Posts Tagged ‘Hedge Funds’

Chasing Like a Pro

Thursday, May 23rd, 2013

Chasing Like a Pro (via Market Shadows)

Chasing Like a Pro Courtesy of Joshua M Brown, The Reformed Broker Put it this way, this is not the sign of a bottom or a young bull market… From Barron’s: Major hedge funds are reportedly buying, or have bought, massive amounts of Standard & Poor’s 500 index calls in the over-the-counter options…

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Some Numbers Worth Thinking About

Thursday, August 16th, 2012

What Are Investors Thinking About Coming Into the Home Stretch?

Whether it is right or wrong, many still think of investing on a calendar year basis. So as we crawl through this period of incredibly low volatility and low volume it is time to start thinking about the home stretch. Coming into year end there are some striking numbers that investors and money managers must be thinking of and are likely to influence their decisions for here on out.

Equities

The S&P 500 is up 11.8% for the year. The Nasdaq is up 16.3%. Had you been lazy and just bought AAPL (which is allegedly the most owned stock by hedge funds), you would be up 55.8%. Had you “tried to lose client money” by buying banks, you would have failed there too. XLF is up 16.4% and even JPM, with the whale trade and LIBOR is still up 11.5% this year (remember how bearish everyone was on banks at the start of the year?).

Okay, what about Europe? Well an investment in the STOX 50 would be down 1% in USD, but still up 4.9% in Euro. The Nikkei is up 7.5% in Yen terms and 4% in dollars.

China, with all of its problems and daily headlines of various types of landings, is down only 4% in local terms and 5% in USD.

In many ways it would have been hard to lose money investing in equities. Just simple equity investments and that’s without timing any of the bigger moves. Yet the composite hedge fund ytd return is only about 3%.

Fixed Income

The fixed income case is even more depressing for hedge funds. It has been almost impossible to find a losing investment here. The 10 year treasury return is over 2.5%, Investment Grade bond index is 7.9%, High Yield bond index is 8.6% and even boring, senior secured, floating rate leveraged loans have generated 7.1%. The Municipal bond index is up only 5% but some of that income is tax-free. Emerging markets have been stellar with core dollar denominated debt up 11.9% and even local currency debt now up 4.4%.

Even an investment in a 5 year Italian bond would be up 8.8% so far. I haven’t converted that to dollars where it is less, but this number is worth thinking about. Close your eyes, but Italian 5 year bonds at the start of the year, and you would be up 8.8% so far in Euros. At least Spain has had the decency to be down. Had you bought 5 year Spanish bonds at the start of the year you would have a 2.1% loss in Euros (slightly less in dollars). All the time and focus spent on how bad Spain is and you would only be down 2.1% on a five year bond, strikes me as surprising.

On fixed income, I continue to believe that specific credit and bond selection is necessary here, as the “go go” bonds have gone about all they can. The ETF’s are underperforming the benchmarks in many cases now, at least in part because the “beta” has been played out.

Others

The dollar has done well this year. Investing in DXY would have produced a 3.2% return. Investing in commodities would have lost 3.3% based on the CRB index. That surprised me, given how much talk there is about inflation.

Can You Sell Sharpe Ratio?

At a glance, the hedge fund composite index returns are pretty lackluster. Obviously some funds have done a great job, some are designed for low volatility or tail risk environments, etc., but some are designed to generate total returns for their investors. It must be getting hard for some investors to wonder why they are paying 2 and 20 to get returns that just aren’t that good. So many investments have outperformed, and there are so few losers, some investors will question how it was possible to achieve such low returns.

That is the key game that is getting played out now. The weaker hedge funds, those without long track records and good relationships with their investors are racking their brain on how to outperform coming into year end. Clients may say they want steady returns, especially in bad times, but we all know that many of them are as likely to chase returns as stick with that philosophy.

These weak funds need returns, not sharpe ratio. They need to keep assets under management. They need to justify their existence. It is reasonably safe to assume that many of the laggards have been short the market, since so much has gone up. They can add to that position, or they can decide not to fight the Fed and ECB and go long chasing returns that way. I think every day now that we continue in this low volume, low volatility environment, these funds will become more and more tempted to chase returns from the long end and will scrounge the world for the highest beta assets that they can buy and push up in this low liquidity environment.

Clearly the good funds remain in the driver seat, but they have the luxury of being patient and figuring out what they want to do. It is those most desperate for returns into year-end that are likely to swing for the fences, and I think it is becoming more likely that means another big push higher in risk assets.

