Unhedged Commentary

Tuesday, May 26, 2015

How an Inefficient Hedge Fund Market Works for Investors

There has been a lot of talk in the financial media about hedge funds recently. The discussion has not been characterized by glowing optimism. The media’s primary complaint — that average hedge funds don’t add enough value to justify their fees — is legitimate. We’ve been saying this for years. But it’s not true for the reasons that most media critics give. And it’s not universally true: Sophisticated and careful investors can create portfolios of hedge funds that add substantial value.

Much of the criticism stems from a comparison of nominal hedge fund returns with equity market returns. This misses the point. Nobody buys ten-year U.S. government bonds with 2 percent yields because they love the expected returns; they buy them to diversify their portfolios. For this reason, bond investors aren’t criticized for failing to keep up with equity markets. Similarly, hedge fund investments make sense only if they add value to a broader portfolio. Sophisticated hedge fund investors call that added value alpha: skill-based returns that don’t depend on passive market exposures to other asset classes.

Why are hedge funds subjected to this odd comparison with equities? Mostly because benchmarking them isn’t easy. Individual hedge funds differ widely, and the industry just isn’t that tightly correlated with any single asset class.

Luckily, introductory finance classes offer students a basic tool for finding a more reasonable benchmark for hedge funds. Using a linear regression, an investor can measure the passive return a fund achieves from persistent exposures to equities, credit and fixed income (or whatever mix of risks seems sensible for a given track record). The difference between a fund’s return and the return of this customized benchmark can be thought of as the return attributable to manager skill. A simple approach like this really isn’t enough. It ignores all kinds of information about current market opportunities, manager differentiation and nonlinear risk exposures. But it’s a good start.

When we evaluate hedge funds this way, we learn a couple of things. First, hedge funds as a class aren’t underperforming that much. Second, recent results for average funds still aren’t great. Their alpha has steadily declined over the past decade. Although the average alpha for the HFRI Fund Weighted Composite Index of hedge fund performance was about 5 percent from 2003 to 2007, it has been zero for the past five years. This shouldn’t shock anyone. Alpha is a negative-sum game after fees, frictions and financing. Over the past couple of decades, we’ve seen the development of a much more sophisticated professional investment community and the flow of a lot more money into hedge funds. A more competitive and efficient market is good for the world, but it’s a tougher environment in which to add value as an investment manager.

So should we all just pack up our tents and head back to the land of the 60-40 portfolio? Probably not — or at least, not all of us. Though the average investor will (by definition) buy average hedge funds, more-careful investors can do better. Why? Because the market for hedge funds is still not efficient.

The Efficient Market Hypothesis has various flavors, but the basic idea is that under certain conditions investor decisions will result in efficient prices and the expected return on expertise will be zero. For this mechanism to work properly, the market needs lots of well-informed investors making frequent decisions.

The hedge fund marketplace has relatively few investors, limited and variable access to information, and modest liquidity. Accordingly, expert investors should be able to add substantial value.

How? Smart hedge fund investing requires access to an investment team with the skills, resources and experience to identify attractive opportunities across a wide array of complex strategies, to differentiate among managers with varying levels of skill and to evaluate risk management in normal and shock scenarios. More generally, it requires an organizational culture of accountability for measuring outcomes with sensible benchmarks.

Doing this well is hard, but it’s not impossible, and it is important. The payoff from adding alpha to a portfolio can be very substantial: Raising a portfolio’s annual returns by just 1 percent a year can materially improve ultimate outcomes. To achieve this, investors need to be disciplined about selecting only the best managers. As the data shows, average is no longer good enough. a

Benjamin Appen and James Hall are founding partners of New York–based Magnitude Capital. Readers interested in exploring this idea further can do so at www.betterbenchmarking.org, a website developed by Magnitude Capital.

Tuesday, February 10, 2015

Unhedged Commentary: Putin Will Never Back Down

   
   Bill Browder, Hermitage Capital Management (Photo credit:
Peter Lindbergh)

Nearly every investor, world leader and concerned citizen is looking at Vladimir Putin right now and wondering if he will back down or escalate Russia's military involvement in Ukraine. That one outcome will determine the future of European security and economic stability for years to come.

