U.K. Pension Funds Rose for Third Straight Quarter, Mellon Says
By David Clarke

April 27 (Bloomberg) — U.K. balanced pension funds advanced 2.3 percent in the first quarter, the third straight three-month stretch of gains, according to Mellon Financial Corp.

The best performer was Glasgow Investment Managers’ 46 million-pound ($92 million) fund, which advanced 3.9 percent, Mellon’s London-based fund measurement unit said in an e-mailed statement today. The laggard of the 57 funds was the 229 million-pound St James’s Place Newton GBL Fund, which fell 0.5 percent, Mellon said.

Balanced funds invest in a variety of stocks, bonds and other assets and are used by pension funds seeking to put money into a range of securities. The U.K’s FTSE 100 index advanced 1.4 percent in the first quarter of the year.

To contact the reporter for this story: David Clarke in Edinburgh at dclarke3@bloomberg.net

Last Updated: April 27, 2007 07:24 EDT

http://www.bloomberg.com/apps/news?pid=20601014&sid=aK9AqmpQpsBE&refer=funds

A fund of funds gets found out

By James Altucher

FINANCIAL TIMES

Published: April 23 2007 18:51 | Last updated: April 23 2007 18:51

I was talking to Bert Jones (not his real name) on the phone the other day. Bert runs a $2bn fund of funds. “We’re kind of in trouble,” he told me.

“How come?”, I said. “You guys are the best. You haven’t had a down month since you started seven years ago.”

Bert is a worrier. When he says he’s in trouble it may mean something like Starbucks raising prices at his local outlet. Or, worse, like the last time he called me when he was upset that ABC had moved Lost from the 9pm slot to 10pm (“I can’t stay up that late!” he complained).

“Well,” he said, “we returned 8.3 per cent last year. We returned 8.5 per cent the year before and 7.8 per cent the year before that. So we’re beating the risk-free investment by 3 per cent per year. And, you know, we beat the market in 2005 and, of course, in the bear market years we destroyed the market.”

“Yeah,” I told him, “You suck. I can see why you have nightmares and your kids hate you.” I was kidding but I was almost angry about it.

“The problem,” he said in that slow, methodical way of his, “is that investors are starting to ask the basic question: I can get 5-6 per cent sitting in a risk-free investment like T-bills. Is it really worth getting 2-3 per cent more than that and risk dealing with fraud issues, having my money locked up for years, having to keep track of everything, etc? I’m afraid investors are going to start pulling out.”

And you know what? Bert’s investors are probably right. It’s not worth it. A friend of mine recently sold an expensive work of art and was looking to put his money to work in a fund of hedge funds. He asked me if I knew of a good one. I asked my friend: why would he want to flush his money down the toilet?

It’s double-locked up: The fund of funds and then the underlying hedge funds. And it really is fees on top of fees. A 10 per cent return in a fund of funds means that the final, underlying investments have to return approximately 18 per cent. That’s very difficult when the market itself averages about 7 per cent and T-bills are at 5-6 per cent.

There are 9,000 hedge funds out there. Nine thousand hedge funds aren’t returning 18 per cent. It would be amazing if there were an investment out there that was generating 18 per cent for 9,000 institutions while the rest of the world is making 7 per cent.

My friend didn’t like my answer. “Why are you saying that? You run a fund of funds.”

Well, what can I tell you? And I didn’t know what to tell Bert, either.

He’s got a problem. The entire industry has a problem. Well, I shouldn’t say that. Citadel doesn’t have a problem. It can return 9 per cent a year for ever and institutions will love it. When you’re big enough, you’re an institution also.

And SAC Capital won’t have a problem. How come? Because it returns 50 per cent a year. Hey, someone has to do it and they are the best, along with a select handful of others. But you can’t invest in them. I wrote to Steve Cohen once and asked if I could invest. No response. And why should he let me invest? Half his $12bn fund is probably his own money. He’s got other things to worry about. Let’s forget the fact that he’s on my IM buddy list.

But let’s invest in SAC anyway. At Stockpickr.com, a website I set up and run, I keep track of the SAC Capital positions (among others) that he’s either been increasing or are new. He’s been piggybacking Carl Icahn a bit lately, so he’s still long Time Warner although my guess is he’s reducing that, along with Icahn. But a new position as of December 31 was WCI Communities, a company for which Icahn recently made a $22 per share offer because he felt it was very undervalued.

Another new position is Ionatron. This company makes Buck Rogers-style laser weapons systems. It has $30m of cash in the bank, it loses money, but the Navy is evaluating its latest products and could decide any day. With SAC’s ability to do deep investigative investing, my guess is the managers feel comfortable the products will get sold. And with 24m shares short on Ionatron, there are an awful lot of people who will be waiting in line to cover their shorts.