I wouldn’t do it if I was them. I remain between 0% and 50% now and continue to be tempted to set shorts (I’m now eyeing the S&P Sept 1,370 puts since they are cheaper than when I started watching the 1,350′s). For now I remain long and biased towards Spain, Italy, banks, and continue to think CDS can have a capitulation tighter (low trading volumes will turn the big banks into net income hogs again, reducing their desire to hedge).

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Knight’s Berserk Algo Bought $2.6 Million Worth Of Stock Every Second

Wednesday, August 8th, 2012

While we already presented, courtesy of Nanex, the modus operandi of the Knight berserker algo, there was one outstanding question. What was the bottom line. And no, not how much the loss on Knight’s Income Statement would be as a result of this glimpse into what really happens in the market: we already knew that would be $440 million. The question is what is the notional amount of stock that this algo bought in the 45 minutes in which it was operational. We now know: $7 billion. Or $155 million per minute. Or $2.6 million per second. Or, assuming the algo impacted just 150 stocks as previously reported, it was buying on average $17,333 in each name every second. Or, assuming an average stock price of the universe of 150 stocks of $30/share, the Knight algo lifted the offer roughly 600 times each second. For 45 minutes straight! That’s right – the market making algorithm of a designated market maker which is responsible for 10% of the order flow in the US stock market, entered a pre-programmed mode (because the computer was told to do whatever it did by someone, and not without reason) that saw it buy up $2.6 million worth of stock every second.

Now there has long been speculation that HFTs are a central planner’s best friend because they traditionally provide not only a floor to the stock market, but a gradual levitation bias especially in a low volume environment (as well as liquidity its advocates claim, but that is total BS – HFT only provides volume and churn – liquidity disappears at the drop of a bat when real selling pressure appears). They do this not because they are evil instruments of Bernanke collusion (although who knows) but simply because they accelerate and accentuate legacy momentum bias, which at least historically, has been up. Now in the aftermath of the Knight debacle we can also extrapolate what would happen if, say, reality were to creep in one day, and all those mutual and hedge funds which have carbon-based life forms making the buy and sell decisions suddenly decided to sell. Well, at $7 billion in 45 minutes, or 1/10th of the trading day, this means that had the Knight algo been running all day, it could have bought $70 billion worth of stock. Throw in the remaining flow routers, aka DMMs in the market which account for the remaining 90% of order flow, and we get a total of $700 billion in vacuum tube mediated purchasing power.

In other words, this is the market “worst case” shock absorber, or inverse escape velocity, that Bernanke has at his disposal if things turn sour. That said, with hedge funds, aka fast money, holding about $3 trillion in unlevered assets, and about $6-9 trillion with leverage (ignoring plain vanilla slow mutual funds), and one can see why not even the HFT levitation bid would be sufficient to offset a wholesale market dump.

There is one last open question remaining on Knight: what discount did Goldman extract out of the firm to rid it of its residual position which as the WSj explains declined slightly from its peak as “traders worked frantically Aug. 1 to sell shares while trying to minimize losses due to a software problem, ultimately paring the total position to about $4.6 billion by the end of the trading day” (one wonders if the market would have just blown up if the Knight algo were to run in reverse, and just take out layer after layer of bids to unwind the inventory asap). We now know thanks to the WSJ:

Knight avoided that scenario by agreeing in the early morning hours last Thursday to sell the portfolio to Goldman Sachs Group Inc.,  after rejecting an offer from UBS.

 

The terms sought by the banks reflected how dire Knight’s situation was: UBS wanted an 8% to 9% discount on the position, according to people familiar with the matter.

 

The equities trading desk at UBS, headed by Mike Stewart, bid for the portfolio around 6:30 p.m. Wednesday, people familiar with the discussions said. Mr. Stewart was a former colleague of Knight Chief Executive Thomas Joyce’s at Merrill Lynch. The talks with UBS fell apart later that night.

 

Goldman ultimately negotiated buying the portfolio at a 5% discount, or about $230 million less than the value of the stocks, the people said. That amount, not previously reported, represents more than half the loss Knight disclosed on Thursday that it incurred as a result of the technology errors.

 

The deal with Goldman allowed Knight to move ahead. Last weekend, Knight negotiated a rescue package with six financial firms that injected $400 million in capital in exchange for securities that can convert to ownership of 73% of the trading firm.

And now you know why having cash on your balance sheet in a ZIRP environment may well be the best investment, because just like Goldman, one never knows just where a slam dunk distressed opportunity could come from in exchange for an immediate 5% pick up.

More importantly, the Goldman deal demonstrates what the true liquidity cost is in this market when one wishes to do a wholesale stock transaction (either BWIC or OWIC): it is not less than 5% and tops out at 9%.

