Its all rather confusing. But not any more so than usual. Things are always confusing in the present and clear in the past. What is confusing today, are the number and strength of the conflicting signals. We therefore consider, in broad summary, the bull and bear cases for general conditions. 

The bull case.

The US economy is onto a sustainable recovery. Europe appears to be editing recession bnnand establishing a sustainable recovery. Even China appears to be stabilizing sufficiently for the government to embark upon structural reform. Japan has staged a remarkable comeback under the new, or old, prime minister. Only the emerging markets look a bit tired. Markets have experienced some turbulence mostly because the US Fed has publicly contemplated the gradual withdrawal of extraordinary stimulus. This has send interest rates higher and bonds lower. Emerging market assets have corrected sharply on an apparent switch in capital allocation. However, generally, the signs mostly point to a healthier global economy with the tapering of QE testament to central bank confidence in the US and China, which is undergoing their own brand if QE tapering.

The bear case.

There is some convexity around the bear case. Fundamentally, the US economy’s growth is both weak and potentially unstable. Unemployment numbers are only suppressed by a declining participation rate. Inflation numbers are not indicative of a strong recovery. The housing market seems to be slowing as mortgage rates climb. Corporate profitability seems to have peaked. Earnings growth has been powered by the financial sector and only then by a reduction in provisions for bad loans.

Europe remains financially fragile with most of the problems back ended until after Merkel, hopefully, wins the German elections. Greece, Spain, and Portugal are cash flow insolvent with Italy not far behind. The Draghi Put is untested and hopefully will remain so.

In the emerging markets, Brazil and India struggle to regain competitiveness while the current accounts of Indonesia, India and Turkey lead a pack of deficit countries raising fears of crisis. And China’s semi closed capital account may insulate it from contagion, but its debt levels and opaque shadow banking system represent a significant tail risk.

Making sense of all the signals.

Both bull and bear signals coexist as they often do. Complicating the analysis are the outright conflicting signals between fundamentals and market prices. With little evidence of inflation, US rates are expected to rise and the term structure has indeed already steepened. The market regards QE tapering with trepidation even as it is a sign of underlying strength in the economy. Emerging markets still represent the main marginal driver of global growth yet capital has fled on apparently no significant catalyst.

One of the complicating factors is QE itself. Administered as an analgesic during the crisis it has sheltered the economy and the market to the extent that it is hard to estimate the health of the economy without QE. Such uncertainties plague asset markets.

The lack or an unadulterated signal also impairs the ability of policy makers to measure the normal equilibrium condition of the economy. Policy makers end up making policy to manage legacy policies, and are required to think iteratively through the feedback loop. Feedback loops are as we have experienced in the past, rather unstable and unpredictable. This makes policy increasingly difficult to get right.

For the investor, the level of noise risks swamping signal. Short term trends can be confusing and provide false signals. Longer term horizons can mitigate some of this. What it means is that I am for the moment suspending my usual reliance on shorter to medium term signals in favor of longer term ones, and relying more on fundamental, bottom-up security selection than on tactical, momentum driven, macro trading. For the moment.

Is Caterpillar a US company or a Latin American one, or a European one, or an Asian one? Is Santander Spanish, British, or Latin American? Is Alstom French, or Nestle Swiss, or HSBC British, or Chinese? Are any of the large listed Swiss companies Swiss?

When we say equities are cheap and bonds expensive, to which companies do we refer?  Should we compare the equity valuations of large caps with the bond yields of high yield issuers? Could the cheap equity issuers have even cheaper bonds?

The world fears peripheral European banks. How then should an investor regard the securities of the German operations of a Spanish bank? Or the securities of the Swiss operations of a US investment bank? How much did the holder of Lehman International UK bonds get in recovery, 9 cents or a dollar and change?

Established investment methodology has always puzzled me. The modus operandi involves having a top down macro view, from which the regional and country allocations are made. A macro analysis of the relative attractiveness of equities and bonds are made, sometimes before, sometimes after the regional and country allocations are established. Bottom up stock picks are then made to populate the asset allocation. In an increasingly globalized world, this approach appears less relevant. Companies are more global than ever before. They do business and thus derive their revenues from various regions and countries and they fund themselves sometimes locally and sometimes globally, making their commercial prospects the result of complex interactions not captured by traditional methods of asset allocation.

Instead, companies should be analyzed from the bottom up by assessing the revenues from each region and country, and their costs and financing, in the same manner, from where they originate. Top down macro analysis can direct the search for opportunities but should not determine the asset allocation directly. Once the fundamentals of a company or business have been estimated, the value of the firm needs to be distributed across its corporate and capital structure. Each security is therefore valued on fundamentals. Then the hard work begins.

Asset prices and markets are driven by fundamentals not through a mechanical couple but through an elastic or viscous couple. Having a fundamental valuation of each asset is necessary but not sufficient. Market technicals and psychology need to be considered in the investment decision. For each market, an intimate understanding of all the major market participants, their motivations and capabilities, needs to be obtained and factored into the investment decision. Market participants are motivated by their economics, agency compensation, cultural peculiarities, regulation, et al. Their capabilities will involve their sources, costs, availability and stability of funding.