Another interesting new position is Radiation Therapy Services. It provides radiation services for cancer patients. This is clearly an area that is growing. It has a forward price/earnings ratio of 14 and trades for just 11 times earnings before interest, taxes, depreciation and amortisation, making it a potential buyout candidate. Analysts expect earnings to go from $1.26 a share in 2006 to $1.64 in 2007. Revenues have gone up every year since it went public.

“Bert,” I finally said, “What are you guys going to do?”

Bert, ever the worrier, said, “I just don’t know.”

james@formulacapital.com

Copyright The Financial Times Limited 2007

http://www.ft.com/cms/s/276f56c2-f1bd-11db-b5b6-000b5df10621,dwp_uuid=d8e9ac2a-30dc-11da-ac1b-00000e2511c8.html

 Rewriting the Rules

Ewen McMillan, a capital markets officer at the Luxembourg- based European Investment Bank, said it’s easier to sell debt with longer maturities in Canada because of demand from the country’s pension funds and insurance companies. The EIB sold two Maple issues due in 30 years and one that matures in 2045.

Maple bonds have an average duration of more than six years, compared with less than four years in Australia’s Kangaroo market, according to Bloomberg data.

Until February 2005, when former Finance Minister Ralph Goodale rewrote the rules on foreign holdings, the country’s pension funds and employee retirement-savings plans couldn’t have more than 30 percent of their C$850 billion of assets outside Canada. By lifting the 34-year-old cap, the government freed up money that had been stuck in domestic stocks and bonds.

:::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::

Canada Outgrows China as Newest Market for Worldwide Borrowers
By Doug Alexander

April 30 (Bloomberg) — From Reykjavik to Wellington, the queue in Toronto is making Canada the fastest-growing market for international borrowers. Not even China’s burgeoning bond sales can keep up with the pace of foreign debt being issued in Canadian dollars.

Canada’s supremacy as the capital market of choice for companies as diverse as New Zealand’s Telecom Corp. and Iceland’s Kaupthing Bank hf has a lot to do with the Ottawa- based government’s obsession with balanced budgets, some of the lowest interest rates available anywhere, a sinking currency against the euro and a 2-year-old law that lets pension funds own as much foreign debt as they want without a tax penalty.

While the C$21.3 billion ($19.1 billion) of so-called Maple bonds represent 10 percent of the Yankee debt sold by international issuers in the U.S. last year, the Canadian market is growing twice as fast and may exceed C$50 billion in 2007. For RBC Capital Markets and Merrill Lynch & Co., the firms that have arranged more than half of the new offerings, which were scarce prior to 2005, the fees from these deals will top C$160 million, according to data compiled by Bloomberg.

“The Maple bond phenomenon is certainly one of the biggest things to hit the fixed-income market in Canada in many, many years,” said Andy McNair, managing director of debt syndication at TD Securities Inc. in Toronto, which has hired and transferred employees to London, New York and Sydney to meet demand for the securities.

Wellington-based Telecom Corp., New Zealand’s largest phone company, picked Canada for its C$275 million of 4.75 percent bonds, its biggest debt offering yet. Reykjavik-based Kaupthing Bank raised C$500 million, taking advantage of the lowest interest rates outside Japan and a currency that has dropped 7 percent in the past six months against the euro.

Tax Shelter

The government of Prime Minister Paul Martin transformed the market in 2005 by scrapping a limit on tax-sheltered holdings in foreign stocks and bonds. Pension funds, the country’s biggest institutional investors, needed a substitute for the shrinking supply of federal debt after eight straight years of budget surpluses. That year, sales of Maple bonds climbed to C$8.65 billion from C$600 million in 2004.

The markets competing with Canada aren’t keeping pace. In Japan, sales of so-called Samurai bonds shrank by 59 percent to 741 billion yen ($6.2 billion) last year. Australia’s Kangaroo bond offerings totaled A$32.7 billion ($27.1 billon), up 30 percent from 2005.

While China has so far limited the ability of foreign companies to sell debt to domestic investors, bonds sold by Chinese companies on the mainland and in Hong Kong totaled $193 billion last year, up 91 percent from 2005, Bloomberg data show. That compares with the 146 percent gain for Canada’s Maple bonds.

Maple Leaf

The Maple leaf, a Canadian symbol for centuries that graces the national flag, found its way into the bond market in January 2005. After hosting a lunch at which moose, beaver and Canuck were proposed as monikers, Toronto-Dominion Bank’s TD Securities unit settled on maple for its next deal, and the name stuck.

Telecom Corp. was attracted by interest rates a half-point lower than comparable U.S. borrowing costs and the opportunity to sell longer-dated bonds, said Nick Olson, the company’s general manager of finance. “The pricing was good relative to other international options,” he said. Telecom Corp. sold seven-year bonds in September, Bloomberg data show.

Canada’s biggest Maple deal so far was for Morgan Stanley, which raised C$2.5 billion in February.

