Unhedged Commentary

Wednesday, April 02, 2014

Unhedged Commentary: Hedge Funds Must Act Against Cyberthreats

   Eze Castle Integration's Bob Guilbert

By Bob Guilbert

If you’re a hedge fund manager, you probably have a good understanding of risk and the potentially valuable role it can play within your business model. Taking investment risks can often pay off, positioning your firm for better returns. But systemic technology risk offers no value to your company; in fact, taking chances with your technology will only cause undue harm and can damage more than just your firm’s infrastructure.

We’ve seen high-profile security breaches dominate news headlines over the past year. Such breaches have elicited fear in businesses and consumers around the world, which are on high alert for potential cyberattacks. But can we be sure these businesses are taking proactive measures to ensure they do not become the next cybervictims? In the “hacktivist” world, if you aren’t one step ahead, you’re ten steps behind.

With the financial services industry an obvious target for hackers, it’s more critical than ever that hedge fund managers take notice of the changing security landscape and implement measures to protect their investments. Probably the most critical piece of advice we can offer to hedge funds is to prepare for the inevitable. What exactly is inevitable?

The reality is, security will fail you. Odds are that at some point your firm will suffer some sort of security incident. That could mean a large-scale external attack, or it could equate to an employee downloading a secure file onto an external, insecure device. A security incident will occur, but the seriousness of that incident and the extent of the damage are factors that you can mitigate.

Staying on the offensive will go a long way in reducing your firm’s technology risk and minimizing the damage inflicted by a security threat. If you’re in charge of your firm’s security, don’t go it alone. Start by creating a cyberincident response team and clarifying roles and responsibilities for team members. Traditional organizational structures often hamper the swift and decisive responses necessary to combat security incidents, so think outside the box and include response team members who can think on their feet and will be readily available if an incident strikes during nonworking hours.

Offensive security measures also include implementing sound technology principles to protect all aspects of the business. We recommend adopting the principle of “defense in depth” and employing multiple layers of security across your firm’s systems. It is not enough to simply have antivirus software and a network firewall. Experienced hackers know their way around these barriers. A more proactive approach is to implement host-based and network intrusion detection systems, which will proactively monitor your firm’s environment for external activity and potential threats. Beyond IDS detection, we also strongly encourage funds to conduct periodic vulnerability assessments — completed by a third party — which assess the weaknesses in a firm’s infrastructure and areas susceptible to attacks.

Beyond monitoring for external security threats, it is critical that firms enforce internal security policies to ensure sensitive company information stays within the company and does not get into the wrong hands. By limiting data and systems access to only those who need it (often called the principle of least privilege), you take control of your firm’s security. Create access control lists for each and every system you operate, and utilize secure authentication protocols to validate users’ identities and control access. We recommend taking things even a step further and implementing a central logging system to record all log-in and log-out events as well as information on who accessed what files and if the files were copied, modified, deleted, etc.

Enforcing these active security measures will go a long way in combating any potential cybercrime that may be directed toward your firm. But there may be another critical step to curbing security attacks beyond technology. Communication could play a key role in thwarting hackers, particularly if firms opt to share their experiences publicly. Communicating threats as well as response plans will ultimately increase the amount of knowledge being shared within the industry and, hopefully, call more attention to the importance of proactive security. With the Securities and Exchange Commission taking a closer look at cybersecurity in 2014 and recommending disclosures (perhaps even making them mandatory in the future), a vastly different marketplace for hackers looking to invade networks could result.

Bob Guilbert is the managing director of marketing and products for Eze Castle Integration, a provider of private cloud and outsourced technology services to more than 650 hedge funds and alternative investment firms worldwide.

Thursday, March 20, 2014

Unhedged Commentary: Proposed Tax Change Targets Reinsurance Vehicles

   Crown Global Insurance chairman and CEO Perry Lerner

By Perry Lerner

Several high profile hedge funds have recently raised significant amounts of capital for offshore reinsurance companies, which invest in or along-side their principal investment strategies. Investing in a reinsurance affiliate of a hedge fund is an attractive proposition for both the fund and its investors. For the fund managers, the capital is permanent and thus not subject to redemption. As an offshore company earnings on its reserves are exempt from current U.S. taxation, as long as the company is not conducting business in the U.S. In lieu of redemptions, investors seeking liquidity may sell their shares in the market. For investors, if they have held their shares for 12 months, their gains on selling their reinsurer shares are long-term capital gains, taxed at more favorable rates than the underlying hedge fund’s earnings, which often consist of short-term gains. As long as the exposure to reinsurance risk is kept under control — often through a variety of third party risk reducing arrangements — the investor has all the economic benefits of investing in the hedge fund, with favorable tax treatment and fewer administrative burdens. As a result, many hedge fund-sponsored reinsurance vehicles trade at a premium to book value.