The result of all this analysis is the efficient portfolio. Asset allocation between equities and bonds, between regions or countries, is a consequence of the process, not the root of it.

Concepts like volatility and correlation can be hard to visualize or grasp intuitively. I sometimes like to think simplistically about complicated matters. The insights gained are often far from simplistic. Hedge funds are unfortunately, a complicated subject, and try as one might, it is difficult to reduce the complexity of the issues.

One of the reasons that hedge funds are an attractive investment is that because they don’t spend long spells in decline, they are a useful investment for someone who doesn’t know when they might need liquidity and have to sell their investment. A steadily rising NAV provides a useful store of value which can be realized based on ones’ needs and liabilities rather than based on the performance of the asset. Nothing is without volatility or risk but hedge funds dampen volatility sufficiently to make the liquidation decision less dependent on the asset performance. With long only, exposure based investments the liquidation and indeed investment decision often depends on an assessment of both the investors’ liability requirements as well as the historical, current and prospective asset performance. A simple example is the following. An investor’s decision whether to liquidate their position in an S&P 500 index ETF depends not just on whether they need cash or not but whether the S&P500 is expected to rise or fall going forward or on whether the market is cheap or expensive. Investor regret is another psychological factor that complicates the decision. The investor is discouraged from disinvesting if it means crystallizing a loss or if they have recently experienced a large drawdown. Memoryless investing is a difficult ideal.

Low volatility is a useful feature in an investment as it allows the investor to compound their returns. Of course low volatility should be coupled with a positive return. Compounding is one of the most powerful concepts in investing and one often misunderstood even by seasoned investors. If investors understood compounding there might be fewer investors who fail to reinvest their dividends. A cursory survey of the proliferation of dividend paying mutual funds, some even paying out of capital, will illustrate this.

Hedge funds specialize in niche markets and strategies. Even when they invest in broad markets, the successful ones always have unique approach. Often, hedge fund techniques have been honed by years of trading on a prop desk risking bank shareholders’ capital allowing the hedge fund manager to learn without fear. Hedge funds excel in ‘closed’ markets which are not well known by garden variety investors. Their consistent returns are often supplied by itinerant and unfamiliar investors or tourists as they are known euphemistically. A large bond mutual fund manager trafficking in the mortgage backed security market is an example of such tourists. Dedicated MBS traders whose careers have been focused on the MBS market tend to fare much better than their generalist cousins in a game that is not entirely but fairly close to, zero sum. That the MBS market is one of the largest and most liquid in the world is no protection for the unfamiliar. The insularity of that market, the peculiarities of its culture and regulation, make it a difficult place for tourists. Merger arbitrage is another great example of equity investors employing more than just equity valuation and analysis to what are often complex legal and strategic events. The best merger arbitrageurs are those who combine legal expertise with corporate finance, private equity, and equity analysis and an understanding of the options market to employ optimal trade expressions so as to eke out all the available returns in a merger deal. A lacking in any one are puts one at a disadvantage against traders with the full range of skills. The best merger arbitrageurs benefit from the liquidity provided by less well equipped merger arbitrageurs and long only fundamental or speculative investors.

Hedge fund detractors argue that hedge funds have failed to outperform equities. Depending on the time frame hedge funds have either outperformed by a wide margin, 1993-2013, averaging 9.23% p.a. versus 4.86% p.a. for the MSCI World. In the last 10 years, however, hedge funds have done a paltry 6.14% p.a. against 8.55% p.a. for equities. That said, the volatility of hedge funds have tended to be less than 6% whereas equity vols have been about 15%. Practically, what this means is that the amount of risk assumed to obtain a unit of return was much higher for equities than hedge funds. This point is very much related to the first concept we discussed, that investing in equities needs good timing.

When comparing the performance of hedge funds with other investments it is necessary to use some kind of benchmark or index. One should be circumspect about the utility of hedge fund indices. Apart from data and construction issues which are well documented, there is the question of what such an index measures. Mutual funds can easily be benchmarked against market indices. However, while the average mutual fund is, well, average, the average hedge fund is quite poor. Low barriers to entry, light regulation, even as standards are tightened, the absolute return objective, make it hard to excel in a highly competitive industry. An index designed to be representative of the collective, if successful, might reasonably be expected to display lackluster returns.

Hedge fund investing is all about seeking out the best in their respective fields. The successful hedge fund allocator should assemble a portfolio that p
erforms and looks very unlike the index. Hedge funds are not a homogenous group but display significant dispersion of behavior and results. The potential for finding the exceptional is high. The risk of finding the mediocre or the poor is high.

One of the problems with any investment is that with wide acceptance comes correlation. While hedge funds are not homogenous and many have unique strategies, even independent strategies can become correlated through the behavior of their investors and prime brokers. Investors control the source of equity capital available to hedge funds while prime brokers control the leverage available. Herd psychology and cross contamination can lead to group behavior among investors. That prime brokers are almost always leveraged by a multiple or several multiples more than the hedge funds they finance adds to potential instability. Hedge funds with adequate liquidity restrictions can in fact be a strength although very few investors recognize this or accept it; exhibiting a strong liquidity preference. This liquidity comes at a significant cost.