Saving C$1 Million

“We started looking at the market more actively, looking at cost differentials, as well as the investor diversification benefit, and thought it was the right time to go ahead with a transaction,” said Jai Sooklal, assistant treasurer and global head of financing at New York-based Morgan Stanley, the second- biggest U.S. securities firm by market value. “We would have been happy with anywhere from C$1 billion to C$1.5 billion, so to see the response that we got, we were extremely pleased.”

With the euro rising against the U.S. and Canadian dollars, European borrowers have become the biggest Maple bond issuers, accounting for about half the sales. As the currency gains, the cost of paying interest and principal in Canadian dollars falls.

France Telecom SA, Europe’s second-largest phone company, was drawn to Canada “by the attractive cost of funding” and the chance to broaden its investor base, said Herve Labbe, who’s responsible for bond sales at the Paris-based company, in e- mailed comments. On one of its two Maple sales, a C$250 million offering last year, France Telecom figures it saved more than C$1 million in interest over the life of the bond by issuing in Canada and then swapping the currency risk into euros.

Rewriting the Rules

Ewen McMillan, a capital markets officer at the Luxembourg- based European Investment Bank, said it’s easier to sell debt with longer maturities in Canada because of demand from the country’s pension funds and insurance companies. The EIB sold two Maple issues due in 30 years and one that matures in 2045.

Maple bonds have an average duration of more than six years, compared with less than four years in Australia’s Kangaroo market, according to Bloomberg data.

Until February 2005, when former Finance Minister Ralph Goodale rewrote the rules on foreign holdings, the country’s pension funds and employee retirement-savings plans couldn’t have more than 30 percent of their C$850 billion of assets outside Canada. By lifting the 34-year-old cap, the government freed up money that had been stuck in domestic stocks and bonds.

At the same time, the federal government has reduced its supply of outstanding debt by C$79.3 billion, or 22 percent, in the past six years, giving the country’s bond investors fewer options at home. As a result, Canadians bought a net C$78 billion of international securities in 2006, more than four times as much as in 2004, according to Statistics Canada. Most of that total was foreign bonds.

Dispatched From Reykjavik

Sun Life Financial Inc., Canada’s third-biggest insurer, has more than C$400 million invested in Maple bonds, mostly corporate issues by European banks, said Candace Shaw, head of North American public fixed-income.

“The reception from the Canadian investors was extremely good,” said Kaupthing Chief Treasurer Gudni Adalsteinsson, who almost doubled the size of a Maple bond issue for Iceland’s biggest bank in February after sending a team to four Canadian cities from Reykjavik.

The Maple bond market has thrived because Canada’s sinking dollar relative to the euro and low interest rates relative to the U.S. cut costs for foreign companies. Demand may wane if that rate gap narrows, the Canadian dollar reverses course and gains against the euro, as it did in 2005, or banks charge borrowers more to neutralize the currency risk.

Incipient Indigestion

“We don’t have a need for Canadian dollars, so we swap out into U.S. dollars or euros and the cost of the swap has risen, especially last year,” said Petra Wehlert, co-head of funding at KfW Group, the German state-owned development bank in Frankfurt that ranks as Europe’s largest issuer of non- government bonds. “Many borrowers have a need to swap out and it’s getting harder.”

Robert Follis, director of corporate-bond research at Bank of Nova Scotia’s Scotia Capital unit, said investors may lose interest if underwriters aren’t able to attract a broader range of issuers. So far, most Maple bond sales have been by banks, securities firms and insurers.

“The market is starting to feel a bit of indigestion about financial issuers,” he said. “There is a real need and desire to get non-financial Maple issuers into the market.”

Record Pace

For now, Iceland’s Kaupthing is one of the clients making Merrill, the world’s third-largest securities firm, an unlikely leader in Maple bonds. A perennial also-ran in the Canadian debt markets since its 1998 purchase of Toronto-based Midland Walwyn Inc., Merrill ranks second to Royal Bank of Canada’s RBC Capital Markets after helping to arrange $3.27 billion of the $15.2 billion in sales so far this year. Those deals have earned the firm about C$8.7 million in fees.

Merrill’s other clients include New York Life Insurance Co., the largest U.S. insurer owned by its policy holders, Edinburgh-based Royal Bank of Scotland Group Plc and Network Rail, the government-backed U.K. railway owner. Kaupthing hired New York-based Merrill and TD Securities to sell C$500 million of five-year Maple bonds with a 4.7 percent coupon in February.

Demand for the securities has been growing so fast that underwriting fees this year may be more than double the C$80 million that banks made selling debt for the Canadian government last year, Bloomberg data show. TD Securities, ranked third after RBC Capital and Merrill, estimates that C$40 billion to C$50 billion of Maple bonds will be issued this year.

Canadian Banks

“We’ve had a very active first quarter,” said Larry Bates, head of debt capital at Toronto-based RBC. “I expect another record year.”

