Hedge Funds

Investment Manager's Letter December 2003

Junk Bonds

“To judge by today's low yields, the corporate debt market has relocated from planet Earth to a far better place. In this paradise, compa­nies don't default, interest rates don't rise and rating agencies don't down­grade.”

This Quote is from the November 2003 issue of “The Grant Interest Rate Observer”. According to Jim Grant the Junk bond market is approaching a state of galloping hysteria.

“Within 18 short months, a panic to sell low-rated bonds has given way to a stampede to buy them.”

We are left to speculate not only on Berkshire Hathaway’s timely $7 billion junk purchase last year but also the probable impact on the bottom line this year. If the current over valuation continues, and if Junk is now as rich as Grant thinks it is, then we can expect to see more realized gains in the fourth quarter as Warren Buffett liquidates more of his high yield portfolio.

For a man who does not believe in trying to predict the market Warren Buffett has made some awesome timing calls in the last three years. First he was selling S&P puts in June of 2000, and then he was buying junk bonds in late 2002. Early this year, Warren Buffett was selling treasuries at the top of a forty year bond rally. Not bad for a guy whose favorite holding period is forever.

High on Jim Grant’s list of probable villains in this speculation are hedge funds. Money (according to the Grant letter) has been pouring into hedge funds that use various strategies to speculate in convertible and junk debt. These strategies include the liberal use of derivatives and lots of leverage. For example the article estimates that hedge funds with $60–80 billion in equity from investors have invested $200 billion in various hedged convertible securities.

The temptation for hedge funds use leverage is large, and results from the following factors:

  1. Leverage pumps up your results, increases your bonus payments, and makes it possible to attract big lumps of new capital.
  2. Leverage right now is very cheap. For example the cost of borrowing to finance convertible arbitrage is less than 2%.
  3. Hedge funds can use the derivatives market to hedge the risk created by leverage. (At least their perception of the risk).

With Just 700 million in assets it would seem that the impact of the Hedge funds would be dwarfed by activity of the $7 trillion mutual fund business, but the impact of the hedge fund business is certainly magnified by cheap leverage and wide spread use of derivatives. And the current stratospheric prices in the junk and convertible bond market would seem to offer evidence that Hedge funds can move markets. It also may be evidence that Mr. Market will eventually have the opportunity to relearn some of the lessons first offered By Long Term Capital Management.

One Unbroken Rule

Over $100 billion in equity was added to Hedge Funds in the first six months of this year and with leverage very cheap the capacity for mischief (both intentional and accidental) is growing like mad. The one unbroken rule on Wall Street is that easy equity and cheap leverage inevitably attract those species most dangerous to investment capital (mediocre talent with no comprehension of the limits of their talent, and intelligent people who are ethically impaired).

A story in the New York Times “When All Numbers In, Do Hedge Funds Shine?” 11/30/2003 quoted a study that claims hedge funds have been able to massage their performance figures to make their record look a lot better than they really are. My personal opinion is, given the lack of regulation, and the inevitability of above rule the only thing that would shock me, would be that no one was massaging their numbers.

This rapid growth of Hedge Fund equity and their easy access to cheap leverage leads me to make two predictions. (1) Not matter how good their past returns have been, it will be very difficult for the industry as a whole to out-perform in the future, and (2) while their many ethical and well managed Hedge Funds the current environment will generate lots of bad behavior.

Buy High Sell Low

Evidence of the ability of Hedge Funds to out perform the market was offered earlier in the year, in a story from “The Investment News”.

Hedge funds held about 33% of their assets in cash on average at the end of the first quarter (2003), up from 23% at the end of 2002 and 17% at the end of 2001, according to a recent survey of managers.

""We have probably not seen a time when cash has been this high for hedge funds," says Annette Cazenave, vice president of marketing at Horizon Cash Management LLC inmChicago."

In other words at the bottom in March, hedge funds where holding their highest level of cash in history. But wait, it gets better, hedge funds like to short; so if you subtract their short positions from the value of the long positions their net long exposure at the end of the first quarter was 23%. That was down from 33% at the end of 2002 and 44% ant the end of 2001. Now that’s what I call market timing.

These numbers are just estimates that come from businesses that service this industry and are a guess at best. As a congenital libertarian I, as investment manager, find it difficult to argue for more regulation of anything, but it sure would be nice to know what was going on under this tent.

We do not know how much hedge funds as a whole are leveraged. Hennessee Group LLC reports figures that their clients give to them, and they claim industry wide leverage for Hedge Funds is less than 200%, but they only know what their clients want them to know. Long Tem Capital Management turned out to have been leveraged to an extent that no rational person would have believed possible. My, as investment manager, guess would be that if the hedge funds were smart enough to be 23% long in march they are probably smart enough to be nose deep in bank debt at the top.

Keep in mind that for the investment managers, the big cookie comes only from gains, and they have to perform to keep the money from migrating. So given their position earlier this year they are going to have to be peddling like crazy to catch up. The typical hedge fund fee structure begs for abuse because the incentives are crazy. This system only works if the managers have integrity and understand the risks ahead.

Getting back to the regulation thing, I, as investment manager, will have to admit a have selfish motive for bringing this up. I, investment manager, want to know more about what Hedge Funds are doing so when I see they are 90% long I will know it is time to go to cash.

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