This happy state of affairs may come to an end, however. A little-noticed provision of the Tax Reform Act of 2014, proposed by House Ways and Means Committee Chairman Dave Camp (R-MI), strikes at the heart of this strategy, undermining growing hedge fund interest in creating offshore reinsurance companies to attract permanent capital. For now, capital exposed to a fund’s reinsurance business is limited to the amount needed for the offshore company to be classified as an insurance company under local insurance law. As a result of operating as an insurance company, the hedge fund reinsurer is excluded from taxation that would normally apply to an offshore investment vehicle under the Passive Foreign Investment Company rules. Current law does not provide any minimum level of insurance premium income to qualify for this exemption. Accordingly, only a minimal amount of the company’s income need be from reinsurance activities and the preponderance of the income can be from its hedge fund investments.

Representative Camp’s proposal would require that 50 percent of the reinsurer’s gross receipts consist of insurance premiums to avoid being treated as a PFIC. This is a departure from the current PFIC test, which is based solely on a carrier’s reasonable reserves. As a result, a reinsurer’s investment income would be limited and its earnings capped. Should a reinsurer not satisfy the proposed new standard and therefore receive PFIC treatment, it would result in the current inclusion of income, conversion of long-term gain to ordinary income, and, in some cases, an additional charge when tax is deferred. The proposal, if enacted, would significantly decrease the benefits of the reinsurance model among fund managers.

We think the tax proposal targets the reinsurance strategy and will attract continued attention from tax reformers and regulators as the legislative process evolves in Washington, D.C. Hedge fund managers and investors should take note of the ongoing legislative debate and prepare accordingly.

At a minimum, the existing reinsurance vehicles should determine the feasibility of increasing their premium income. The issue, of course, is whether this can be done without increasing the risk of loss in the fund’s insurance operations. Investors seeking returns from insurance company investments can easily invest in traditional insurance companies. As for those thinking of this strategy, the time and expense of creating and operating a reinsurance vehicle is considerable and may cause many to pause until there is greater clarity on the potential tax risks.

Hedge fund managers considering the reinsurance strategy should look at the potential benefits of creating an Insurance Dedicated Fund for the benefit of their investors. An IDF offers many of the benefits of reinsurance affiliates without the insurance or tax risks. An IDF is a fund, often a hedge fund clone,that is only available to life insurance or annuity investors.

For investors reluctant to take the risk of insurance company operations, individuals or institutions can simply purchase a private placement life insurance policy or annuity, which invests in an IDF invested in a strategy similar to the sponsor’s hedge fund. In the case of life insurance, there is no current income taxation and all gains are exempt from income tax on the death of an insured. Where an investment is held in an annuity, tax is deferred until the time of withdrawal. Every withdrawal is treated as a partial recovery of the investment in the insurance contract so the rate of tax is always reduced until the entire investment has been withdrawn. This more than compensates for the loss of capital gains treatment. An increasing number of funds are creating IDFs either instead of, or as a complement to, the creation of a reinsurance company. First, the experience of most of the entities with IDFs is that withdrawals are less frequent than customary hedge fund redemptions. Second, the costs of creating and operating an IDF are considerably lower than operating a reinsurance company. Third, managers of an IDF can concentrate on what they know best- generating alpha and positive returns while avoiding the risks entering a business that is far less familiar. Moreover, none of the recent tax reform proposals affect the taxation of life insurance and annuity products.

Perry Lerner is chairman and CEO of Crown Global Insurance LLC, which partners with clients to enhance alternative investments.

Wednesday, March 12, 2014

Unhedged Commentary: In Turkey, Foreshortened Is Forearmed

   Macro Risk Solutions director and strategist Ed Lalanne

By Ed Lalanne

We’ve entered the next phase of the emerging-markets crisis. Over the summer weak emerging markets were selling off due to the dual catalysts of a slowing China and rising U.S. yields, triggered when the Federal Reserve began to taper its massive bond-buying program. Today, China has stabilized somewhat with the prospect of reforms, and U.S. rates are no longer rising. But the latest episode of emerging-markets stress was triggered internally by the political crisis in Turkey that began with street demonstrations last May and escalated in December with a corruption scandal.

