If the actions of some of the hedge fund industry’s leading managers is any indication, the attractiveness of gold as an asset class is on the rise.  Several recent disclosures support such a conclusion.  First, a recent survey performed by London-based researcher, Moonraker, found that 20 out of 22 hedge funds had added exposure to gold bullion to their portfolios.

In addition, well known managers John Paulson of Paulson & Company, Inc. and David Einhorn of Greenlight Capital have upped their stakes in gold this past year.  Paulson, who will soon start a hedge fund aimed specifically at gold investments, has swallowed up shares in mining groups AngloGold Ashanti and Gabriel Resources.  AngloGold currently represents his fourth-largest holding at $108 million, while SPDR Gold Trust represents his largest holding, at $2.87 billion.  Likewise, Einhorn has reportedly resorted to purchasing and physically storing a sizeable position in gold, citing the cost effectiveness stemming from reduced fee exposure.

What, if anything, can investors glean from such information?  For starters, it is safe to assume that money managers are using gold investments as a hedge against the fluctuating value of the dollar.  Recent actions by the Federal Reserve to inject liquidity into the monetary system, as well as the funding of massive bailout and stimulus projects supported by the Obama Administration will likely place future downward pressure on the value of the US Dollar.  However, predicting the timing of such a drop in value is difficult, and depends upon a wide range of economic variables.  If one thing is for certain, the aggressive moves of Paulson and Einhorn suggest that the time to move into gold is right now.

Second, by claiming such massive stakes in gold, hedge fund managers may be steering clear of traditional equities.  As Market Folly reports, Einhorn claims “almost no net long exposure to equities.”  Such a position does not represent a vote of confidence for the broader stock market indices, and his comment may even hint that equities are currently overbought.  Moving into such a liquid investment as gold may hint a belief that we are in for a bout of market volatility in the near future.   Equities investors, particularly those with shorter time constraints, may want to take heed.

If the actions of some of the world’s leading investors is any indication, it may be worthwhile to reexamine your portfolio’s exposure to gold.  Given the enormity of our current fiscal, monetary, and economic concerns, such a position could add a safe and effective hedging option to your investment mix.

Tags: gold investments, hedge fund, Not Categorized, start a hedge fund

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The market downturn last year has led mutual funds to begin testing new strategies to produce gains with lower risk. Many managers are trying to replicate the methods used by long/short hedge fund managers. By finding negatively correlated positions, fund managers are able to offset losses with gains from other assets in the portfolio.

“130/30” Funds

“130/30” funds short securities valued at 30% of the value of the assets in the fund, and can use the proceeds to purchase long positions in other securities, allowing the fund to invest 130% of the fund’s value in a long position. For instance, if the fund manager believes Visa is a superior stock to Mastercard and has a $1,000,000 fund, he could short Mastercard for $300,000 and use that $300,000 plus the $1,000,000 he has in the fund to buy $1,300,000 in Visa stock. Now the fund manager has a net $1,000,000 long position because he is holding $1,300,000 in a long position and $300,000 in a short position.

If the assumption about Visa outperforming Mastercard is correct, and the market is up, The gain on the extra $300,000 in the long position is higher than the loss on $300,000 short position. If the market is down, the gain on the $300,000 short position will be higher than the extra $300,000 in the long position and offset some of the loss on the whole long position.

Market Neutral Long Short Funds

A long/short fund can be similar to market neutral funds if the size of the investments in the long position equal the short position investments. For example, if a long/short fund manager believes that Coca Cola is a better stock than Pepsi Cola and puts $1,000,000 into a long position on Coke and sells another $1,000,000 in a short position on Pepsi, he has taken a market neutral position because he has net zero position.

Downside to Long/Short Strategies

The purpose of a long/short fund is to create stable returns, but there is a downside. In the Visa/Mastercard example above, the long/short fund doesn’t make nearly the amount of gains as a long position during an aggressive bull market. Also, the profitability of a long/short fund is predicated on picking one investment to outperform the other. Like market neutral funds, there is the unique risk in long/short positions called “beta mismatch”. If the beta of the long position is larger than the short position, a market downturn should cause the long position to lose more, as market moves affect the long position more. Furthermore, if the beta of the short position is larger, a market upswing should increase the short position’s loss more than the long position’s gain.