Scotia Capital, a unit of Bank of Nova Scotia, and Bank of Montreal’s BMO Capital Markets rank fourth and fifth, respectively. CIBC World Markets, No. 1 in Canadian government bond sales this year, is sixth.

Bloomberg determines Canadian debt rankings by dividing the amount raised among the banks managing the sale and giving a bonus credit to the lead arranger, in line with local-market practice. Underwriters earn an average fee of 0.32 percent on Maple bonds, about the same as for a domestic corporate offering, according to Bloomberg data.

Holger Koncewicz, funding official at Landwirtschaftsliche Rentenbank in Frankfurt, said Canada’s Maple bonds are “on the right track to become a major international market.”

No Currency Risk

The securities still appeal to Canadian investors because they offer a chance to buy international debt without the risk that currency movements will dent profits. That’s what happened in 2005, when Canadians who bet on European corporate bonds lost almost 12 percent as the Canadian dollar surged against the euro, according to the Merrill Lynch EMU Corporate Index.

The Scotia Capital Maple Bond Index, which includes 96 government and corporate issues with a total market value of C$39.6 billion, returned 5.62 percent in the year ended March 31. The Scotia Capital Universe Bond index, which includes Canadian corporate and government bonds, had a 5.46 percent return during the same period.

“They’ve done exactly what we’ve wanted them to do in our portfolio and they’ve performed as well, or better, as any of our Canadian names, so we’re very happy with it,” said Sun Life’s Shaw.

To contact the reporter on this story: Doug Alexander in Toronto at dalexander3@bloomberg.net

Last Updated: April 29, 2007 19:02 EDT

http://www.bloomberg.com/apps/news?pid=20601009&sid=aNjUKOH1Mjas&refer=bond

July 21, 2006

Broadening the Multi-Strategy Mandate - Where do Hedge Funds end and Private Equity Funds begin?

I don’t think it’s any secret that larger, multi-strategy hedge funds are investing in an increasingly broad (and unusual) array of assets - loans for leveraged buyouts, PIPES and convertible structures for later-stage venture-backed companies, purchase of life insurance payouts and even financing for litigation. Hedge funds are even battling directly in the buyout world, as evidenced by the recent scrap between Fortress and Polygon over the UK-based telecom equipment provider Telent. I wonder what Alfred Jones, the father of the hedge fund industry, would think of these gymnastics. From my vantage point it appears that two principal motivations are driving this phenomenon: (1) reaching for returns in a very crowded and difficult market; and (2) trying to create increasingly non-correlated (read: alpha generating) portfolios when most public-market asset classes, regardless of geography or place in the capital structure, are moving more in lock-step than they have in years. Oh, and by the way, it is also true that private equity complexes are spending more time in hedge-fund land than ever before, whether it is the build-up of Blackstone Group’s highly successful alternative asset management group or Texas Pacific Group’s hedge fund venture with Dinakar Singh in the formation of TPG-Axon. This, in addition to Eric Mindich’s mega-launch of his Eton Park hedge fund, whose offering document I am told provided that up to 30% of the fund’s assets could be invested in illiquid securities. To say that a blurring of the lines between hedge funds and private equity has occurred (and one, might argue, banks themselves, given the increasing role both private equity and hedge fund firms are playing in the first-loan market) is the understatement of the century.

While this is kind of interesting, I think what is more interesting is to look at the structural differences between hedge fund firms and private equity firms and how this might impact performance-based compensation, disclosure and regulation. Private equity firms generally collect commitments for investment, draw on those commitments, make investments, and get paid performance fees as those investments become liquid over time, e.g., perform. Seems to make sense - match the payment for success with the successes themselves. Hedge funds, interestingly enough, grew up differently, as the concept of a “hedge fund” generally meant buying good stuff (long) and selling bad stuff (short) in an effort to minimize the impact of the broad market on performance (beta) and isolating the manager’s skill (alpha). Since this buying and selling, by necessity, took place in the public markets, there were readily ascertainable values for the hedge fund’s positions at each reporting period. It was these values that were used to compute the payment of performance fees (the net asset value or NAV). As long as the portfolio is liquid, fair values are readily observable and, in theory, the entire book could be liquidated at the NAV (absent bid-offer spread). But as I mentioned above the world has changed - a lot. Hedge funds now have portfolios that are a mish-mash of liquid assets, somewhat liquid assets (where one could go and get bids from 5 dealers and obtain a fair value) and totally illiquid assets (where the value is highly subjective a dealer would not be willing to provide a 2-way quote). So how have hedge fund compensation customs changed to reflect these altered portfolio characteristics? Not much.