I'm afraid that, based on the reasons behind Putin's motivations for invading Ukraine in the first place, there is no chance that he will back down. To understand this, all it takes is a simple analysis of how this crisis unfolded.

First, Putin didn't start this war because of NATO enlargement or historical ties to Crimea, as many analysts have stated. Putin started this war out of fear of being overthrown like Ukrainian president Yanukovych in February 2014. Yanukovych had been stealing billions from the state over many years, and the Ukrainian people finally snapped and overthrew him. Compared with Putin, Yanukovych was a junior varsity player in the field of kleptocracy. For every dollar Yanukovych stole, Putin and his cronies probably stole 50. Putin understands that if he loses power in Russia, he and his underlings will lose all the money they stole; he will lose his freedom and possibly even his life.

Putin may not have been at risk of an imminent revolution in February of last year, but he could see the writing on the wall. So in March he took aggressive preemptive action. His 1999 invasion of Chechnya, which led to his presidential election, had taught him the value of war in shoring up his popular support.

As Putin and his colleagues evaluated their options, they realized they didn't need to launch an expensive and deadly invasion anywhere. Russia already had 12,000 troops in Crimea stationed at a naval base in Sevastopol — they could reclaim Crimea with almost no effort. In March 2014, using irregular troops and mercenaries, Russia retook Crimea with almost no loss of life. At the same time, Putin ran a propaganda blitz at home to convince the Russian people that the Ukrainians were fascist Nazis who were going to kill the "good Russians" living in Crimea.

Putin's plan worked perfectly, with his approval rating shooting up from 55 percent to 88 percent. Unfortunately, he couldn't just stop at Crimea. If he had, a more strident nationalist would have come along and accused Putin of being weak, taking his spot and putting him in the position he was trying to avoid by starting the war in the first place.

So Putin had no choice but to escalate by going into eastern Ukraine. Unfortunately for Putin, this didn't work out nearly as neatly as in Crimea. There were no Russian troops stationed in eastern Ukraine, and Russia had to send in much bigger groups of mercenaries, criminals and secret policemen. This group didn't hold up well when the Ukrainian army finally came in to challenge them, and to maintain the effort, Putin was forced to send in regular Russian troops and heavy artillery last summer. The shooting down of Malaysia Airlines Flight MH17 was the turning point for Putin. Europe imposed devastating sanctions on Russia.

The sanctions forbid Westerners from lending to Russian companies. This means that the $650 billion of hard currency debt owned by Russian companies can only be refinanced inside of Russia. This has led to massive capital flight, a devaluation of the ruble of more than 50 percent and a monumental recession, which is only just beginning.

Putin has never dealt with economic chaos before. Though some may argue that this will bring him to the table to negotiate with the West, in my opinion any negotiation would be seen as a sign of weakness and is therefore the last thing Putin would want to do.

Putin's only likely response is to escalate in Ukraine and possibly open up new fronts in other countries where there are "Russians to protect." But doing so will only harden the sanctions, leading to further economic pain in Russia — and further military adventures to distract Russia's people from that pain.

I cannot imagine a scenario in which there is any compromise, because for Putin compromise means being overthrown. Judging from all of his actions to date, he is ready to destroy his country for his own self-preservation.

We should start preparing ourselves for a war in Europe that may spread well beyond the borders of Ukraine. The only Western response to this has to be containment. This all may sound alarmist, but I've spent the past eight years in my own war with Putin, and I have a few insights about him that are worth knowing.

Bill Browder is the founder of London-based Hermitage Capital Management and the author of Red Notice: A True Story of High Finance, Murder, and One Man's Fight for Justice.

Friday, January 16, 2015

Unhedged Commentary: Why Friendly Activism Won’t Fly in Japan

   
   Tak Aoyama, AIFAM
By Tak Aoyama

A friendly approach to activist investing has been gaining steam in Japan and has proven successful in raising money — but not in generating excess returns above the market.

