The quarter past: Editorial Analysis of Recent Market Developments
Lipper HedgeWorld Staff.
For many in the investment management world, 2007 couldn’t end fast enough. Credit markets were crumbling, stock prices were stumbling and the economy was sputtering — at least in the United States.
It was a quarter during which we became familiar with some uncomfortable terms like ‘write-down’ and ‘sovereign wealth fund’, and re-acquainted ourselves with ‘liquidation’. The quarter, it seemed, was dominated by news of major investment banks posting huge losses as a result of exposure to sub-prime assets, including mortgages and pools of mortgages, and other debt that turned out to not be worth what many — including the rating agencies — thought they were.
And yet, amid all the gloom, some profited and others saw opportunity to profit in the future. The world didn’t end, although there were a couple days when people in the financial industry probably thought they could see the end from where they were. We will probably look back on the fourth quarter of 2007 as the point where it all started heading south… or not. Maybe it will be where we saw what was ahead and changed course. Time will tell. In the meantime, here’s a look back at the quarter that was.
The bad news
Citigroup disclosed on 4 November that it would write down between $8 billion and $11 billion in exposure to sub-prime mortgage assets. Citi’s chairman and chief executive, Chuck Prince, resigned. The write-downs were related to US sub-prime mortgage exposure.
In a statement made in November, Morgan Stanley said that it had $12.3 billion in US sub-prime related balance sheet exposure at the end of August. Morgan Stanley also reported losing $2.5 billion in fourth-quarter profits, due to losses incurred in two months (from the end of August to the end of October). As a result of the market decline since August, Morgan Stanley’s revenues for those two months were reduced by $3.7 billion. This represents a decline of approximately $2.5 billion in net income on an after-tax basis, the bank said in the statement.
Merrill Lynch also reported the biggest quarterly loss in its history on 24 October after writing down $8.4 billion, mostly from bad investments related to risky sub-prime mortgages. ‘The bottom line is we got it wrong by being over exposed to sub-prime’, Merrill Lynch chairman and chief executive, Stan O’Neal, said on a conference call.
The first of a new round of investor claims was filed against Bear Stearns Cos. on 5 December for its role in managing two mortgage hedge funds that collapsed earlier this year, securities lawyers said. The claims, which will be submitted to the Financial Industry Regulatory Authority for arbitration, represent more legal challenges for Bear Stearns, which recorded losses this summer. The first of at least 11 new claims involves an unidentified Cayman Islands fund of hedge funds manager that lost $1 million in the Bear Stearns High Grade Structured Credit Strategies Enhanced Leverage (Overseas) Fund.
130/30 Strategies: A New Paradigm or a Fad? Exclusive Results From a Survey
Christopher Holt, AllAboutAlpha.com.
How would you complete the following statement? ‘I consider 130/30 strategies to be’:
a) a marketing fad; or
b) a new investment paradigm with long-term potential.
In a recent survey of 135 institutional investors, asset managers, consultants, and service providers, 62% chose ‘b) a new investment paradigm with long-term potential’.
The survey was conducted jointly by Terrapinn, a producer of conferences on this sort of topic, and www.AllAboutAlpha.com, a website which has more than a passing interest in emerging asset management ideas like this.
As regular readers of are aware, ‘130/30’ (‘120/20’, ‘140/40’ or, more generically, ‘1X0/X0’) is a hybrid strategy involving some elements of hedge funds and some elements of traditional long-only asset management. As such, it offers what some might say is a bridge between these two, often diametrically opposed, worlds.
Terrapinn’s press release of the survey highlights is available to read at www.AllAboutAlpha.com. Key findings of the study include:
• 16% of the investors polled have already implemented 130/30 strategies;
• 26% of investors polled are planning to use a 130/30 approach in the next 12 months;
• 25% of consultants polled are actively researching and advising on it;
• 16% of asset managers polled offer 130/30 strategies; and
• 31% of asset managers polled are planning to use a 130/30 approach in the next 12 months.
The study also examined how investors allocate to the strategy and what approach asset managers offer. Quantitative approaches to 130/30 were more common for investors and asset managers alike. Of investors actively allocating to 130/30 funds, or planning to do so in the next 12 months, 55% preferred quantitative strategies, while 18% preferred fundamental strategies. The most frequently cited benefits of 130/30 funds were ‘their higher information ratio’ and ‘the fact that they can capture alpha, but are not a hedge fund’.
For much more information on this topic, www.AllAboutAlpha.com has over 20 postings on 130/30, or access the library of academic papers and PDF articles on 1X0/X0.