Keep that in mind, because if and when the day when VWAPing in and out of positions is no longer possible, each and every fund will have no choice but to assume a guaranteed 5% minimum (up to 9%) haircut on one’s entire portfolio of allegedly liquid stocks.

We dread to think what the wholesale implied liquidity premium is on less liquid products than stocks, which nowadays is virtually everything…

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Finally, we leave readers with yet another transformative animation from Nanex, after our first rendition of the “rise of the machines” back in February left many speechless, and which recently appears to have been rediscovered by some of the slower elements in the blogosphere. Why: because it’s pretty, and we feel like it. And because it once again confirms that only vacuum tubes with infinite balance sheets should be gambling in this loaded market.

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“Did Somebody Repeal The Laws Of Mathematics?”

Sunday, August 5th, 2012

 

From Grant Williams’ latest Things That Make you Go Hmmm

Remember late-2010? When Spain wasn’t a problem, but merely a potential problem? I do:

(FT, November 17, 2010): For some of the world’s biggest hedge funds, typically regarded as the savviest traders in the market, there is now one big question facing the eurozone: what is going to happen to Spain?

While Europe’s politicians are grappling with the crisis unravelling in Ireland, hedge fund managers are already turning their attention to the issue of how – and if – a peripheral crisis in Ireland could leap via Portugal and Spain to become a systemic crisis for the eurozone as a whole.

“The Irish problem will be contained,” says Guillaume Fonkenell, chief investment officer at Pharo, one of Europe’s biggest and most successful macro funds, which specialises in trading on macroeconomic events and trends. “For us contagion is the issue … If the market loses confidence in Spain, then all bets are off. Spain is too big to bail.”…

Back then, the general opinion was that if the contagion spread to Spain the game was over because there wasn’t enough money with which to bail out an economy the size of The Kingdom of Spain. I’m not sure exactly what happened— maybe I wasn’t paying attention—but suddenly, almost two years on and in an environment where even the rich nations of Europe are seeing an undeniable slide towards recession, there is no talk about Spain being ‘too-big-to-bail’ anymore.

Did somebody repeal the laws of mathematics?

Presumably, if the contagion reaches Italy that would be OK too now, I guess.

As it first hit the headlines as a potential problem, Spain made a presentation to potential investors that highlighted how strong the country actually was despite the conjecture amongst market participants. The presentation is highly educational and can be found in full HERE, but as a taster, here’s one particular slide that caught my eye:

Oh, to hell with it… here’s another:

Some opportunity.

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Full letter:

Hmmm 05 Aug 2012a

Grant Williams
Portfolio & Strategy Advisor at Vulpes Investment Management Private Ltd
2 Battery Road #26-01, Maybank Tower Singapore 049907
http://www.vulpesinvest.com/

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Corporate Bond Chaos, ETF’s, and JPM’s “additional losses”

Friday, May 18th, 2012

 

by Peter Tchir, TF Market Advisors

Corporate bonds in the U.S. took a beating in the past 48 hours. The high yield market, which had been spared much of the carnage seen in the HY CDS markets, finally succumbed.

This chart is key for a couple of reasons. First it shows that the 3 point drop this week and the 2 point drop in the past two days for HYG is largely a catch up to moves that had already occurred in the CDS market. We still think of HYG as a “retail” product, but volumes have spiked in recent days as it has become a valued source of liquidity. Hedge Funds have been looking at the ETF versus the HY CDS index. A trade we have liked, that as recent as 4 months ago was generally met by polite grins from some of the HF’s we talk to. Now it is a strategy people like. More investors and market makers are looking at the ETF’s as a better way to hedge themselves than using the CDS index. The HY ETF’s have their own sets of problems, but there is a growing realization, particularly in the high yield market, that at least they move with their bonds more than the CDS indices.

We are starting to see spikes to the downside late in the day. It could be for any number of reasons, but the reality is that I think it is market makers more than anyone who are causing that. To the extent you get hit on bonds in the morning (you didn’t fade your bid fast enough, or the client was too important) you spent the whole day trying to move those bonds. With everything going on in Europe you don’t want (or aren’t allowed) to be long overnight. Your choices are hitting a down bid on the bonds – probably a loss of at least 1%, shorting HY18, which is already very cheap and the index guys get annoyed at anything less than $25 million, or, shorting some HYG. It might cost you a ¼ point, but that is better than selling the bond and it seems closer to the market than the CDS index which feels ripe for a squeeze. That flow is occurring.

