Wednesday, March 12, 2014
|| Macro Risk Advisors 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 Advisors, 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
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
|| 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.
Wednesday, October 09, 2013
By Jeffrey Peskind
|| Phoenix Investment Adviser founder and CIO Jeffrey Peskind|
Over the past year many of our institutional investor clients have expressed growing concern about rising interest rates and the potential impact on their fixed-income portfolios. Many of them have even contemplated selling their fixed-income portfolios entirely.
As a manager of corporate debt, we shared some of those concerns. They turned out to be well founded in the second quarter, when rates rose and bond prices dropped. Nearly all fixed-income assets have lost money this year after an incredible 30-year bull market.
But there is a sector of the fixed-income market that offers an excellent opportunity for investors seeking yield: junk bonds. Although junk bonds have fallen off in price since the Federal Reserve announced in May that it was considering a gradual tapering of its quantitative easing program of buying government bonds, they remain the only sector of the fixed-income market that has made money this year. Indeed, the lowest-rated bonds have been the best performers of 2013.
Historically, junk bonds have had the lowest sensitivity to interest rates of anything in the fixed-income universe, and they have shorter durations than many other instruments. Junk bonds are generally much more sensitive to default rates, which remain at historical lows and could remain low as the economy continues to improve. (Why else would the Fed think about reducing its stimulus?) For those still interested in fixed income, the current environment presents an excellent window of opportunity to invest in junk.
Until recently, money surged into large junk bond mutual funds and exchange-traded funds as investors embarked on a relentless pursuit of higher yields. But because of the liquidity demands of these investors and their need to put large amounts of capital to work, most of this capital flowed into the largest high-yield bond issues, driving prices of those issues to an average of 110.5 percent of par value in April. It was as if prices had nowhere to go but down.
Sure enough, after the taper talk started in May, investors rushed to redeem from their high-yield bond mutual funds and ETFs, causing prices in the largest issues to fall. We actually shorted many of these bonds during that time, but now it appears to us that the fears about Fed tapering are already baked into prices.
Though there are opportunities in all parts of the high-yield bond market, we think the best risk-return is with midcap and smaller issues, generally those less than $600 million. Not only are such issues typically less susceptible to interest rate changes, they also outnumber large-cap issues by a factor of more than eight, creating opportunities to find undervalued names.
In the U.S. high-yield marketplace, there exist only 219 non-investment-grade bond issues greater than $1 billion; this is in stark contrast to more than 1,900 issues that are between $100 million and $1 billion. These smaller issues tend to trade at larger discounts and at higher yields than bigger ones, and they generally fly below the radar screen of the big bond fund managers. In the second quarter midcap and smaller issues performed much better, on average, than their larger counterparts, and they weren’t as vulnerable to the huge wave of liquidity-forced selling by ETFs and mutual fund managers.
Smaller companies are often seen as riskier because they tend to have a tougher time weathering economic downturns. We don’t think that broad generalization is always true — each company has its own characteristics. We are finding attractive yields and total return opportunities in smaller companies that have solid and growing underlying businesses. To us, rising interest rates signal an improving economy, so as the economy picks up speed, we believe these companies should perform even better.
Investors are right to be concerned about the risks of rising interest rates and the effect the Fed can have on their fixed-income portfolios. Bonds have taken a beating over the past several months. But junk bonds, especially smaller corporate credits, have held up better than the rest and now could be an interesting buying opportunity. When interest rates are rising, investors should be getting out of debt issued by countries and into debt issued by companies.
Jeffrey Peskind is founder and chief investment officer of Phoenix Investment Adviser, a New York–based hedge fund manager that specializes in corporate credit, with nearly $800 million in assets under management.
Tuesday, October 01, 2013
|| Group SJR managing partner Alexander Jutkowitz|
When the Securities and Exchange Commission decided recently to lift its 80-year-old ban on advertising by hedge funds and private equity firms, Twitter erupted with spoof slogans — such as “Fee all that you can fee” (@SconsetCapital) and “There is no information quite like inside information” (@Tradingpoints). Who knew industry insiders had such a sense of humor? But seriously, before we laugh off advertising, let’s take a moment to consider just how big an impact the Jumpstart Our Business Startups (JOBS) Act could have on firms and investors.
First, competition for precious dollars from pension funds, endowments, family offices — your principal investors — has never been fiercer, and leaders in the industry are smartly turning elsewhere. Witness Carlyle Group co-CEO David Rubenstein’s recent comments in Barron’s about why mom-and-pop investors should look to add alternative investments to their portfolios.
Second, the JOBS Act permits general solicitation and general advertising (emphasis mine). In other words, managers now have license to tap nearly any marketing tool they choose — from advertising to public relations to the new and evolving field of digital marketing (which potentially levels the playing field for new or smaller firms).
All in all, we’re talking about new freedoms to source investors in an ever more competitive world. That’s as big as it gets. So how do you do it? Let’s start with something immediately familiar — good old-fashioned advertising.
On the plus side, a full-page in the Financial Times or Wall Street Journal or a TV spot on CNBC almost surely reaches institutional investors, as well as wealthy individuals. Each does so in a prestigious and predictable environment, without any risk to a firm’s brand or credibility.
On the downside, there’s the media buy: a full-page in the FT global edition goes for $252,240 and the WSJ global edition clocks in at $379,597.53, to say nothing of broadcast ad buys. And these ads are here today, gone tomorrow, unless you pay for another one. You do the math.
Advertising is also inefficient. With each full-page spread or TV commercial you’re in front of a lot of eyeballs — in theory. But unless you have a “call to action,” a number to dial or text (hardly the way great managers want to solicit investors), you will never know whether pension funds or wealthy individuals have seen your ads. In the past, marketers made peace with this weakness of TV and print advertising — there was no alternative. Now there is.
Good hedge fund and private equity firms have a worldview, specific strategies and insights to share to make their constituencies smarter. The digital world revolves around the sharing and dissemination of information — knowledge, in other words. Google’s search algorithm is designed to recognize and rank sites with specific, high-quality content (driven by well-defined search terms) that people like, watch, read, link and share.
Here’s your opportunity. Serious investors — your core constituency — are ravenous for information and insights. And you have the unique and timely knowledge they seek. You need to get it to them via smart, accessible, sharable content (i.e., articles, visualizations and videos). Call it a knowledge strategy. The world’s best marketers are already putting it to work for the most sophisticated and timely subject matter. Check out General Electric’s gereports.com for an example of a brand successfully reaching investors, media, partners and regulators.
Of course, we don’t live in a Field of Dreams world. “If you build it, they will come” is not enough. You need to share, syndicate and publicize (a great way to make PR part of the mix). And since the media only intermittently covers hedge fund and private equity strategies from an investor’s point of view, fresh, smart voices are welcome. As mentioned, it also makes sense to consider advertising in media that reach highly targeted audiences you can engage and activate, driving them to your content and site.
Once folks start linking, posting and sharing your stuff, you’ll know you’ve got the goods — and your search rankings for key terms, say, “event driven” or “Japanese long-short” — will soar. And as visitors come to your site, seduced by your knowledge and insights, they will share e-mails, their investor profiles, subscribe to newsletters and more — all critical information you can use to evaluate prospects, make connections, attract investors and build your brand.
A knowledge strategy, in short, lets you connect directly with the people who matter most, track who’s engaging and who’s not, and build a lasting, living online presence. And it can be done at the fraction of the cost of a major advertising campaign. What else do you need to know? Go get started!
Alexander Jutkowitz is a managing partner with Group SJR, a digital consultancy specializing in insights, content creation, curation and audience development.