Sunday, January 25, 2009

Hedge Fund Outlook for 2009 - Say What?

If there was one over-arching lesson from 2008 it might be that every time we – I use a society-wide “we,” here - think we have learned how to control risk, we discover we haven’t. But how can we, really, if risk is tied to the market’s animal spirits, something that will never be quantifiable since it is wholly a bi-product of the human psyche.

But frankly, what scares me more than risks we can’t control is the current impulse, from a governmental point of view, to try and do just that. Free market capitalism is still the most efficient and moral way for a society to organize itself, so one fears there may be medicine coming that, in the desperation for “an answer,” turns out to be worse than the original problem. Beltway panjandrums are surely enjoying this sudden windfall of authority. This is disconcerting, because the halls of Congress are not burdened with economic literacy. You might respond that this affliction runs high on Wall Street as well, to which I would say, touché. Like William Goldman once famously said of the movie industry, no one knows anything.
Let’s pretend we do and turn our attention to what’s ahead.

The Outlook for hedge funds...

Let me start this with something that will sound, on the surface, somewhat shocking: the outlook for hedge funds for the next few years is as favorable as I can imagine. Notice I did not say the outlook for the hedge fund industry, for that’s another matter. No one’s head is in a place, psychologically, where they’re ready to hear this, so the industry as a business will continue to suffer. However, as I ponder what drives hedge fund returns, I can come to no other conclusion than we are entering a multi-year period of 20%-like returns, starting probably after the next redemption cycle is complete at the end of March. Let’s go through the salient points:

1. Market volatility is high, but not crazy-high. Hedge funds like volatility because it causes investors to make sub-optimal decisions which, in turn, create price inefficiencies. Mind you, volatility like October’s – where all security prices are affected indiscriminately - makes it near impossible for anyone to operate. But this is very rare. Plain vanilla high vol is a good thing.

2. Somewhat related to the previous point, market inefficiencies are as glaring as I’ve ever seen. Bonds priced like the whole world’s going bankrupt, munis trading way cheaper than governments…it’s a long list. Understand that it’s not just that prices are cheap, it’s that they don’t make sense, particularly when compared with each other. This contrasts markedly to the generally “efficient” market we saw during the bull market.

3. Borrowing costs are at an all-time low. Almost all hedge funds borrow money to one degree or another. If a fund borrows 1-1 on its portfolio, a two point reduction in margin rates results in a two point improvement in its performance, all other things being equal. Almost no one is pointing this out.

4. The competition has gone ka-blooey (little bit of industry lingo, that). This is the biggest point of all, so just in case you forget points 1 -3, remember this one.

When I ran my own hedge fund, I got out in ’06 because there was just too much money in my strategic space. In my case it was quant, a sector that was being overwhelmed by the likes of DE Shaw and Renaissance. But the same thing was happening across all hedge fund sectors. Too much money reduces opportunity and increases risk. This is particularly true of spread-driven arbitrage strategies where everyone is looking at the same trades. But now the opposite is occurring.

Let me take you through some numbers as estimated by Peter Douglas, an industry professional based in Singapore. He estimates that until a few months ago, there was $6 trillion of “alpha seeking” capital in the world, $4 trillion of which was on bank proprietary trading desks and $2 trillion in hedge funds. The hedge funds, he figures, were levered 3 – 1 (on average) while the prop desks more like 20 -1 (if that seems like a crazy number, consider that Bear and Lehman were levered, as institutions, 30 -1). Do the multiplication and you get to $86 trillion of hedge-fund-like money in the world. No wonder it was getting tough to find good trades!

Douglas predicts a third of the hedge funds are vaporizing as well as 75% of the prop desks. This brings the number down to $24 trillion. But don’t stop there. Whoever’s left in the game will have delevered considerably. Douglas guesses hedge funds take it down to 1 1/2 – 1 and banks 10 – 1. This brings our number all the way down to $12 trillion, an unfathomable 86% decrease.