The HY ETF’s are both trading at a discount. That is encouraging the arb which means arb clients will be selling bonds, buying shares, and then using share redemptions to monetize the trade. Again, it seems like a “market neutral” strategy, but for some reason, the selling of bonds seems to weigh more on the market than the purchase of the ETF’s. That adds to the downside pressure, and there is currently a big game going on of “which bond will the ETF’s sell”. That is adding to the volatility in the cash market.

I’m struggling to figure out what is affecting U.S. high yield so much. Hedge funds don’t seem too leveraged. Banks don’t have much inventory. Retail doesn’t seem spooked (the redemptions seem to have as much to do with arb activity as retail outflows). I think this is the opportunity we have been waiting for to increase our allocation in HY in our Fixed Income Allocation.

I have to say something about JPM here. The positions at some level were long assets in an available for sale account (which had over $7 billion of untapped profits on a portfolio of $200 billion, according to the transcript). From everything else I have pieced together they were short HY market via CDS and long IG via CDA – JPM details. You notice how HY CDS got tighter every day from the 21st until the 30th. That would likely have produced a loss in the whale trade. According to the WSJ, there was a meeting on the 30th. Between then and the 10th when the call occurred, HY moved in their direction every day. That move has accelerated. How much of this hedge did they keep? Did the funky nature of their hedge perform the same as the on the run index? There is no way to know what happened, but on the HY CDS leg, the market has done nothing but move in their direction since that first emergency meeting. Their cash positions in the AFS, which should be marked at the lower of cost and market value, had an average gain of 3.5%. That portfolio, using that form of accounting won’t have had a loss (it probably has less untapped gains, but no accounting loss). Again, impossible to know what happened there, but certainly food for thought.

Investment grade also was in real trouble yesterday, though the CDS market has been indicating that for days. LQD was down almost a point, and that is on a day where TLH was up over a point, amplifying the spread widening. While cash was that weak, IG18 only weakened into the close at it, somewhat surprisingly spent most of the day near unchanged. While the selling pressure in the cash market was real, and somewhat scary, the relative strength in CDS was encouraging as it has been the leading indicator in this entire sell-off that really started after the JPM announcement.

This graph shows the IG9 10 year index and the IG17 5yr since the start of the year. You can clearly see how fast the widening has been, which started in early May and accelerated after the JPM conference call. There are a couple of things worth thinking about here. For everyone just looking at the performance of IG9 10 year and “guessing” what the additional JPM loss is, it makes almost no sense. If it was that simple, JPM would have had huge gains on this trade in the first quarter. Even in April the change wasn’t much. If it was all the “basis” and the difference between the indices that caused the problem, you have the same issue, that it was fairly stable though out the year. It has widened, which is likely bad, but again, doesn’t really explain the P&L. If IG9 was actually tightening coming into April 30th, why was JPM having losses? First, IG9 did seem to move slightly less than IG17 in those last few days of April. But if JPM was long the index, they should have some gains. The problem, I believe, and am trying to confirm, is the tranches didn’t move with the overall index. A quick look at MBIA, which would be a driver to the tranche price (the ones JPM had on, have a higher “delta” on the weakest names) supports that. MBIA CDS actually widened from April 17th when it was 884, to 970 by April 30th. Radian had an even larger move wider, which again would have hit pricing on “mezz” and “equity” IG tranches. Doing more work, but it will have been a widening in high beta names, driving the tranches they owned wider that would explain the loss. The underperformance of IG9 vs IG18 in that period is largely because of the high beta names, the ones JPM had the most exposure too. The big question here, is did they just go very short IG17 or IG18 against the tranches in that first part of May when it was freely for sale, still trading rich, and priced as low as 93 for IG18 which is currently at 120? Again, impossible to know, but the simplistic IG9 10 year explanation that is out there has no real basis in fact.

Maybe the G8 will threaten Germany with becoming the Growth 7 and she will cozy up and change her tough stance? It is scary that the ECB and Germany seem oblivious to the risk of a Grexit, and I’m frankly scared at some of the simple solutions the ECB seems to have for their losses – put them into the EFSF. But more people are coming out and pointing out the dangers, and Europe if anything, has demonstrated great fear of decision and kicking the can with a skill that even Messi envies.

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E-mail: tchir@tfmarketadvisors.com

Twitter: @TFMkts

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So How Are JPM’s Prop “Counterparties” Faring?