Now we have a perfect recipe for a bear raid. Though a greater downturn would affect a number of emerging markets, it would be likely to start in Turkey thanks to the confluence of legacy current account deficits, high short-term external debt, highly liquid external debt in the form of deposits and tradable bonds, and too few foreign exchange reserves held by the Turkish central bank. While today’s fragilities are far different from Southeast Asia’s in 1997, when most emerging markets were running large current account deficits and pegged currencies and had large foreign currency–denominated external debts, the changing nature of the vulnerability does not make it less real.

Massive capital inflows to emerging-markets shares, bonds and loans have created an unprecedented landscape. Emerging markets may be stronger on average than they were in the late 1990s, but this reduction ignores the composition of that average. In the wake of last summer, weak emerging markets and strong emerging markets form distinct sets in the minds of portfolio managers with mandates to invest in these parts of the world. Turkey tops the list of emerging-markets debtor countries that were market darlings in recent years.

Turkey’s net international investment position is -60 percent of GDP and fast worsening. Thailand’s bottomed at -50 percent in 1997. If a serious crisis unfolds, investors will likely focus on this metric, similar to the way the debt-to-GDP ratio became the key metric for peripherals in the euro crisis. Much of Turkey’s foreign liabilities are in the form of very liquid shares and bonds. This was not the case for Thailand in 1997. Turkey’s foreign exchange reserves are likely in the neighborhood of $30 billion, down from $48 billion midyear, after netting out foreign currency deposits due to local banks. External debt totals $382 billion, of which $357 billion, or 48 percent of GDP at the current exchange rate, is denominated in U.S. dollars, euros and other foreign currencies. Foreign currency external debt becomes ever more onerous as the lira depreciates.


Given the history of deficit countries in Turkey’s position, it is surprising the lira hasn’t been subjected to increased speculative attacks by hedge funds. That may be partly due to the current risk tolerance climate. Also notable is that many consensus macro trades have been disappointing so far this year, limiting risk taking as hedge funds nurse losses.

In addition, perhaps speculators are afraid of a snapback of official intervention. If past experience provides direction, however, we should expect any international aid to arrive in dribs and drabs as the crisis gets progressively worse. In the Mexican peso crisis of 1994, the U.S. initially extended a limited dollar swap line of $7 billion. The crisis worsened, and lines of credit from the U.S. and other countries were established. Another month passed and the crisis deepened still. A loan package of $50 billion from the U.S., the International Monetary Fund and a consortium of banks was arranged. But it was not until Mexico adopted stringent austerity measures in March 1995, yet another two months after the loan package, that the peso stabilized.

In the case of Turkey, however, it is unlikely that the U.S. Federal Reserve or the European Central Bank would extend currency swap lines. In both cases, there are governments and municipalities short of dollars and euros much closer to home. In all probability, Turkey would have to wait for a lengthy and complicated IMF-sponsored bailout, giving plenty of time for traders to make money from shorting the lira.

Yet despite the momentary calm, the lira remains an attractive outright short. A rush to the exits by foreigners currently holding any Turkish risk, including the country’s bonds, stocks, loans and even foreign direct investment, weakens the currency. While the lira is far more volatile this year than last, it is still cheap in the context of the destabilization that might ensue. The fundamentals continue to wear on Turkey. Sharply higher rates are squeezing the banks and the economy. A onetime revaluation that makes everything else worse will not be sustainable.

Portfolio managers with broad emerging-markets mandates are wisely allocating funds away from Turkey and other former favorites with current account deficits. Turkey, Brazil, India, Indonesia, and South Africa form the so-called Fragile Five. New investment dollars and proceeds from bond maturities are heading for stronger emerging markets such as South Korea, Taiwan and the Philippines. Even so, fund exposure to Turkey remains high. With currency losses compounding negative returns, however, one has to wonder how long foreign investors are willing to suffer. Additionally, every step in the normalization of U.S. rates will dim the appeal of risky emerging-markets carry trades. The next stage of the crisis in Turkey is probably not far away.

The prize for the short-seller may be considerably bigger than that of short-sellers in historical currency crises. Turkey is the first in a series of weak emerging-markets dominos. Managing an international crisis of this scale would require the coordination of very disparate interests.