You can quibble with the numbers a bit if you want, but people I talk to think that he may even be underestimating by a bit. Whatever, the industry has all but disappeared, which makes me naturally think of…Bubba Gump Shrimp.

Shrimp Creole, shrimp gumbo, coconut shrimp…

I’m sure you saw Forrest Gump. If you didn’t, there’s a scene where Forrest and a friend, who have scrapped together some money to buy a shrimp boat, take it out in the middle of a hurricane. While this seemed foolish, all the boats tethered to their docks are smashed to bits, and Forrest finds himself with the only boat in the Gulf. All the shrimp were theirs for the taking, and the Bubba Gump Shrimp Company went on to riches and fame.

We’ve been pondering this a great deal in our office. Those able to stick around in the hedge fund business will get all the shrimp or, more precisely, feast on spreads big enough to drive a truck through. It will resemble the early-middle 1990s, the days before your cleaning lady quit to start a fund.

Interestingly, this bull market for hedge funds is likely to occur while the stock market goes nowhere. I don’t pretend to know where stocks are going, but this recession will be long and deep, so it’s hard to make the case for a bull market anytime soon. Big trading rallies, sure, but not a secular bull market. (Of course, as a naturally bullish person, I recognize my own possible utility here as a contrary indicator.)

Many people want to know how long the economic pain will last. First, let me say, that we no longer appear to be staring off the edge of the cliff the way we were in October, when we had a global counterparty crisis that could have ended much worse than it did. Think a run on all the world’s banks. It was close, maybe days away. Now, it’s not as if everything’s better, but at least it’s a problem that we can get our arms around, namely a recession. Recessions, unpleasant they may be, are a part of life. We’ve had them before, and we’ll have them again. This one will be a bad one, for sure, but at least the world’s not coming to an end.

So how bad will it be? I find a good starting point is some historical context. Here is what the recessions have looked like for the last 100 years or so:

Note that the average recession lasts 13 months. Our current recession actually started in December, 2007. I know it feels like it just hit this fall, but that’s the reality of it, according to the National Bureau of Economic Research, which means by February this recession will already be long in the tooth. Also note that with current unemployment rate of 7.2%, we have almost reached the average on that score as well. But no one thinks this recession is going to be average.

Our longest recession was actually the Great Depression at 43 months. I’m going to say this one will last 20 months or so, which would make it the longest since. But this means we’re out of it by July. Why do I say this? I am but an armchair economist, after all. But there’s just too much stimulus being thrown at the problem for the economy not to stir. In the Depression, they raised taxes and cut the money supply, both painful mistakes. Lesson learned. Bernanke, a student of the Depression, will juice the money supply like never before. He knows that given a choice of a bad recession and a depression, you take the bad recession every time. And Obama looks like he won’t raise taxes any time soon, despite his original plans. So, all in all, some nastiness for ’09 with 8-10% unemployment, if I had to guess.

It’s an open question, though, as to what awaits on the far side. Unfortunately, I don’t think it’s a v-shaped recovery. All in all, it looks a lot like…

The Me Decade

It’s always worth remembering Twain’s famous quote about how while history never repeats itself, it rhymes. In that spirit, let’s hope we see no more album covers like the one above (side note: the guy in the middle is my Congressman, whom, on account of my highly developed sense of fashion, I could not support). But there are some looming similarities between now and the 70s that are too pressing to ignore. The one that sticks out for us is the prospect for inflation. My partners and I think 10% inflation is possible a year or two out. (We don’t always agree, but we agree on this.) The printing presses will be working overtime to pay for everything that’s being promised. Many are also forgetting one other thing: the tidal wave of baby boomer entitlements that looms in the not-too-distant future. Keep those presses humming!

Another way to think of it is to ask yourself, who wins and who loses when inflation accelerates? In a nutshell, borrowers win, and lenders lose. Think of inflation as a wealth transfer from lenders to borrowers. Who is the biggest borrower in the world, and getting bigger by the second? The U.S. Government. Who is the biggest lender? After us, it is Japan and China. From a purely self-interested point of view, what would you do, if you were the U.S. Government?

