Morality and social norms are informal rules of law which humans invent to deal with conflicts which do not yet warrant formalization in law. Morality exists for pragmatic reasons, the result of a Folk Theorem.

Humans are entirely self interested. I offer this without proof because it is patently self evident. Charity or selflessness is only the product of fear, guilt, mistaken strategy and superstition. Individually, the human being is interested in one thing and one thing alone and that is to achieve whatever they wish to achieve unimpeded. How do we pass from the self interested individual to a system of social norms or morality that governs collections of individuals? Humans interactive repeatedly, thus engaging in repeated games, and hence any grim trigger strategy will punish deviation to such an extent that cooperative behavior becomes accepted as a social norm or a form of morality.

It is useful to understand behavior with these basic axioms. The analysis can be extended to policy makers, government, individuals, economic agents, crowds and markets. These axioms do not replace the basic motivations of fear and greed. They do, however, animate these motivations.

Prior to the financial crisis of 2008, the world was driven by greed, not fear. The objectives of profit, of gain, dominated the world. Under our assumptions of human behavior, the boundaries of moral and socially accepted behavior, even lawful behavior would be tested by the most ambitious examples of humankind. The types of behavior under greed were concentrated in fraud, the inflation of one’s own abilities or achievements in order to obtain acclaim or reward. Some of this fraud has been discovered but it is almost certain than some have escaped detection, at least until another day.

The current climate is characterized by a shrinking economic pie and increasing desperation, resulting in a more contentious atmosphere, protectionism and a latent state of conflict. Fear will drive behavior and test the boundaries of social norms and morality for the foreseeable future. Our analysis of human behavior should be advised by this regime.

• Protectionism and Mercantilism including for example, competitive currency debasement.
• Martial conflict, over resources and territory for example. As a species we have matured beyond conflict over ideology and other such high principles.
• Fraud to hide weaknesses rather than advertise strengths.
• Risk of expropriation by means direct or indirect, overt or covert, including financial oppression.
• Increased risk of Class Conflict arising from wide and growing disparity of wealth, income, and opportunity.

Never write off the US consumer, particularly when the Fed is providing them with financing.

There is a recovery underway in the US, beginning in housing, but through legislation and Fed policy, expected to extend to consumption through the potential monetization of home equity.

The Fed is not only no longer the safekeeper of the punchbowl, they are spiking the brew.

Given the track record of the experts, the EUR is likely to be strong, and European yields will go to zero in the long run, supporting bonds of Eurozone members, at least the ones who are less insolvent than others. Check out Euro area competitiveness and trade balances if you think I’m crazy.

Correlation is introduced between assets by vehicles which connect them in unexpected ways. For example, US treasuries being widely used as collateral in total return swaps can correlate with swap reference assets even if they are unrelated in any other way. Think of Gold ETFs done on swap.

Yield addiction beats rationality every time.

For every yield junkie, there exists a dealer.

Note that the US economy had begun its recovery in October 2011. Stage 1 of the recovery came from exports. Countries that benefited were not the natural exporters like China and Japan but rather anyone exporting to emerging markets, since they were the only importers with any ability to pay. Now even this game appears to have run its course as every country on earth seeks to export amid the current synchronized slump. Exacerbating this is a dearth of trade finance whose natural source has been the European banks who now find themselves a little bit short on capital.

Thus the global synchronized economic slowdown rolls on, and it took the announcement of unlimited quantitative easing by both the Fed and the ECB to stop the rally in risk assets. All other central banks have already got with the program and are minting empty promises at best speed.

In June, the market wrote off India as a lost cause, mired in political deadlock and stagnation. This seemed to be the catalyst for some maneuvering by the Prime Minister to push forward a slew of reforms, which have yet to be ratified, but have boosted expectations and the Sensex into a 20% rally. Whatever happens, the fiscal deficit is bound to widen on the back of more pork barrel politics.

On this basis, the weakness in data from the UK and the acutely poor sentiment for the UK economy suggests that the UK economy has probably troughed. Unfortunately, there is a corollary to Murphy’s Law that says that you cannot make it rain by washing your car.