Now, I am firmly convinced that this trend - hedge funds and private equity firms looking more and more alike - will not stop, and I am also a strong believer in market-based regulation (as opposed to ill-conceived legislation developed by bureaucrats who don’t understand the investment business). But this issue - getting paid on NAV when NAV itself is highly questionable - is a real problem. It looks bad. Real bad. The implications extend beyond compensation. For instance, if you can’t arrive at a fair value for an asset, a “thumb in the air” method is used like book value minus an illiquidity haircut. This approach dear friends, is not very scientific and is extremely prone to error. Beyond error, once an approach is used for a particular asset that approach tends to be used again and again and again. This has two potentially adverse effects upon disclosure and compensation: (1) compensation may be overstated because NAV might be much lower that the level reflected in the NAV calculation; and (2) volatility of returns will be understated since this asset, whose value invariably is moving up and down but whose value is difficult to measure, is being valued in the same way quarter after quarter after quarter. This is called autocorrelation. This skews the analysis of fund returns and makes a fair comparision across different firms and different strategies nearly impossible. Does any of this sound good?

And if the industry doesn’t take steps to address this issue, my sense is that the issue will be dealt with for them by constituencies they’d rather not deal with (read: the SEC or Congress). It is just too big a problem to be ignored, and the problem is growing every day as more funds pile into less liquid assets for the reasons mentioned above. One way to possibly deal with this is to create a fund with two share classes - one which tracks the liquid assets (and therefore has a calculable NAV) and another which captures the illiquid assets (which does not have a readily calculable NAV). The liquid asset class could attract performance compensation in the same way hedge funds are paid today, which is generally quarterly. The illiquid asset class, however, could be treated much the way private equity compensation is handled today, based upon realization of the value of the illiquid investments. A manager could then report two NAVs, one for each share class. This would seem to restore the original intention of hedge fund compensation model, while providing for a better matching of performance generation and performance payment. This would also be a great PR move for the industry, proactively dealing with an issue before it becomes a PR nightmare.

Hedge fund managers are generally super smart and excellent asset allocators. But today’s changed world calls for a new model - a fairer model, a more sensible model. Just as the most innovative managers have been pushing the edge of new and different asset classes, they should aggressively lead the charge in pushing best practices on this rapidly growing and influential industry.

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Comments

Noah, based upon my earlier posts clearly I agree with your first point. My contention has nothing to do with what’s right, but that the issue of portfolio valuation is a “hot button” issue for both the SEC and Congress given the rise of pension dollars into hedge funds. By extension, they view this investment as being on behalf of unsophisticated investors which to me places added pressure on fiduciaries (warranted) as opposed to burdening hedge fund managers with what’s likely to be ill-conceived regulation (unwarranted).

Concerning your second point, I am planning on devoting a separate post to this important issue. If sidepockets were only used for the purpose you described, that would be fine. But this is not what happens in practice. Often sidepockets hold new strategies in incubation whose benefits are not shared with existing fund investors, and can hold “best trades” vehicles for larger investors who are invited to participate but which are not offered to all fund investors. So, to be clear, if sidepockets were limited to illiquid assets held for the benefit of all investors, that would be a possible solution. But I am not sure that sidepockets are always used in this way.

Posted by: Roger Ehrenberg | July 23, 2006 at 06:35 PM

Roger - I have enjoyed your blog which was distributed to me as a member of NYAngels. Two comments on “Broadening the Multi-Strategy Mandate - Where do Hedge Funds end and Private Equity Funds begin?” First, investors in hedge funds are sophisticated types. By law they have to be, or at least say they are. If they feel that they are being ripped off, or not getting enough information from/on the managers they select, then they can simply take their investment capital elsewhere. That is the way the market works and seems to have done a good job so far. Second, there already are many funds that do exactly as you suggest by establishing two differnt NAV’s via a sidepocket for their illiquid investments. Compute the NAV of the sidepocket at cost until realized, and things should be reasonably transparent. If not, see my first point. neg

Posted by: Noah E Gotbaum | July 22, 2006 at 11:07 PM

http://www.informationarbitrage.com/2006/07/broadening_the_.html

Hedge Funds as Asset Management Complexes - The Day Has Come

Yesterday’s story in the FT about DE Shaw making a push into traditional asset management was the straw that broke this camel’s back. The theme of convergence is one I’ve written about on several occasions during my short stint as a blogger. Closely related to this theme is that of the structure of the hedge fund industry in general, which, in my opinion, will increasingly resemble that of a barbell (mega-institutional asset managers on one end and emergent single strategy managers on the other). But come on, a few days ago it was talk of the $20+ billion Fortress Investment Management’s lingering plans to go public (at some say a valuation of, what, $6 billion?!?) and now this? It was the language in the FT story that really made me sit up and take notice:

Trey Beck, who is in charge of developing the institutional business for DE Shaw, said the group, which manages $23bn in hedge fund strategies, had only about $300m in traditional asset management but planned to increase this substantially and had just won three new mandates.