Paired Trades

While long/short funds can be used to decrease market risk, fund managers can reduce other types of risks by making “paired trades”. Using the Coke/Pepsi example from above, the fund was protected whether the market moved up or down. Also, the fund was protected even if the soda industry moved up and down. By using this “paired trade” model, fund managers can hedge against market swings in particular sectors, industries, regions, and currencies.

Read Part 1 Mutual Funds Emulate Hedge Fund Strategies

Read Part 2 Market Neutral Funds

Tags: 130/30, Beta Mismatch, hedge fund, Hedge Fund Strategies, Investment Strategies, Long/Short, Market Neutral, Mutual fund, Mutual Funds, Not Categorized

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Emerging markets have seen explosive growth over the past decade, but with the recent contraction in the global economy, investors have a chance to look at real growth in individual markets. There is no doubt in my mind that the boom over the past couple of years in some countries were due to insatiable

investors overbuying in whatever country the talking heads mentioned. However, as the global economy worsened over 2008 and the first part of 2009, investors switched from the greed mentality and into a fearful and defensive position. Investors began pulling capital out of the emerging markets around the world, and what is left in these economies is real growth in GDP.

Investors now have a chance to analyze the fundamentals of the emerging markets and look for real potential value. Some of the markets stood up, while others folded to the economic pressure. MSCI Barra provides country specific indices based on equities listed by a specific country. The MSCI China Standard Core and the MSCI Brazil Standard Core have already doubled from their lows in October and November respectively. China is up almost 10 percent for the past year, but Brazil is down 13 percent over the same period. The MSCI India Standard Core is up almost 100 percent since its low in March of this year but is down almost 10 percent since August of last year. India has made it difficult for individual foreign investors to invest in Indian equity. Russia is struggling to recover as the MSCI Russia Standard Core is down almost 50 percent from this time last year.

As the market has started recovering over the past couple of months, many of these emerging markets are recovering quickly. Most of the emerging markets listed by MSCI are up 30 to 60 percent year to date, but hopefully investors will be weary of overbuying into emerging market funds just because it’s trendy. Hopefully, as a global society, we can stop to get our breath and think about building the economy back based on innovation, ingenuity, and real growth.

Tags: Brazil, China, Emerging Market, etf, hedge fund, Index, india, Not Categorized, Russia

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 The HedgeCo Q & A Board provides a forum for parties interested in the hedge fund industry to share information. Questions range from people trying to understand what makes hedge fund different from mutual funds to how to calculate complex statistics for portfolio performance. Here is a summary of five of the most popular questions.

 Every industry has its excesses. If you had to name one for the hedge fund industry what would it be?

I’m going to post the answer given by Richard Wilson: “Besides the total number of hedge fund managers possibly approaching excess, I would say base management fees run high. They are typically 2% of total funds managed and I think that should come down to 1 or 1.25% or hopefully 0. If you are out there to make money for your investors than take it to the next level and only charge for positive performance.”

However, I would contend that while 2% management fees are high, large amount of the actively managed mutual funds approach 2% management fees, and managed accounts often are much more expensive when you include introducing broker fees.

Rather, leverage is an excess I would like to see fund managers cut back on. Leverage is not categorically risky, but in the past some of the excessively leveraged funds have proved calamitous. Long Term Capital Management provides an excellent example. LTCM took a relatively safe strategy and leveraged it to about thirty times their invested capital. With a leverage ratio of thirty, a 2% loss in the total position means about a 60% loss on capital. It didn’t take long for negative turn in the trading strategy of LTCM to bankrupt the fund.

While options and short positions are inherently leveraged, other types of leverage add unnecessary risk in an effort to increase profitability. But the risk is increased by the same leverage factor as profits.

 Are hedge funds regulated?

Yes and no.

Hedge funds are regulated as to who can manage, who can invest, how many investors it can have, how the company is created, basically how the business of the fund is managed.

However, hedge funds have the freedom to invest based on whatever trading strategies it has developed. Also, hedge funds aren’t required to register to SEC, report returns, or disclose their trading strategies.