We have already noted in the past that QE limited on unlimited is only half of the equation, that it represents the financial part of a reorganization but not the operational side of it. As a business reorganization, QE is therefore incomplete and requires in addition, a new business plan to demonstrate a viable path to recovery. We have not seen such a plan on the fiscal or budgetary side. Austerity seems to be the only tool in policymakers’ toolkit; however, this is to be expected since in most debt negotiations, creditors drive the discussion, that is, until default or liquidation.

So extremely inflated is the monetary base and so great the expansion of the banking system’s balance sheet that one should consider the current strategy of the central banks highly non-robust to errors in policy. It has become difficult if not impossible to predict the consequences of policy, because all predictions are probabilistic and subject to envelopes of uncertainty, so high has this uncertainty become that it must encompass all manner of ‘tail’ possibilities.

Macro strategy based on expectations for economic variables and their impact on liquid assets pricing is therefore extremely prone to error. The only safe alternatives are direct lending and arbitrage.

There is a shortage of bank capital and thus bank lending. As a result private capital is finding less competition. On the other side, excess demand for funding allows lenders to be pickier and for underwriting standards to be higher. Trade finance, factoring, payroll finance, mezzanine finance, venture capital, private equity, real estate sale and leasebacks, equipment leasing, are lucrative investments. Even leveraged loans, particularly in Europe are looking interesting as European regulations drive capital away from the securitization markets. If the economic cycle proves less rosy than expectations, exchange offers and debtor in possession financings will not be far behind. 

Arbitrage or quasi arbitrage opportunities are also usually available in abundance when markets dislocate. Bank regulatory capital relief trades, capital structure arbitrage, convertible arbitrage, all involve a mispricing of different claims, either for regulatory reasons, or adverse selection reasons. Either way, in credit, when demand and supply are driven by psychology and differing claims imply differing default probabilities or recoveries, arbitrage becomes possible. In equities, the trade is more one of relative value than arbitrage, a far less robust strategy prone to being confounded by persistently irrational markets. Only in event driven hard catalyst strategies can equities be more robustly applied to arbitrage. In the absence of an announced event, price convergence is subject to excessive extraneous factors.

If I was a macro strategist, in other words a betting man, I would say that the UK economy will outperform, so will the US, while Germany slips into recession taking the rest of Europe deeper into the abyss, and India slip
s back as fiscal constraints strangle pork barrel policies and China continues to slump taking the commodity countries with it. The trade expression is even more unclear; shorting German (and other developed countries’) exporters to China is top of the list, shorting high yield (still an expensive trade to maintain), buying non-agency mortgages and US homebuilders (to capitalize on the housing recovery, and even that is pretty uncertain), selling Italy CDS protection and buying German protection is a convergence “the Euro will hold together trade (which incidentally is a short Brent trade in disguise), US 5 10 flatteners through the cash or through payers and receivers (the other wings are too expensive),

Happy Friday

• China is going to have another bad year. Time to short German exporters.

• The CLO trade in the US is done. Apply similar recipe for Europe.

• The trouble with central banks trying to inflate asset prices is that eventually, hedge funds start shorting something real.

• Austerity for fiscal balance is like giving up your right arm to be ambidextrous.

• Governments lie and cheat. So does everyone else but governments do it with impunity, and its part of their standard process.

• Buy the USD. Every central bank is debasing their currencies but the US have the better print quality.

• You can rely on human nature. On that basis, expect the economic crisis to escalate into war.

• The Japanese and Taiwanese have descended into a spitting match in the East China Sea. They do not stand a chance if the Chinese get involved.

• Consensus in government means you can debate all you want but the final decision is mine.

• The world’s oldest central bank was a failed bank.

• The world’s second oldest bank was a distressed debt hedge fund.

• All the world’s central banks are now pawn shops.

Hedge funds are now more useful than ever now that many investors have given up on them.