The situation is so delicate that a large macro fund might be able to precipitate the next stage of crisis. But at the same time, investors still in this market would do well to protect themselves against an escalating crisis with short lira positions, especially because they might not know there is serious trouble until it’s too late. It is typical in an emerging-markets crisis for foreign exchange reserves to be essentially depleted before the central bank admits its untenable condition. As Ernest Hemingway wrote of the way one goes bankrupt: “Two ways. Gradually and then suddenly.”

Ed Lalanne is a director and strategist for Macro Risk Solutions, a firm that advises clients on how to strengthen investment portfolios through periods of market uncertainty. The New York-based firm is in the process of becoming an SEC-registered investment adviser.

Wednesday, January 22, 2014

Unhedged Commentary: Why Investors Should Bet on Structured Credit

By Brian Walsh


It is easy to understand why investors are flocking to equities, despite the fact that most liquid assets today are looking relatively expensive. Equities clearly have momentum behind them, and the path of least resistance is higher. For example, since 1870 there have been 30 times that the annual stock return exceeded 25 percent, and in 23 of the following years stocks were up an average of 12 percent, according to BCA Research. In addition investors are generally not fully allocated to stocks, and there is a definite pattern of catching up or chasing returns. Equity mutual fund flows were positive this year for the first time since the financial crisis.

From a more fundamental perspective, however, the picture is more challenging. Consider the following, which may temper enthusiasm for stocks: Since the market bottom in March 2009, the S&P 500 is up 170 percent; never before has the market gone up that much without at least one 20 percent correction. Earnings multiples are at their post 2008 high. If at the beginning of 2013, a genie had told you earnings by the end of year would be close to 70 percent less than forecasted and that bond yields would rise approximately 1 percent, you probably would not have predicted a 30 percent rise in stocks. Furthermore, while record profit margins continued to expand last year, at some point profit margins have to revert to the mean, or the basic rules of capitalism need to be rewritten.

For these reasons, the amount of risk investors may be taking on by investing in equities and credit-sensitive fixed income products may not justify the returns these products generate. But one asset class that does offer an attractive risk/reward profile is structured credit. Structured credit generated great returns in 2012 and 2013 (15 percent to 20 percent-plus), and it continues to provide interesting opportunities. The yields available in certain structured credit bonds are less than they were 18 months ago, but on an absolute and relative basis, the asset class is more appealing than most.

There are three main reasons why structured credit remains attractive. First, there still is a stigma attached to these bonds — structured credit was the toxic waste of 2008, and many traditional investors continue to avoid it. Second, structured credit is more complex and opaque, and many bonds have uncertain duration. These features make them less attractive to traditional fixed income investors.

Third, new banking regulations are especially targeted at structured credit; capital rules mean that less market-making capital will be devoted to more complex and generally less liquid segments of the market such as structured credit. These regulations impede a bank’s participation in the sector, which means enhanced opportunities for pools of private capital, like hedge funds. The overall result is a sector with less competition, where investors with the tools to analyze and research these complex and opaque bonds can capture “information arbitrage”-style incremental yield. This combination of less competition with greater complexity translates into genuine opportunities to generate excess return, as well as significant price disparities of bonds with similar risk profiles.

The best opportunities today are in both legacy paper and new issue securitizations. In the legacy paper, opportunities exist in a variety of sectors, including non-agency residential mortgage-backed securities, whole loan non-performing residential mortgages, student loans, trust preferred securities, commercial real estate collateralized debt obligations and commercial mortgage-backed securities. The yields achievable vary but in many cases approach 10 percent, with high probability of no principal loss (from the purchase price). There can be mark to market losses, of course, but based on underlying collateral and subordination in bond structures, bond prices have good safety margins.

In addition, within the U.S., RMBS investors can buy interest-only strips, which increase in value when rates are rising, thus providing a hedge to rising rates. Certain assets yield in excess of 10 percent with a similar margin of safety, but these assets are much less liquid and require a longer holding period.

Lastly, the opportunity set in Europe is good and growing as European banks decrease their financial leverage and exit sectors of the market. For example, total bank assets relative to gross domestic product is greater than 300 percent in the Eurozone, versus 90 percent in the US, and it is generally recognized that U.S. banks have been much more active in shedding assets. Still, even in the U.S., the top 100 banks hold $150 billion of non-performing and $80 billion of re-performing residential whole loans respectively. Overall, this should continue to create a steady pipeline of opportunities, both in the U.S. and abroad.

