contributed to better numbers.
2. Overall, the lower volatility and downside risk focus of Canadian Hedge Funds was prominent. This is a definite plus and one that is broadly unknown given the propensity for media headlines to focus on hedge funds in their most volatile months. However, on a risk-adjusted basis, their rankings are much lower and disappointing. Unquestionably, the high fees of hedge fund managers are a major factor impairing their absolute and risk-adjusted performance. Competition on this basis would be healthy evolution.
3. From an asset management perspective, Canadian Hedge Funds earned a role in a well diversified portfolio, but it is not near as prominent as many of its zealous advocates proclaim. Stock-like returns with bond-like volatility is a marketing claim not a reality. The traditional instruments of Cash, Bonds and Stocks continued to be the main components of a well-diversified portfolio. Nevertheless, investors who used Canadian Hedge Funds in lieu of Canadian small cap stocks in their portfolio design were well rewarded for this choice.
4. Finally, as to the question of alpha generation, beauty is in the eye of the beholder, or should we say modeller. We believe the primary benefit of hedge funds is their exposure to risk factors other than the market, which can contribute to overall portfolio diversification. Our experience is that there are a small number of hedge fund managers in Canada who have distinctive and stable investment processes that can deliver a return and risk profile that enhances the diversification of our clients’ portfolios. Most managers don’t make the grade. Overall, we care less about alpha than a manager’s ability to enhance total portfolio performance - that is the paramount metric.

Sector Analysis

We conducted a multiple regression analysis on the SC Equal Weight HF relative to the major sectors of the S&P/TSX. Our results confirm the common perception that hedge fund investment has been concentrated in Materials and Energy long positions - see the positive and larger coefficients and t Statistics and low P-values for these sectors below.

The Materials sector, in particular, was a focus of investment. Although not statistically significant, the data suggests hedge funds were slightly short not only Financials but also Industrials, Technology and Utilities.
The coefficient of determination (R squared) of 0.80 for this regression suggests that although other variables besides sector weighting and direction contributed to hedge fund performance, sector selection has been a key factor in explaining their performance.

Performance Review

We reviewed the performance of the SC Equal Weight HF relative to certain size, style and sector indices. We also compared its performance to the Hennessee Hedge Fund Index. We use a currency hedged Hennessee Index; our experience is that many US-focused hedge funds in Canada currency hedge or have offsetting long and short positions.

In absolute performance - as measured by the geometric return - the SC Equal Weight HF was outperformed by the S&P/TSX Composite, the DJ Growth and Value Indices as well as the Materials and Energy Sectors. Canadian hedge funds did outperform Financials but only by a small amount. The performance gain relative to US hedge funds and Canadian small cap stocks was more respectable.

It is in volatility management, not absolute performance that Canadian hedge funds led; only US hedge funds had a lower standard deviation. Interestingly, although the media often portrays the hedge fund industry as a casino of high risk, high performance bets, these findings clearly indicate that in aggregate the industry’s performance has been about limiting volatility, not shooting for top numbers.

However, the real story is the risk-adjusted measures. Canadian hedge funds ranked a disappointing seventh on both the Sharpe and Sortino ratios. Only Financials and Canadian small cap stocks performed more poorly. Notably, US hedge funds outperformed Canada on these measures, likely reflecting their greater geographic coverage and diversity. These low rankings suggest that investors were not getting enough reward for the risks taken, at least as measured by deviation.

In measures of downside risk, Canadian hedge funds ranked better. As the following table shows, they outperformed the S&P/TSX Composite and Small Cap Indexes in the number of periods experiencing positive performance. Canadian hedge funds were highly ranked in terms of maximum decline experience - only US hedge funds have a lower maximum decline experience. Notably, Canadian small cap stocks overall experienced nearly three times the maximum loss.

These results are again consistent with a focus on downside risk management. Clearly, hedge funds are hedging!

The Alpha Question

We used two models to determine whether Canadian hedge funds have generated alpha.

The first is the Capital Asset Pricing Model - we used the S&P/TSX as the market portfolio and the DEX 30 Bay T-Bill Index as the risk-free rate. Our finding here - see the alpha score of -0.0005 - indicates that Canadian hedge funds as a group did not generate alpha.