The thirst for yield has led to companies raising more debt at cheaper funding levels than before. This has led to a deterioration of credit quality. Of late some companies have been raising debt for share buy backs recognizing the gap between the cost of equity funding and debt funding. This should imply that investors should prefer equities to bonds since the insiders are clearly signaling this through their adjustments to their capital structures and additionally, since debt issuance has increased to the extent that companies have sufficient liquidity for the foreseeable future, risk of default is low and yet leverage has increased, an ideal confluence for equities which can be regarded as a call option on the underlying value of the firm. 

Hedge funds don’t make investors rich, they preserve the wealth of the investor who is already rich. Most hedge funds are aware of and carefully manage downside risk and volatility. Long only mutual funds have benchmarks to which they tend to cling. A volatile benchmark can seriously injure an investor’s portfolio.

Given that hedge funds are in fact lower return and lower risk, why is it that both regulators and professional intermediaries both consider them to be more risky than long only mutual funds? This is fact. Ask any regulator or professional investment intermediary and they will always allocate more hedge fund exposure to aggressive risk client’s portfolios and less exposure to conservative client’s portfolios. This absurdity is lost on all but children and rational individuals untainted by the superstition perpetuated in the financial industry. Clearly the regulators and financial intermediaries cannot be well informed. On the other hand, we may ask how a hedge fund manager invests their own capital since they are unlikely to get rich from investing in their own risk controlled strategies. The hedge fund manager must either have made his money elsewhere and is seeking to now preserve his wealth, or he is trying to get rich by charging the usual high fees associated with hedge funds, which he can only do if he attracts sufficient third party fee paying investment capital. A hedge fund manager trying to get rich investing in his own strategy should attempt to apply significant leverage to his own investment in his fund. He should not apply leverage within the fund, but should apply it to his own investment portion only, since if he leveraged he fund, he would only be diluting his fees, and scaring away a lot of less sophisticated investors. Regulators who understand these dynamics  should therefore not prohibit less sophisticated investors from investing in hedge funds but rather regulate the degree of leverage investors of various levels if sophistication may apply to investments in general. They may achieve this by regulating the borrower or the lender. One way of regulating the lender is to withdraw the lender of last resort from the system since poor credit standards would injure the lender.

The Wide Angle:

• Customers of a company should want to see the employees of the said company buy their own products and services and own shares in the company or at least have a direct link between their compensation and the quality of the products and the satisfaction of the customers. As an employee of a company, I want to diversify my share holdings among my company’s competitors and other industries as well. 

• In some industries, the asymmetry of information between the seller and the buyer of the service is more acute. Examples are financial services, in particular retail financial services. There is the additional problem of institutions which represent systemic risk by being too big to fail. One solution to these problems is to require such institutions to constitute themselves as unlimited liability partnerships.

• The encouragement to greater scope for risk taking and risk sharing is incompatible with the concept of limited liability. On the one hand economists encourage individuals to take more entrepreneurial risk and on the other they condone limited liability business structures. In fact the limited liability institution is a structure designed to encourage risk taking.

•  The interests of the shareholder, customer, employee troika is beyond resolution.

I discourage investors from investing in anything they don’t understand. Hedge funds are fairly complex as far as investment strategies go, so I often discourage investors from investing in them unless they are sufficiently knowledgeable. If they want to invest in hedge funds, I tend to steer them towards funds of hedge funds or asset managers who run portfolios of hedge funds, professional hedge fund investors who can help with due diligence and portfolio construction.

The other reason is that the uninformed investor is a liability to everyone.  When an investor invests in ignorance they do not react rationally to the evolution of prices or to new information. On the one hand this makes the uninformed investor an excellent provider of liquidity in their capacity as counterparty. On the other hand, they represent unreliable sources of capital if they happen to be on your side of the fence. Better to have them on the other side of the fence. And yet, an erratic opponent is not always easy to deal with. Often the best opponent is someone with a systematic bias the result of regulation or some other persistent inefficiency. Random players are not easy to play. They may lose consistently but they can also confound your best laid plans.

Another issue is capacity. The best hedge funds have capacity constraints. The best opportunities are not easy to find, and are not limitless in terms of how much can be invested in it at a time. As a result, good hedge funds often limit how much capital they will take into their fund so as not to dilute their returns.