Proponents of regulating the hedge fund industry are intensifying pressure on legislators to create new regulations that increase transparency in hedge funds. The United States Congress is one of many legislative bodies in the process of developing new regulations on the hedge fund industry. The proposed bill in the United States Senate called the Hedge Fund Transparency Act of 2009 could be voted on as early as the end of this year.

 Does the size of a Hedge Funds have any correlation to the risk involved in investing in it?

There does seem to be some correlation between assets under management (AUM) and standard deviation of returns, but it is important to look for factors driving the correlation and determine the causation of risk in hedge funds.

Funds with less risk might appeal to more investors and become more sizable. There are less assets in which a large fund can take a meaningful position, and those assets might be less risky. “Too big to fail” is a term that refers to any institution large enough that its failure would affect society as a whole. Institutions that are deemed “too big to fail” warrant government intervention in the event of a failure like the bank bailouts last year.

However, large hedge funds do fail, and some small funds, which contain some risk (like all financial investments) fit the needs of some risk-averse investors. You need to contact an investment advisor to find investments that meet your specific risk profile.

 What is a High Water Mark and should that matter when I’m shopping for a hedge fund?

A high water mark is the previous high value of the investment. The fund has to reach this value before the manager can start taking performance fees. For example, if a fund in 2007 was valued at $100 million, and in 2008 lost 20% or was worth $80 million, in 2009, the fund manager can only charge incentive fees once the fund is above the $100 million mark.

Here’s another example: imagine two funds, each with a $1 million in assets with no management fees and a 20% incentive fee. The first fund takes a 50% loss in year one and has a 100% gain in year two, leaving total fund assets at $1 million at the end of year two. The second fund loses 5% in year one and has 10% gain in year two, leaving the fund with $1.045 million in year two.

Without a high water mark, the incentive fee for the first fund in year two is 20% of the 100% gain on $500,000 or $100,000.

The incentive fee for the second fund in year two is 20% of the 10% gain on $950,000 or $19,000.

The fund that produced an overall gain of 4.5% makes 19% of the fund that has flat returns over a two year period. If a high water mark is used, the first fund can’t charge incentive fees, and the second fund charges 20% of $45,000 gain above the original high water mark of $1 million.

The problem with the high water mark is the fund manager whose fund is below the high water mark has incentive to walk away and start a new fund or increase risky trading trying to get back above the mark. The idea of a high water mark is to protect investors but does the exact opposite in application.

 What are some advantages to investing in an offshore fund?

Basically, offshore funds offer tax advantages. Most of these offshore funds are set up in countries with low tax rates and are not subjected to US tax laws. Non-US investors are able to avoid US taxes all together, and managers of offshore funds can leave their management and incentive fees in the fund to defer payment of taxes on their income.

Tags: hedge fund, Hedge Fund Legislation, Hedge Fund Q & A, Hedge Fund Regulation, high water mark, Incentive Fee, Leverage, Management Fee, Not Categorized, Offshore Funds, Performance Fee

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With last year’s market-wide slump, mutual funds are trying to take a play out of the hedge fund playbook. One of the more common strategies employed by hedge-like funds is market neutrality. By taking off-setting positions in equities, fixed-income securities, options, etc., managers can eliminate market risk.

Market neutrality conceptually works like this: If a fund manager believes that Visa will outperform Master Card, he can eliminate the market risk by buying Visa and short-selling Master Card in equal amounts. Assuming Visa does outperform Master Card and the market is on an upswing, the long position in Visa gains more than the short position in Master Card loses. Furthermore, if the market falls, but Visa still outperforms Master Card, the short position in Master Card gains more than the long position in Visa loses. No matter which way the market moves, the fund has made a net profit.

In practice, the math is more complicated. The beta of the short position has to be equal to the beta of the long position, so market moves affect the two positions equally but in opposite directions. Furthermore, the portfolio manager could short the market through one of the available short-selling or inverse ETFs and match the beta of his long holdings to 1, which represents the beta of the market as a whole.