“We are in the [traditional] business to manage tens of billions of dollars, and I can envisage a time when DE Shaw will have traditional asset management funds in excess of the hedge fund business,” he said.

“In ten years’ time it will be less important whether you are a hedge fund or a traditional manager, but whether you can generate alpha [above-benchmark returns]”, he said.

Trey is certainly sounding very institutional, very un-hedge fund like. He sounds like Barclays Global Investors’ describing their Alpha Tilts (index plus alpha) strategy. Let me reiterate; very un-hedge fund like. This is not to say that what DE Shaw is doing is bad or wrong, or that Jim Simons earlier decision to open a long-only strategy at Renaissance is either, only that the hedge fund industry as we know it is changing and will continue to do so.

Take Fortress for a moment. They have special situations, macro, distressed, second-lien financing, and private equity. This, my friends, is an institutional asset manager. All they need is a long-only equity book and they’ll have it all. DE Shaw itself has statistical arbitrage, both quantitative and bottoms-up long/short strategies, as well as Laminar, which does distressed debt investing and which occasionally takes an activist stance in reorganizations. I am sure they have other strategies under that massive umbrella as well. With the inclusion of a long-only (or primarily long with a limited ability to short) strategy of scale, DE Shaw itself will become a diversified asset management complex. But why?

Let me offer a few possible reasons:

1. Legacy: Managers like Jim Simons and David Shaw (not to mention Wes Edens and his partners) want to build something that will last beyond their personal involvement. By creating a diversified array of strategies and delegating a sufficient amount of investment and risk management control to their portfolio managers, one can envision a DE Shaw, a Renaissance or a Fortress being successful long after their rock star founders have moved on.

2. Scale: Long/short strategies, by their nature, do not have massive capacity. The short side is forever a constraint that weighs on asset growth beyond a certain threshold, depending upon the capitalization and float of the stocks being shorted. Long-only (or principally long-only) strategies have the benefit of growth far in excess of that of conventional hedge funds; one only need look at the monster funds run by Capital Research or Fidelity to see how performance can be maintained in the face of scale on the long side. Jim Simons said his long-only strategy had capacity of $100 billion. Even without the performance fee that kind of cash flow looks pretty good.

3. Addressing a market need: Top performing managers running high quality, institutional-caliber infrastructures are not easily found. DE Shaw is one of those managers as is Renaissance. There is, quite simply, excess demand for their services. Given the constraints mentioned above concerning scalability of long/short strategies, it stands to reason that they would look beyond their principal areas of focus to address this burgeoning demand. Further, given that they are both quantitatively-oriented shops, it is not a leap for them to adapt their algorithms to a long-only model. This is smart from a business sense and neatly helps to address points (1) and (2) above.

This emergence of the institutional asset manager from traditional hedge fund roots is a new thing and, I believe, a positive thing both for these firms and for their clients. I am very confident in saying that this won’t be the last we hear of top hedge funds making the leap into the long-only domain, with the consequence being the development of a hedge fund uber class that dominates the alternative investment landscape.

August 14, 2006

http://www.informationarbitrage.com/2006/08/hedge_funds_as_.html 

http://nerdsonwallstreet.typepad.com/my_weblog/2007/04/stupid_data_min.html

April 10, 2007

Stupid Data Miner Tricks

This collective web thing actually works. I got an email from ace quant investment manager John Bogle who’d seen a post from  Paul Kedrosky.  Both were looking for a copy of Stupid Data Miner tricks, a paper in the current Journal of Investing.

The JoI is not fully onboard the “information wants to free” train, so as a good citizen of the interweb series of tubes, I’m depositing an earlier version right here. Download dataminejune_2000.pdf

Here’s the introduction:

Disraeli’s warning that “there are three kinds of lies: lies, damn lies and statistics”  is particularly true when too much computation is applied to too little data. This paper presents some egregious yet instructional examples of data mining, and describes ways to avoid similar mishaps.

It started out as a set of joke slides showing silly spurious correlations over ten years ago. These statistically appealing relationships between the stock market and diary products and third world livestock populations have been cited often, in Business Week, the Wall Street Journal, the book “A Mathematician Looks at the Stock Market”, and many others. Students from Bill Sharpe’s classes at Stanford seem to be familiar with them. This was expanded, to have some actual content about data mining, and reissued as an academic working paper in 2001. Occasional requests for this arrive from distant corners of the world. So I’d like to thank the editors of the Journal of Trading for publishing this.

Without taking a hatchet to the original, the advice here is still valuable, perhaps more so, now that there is so much more data to mine. Monthly data arrives as one data point, once a month. It’s hard to avoid data mining sins if you look twice. Ticks, quotes, and executions arrive in millions per minute, and many of the practices which fail the statistical sniff tests for low frequency data can now be used responsibly. New frontiers in data mining have been opened up by the availability of vast amounts of textual information. Whatever raw material you choose, fooling yourself remains an occupational hazard in quantitative trading.