At the strategy level also, capacity is an issue. If too many funds invest in a particular opportunity, prices tend to move in such a way as to erode the opportunity. If too many people invest in hedge funds then the superior risk adjusted returns they generate will be eroded. Professional hedge fund investors would reasonably be expected to prefer fewer investors or less capital deployed to hedge funds so as to maintain their returns. One of the phenomena just prior to the crisis in 2008 was the compression in returns on assets employed in hedge fund strategies due to the influx of capital to these capacity constrained strategies. As a result, managers seeking to maintain returns on equity capital increased their leverage and therefore their risk. Existing investors might reasonably consider themselves diluted by additional investors.

The current environment is conducive to relative value and arbitrage. The aftermath of the credit crisis has created very compelling and rich opportunities in event driven, merger arbitrage and credit strategies. Equity strategies and macro strategies have and will not have an easy time. In addition to the opportunities created by the crisis, regulation, popular opinion, political pressure and investor superstition maintain and generate a constant supply of opportunities. That investors have been slow to adopt or re adopt hedge fund strategies has helped returns. Just look at how the visible and popular strategies have done in the last 3 years. Macro and trend following strategies have done exceptionally poorly given the expectations implied by the environment. Unpopular, apparently risky, strategies like mortgage backed securities, structured credit, credit arbitrage, merger arbitrage have done well. This observer is conflicted as he surveys the landscape. On the one hand, it would be nice to see investors returning in greater mass to hedge fund strategies, but on the other, as an investor in such strategies, its is equally encouraging to see that trades are not getting crowded. Hedge funds used to be a smallish, private, sometimes secretive industry profiting the few. It’s getting to be like that again.

The Parallel Stages of the Credit Bubble 2001 versus 2009

Stage 1: An event drives investors into a particular asset class. At this stage the investment thesis for investing in such asset class is likely still sound. When interest rates were cut aggressively in 2001 in the aftermath of the Dotcom bubble bursting investors fled equities and went into fixed income compounding the problem of finding attractive high yielding assets. In the aftermath of the 2008 credit crisis investors fled risky assets such as equities and reallocating into risk free assets like US treasuries.

Stage 2: Valuations in the security asset (that’s the asset investor flee into as they exit the distressed asset), in 2001 corporate bonds, and in 2008 US treasuries, rise, causing yields to compress.

Stage 3: In 2001 as valuations of corporate bonds rose and their yields compressed, alternatives had to be found. Investors moved out the term structure as well as down the credit quality curve leading to a yield drought. In 2008 investors diversified out of US treasuries to corporate credit in a similar pattern moving out the term structure and flattening he yield curve as well as moving down the credit quality ranking from investment grade to junk.

Stage 4: Investors sacrifice quality and prudence for immediate gratification. In the 2001 story, investors later piled into SIVs and CDOs because of the higher yields and at times, a favorable credit rating, for whatever that was worth. In 2008, structured credit was at the heart of the crisis and as a result investors have remained cautious about the asset class. However, investors have managed to pile into everything from emerging market hard currency and local currency debt, junk bonds (or high yield as they are now more respectfully referred to), option writing on any underlying instrument with even a shred of volatility, and dividend paying equites.

Stage 5: When investors seek a specific type of product, regardless of the rationality of that objective, the financial industry always obliges. In the aftermath of 2001 investors sought yield as well as some form of validation in the form of a credit rating. The financial industry packaged assets of varying quality and then issued tranches liabilities of differing claims, often obtaining a credit rating, and a high one at that, in order to satisfy both yield and credit rating criteria. The result were SIVs and CDOs. The perversion of these constructs did not happen immediately but set in when demand for liabilities outstripped the availability of assets and led to serious adverse selection issues in credit markets, most notably the mortgage market. The rest is history. It is also poetic that a construct designed for the dynamics of an earlier crisis should precipitate the second one. We haven’t yet seen a construct addressing the insatiable thirst for yield this time but we have seen some questionable solutions. Mutual funds which pay dividends come hell or high water are one example. These funds may be equity funds or bond funds or balanced funds but their defining feature is a promise to pay a frequent (often monthly, sometimes quarterly) dividend. Some of these funds will even pay out of capital when income is insufficient, a practice which simply doesn’t smell right. Having squashed bond yields, some funds have specifically targeted high dividend paying equities, creating a surreal bull market in these types of stocks. One can only hope that fund managers do not go so far as to invest in companies who pay dividends out of capital or new debt. That would be too comical. Other strategies involve employing increasing leverage to portfolios of bonds, a stratagem which finds parallels if not analogues in CDOs and SIVs. Still other desperate measure for yield junkies involve option writing on any convenient underlying instrument within easy reach.

The parallels between the reaction to the Dotcom bust and the reaction to the 2008 financial crisis are remarkable. History doesn’t repeat itself but it does seem to exhibit a consistent autocorrelation.