Since the end of 2012, Japan-specific activist funds fashioning themselves as friendly have doubled assets under management, to an estimated $8 billion. At the same time, activist firms that employ a more confrontational approach, such as Cerberus Capital Management and Third Point, appear to be reducing their exposure to Japan by not replacing positions in Japanese companies with new names, a move notably coinciding with the rally in Japanese equities. These hostile managers are not adopting a friendly approach; rather, friendly activist managers and entrants are gaining market share, touting that their approach is more suited for Japanese corporate culture.

While these managers may identify themselves as activists, their investors may have them earmarked for allocation to active Japan equity investments. Japanese equity funds have averaged a tracking error of 5 percent or less — too low to be considered active investments. Activist funds, with their potential for higher returns and concentrated position taking, are a good substitute for any investor outside Japan looking for Japanese equity with a kick.

Seeing the fundraising success of their overseas counterparts, domestic managers have launched funds in the past two years with hopes of attracting investments from domestic pension plans. They anticipate allocation from government pension plans — such as the ¥130 trillion ($1.1 trillion) Government Pension Investment Fund — that are expected to help carry out Abenomics, the round of stimulus measures enacted by Prime Minister Shinzo Abe after his election in December 2012. These managers’ marketing materials read like those of a venture capital fund or an early-stage private equity fund, avowing adding value to target companies through elaborative dialogues with management, proposing business plans, and offering corporate finance solutions and access to funding.

While a friendly approach purportedly works better than a hostile one in Japan, challenges remain. These funds typically take a nonthreatening minority stake, meaning they lack the clout necessary to implement meaningful and often painful changes, namely, restructuring or selling off noncore business lines. Corporate managers in Japan are typically appointed from employee ranks, and they tend to avoid laying off workers until their hands are forced by external pressure. A friendly minority shareholder cannot catalyze the kinds of big changes that may be one of the most effective ways to increase the value of a company.

Non-Japanese managers investing on behalf of opportunistic risk-on, risk-off investors may need to divest before an activist campaign has time to bear fruit. Since 2013 overseas investors have enjoyed a sizable return from Japanese equities as seen in the Topix return of 18 percent on a dollar basis and 65 percent on a yen basis. A downturn in the Japanese equity market would trigger redemption requests from activist managers, some of whom have seen this scenario play out before. And target companies and the activist funds investing in them may differ on expectations on exit timing. These conditions make it difficult for funds to sustain an effective activist strategy, and they may pursue a friendly approach at entry but not necessarily at exit.

Domestic investors are expected to be more loyal to domestic funds, but these managers have not been around long enough to demonstrate their capabilities. It remains to be seen how effective their activist strategies will be when the overall equity market is down.

While managers and investors may have initially entered activist investing with different motives, there is definitely a role to be filled by activists to improve the value of Japanese companies. Free advice provided by the minority shareholder is valuable for corporate Japan, where there is no custom of hiring external advisers. As Japanese management is often comprised of former employees with manufacturing or sales backgrounds, external expertise is particularly useful in areas of corporate finance.

The environment has become favorable to friendly activism in Japan as well. The percentage of non-Japanese shareholders has grown from less than 20 percent in 2000 to more than 30 percent in 2014, and the practice of cross-holding, where companies buy each other’s shares to be silent shareholders, has largely declined. The corporate climate has shifted emphasis on financial performance metrics from retained ratios closely tracked by debt holders to return on equity valued by shareholders. In February 2014 the Japanese government introduced its own stewardship code to improve dialogue between shareholders and management.

Despite these changes toward a more shareholder-friendly environment, the fundamental culture of Japan remains that management answers to customers and employees first. Uniquely, the same is expected of shareholders. Ultimately, this is an insurmountable challenge for would-be activist investors in Japanese companies — and that’s on top of potential traps an activist investor anywhere can fall into, such as stubbornly continuing an investment despite its deviating from the initial investment thesis or choosing to suspend investor redemptions over suspending activist goals.