Basics of Seeding and Incubation
Ian Morley, Dawnay, Day Group.
Introduction
The message of this article is stark and simple: back talent. If you back poor or mediocre people, it doesn’t matter how good the infrastructure or financing or how benign the incubation — the outcome will be mediocre. A good incubation structure may well save you from gross incompetence and fraud. But it will not save you from difficult markets or from the inadequacies of incubatees who cannot navigate their way through tough market conditions. So, if you retain nothing else from reading this, allow me to repeat: the best form of seeding and incubation is to back talented people right from the start. When you back quality in a joint venture or incubation, the end result should be a win-win situation. Remember, too, that you won’t just lose the seed and ongoing capital. If you back people without talent, you will also lose the opportunity of backing another business venture, not to mention the waste of executive time that you and your colleagues have invested.
This article draws on not only seeding and incubation in hedge funds, but also the experience of seeding and incubating alternative investments and new financial services businesses.
Finding the businesses to back
In our experience, there is no magic formula for finding the best businesses or the best people to back. However, we have found it valuable to take an ecumenical view. Don’t exclude any type of business when they indiscriminately come to you, but do be more discriminating when you go out objectively looking for a business to back. Two of our most successful businesses are in Islamic finance and property finance. Neither of these were obvious areas, because of the speciality of the former and the fact that we have had to erect Chinese walls to fully protect our competitors dealing with the property finance business. Yet, because we found the right teams, these have proved highly successful business ventures. On the other hand, when you are looking to acquire teams, it makes sense to look for the areas which are, to use that horrible word, synergistic. You certainly do not want to deliberately compete with your existing businesses. It also makes sense to seed and incubate businesses that you understand. Beware of business areas in which you have no background or experience.
One of the best routes for successful incubation is by word of mouth and positive references from existing networks. There are no shortcuts. Our success has been built on a 20-year track record of backing businesses, and on the positive vibrations that have spread around the market in the wake of this success. If you don’t have a similar track record, take the conventional routes. Contact lawyers and accountancy firms, headhunters, specialist tax advisory companies, merger and acquisition businesses, private banks and the Institute of Directors (IOD). In fact, contact any obvious conduit that could be a source for introducing seeding or incubation business potential. Direct advertising in the Economist or the Financial Times may be useful for a highly-targeted pursuit. But you should probably avoid this route if it’s being used for a general trawl, since every failed business person with an idea that is a non-starter will probably contact you and clog up the works. Then you will find yourself having to filter them all out with time-consuming due diligence.
The Role of Independent Directors
Geoff Ruddick, International Management Services Ltd.
This article addresses some of the typical questions posed during the selection process of an independent hedge fund director and provides some background to the role.
One of the first considerations when looking for an independent director is the underlying reason behind your search. Probably, given the spectacular hedge fund and corporate collapses in recent years, part of the reason is the desire for effective corporate governance. In today’s environment, corporate governance is no longer a luxury, but a necessity and, often, a requirement. Regulators and exchanges are increasing their scrutiny and investors are demanding it — so should you.
Aside from corporate governance, one of the driving factors for independent directorship is often tax-related. Independent directors may be appointed in a tax-neutral jurisdiction to assist with the tax planning of the investment manager or to secure the fund’s offshore tax status by ensuring that the jurisdiction in which the mind, management and control of the company is exercised, is clearly offshore.
Regardless of the reason, a qualified, experienced, independent director will assist in meeting the underlying requirements. This article addresses some of the frequently asked questions regarding independent directorship, and provides some direction regarding the selection process.
Introduction
We begin with questions, questions and more questions. The runner-up questions often asked during the selection process of an independent director are:
• ‘How much?’ (referring to ‘How much do you charge for the provision of independent directorship services?’)
• ‘How many boards do you sit on?’ (translated as ‘How many manager relationships do you service and do you have the capacity to effectively service another one?’)
However, the grand prize-winning question usually is:
• ‘What do you do?’ (meaning ‘What role do you play and what value will you add if appointed to the board of directors of the fund?’)
These are all questions frequently asked during the selection process of an independent hedge fund director.
The main purpose and underlying theme of this article is to address the latter question, then briefly address the other queries (and more) in turn. That being said, prior to addressing these queries, it’s always good to provide a bit of background and address a couple of related issues.
Duties: What are a director’s duties?
In a nutshell, the basic role of a director is to oversee the business and affairs of the fund, with the fundamental task of being diligent in representing the interests of the investors. In most common law jurisdictions there are specific legal duties underlying the role of directors. Although beyond the scope of this article, these duties can broadly be summarised as follows:
1) fiduciary duties — loyalty, honesty, and good faith; and
2) duties of skill, care, and diligence.