PS - DIY dataminers will want to check this: http://swivel.com/

December 26, 2006

Hedge Fund Convergence: Strategy versus Structure

Strategy convergence across asset management firms in general and hedge funds in particular is one of the most important and defining trends of the past year. This was most recently highlighted by DE Shaw’s increased investment in building a true private equity operation within the $23 billion hedge fund behemoth. And it is, without question, a trend that will continue for the forseeable future. Given its potential for substantially re-shaping the asset management landscape, I have written about several issues either impacting or impacted by the convergence phenomenon over the past six months:

1. 12/07/06 - A Tougher Gate at DE Shaw: Investor Protection vs. Opportunism
2. 09/15/06 - Fortress Going Public? The Writing’s On The Wall
3. 08/14/06 - Hedge Funds as Asset Management Complexes - The Day Has Come
4. 08/04/06 - Side Pockets - Use or Abuse?
5. 08/01/06 - Convergence Redux
6. 07/21/06 - Broadening the Multi-Strategy Mandate - Where do Hedge Funds end and Private Equity Funds begin?

Gating restrictions, strategy diversification, institutionalization, side pockets, blurring of the lines between hedge funds and private equity are just a subset of the issues arising from this transformation. To be clear, this is a very complicated, multi-faceted topic. And I’d like to introduce a new, yet critical distinction to the discussion: strategy convergence vs. structural convergence. While strategy convergence is clearly taking place, structural convergence appears to be lagging behind, with serious implications for investors.

For purposes of this post, let me define these terms as follows:

Strategy convergence - hedge funds investing in progressively less liquid assets with private equity firms investing in progressively more liquid assets, leading to a blurring of the historical distinctions between hedge fund and private equity investing

Structural convergence - hedge funds and private equity firms investing in a similar array of assets, with incentive fee/lock-up/redemption characteristics based upon the nature and liquidity of the assets being managed, i.e., quarterly payment of incentive fees on liquid pools and realization-based payment of incentive fees on illiquid pools

The bottom line is - strategy and structure are different, and is something that will need to be reconciled as convergence continues to take root. I believe it is knowledge of this disparity - in structure, in compensation, in liquidity, in culture -  that pushed Jeff Larson’s Sowood to separate its private equity activities from its (conventional) hedge fund activities. Why? Because there are very good reasons for why hedge fund and private equity structures have evolved they way they have, and are largely centered around the nature, liquidity and investment horizon of assets in the portfolio. And this distinction has been known for quite some time, probably most commonly manifested through the use of side pockets by hedge funds for certain illiquid investments (which are separated from the more liquid, main fund).

But if hedge fund and private equity assets are commingled in order that structure becomes blurred, it is not hard to imagine how the deck eventually becomes stacked in favor of the hedge fund manager. Why? Because hedge fund managers generally receive quarterly incentive-fee payments versus private equity managers receipt of realization-based incentive fee payments, regardless of the characteristics of the assets in their portfolio. And why is this? Let’s first explore the natures of the key risks facing both hedge fund and private equity managers, and then figure out the impact of convergence on these risks. Three of the principal risks facing investors in hedge funds and private equity funds are liquidity risk, timing risk and redemption risk.

Liquidity risk: In conventional hedge fund investing, much of a portfolio could be converted to cash without much trouble. Assets are marketable, there are buyers, sellers and observable prices, and, if need be, can be sold and distributed to investors. This is clearly not the situation with private equity investing. Therefore, all things being equal, would an investor prefer a dollar of returns from a portfolio of assets readily convertible to cash or a portfolio of assets with highly uncertain realizable values? It stands to reason that an investor would place greater value on returns generated from a portfolio with substantially less liquidity risk, arguing for more regular and even potentially higher hedge fund incentive payouts than private equity incentive payouts.

Timing risk: An issue somewhat related to liquidity risk, but different still. Even if one holds a portfolio of liquid assets but chooses to hold on to them for a long time, risk is higher than if one were able to monetize the portfolio more rapidly. It just happens to be that private equity investors, in general, don’t have this choice. They can hold onto investments for years on end, by necessity. Conventional hedge fund investors, conversely, have far shorter investment horizons and, therefore, less timing risk. If you think about it, the ultimate investment strategy would be a super high frequency statistical arbitrage program that exploited a broad array of price anomalies across liquid markets thousands of times each day, and ended up net flat at the end of trading (meaning no overnight exposure). This is a strategy that requires little capital, possesses almost zero liquidity risk and almost zero timing risk - in essence, a cash machine. I’ve known some guys that have done this on relatively small amounts before getting squeezed by other market participants, and it is a beautiful thing. But this isn’t reality. Fact is, conventional hedge fund investing has vastly less (though clearly non-zero) timing risk than private equity, and this is yet another reason why one would expect hedge fund incentive fees to be paid more frequently and even trade at a premium to private equity fees.

