Monday, October 20, 2008

Through the Looking Glass

I don’t have to tell you that the investment world has gone somewhat insane since I wrote you a month ago. Imagine a margin call has been made on the entire economy, because that’s what’s happened. Our final number for September was down 6.25%. Amazingly, this was about in line with the hedge fund industry. Please note that this is a bit worse than the flash estimate we sent out about a week ago. This is simply because some of our underlying funds revised their numbers. That doesn’t happen often, but neither does a market like this. I was working at Salomon Brothers when the market crashed in 1987. That had an end-of-days feel to it as well, but it passed in a single day. For those in the financial industry – those left – and for investors in general, this has been much harder to stomach. I would anticipate that 25-30% of Wall Street will be laid off in the next six months, and perhaps 3000 hedge funds will throw in the towel. Neither of these are tragic events, macroeconomicly speaking, since the financial industry had become bloated, but there are scores of innocent people involved.

I get annoyed when I hear people talk about the Wall Street “bailout” plan. No one on Wall Street is getting bailed out, they’ve all been taken out and shot. I’m told that one Hamptons broker got nine new listings in a single day. While we may not weep for someone who is selling a summer house, the underlying reason is often that those individuals have been wiped out. Many people on the Street - people we know - are contemplating a vastly changed life, and only a very few had anything to do with our current predicament.

Still, if you have read these letters over the years, you know me to be an optimist, and that’s not changing now. Yes, we will have a recession (likely inflationary), but not a depression. Bad policy turns recessions into depressions. In the 1930s we tightened the money supply, reduced free trade, and raised taxes, all measures that reduced much needed liquidity. Today, we have a global policy response to reduce interest rates and inject liquidity. As of this writing, it appears to be slowly working. I do worry that Obama wants to raise a number of taxes including capital gains, and he is anti-trade as well. Moves in this direction, if he follows through on them, would be serious blunders. I suspect that recent events will undermine his ability to move in this direction (not to mention undermine his ability to implement enormous spending programs like universal healthcare).

Yes, there are more shoes to drop, including the CDS market, about which I warned in last December’s letter. But many things differentiate this from the 1920s or even the 1970s. For one, we always underestimate basic human ingenuity and its ability to transform society and create wealth. Every so often I find it useful – and reaffirming- to think about the incredible technological changes that have occurred since I got out of college. Heck, in 1984 the fax machine seemed miraculous. Where will the next incredible innovations come from? Biotech? Nanotech? New innovations that arise from a 100 fold increase in computational power? The answer is all of the above. Bad government can slow this process but not impede it entirely the way it once could. People and capital are much more fluid than they used to be.

The market has also turned its attention more towards the prospects of a bad recession and away from the credit crisis. Believe it or not, this is a good thing. Recessions come and go, but a possible total collapse of the international banking system definitely counted as peering into the abyss. If – if – we are passed this, then we have much less to worry about.

So life, and markets, will go on. Those that sell now will join others selling in a panic. How often does that work out? I think you know the answer. Securities of all kinds are getting terrible marks. Locking them in by selling isn’t likely to be a winning strategy.

Once we reach the far side, we will be in far better shape as an economy as all the leverage will have been wrung out of the system. I don’t know if you remember my letter of a few months ago where I spoke of visiting Indonesia. In 1997, the Indonesian currency, the rupiah, lost over 90% of its value. Can you imagine how calamitous it would seem if that happened here? Yes, the Indonesian economy suffered for a few years but today, rid of its excesses, it thrives.

There’s also a lot of money around. That certainly wasn’t the case in the 1920s or the 1970s. The sovereign wealth funds are loaded. Individuals have been liquefying. There have been billions of dollars raised for distressed funds over the last few months. There is money to come in and start buying. Which leads me to my next point…

The craziness has led to the most remarkable bargains we have seen in our lifetimes. This is what happens when you have forced liquidations. For example, you will recall we have an investment in a manager that buys SPACs, which are basically t-bills sitting in publicly traded trusts. Right now, because they have sold off, you can buy these with an implicit yield of 15%. Imagine, 15% t-bills! Actual t-bills yield close to zero. How could this be? It turns out that convertible arbitrage hedge funds were the biggest owners of these securities. These funds were just killed in September and are now facing massive redemptions, so they have been selling whatever they can, which includes SPACs. There are few buyers to be had.

Goodbye, Beta People

In the fund world, beta is what the market gives you, either a wind in your sails or in your face. Alpha is return attributable solely to skill. We had an interesting discussion in our office about how there are “alpha people” and “beta people” on Wall Street. In bull markets, Wall Street creates legions of beta people, who prosper because they were assigned to a fortunate desk out of their training programs. It’s always good to be in the right place at the right time, but nowhere so much as Wall Street. Naseem Taleb wrote about this at length in his first book, “Fooled by Randomness.” Well, the beta people are toast. The bloodletting has only just begun. I suspect a lot of alpha people – those who really create value – will get caught up in occupational violence as well, but they should fair a lot better.

What Would Sir John Do?

The late John Templeton was a long time client of mine, and a great man. My annual trips to the Bahamas to see him were ostensibly about my teaching him about what we were doing, but really most of the teaching went the other way. The recent turmoil reminded of something he said to me once. “Scott, I like to help people,” he began. As Templeton was one of the great philanthropists of our time, I expected to hear about his latest charitable initiative. “When they are desperate to buy,” he continued, “I like to help them by selling. And when they are desperate to sell, I help them by buying.”

Had Sir John lived another year, I don’t doubt what he’d be doing right now.

The Emergence of a New Asset Class?

Normally, hedge funds are the most nimble of investors. When market inefficiencies occur, they are often in the best position to exploit them. Right now, because of all the forced selling, there are more blatant market inefficiencies than at any time in our lifetimes, the kind of opportunities hedge funds can only normally dream about. Except, hedge funds are facing their own redemptions, so they are actually among the investors being forced to sell positions at crazy valuations (as in the example I gave with the convertible arb funds selling SPACs). The irony abounds.

What if a fund didn’t have to deal with any redemptions? That fund would be in pig heaven right now. The fact is that many wonderful trades sometimes need time to season. Liquidity providers almost always do better than liquidity consumers. This is something the endowments figured out a while ago. This leads me to how I believe the hedge fund industry must reinvent itself. The new model will have less leverage and longer lock-ups, probably two or three years. In essence, there will be a new asset class between the traditional hedge fund model and the private equity model. There will be the added advantage of emphasizing a longer period over which investors should judge returns. People simply have to be weaned of this need to see steady positive returns every month. I’ve been trying to come up with a catchy name…hybrid funds? Middie funds? Feel free to submit your ideas – perhaps we can name an asset class.

The product will be somewhat difficult to sell, as investors like liquidity (as such, overpaying for it). That’s why these new funds should have a lower fee schedule, probably 1 & 15. That would be a fair deal all around.