While eliminating market risk is a valuable tool, market neutrality does not eliminate all risk and in fact, creates some unique risks. Market neutral positions won’t make as much profit in an aggressive bull market as traditional long positions. Also, if the manager picks a stock to outperform another stock, and the opposite happens, the fund will produce net losses whether the market goes up or down. Furthermore, the downside risk to the short position is theoretically unlimited because stock prices are not bound to an upper limit. Another unique risk to the market neutral strategy called “beta mismatch” . If the beta of the long position is larger than the short position, a market downturn should cause the long position to lose more, as it has a higher correlation to the market as a whole. Furthermore, if the beta of the short position is larger, a market upswing should increase the short position’s loss more than the long position’s gain.

Market neutrality has been one of the more popular hedge fund strategies over the years, and this popularity could be extrapolated to the hedge-like mutual fund sectors. Investors should see a large rise in the number of available market neutral mutual funds.

Read Part 3 Long/Short Mutual Funds

Read Part 1 Mutual Funds Emulate Hedge Funds

Tags: Beta, Hedge Fund Strategy, Inverse ETF, Market Neutral, Market Risk, Mutual Fund Strategy, Mutual Funds, Not Categorized, Systematic Risk, Systemic Risk

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Janet Paskin of the Wall Street Journal reports that mutual funds are trying to emulate hedge funds in an attempt to satisfy average investors needs in alternative fund classes. In the past, hedge funds have been the investment country clubs for wealthy investors. The average investor had no access to hedge funds because he/she was deemed too unsophisticated to research the complex strategies utilized be hedge fund managers and were therefore banned from the gated hedge fund community (by the SEC).

According to the investment-research company Morningstar,Inc., 132 mutual funds are offering hedge-like strategies to investors, half of which have been launched since 2006. Why is this appealing to investors? While some hedge funds fell short last year and the hedge fund industry lost 20% on the average, the market lost 39%.

Many of these hedge-like funds are using the traditional strategies of the hedge fund industry. Some use short selling, or borrowing shares to sell and trying to buy them back at a lower price later, which adds leverage to the portfolio. Others try to find arbitrage opportunities to exploit price differences between securities. Other funds try to mimic the returns of the hedge fund universe.

“These are strategies that should have been offered to retail investors a long time ago,” according to Morningstar analyst Nadia Papagiannis. These hedge-like funds have amassed over $41.3 billion in assets, which has grown in each of the last three years. This is a stark contrast to the mutual fund universe, which saw a contraction of over $100 billion of assets in 2008.

Over the next couple of weeks, I will discuss the various trading strategies used by hedge-like mutual funds and where they fit portfolio allocation needs.

Read Part 2 Market Neutral Mutual Funds

Read Part 3 Long/Short Mutual Funds

Tags: Hedge Fund Strategies, Investment Strategies, Market Neutral, Market Neutral Strategy, Mutual Fund Strategies, Mutual Funds, Not Categorized

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Unlike the previously proposed revisions, Pluris believes the approved FASB (Financial Accounting Standards Board) revisions will not hurt hedge funds. The new revisions cover hedge fund transparency and diclosure issues, starting June 2009.

Espen Robak, president of Pluris Valuation Advisors LLC, praised FASB, “This is great news, not only for investors but for reporting entities as well,”  Robak said.  “As a result of the revisions, public companies will have improved guidance on how to apply the rules and investors will get financial information of a higher quality – and more frequent information, too!”

The FASB stated that its revisions were in response to the comments received regarding its initial proposal.

While many details remain to be worked out, the final revisions reaffirm that the measurement goal of fair value is the “exit price,” which is the price that would be paid based on market conditions on the day the asset is being valued, Robak said.  This “mark-to-market” approach prohibits companies from “taking the longer view” and valuing assets based on their own, more optimistic, views of what market conditions might be like in the future.  The new FSP also states explicitly that “a reporting entity’s intention to hold the asset or liability is not relevant in estimating fair value,” an important clarification for many companies.

Read the rest of this entry »

Tags: Not Categorized

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Penny Hersher tries to analyze hedge fund ethics and how they affect regulation over on Huffington Post. There are a a couple things wrong with the assumptions that she makes, but I’ll wanted to discuss something that is taken for granted in this post.