Since the trauma of 2008 when some funds gated redemptions, side pocketed their ugly skeletons of illiquid securities, suspended NAVs altogether, only US institutional investors have resumed investing in any scale. European investors who were significant investors in hedge funds never quite recovered from the Madoff scandal and the general disappointment of what they thought was a bullet proof investments. And yet, hedge funds, even on average, and one should never invest in the average hedge fund, did well relative to equity investments. On a risk adjusted basis, over a multi decade period, they’ve outperformed a balanced portfolio of equities and bonds. Yet Europe turned its attention towards regulated hedge funds, or UCITS III funds, there is now a UCITS 4 directive that extends the already convoluted UCITS III rules… These have also disappointed as me too managers jumped on the bandwagon in the hope of gathering assets. The higher quality managers simply dove underground, eschewed UCITS and me too investors and went about managing partners’ capital. It was a return to the old days. Asia, a late adopter of hedge funds, whose investors had a net negative return in the asset class all told, have simply given up. They turn to real estate and private equity, moving up the risk scale by seeking directs instead of funds, and applying as much leverage as their relationship banks will give them. Given the asset inflationary efforts of the central banks, these investments have worked, thus far. Its not clear if these investors are aware of the levered beta exposure they have assumed. Indeed its not clear the leverage providers are aware of the same. Doomsayers are sidelined as naysayers, who will one day publish their memoirs or tell them in bars.

The hedge funds that have found capital tend to be the larger brand name funds with a strong recent track record. Beware. A strong track record is the confluence of skill and luck and discerning the relative contributions of each is not easy. The risk arbitrageur who suddenly gets lucky in mortgages can generate such a remarkably strong track record that investors throw money at them, which they subsequently halve in their attempt to reinvent themselves as global macro managers. Investors still chase returns, fall for the institutional pitch, the legions of staff, the bold offices, the glossy presentations, and the references of old investors for whom the trade is already done.

As a whole, the hedge fund industry has done a poor job. At least that’s what the HFRI indices indicate. But this was always going to be the case. In an unregulated industry seeking absolute returns, not benchmarked relative returns, more will fail than succeed. Hedge fund detractors claim that hedge funds don’t add value, and they are right. The average hedge fund doesn’t add value, it quite definitely detracts from value, especially with the high fees. There is no question that in this highly talent dependent industry, the average is decidedly poor. The good managers are decidedly good, and decidedly in an acute and elusive minority. How do you find them?

It is not entirely useful to try to pick outperforming strategies. The winds of fortune come and go for each strategy. There will be times when a particular anomaly arises which presents glaring arbitrage opportunities. However, when such opportunities have been harvested, what is an investor to do? Redeeming his investment would not be an unreasonable reaction. The talented hedge fund manager weathers all conditions, except the catastrophic ones. Beware managers who survive catastrophes but are otherwise unspectacular, this is a warning sign of good luck, something the investor is well advised to avoid.

Picking outstanding managers is not easy either but it is much more useful. The dispersion of returns of hedge funds around their peer index is significantly higher than one will find for mutual funds, and understandably so. There is no clustering around a benchmark, no place to hide. Successful managers are expected to make money all of the time. It is therefore important to identify these talented managers and to distinguish between skill and luck.

Of the managers in the portfolio, 7 out of the 10 managers have done significantly better than their peers, and generated strong returns. Year to date August, the merger arbitrageur is up 18%, the credit alternatives fund is up 12%, the credit long short is up 7.5%, the event equity fund is up over 16%, the multi strategy capital structure arb is up over 13%, the Asian carve out by the same manager is up over 7% and finally the credit and converts fund is up 5.9%. Slightly discouraging were the fixed income arb fund at -0.06%, the fixed income relative value and macro fund at 0.13% and  the Asian multi asset at 3.58%. The HFRI Index has only managed 3.52% year to August. The portfolio as a whole is up 9.29% gross year to August and 8.63% net.

None of the managers is a megasized brand name manager. All of them were found after extensive research, analysis and due diligence.