How relevant are hedge funds today? In the post 2008 world, hedge fund indices have indicated a lackluster performance easily eclipsed by equities or corporate credit. Beneath the headline numbers, a group of hedge fund managers have outperformed the market either in absolute terms or in risk adjusted terms. These funds have tended to trade in credit. Some equity funds have managed to excel but these have tended to be merger arbitrage and activists or indeed credit funds extending beyond their normal hunting grounds in the capital structure. Structured credit funds, particularly those involved in mortgage backed securities have also excelled.

The opportunities for making money are ample today. They may be less accessible to long only strategies since markets have recovered strongly from their 2009 lows. The world continues to be a complicated place with a steady stream of tectonic shifts in geopolitics, policy, economic fortunes, regulation and the structure of distribution and allocation of capital. These are very interesting times indeed for investors who seek out and embrace complexity as a source of alpha, or non-market returns.

In this time of emerging market capital flight, governments may be tempted to defend their currencies. This is a mistake. Such a defense rarely works. As governments buy local currency and sell hard currency, foreign reserves are further depleted signaling weakness to speculators who are encouraged to further short the currency. This establishes a death spiral. A better strategy, albeit a rather frightening one, is for governments to join in the carnage and sell local currency for hard currency. This drives the currency down improving the terms of trade and export competitiveness. In the short term it boosts reserves, and in the longer term, it boosts reserves.

There are of course, risks, to this strategy. The currency could depreciate too quickly. Governments have to stand ready to close the capital account in that eventuality. The alternative tends to lead to the same conclusion anyway.

Economic growth in the developed markets appears to be in a general if tepid recovery. The US continues to exhibit steady recovery in economic growth supported by a robust housing recovery and manufacturing which has even now widened to a slightly healthier labor market. Tempering this is a falling participation rate, which is troubling since the unemployment is in the younger cohorts, and the increasing proportion of temporary work, which is more likely a consequence of Obamacare, which requires employers to provide health insurance to full time employees.

In Europe, a nascent recovery is underway, a first quarter of positive growth after six negative ones, led by Germany, and featuring, surprisingly, France.

It is perhaps surprising that the weak spots in the world have come to be the emerging markets, although the emerging markets are far from homogenous. China’s weakness seems the biggest threat given the size of its economy. India is unnerving with the acute weakness of the INR and the shortage of USD unsettling markets.

The last 5 years have been marked by the importance of policy intervention. Central banks have reduced short term interest rates and multiplied their balance sheets to fund their respective governments in the face of bailout bills and flagging tax receipts, as well as to inflate liquidity in the hope of stimulating demand. Success must imply a rollback of such policies if nothing else than to reset their policy weapons, but more importantly to wean the economy off life support. QE tapering can thus be viewed of evidence of strength and not weakness. Currently only the US Fed is contemplating a moderation of QE. Most other central banks still face weak economies and continue to be dovish. But the US Fed faces another problem, if indeed it can be called that. As the economy recovers, tax revenues have recovered also and the US Treasury will not need to borrow as much. At the same time, despite a housing recovery, securitization has slowed compared to pre crisis levels. This presents a supply problem. If the Fed were to continue to purchase a fixed proportion of new issuance, it would be forced to slow its buying anyway. Perhaps to manage market expectations the Fed has telegraphed its intentions well in advance. No such luxury exists elsewhere in the major economies.

I am comfortable with the nature of the recovery in the US, that it is sustainable in the long run. The volatility in US assets is a consequence of the withdrawal of stimulus which should signal strength. Be that as it may, US asset markets have rallied hard and it is time for a breather. Tactically, buying put protection or outright neutralizing the beta may be a good idea. Longer term, the prospects for US assets remains good. Europe is not out of the woods but could, and I emphasize the could because nothing is certain, be 9 months behind the US in terms of recovery. If so, European assets are a good buy, in particular corporate debt, especially high yield since we appear to have good corporate performance coupled with low growth.

While China had me concerned for a while I am a bit more sanguine on her prospects now. While I still regard the innovation deficit in China to be a serious drag on the economy, and I expect growth to moderate further, valuations are sufficiently low to warrant buying. The one impediment was the health of the financial system, in particular the shadow banking industry. It now appears that the government is serious in facing the issue by measuring the risk and then managing it. In some ways, the Chinese economy, while slowing from a frenetic pace, is, at least in the view of policy makers, sufficiently robust to warrant a restructuring which has certain parallels to QE tapering. This is a good thing.

It is perhaps the strength in developed markets that poses the largest threat to emerging markets.

1. The USD and EUR have been stable to strong with expectations for further strength in the USD.
2. The US economy is expected to extend its recovery and Europe appears to be stabilizing.
3. Developed market corporate balance sheets have been rehabilitated quickly.
4. The Refinancing Wall, a trillion USD and change in Europe, a couple of trillion USD in the Americas, is likely to displace demand away from emerging market debt and perhaps even equities.

So far the nascent sell off in emerging markets has found no trigger, no single factor. However, I would not underestimate the impact of competing sources of capital on EM assets as capital first reallocates and next flees away from emerging markets.