Redepmtion risk: Clearly related to liquidity and timing risk, redemption risk relates to how easy/difficult it is for an investor get his/her money out of a fund. With conventional hedge funds it stands to reason that redemption terms should be pretty flexible, as the portfolio’s nearness to cash and the shortness of the investment horizon argues for redepmtion on, say, a quarterly basis. This is in stark contrast to private equity funds, which hold principally illiquid assets that can’t be readily converted to cash under almost any circumstance. Therefore, one would believe that it would be almost impossible to redeem a private equity fund in advance of its maturity, as the illiquid assets need to be converted to cash over time in order to generate returns and distributions for investors. This would also make an investor more willing to pay hedge fund incentive fees more frequently than private equity incentive fees.

Other differences exist, but these are three of the big ones. So given the disparity in nature between hedge fund and private equity investing, what is the problem? The problem is that the risk profiles of hedge funds and private equity funds are beginning to converge, rendering the historical distinctions in incentive compensation and redemption structures obsolete. And this is neither a trifling distinction to the hedge fund investor nor the IRS, which appears to be waking up to convergence (read: hedge funds investing in increasingly illiquid, less marketable assets) which could threaten the favorable “trader” tax treatment afforded hedge funds under IRC Section 162.

And as institutionlization of the hedge fund marketplace continues to progress, it is not hard to see how the most powerful and desirable institutional investors begin to clamor for separate fund structures, compensation schemes and redemption provisions based upon portfolio risk profiles, not whether they are managed under the rubric of a “hedge fund” or a “private equity fund.” If a hedge fund is investing in PIPEs, doing venture capital financings, investing in LBOs and other less liquid activities, does it stand to reason that they should be receiving quarterly incentive fees based upon a mark-to-market(?) figure for net asset value? Why should their compensation scheme be any different than the private equity funds realization-based model for these types of investments? Answer: they shouldn’t. And this is the rub.

Hedge fund? Private equity fund? These are increasingly artifical distinctions that will eventually be expunged from the investment vernacular. How about “alternative asset managers?” Can you tell me where hedge funds end and private equity funds begin, and vice versa? I can’t. So let’s stop using language and labels that mis-represent what’s really going on here. There is a race for alpha, a somewhat small group of investment professionals that will be able to lay claim to this alpha and a limited number of ways of realizing this alpha. And given the flood of assets into the alternative investment asset class, these professionals will increasingly be pushed to use their skills - be they investment, management, legal, etc. - in other areas. And institutional investors want this. But my betting is that they won’t be willing to live with the asymmetry between hedge fund compensation structures and illiquid asset investing. They just won’t. They might today. They might tomorrow. But they won’t over time. Just my two cents.

http://www.informationarbitrage.com/2006/12/hedge_fund_conv.html 

Introduction to Credit Derivatives

• By Anders Sjöman, George Chacko, Vincent Dessain, Hideto Motohashi.
• Sample Chapter is provided courtesy of Wharton School Publishing.
• Date: Jun 9, 2006.

Investors face all sorts of risk and not just credit risk. Grouping risks into different “baskets” helps investors choose which type(s) of risk to accept and which to leave for other investors. They might try to minimize company-specific risk through diversification, or use long-short strategies to cancel out market risk as they speculate on converging prices for individual securities. Interest rate risk is a common concern for anyone else looking to finance a large project. Investors who consume in one currency but invest in another are exposed to currency risk.

This book, however, addresses none of these risks. Instead, it focuses on another important risk that is often borne by investors, namely the risk that a company or individual cannot meet its obligations or liabilities on schedule: credit risk.

Part I, “What Is Credit Risk?,” covers the basics of credit risk. It defines what credit is, what facing credit risk might entail, and also gives a short overview of some common credit derivative tools that transfer credit risk from those investors who do not want to bear it to those investors who are willing to accept it. The two chapters also discuss concepts such as default probabilities, recovery rates, and credit spreads.

After the introduction, Part II, “Credit Risk Modeling,” then goes into detail on how credit risk models can be used to describe and predict credit risk events. It covers three different approaches to modeling credit risk: the structural, empirical, and reduced-form approaches. Chapter 3 focuses on structural models. It features the Merton model as an example of the approach, and also discusses the Black and Cox, and Longstaff and Schwartz models. Chapter 4 looks at empirical models, especially the Z-model, and reduced-form models, such as the Jarrow-Turnbull model.

Part III, “Typical Credit Derivatives,” concludes the book by discussing in detail two specific credit derivative instruments used to transfer credit risk. Chapter 5 looks at credit default swaps (CDSs) and Chapter 6 at collateralized debt obligations (CDOs).

Credit Derivatives: A Primer on Credit Risk, Modeling, and Instruments