In summary, directors must act in what they believe are the best interests of the fund itself, and avoid putting themselves in a position where they are conflicted between their personal interests and the duties owed to the fund. They must exhibit such skills as they possess, and such care and diligence as would be expected of a reasonable person in the same situation.
Hedge Funds in the Middle East
Antoine Massad, Man Investments Middle East Ltd.
Hedge funds have been active for more than 20 years in the Middle East, as investors have looked for superior risk-adjusted returns. Until 2000, however, they were largely the preserve of sophisticated private individuals. The prolonged bear market in equities, which lasted from 2000 to 2003, persuaded a growing number of institutional investors in the region to diversify their global portfolios away from conventional stocks and bonds, into a range of alternative investments, notably hedge funds.
What are the factors which have driven the burgeoning demand for hedge funds in the Middle East? It is instructive to look back on the historical evolution of the hedge fund market. In 1986 when Man Investments became the first hedge fund business to open an office in the region, the investment landscape was radically different. For much of the following two decades, there was almost no competition from other hedge funds and minimal infrastructure to service clients in the region. Local equity markets were in their infancy. Kuwait had had a stock exchange since 1962, but most other exchanges in the region were only just beginning to form, or would emerge over the next decade or even later. Some elements of the stock exchange in the United Arab Emirates (the UAE) were founded as late as 1999. These equity markets were relatively illiquid, volatile and poorly capitalised. Local investors hardly had any other option than to go for developed offshore equity and bond markets, or continue to invest onshore in real estate or local businesses of their own.
By 1990, the hedge fund industry was still in its adolescence. Hedge fund assets amounted to less than $50 billion, a tiny portion of the global fund management industry. The range of investment strategies offered by hedge fund managers was very limited; ‘macro’ strategies — funds focusing on macroeconomic conditions and taking leveraged bets on the direction of currencies, interest rates, commodities and stock markets — accounted for more than 70% of hedge fund assets under management. Against this background, Man Investments launched its first product tailored to Middle Eastern investors — a managed futures fund — shortly to be followed by a capital-protected product. Both offerings attracted a strong following from an investor base almost entirely composed of sophisticated private clients. Throughout the 1990s, the hedge fund industry developed rapidly, with a proliferation of strategies and product structures, offering investors a far wider choice. In partnership with leading local financial institutions, Man Investments developed and distributed new products for Middle East investors — some in local currencies — including a fund of hedge funds. But the client base remained almost entirely made up of private clients.
What came next was a tipping point which defied all expectations. The global equity market turmoil which began in 2000, profoundly changed regional investor attitudes to hedge funds and gave rise to the explosive growth in hedge fund investing that followed. Massive losses sustained in the market downturn persuaded institutional investors — many for the first time — of the benefits of diversification through hedge funds. Equities could no longer be seen as risk-free assets.
Book Review
Rumors in Financial Markets, written by Mark Schindler
(Reviewed by: Fabrice Rouah, State Street Corporation.)
To some people, rumors are nothing but trivial gossip, usually dealing with celebrities engaged in wild and unflattering alcohol-induced antics. To other people, rumors contain useful information that goes beyond the keyboard of an opportunistic tabloid editor or the cameras of obnoxious paparazzi. In this fascinating book, Rumors in Financial Markets, Mark Schindler will convince you that rumors are informational forces that have the power to move financial markets, influence prices and stimulate traders. This book does a great job of explaining rumors in the context of rational behaviour, how rumors form a crucial part of the Behavioural Finance and Signalling Theory and how market professionals, such as traders, use rumors in their daily operations.
The book begins with various definitions of rumors, the conditions under which rumors can spread and criteria for differentiating rumors from gossip or small talk. Rumors have been the subject of academic research since the mid-twentieth century. Not surprisingly, much of the early research into rumors was produced by sociologists, ethnographers, psychologists and philosophers. Broadly speaking, a rumor can be defined as an unverified piece of information. Yet most people usually never verify the information that they are exposed to — be it from the media or other sources — and usually take that information for granted. Hence, the line between newsworthy information and rumors can be easily blurred. Most rumors in financial markets can be classified along two dimensions and four categories: the domain of the rumor can be relevant to the public or to a specific group of individuals only, and the rumor can pertain to a specific industry or to financial markets as a whole. The proper definition and classification of rumors is, therefore, a crucial step in understanding their impact on markets.