Penny assumes that the hedge fund has a high water mark and is down 20% from their HWM. The options she give are:

a) stay with the fund until you have recouped the losses and made your investors whole – working for “psychic income” as Kenneth Griffin of Citadel fame told the New York Times or
b) leave – retire, switch to a new fund, start a few fund – basically start again? If you had many years of excellent performance before this one terrible year you may well be able to raise another fund.

The third option that I’m putting forth (just for the record, it’s a BAD option so don’t try it at home):

c) Increase Risk. Your basic hedge fund strategy (which you’ve documented in your offering documents and pitched to your investors) is a conservative low-risk strategy. If you are down several months and you see that using this conservative strategy isn’t going to work, there is the temptation to increase your risk tolerance to get you back above your hwm.

Increasing risk is very tempting as it is a short term solution which could potentially get you out of a bad slump. The downside is that if the increased risk causes increased losses the manager is likely to raise the risk again and dig themselves deeper. The fact that there were so many Madoff feeder funds was exactly because of this. A fund was struggling through the economic downturn, so to balance the losses they invested in a vehicle which under regular circumstances they would not invest in.

So, why do I bring this obviously bad “solution” up? Simply to make the point that while high water marks sound like a good thing for the investor, they can have catastrophic side effects.

If you’re down 20% and have a fund with a HWM, close the fund, start a new fund without a high water mark and get back to business.

Tags: high water mark, huffington post, hwm, madoff, Not Categorized, Risk

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Informative book by Jason Scharfman on, well, pretty much everything you need to run a hedge fund, from risk management to disaster recovery, all need-to-know material for both investors and hedge fund analysts.

Included are examples of past hedge fund management mistakes, showing exactly where the managers went wrong, and how to avoid downfalls such as the ‘but everyone is doing it’ excuse, among others.

Technical though understandable, Scharfman also expains the reliance on technology that is becoming ever more apparent in hedge funds, the dangers of phantomware, and questions that should be asked before commiting to any new technology.

I liked this book for the simple reason that it explains just about everything, almost like a handbook, the index makes an excellent resource.

Available at Amazon.

Since writing the book he has left his position at Morgan Stanley and now runs an operational due diligence consulting firm called Corgentum Consulting. Corgentum works with hedge funds and investors to diagnose and mitigate operational risk at hedge funds and improve upon the of the operational due diligence process.

Tags: book review, due diligence, Not Categorized

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Big news in the Hedge Fund world this weekend when unofficial reports filtered out of the New York Post that one of the original Hedge Fund portals plans to close its doors on August the 15th.

Hedgeworld has been active since the late 1990s and has been a great source of reference both for Hedge Fund news and Fund information but also contained a fairly comprehensive Hedge Fund service provider directory. There is no information about what will become of the Lipper/TASS database a hedge fund datasource of which HedgeWorld.com was the exclusive distributer.

Hedgeworld was acquired by Reuters in March 2005. Nothing has been made public by HedgeWorld or Reuters regarding this. No changes are made on the HedgeWorld page on Reuters.com.

While HedgeWorld has provided very similar services to those of HedgeCo.Net, due to a fundimental difference in business models they were never regarded as competition. From it’s inception HedgeCo.Net has always provided free access to accredited Hedge Fund investors. With the growing commoditization of Hedge Funds and a intrest amongst people outside of the industry, we’ve chosen to make our news and community memberships free, and then turn a profit from our other services.

We are sad to see such a useful hedge Fund portal  go – and hope that the content and reseach on the site will remain available in some form.

[UPDATE FROM OPALESQUE]

In an exclusive report Opalesque they add: “However according to information obtained by Opalesque, Thomson Reuters would continue to run the HedgeWorld events, website, databases and news, while the editorial duties would be covered by existing Thomson Reuters staff.” That would make sense

[UPDATE FROM REUTERS]

I just got off the phone with Reuters, and they stated that the story as reported in the New York Post is incorrect

They said that Hedge World will stay in the same format that it is in currently. They will continue to offer TASS database, and have the service provider/jobs/conference section as well as publish several newsletters including the alternative advantage newsletter.

I asked regarding the rumors of staff changes and he said that he couldn’t comment on internal staff issues, but said that everything they are doing follows the product strategy that Reuters has had since they acquired Hedge World in 2005.

Tags: hedge world, Not Categorized

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