Tak Aoyama is the CEO of AIFAM, an asset management and advisory firm focusing on alternative investments.

Wednesday, December 03, 2014

Unhedged Commentary: The Case for Nonprime Mortgage Loans

   
   Philip Weingord, Seer Capital Management
By Philip Weingord

Is there a prudent way to originate a mortgage loan that isn't prime? The answer is yes, there is, and it's time to start making nonprime mortgage loans again.

Of course, some products originated during the U.S. housing bubble made no sense; some loans should never have been made. But history is replete with examples of the pendulum swinging too far in response to crises, and that has been the case in mortgages.

You may recall arcane terms like subprime and Alt-A and Alt-B, which were used to describe mortgages but not broadly understood by the average borrower. The mortgage market today has a new mission and new monikers: qualifying mortgage, or QM, and non-QM. A QM mortgage meets new standards, including a debt-to-income limit of 43 percent and a 3 percent limit on points and origination fees; also, these mortgages don't have risky features such as interest-only payments. A QM provides lenders protection against lender-liability lawsuits. Non-QM loans do not meet QM standards and are considered riskier. (Jumbo mortgages are also non-QM, but they are not the focus of this article.)

There has been a lot of media coverage about the non-QM market, but origination volumes outside of jumbo loans won't even reach $1 billion in the U.S. this year. Why so meager? Some housing analysts have said rating agency requirements are too onerous to make securitization of non-QM loans appealing, but in fact, the economics of securitization appear quite attractive. Others have suggested that there is simply not enough demand — there are not enough borrowers with these credit profiles looking for mortgages. We find this hypothesis unlikely. Consumers are generally willing to take advantage of credit when it is offered.

Many point to the Federal Housing Administration as the reason that non-QM lending has not taken off, and this is valid to a point. FHA lending, which serves weaker borrowers, was pushed aside when subprime was in its heyday and grew back rapidly with the demise of subprime. Nonprime loans peaked at $1 trillion of origination in 2006; that year FHA originations totaled $80 billion. By the end of 2009, nonprime loans were at essentially zero, whereas FHA originations reached $451 billion.

The non-QM product, however, serves borrowers that FHA does not. FHA loans are difficult to obtain for self-employed borrowers and unavailable for second homes or investor properties, which continue to grow in share as home ownership continues to decline postcrisis. That financing has to come from somewhere. FHA loans are not available to borrowers with a recent short sale, bankruptcy or foreclosure (typically, within the preceding three years). They are not available above FHA maximum loan sizes, and although FHA programs allow fairly low credit scores, most originators won't go below a 640 FICO score because of additional scrutiny for lenders with higher default rates. Loans have to be sound, of course, and a non-QM loan needs mitigating factors that offset risk, in addition to appropriate risk-based pricing.

The greatest factor holding back volumes is that non-QM origination is simply not up and running. The nonagency mortgage origination business was decimated in the crisis and has not returned. An infamous blog called the Implode-o-Meter tracked the demise of 388 subprime mortgage lenders. The few companies that survived reinvented themselves as prime and/or agency lenders. The economics of originating agency mortgages have become more attractive with less competition, as the overall mortgage industry has shrunk. In addition, banks still dealing with the legacy of subprime are paying out huge settlements in lawsuits. For example, Bank of America Corp. is paying $17 billion.

As a result, origination platforms and brokers have been entirely committed to agency and jumbo mortgages for several years now, and with little capital flowing to the segment, nonprime has not been an area of focus. Non-QM lending is an attractive opportunity for investors because of its expected robust return profile and the market's scalability.

My firm started exploring the sourcing of non-QM mortgages in early 2013 and made our first purchases in mid-2013; we expect to do our first securitization in early 2015. We see this market growing to $150 billion over the next several years, with 80 to 90 percent of it being securitized. With return potential in the mid- to high-teens, we see the non-QM lending market as an ideal way to generate alpha.

Philip Weingord is the managing principal and chief executive officer of New York-based Seer Capital Management, a credit-focused investment firm.

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