Wednesday, January 21, 2009

Travelogue - Houston

Despite knowing a number of people here, I had never before traveled to Houston, America’s fourth largest city (a fact oft quoted here and little known elsewhere). After two days of meetings, lunches, and dinners, it’s clear that this is a town with its own rhythms, economic and otherwise. It is reassuring to know our whole country is not a complete slave to the same economic cycles.

Not that it’s all wine and roses here. Houston can’t stomach a 78% drop in oil without catching a cold. But this is a town that remembers well the boom and bust of the 70s and 80s and has modified its behavior accordingly. No one here thought $147 oil was going to last. A more cynical view might be that the run-up in oil was so fast that no one had a chance to make stupid lifestyle decisions. Either way, the real estate market here has held up and the restaurants are full.

As a free-marketer, it’s hard not to have some affection for Houston. There are no zoning laws, for instance. What sounds (to some) like a recipe for developmental chaos somehow self-organizes in a way that makes sense, and it also removes an entire layer of political corruption. Also, nearly everyone I met felt it important to tell me that Houston is a true meritocracy; come, work hard, succeed. They note that this is very different from Dallas and many other southern cities.

Nearly everyone here is a civic booster, which is refreshing coming from New York, a city that elicits complex emotions from its own even in the best of times.

Last night I attended a large black tie fundraiser to mark the awarding of the Dr. Denton Cooley Award to Dr. Michael DeBakey. Cooley and DeBakey are two of the giants of the medical world, and both are based here (where there is a huge medical research community). In recent years, a great feud had erupted between them, something everyone around the world with any connection to the medical community apparently followed like a soap opera. In Houston, the feud had practical implications because it hampered collaborative research.

In recent months, they reconciled at long last. The award, from one to the other, was to make it “official,” but sadly, Dr. DeBakey died just before he could receive it, so it was awarded posthumously.

Dr. Cooley is quite a character himself. He was once allegedly asked who the best surgeon he’d ever seen was, and he replied, in full drawl, “Well I am, of course.” Frustrated, the interviewer asked who the second best was.

“Me, when I’m drunk.”

Tuesday, January 20, 2009

Madoff/Fairfield Update

I rushed out a letter on this subject last month and I’m thinking it got circulated around a bit, as I subsequently saw many references to Madoff’s golf scores, and now many others seem to be calling the Fairfields and Tremonts “enablers” as well. My view on the affair hasn’t changed: con men come and go, but it was irresponsible third party fund raisers who made this one the biggest con job in human history. Few end investors bothered to do due diligence themselves on Madoff since such respectable groups had presumably checked him out.

What’s kind of interesting, sociologically, is how big this story remains. The media are breathless, and bloggers are ferreting out every conceivable angle. I personally know a score of people who are addicted to every new scrap of new information, and they are not disappointed with what each new day offers. Just the other day it was revealed that Madoff’s own sister lost a pile. Wow, that is cold. And just yesterday, a small item on Fairfield Greenwich jumped out at me. They had a close relationship with Union Bancaire Privée, a Swiss bank that had its own Madoff feeder fund. Apparently, three of Fairfield’s other funds-of-funds - the ones that theoretically had nothing to do with Madoff - had money in this feeder. Huh? Fairfield had direct access to Madoff, so why would it pay someone else for access? One guess is that it was some kind of quid quo pro arrangement; Fairfield and Bank Privée did business on a number of levels, so perhaps they were getting a fee break somewhere else, perhaps on advisory services their management company was receiving from Privee. Very bad. Another possibility is that this was a way to channel money to Madoff from other Fairfield funds without letting this fact be completely clear to investors (i.e. ones that had possibly taken a pass on the direct Madoff feeder). Also very bad.

Fairfield’s already the subject of three class actions on its Madoff feeder (the Sentry Fund). Me thinks the other investors will sue also once they figure all this out. I harp on this because these “feeders” have given the entire industry a black eye and they deserve whatever’s coming to them.