The opportunities for new issue securitizations are focused on non-conventional residential mortgages and more esoteric market segments. These opportunities involve taking leverage and first loss exposure, but the excess interest and the amount of equity underlying the collateral significantly mitigate the risks involved. In these cases, equity-like returns are available without as much downside exposure associated with equities.

The main risk in the sector is liquidity. This assumes you are investing with someone who has the capabilities to do the required research and analysis on the bonds both in terms of the underlying collateral and the structure on the bond securitization. The other side of liquidity risk is of course increased return, as the best opportunities are in the more illiquid sectors of the market.

Brian Walsh is chairman and chief investment officer of Saguenay Strathmore Capital.

Monday, December 30, 2013

Unhedged Commentary: How the JOBS Act Will Play Out in 2014

   MFA executive vice president and managing director D. Brooke Harlow

By D. Brooke Harlow

Many in the hedge fund industry will look back on 2013 as a year of important change that ushered in a new — overdue — era of communication and transparency between funds and investors, though that era has yet to begin. Throughout the year leaders in the industry eagerly anticipated action by the Securities and Exchange Commission to finalize a set of rules mandated by the Jumpstart Our Business Startups Act (known as the JOBS Act) to remove the ban on general solicitation and advertising in certain offerings by private funds.

For years the general solicitation ban left fund managers at a clear disadvantage, unable to discuss — or defend — their funds in public for fear of regulators interpreting their words as an advertisement for new investors. These antiquated regulations created a communications vacuum around the industry, allowing for dangerous misconceptions to take root and go unchallenged.

Removal of the advertising ban led many observers to speculate about when we might see the first wave of advertisements from hedge funds on interstate billboards or as Super Bowl commercials. Anyone holding their breath for a flurry of hedge fund ads running alongside holiday commercials as we close out the year might be disappointed, but commentators attributing managers’ lack of engagement in public communication to widespread disinterest or fear of tarnishing their image with investors are ill-informed.

While the new SEC rules removed restrictions for many funds, limitations remain for others. Many SEC-registered managers also claim a registration exemption from the Commodity Futures Trading Commission, and to qualify for the exemption managers are forbidden from marketing interests in commodity pools to the public in the U.S. The CFTC’s rule has not yet been harmonized with the changes the SEC has made, leaving many managers in a regulatory limbo — able to take advantage of the SEC’s rule change but unwilling to endanger their CFTC exemption.

Further, as the SEC finalized rules to roll back the ban on general solicitation, the commission simultaneously proposed rules that would seek to govern those solicitation activities — reports managers must file, disclosures that should be included on solicitation materials and penalties for violating these proposed requirements. Managers must also make extensive disclosures through form ADV and additionally, for larger managers, file quarterly reports through form PF. The proposed rules have not been made final, and the SEC has given no indication when it will act to do so. In effect, managers have been given permission to drive on the highway for the first time but with very limited information on the speed limit or the rules of the road.

The watchword for the industry with regard to general solicitation is uncertainty. Should that uncertainty be resolved, it is more likely that many managers will take advantage of their new ability to communicate freely. One of the areas where we are likely to first observe any change is to fund manager websites. In this digital age, most companies find they need a robust, informative and engaging web presence to thrive. Prior to the SEC rulemaking removing the advertising ban, funds were unable to use the web to tell their story. In fact, many websites were merely landing pages with limited content — often just a login for investors and a contact number for information. Removing the ban allows funds to enhance their web presence to engage and inform visitors, including investors, the media and the public, to better articulate their philosophy, performance history and approach to fund governance.

Fund managers are also likely to take greater advantage of public speaking opportunities. Previously, managers had to walk a tightrope when speaking in public to ensure their words could not be interpreted as a solicitation for investment capital. Once they obtain greater certainty of the rules, managers might engage more frequently and at a deeper level, sharing their view of current trends and issues in financial markets. This will also serve to inform the public about how the industry operates and benefits individuals who might not always understand how they are connected to hedge funds.

For too long, the hedge fund industry was at a competitive disadvantage in the communications landscape. Recent regulatory changes will help the industry evolve to provide a greater level of transparency and information sharing with investors and the public. While more regulatory work is needed, the rules written in 2013 could help ensure that next year is one in which hedge funds are able to seize new opportunities to grow and educate the public – to the benefit of everyone involved.

D. Brooke Harlow is executive vice president and managing director of the Managed Funds Association.

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