Friday, May 18th, 2012

We already know that JPM has lost billions on its prop trade, and as suggested earlier (and as the FT picked up subsequently), JPM’s prop desk (not to mention its actual standalone hedge fund, $29 billion Highbridge, which nobody has oddly enough discussed in the mainstream press yet) is so large that unwinding the full trade, as well as all other positions held by the CIO, would be unwieldy, allowing us to mock “the fun of negative convexity - especially when you ARE the market and there is no-one to unwind the actual tranches to.” The FT then phrased it as follows: “I can’t see how they could unwind these positions because no one can replace them in terms of size. It’s a bit of the same problem they face with the derivatives trade,” said a credit trader at a rival bank. “They pretty much are the market.” Which actually is funny, because if the media were to actually read a paper or two on how the market works, and puts two and two together, it just may figure out that the biggest beneficial counterparty for JPM is none other than the Fed, using the conduits of the Tri-Party repo system. But that is for Long-Term Capital MorganTM and its new CIO head Matt “LTCM” Zames to worry about. In the meantime, a question nobody has asked is how have the purported JPM counterparties, the most public of which are BlueMountain and BlueCrest who leaked the trade to the press in the first place, and are allegedly on the other side of the IG9 blow up doing. Well, according to the latest HSBC hedge fund update looking at the week ended May 11, not that hot.

Now one thing we know is that when it comes to reporting one’s results to an aggregator: when you have a profit you never under-represent it. And in this special case, since the funds are likely eager to recruit more like-minded hedge funds to their side of the trade, the best way to do it is by showing profits.

Which, for the early part of May, when the bulk of the JPM losses took place, are oddly missing for the two biggest players across from JPM…

So: where are the profits really going?

And is there much more here than the “access journalism” press has been let on to know?

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Gundlach On Debt Market and AAPL’s ‘Monster Legs’

Thursday, May 17th, 2012

Jeff Gundlach discussed mortgages, models, math, and moronic delusion with Tom Keene on Bloomberg TV this morning. Starting with why Europe matters to US Treasury and mortgage markets, the DoubleLine boss goes to address whether banks/hedge-funds have become too math-centric. “I don’t believe in models” is how Gundlach begins his diatribe on the over-confidence in math and empirical relationships, adding that they use ‘scenarios’ or ‘space-relations’ and build portfolios as one would stack a dishwasher – piece by piece. He discusses the model-implications of JPM (and other hedge funds) as they seemed to ignorantly utilize and rely on correlations – which, unlike certain talking-heads who in a know-nothing manner discuss JPM’s ‘spread’ trade incorrectly – leading to models-behaving-badly which are generally at the heart of most unexpected blow-ups.

Shifting gears to practical matters, Jeff believes there is no reason to hold any investment grade bonds that are inside of 3 years (and perhaps even 5 years) because they “just basically have no yield” and further, it is non-sensical to think that short-term interest rates are going up in the US. Even if you are worried about inflation – the Fed will still not allow interest rates to rise to implicitly suppress nominal GDP.

The new king of bonds also goes on to note that price action in bonds is almost everything nowadays as the old-school coupon-reinvestment-growth models no longer work since coupons are implicitly lower and lower in this new ZIRP world. This in our view means that prices will become more volatile as the coupon reinvestment flow becomes less of a smoothing effect – especially when the Fed tightens its liquidity spigot a little as it is now. As Socrates said, Gundlach echoes the fact that ‘one should not try to know everything; but respect the things that one cannot know’ – don’t delude yourself – which seems like good advice for all those with such high convictions of sustained reality.

Towards the end he discusses his already-infamous short-AAPL, Long-Nattie trade – adding that the trade has ‘monster legs’ and the biggest mistake investors make is exiting winners too early.

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Benchmarking Tail Risk Management (PIMCO)

Friday, May 11th, 2012

 

by Vineer Bhansali, PIMCO

- While tail risk hedging is a new and critically important area of modern portfolio management practice, the relative newness of the area means standard frameworks for benchmarking such portfolios have not developed.
- In fact, we’ve found that once the framework for proper tail hedge construction is defined based on key guidelines (including exposures, attachment, cost, and basis risk), the task of creating a proper index becomes relatively straightforward.
- To compensate for insufficient real-time performance measurement, we believe that tail hedges need to be evaluated on the basis of scenario analysis.

​This article was originally published in the May/June 2012 edition of the Journal of Indexes, www.indexuniverse.com.
No topic has gathered more interest since the financial crisis of 2008 than the topic broadly called “tail risk management.” The term and its practice have been open to much interpretation; this phenomenon of initial confusion is not particularly different from the growing pains experienced by many other market sectors. Mutual funds, hedge funds, even ETFs at the very beginning of their life cycle operated without much uniformity or proper reference indexes. As the market for tail-hedging solutions evolves, it will become critical that the end-user at least have a framework within which to evaluate the potential and realized costs and benefits of particular practices. We believe that to add value over time, tail risk management has to be active rather than purely passive; thus, a proper benchmarking framework is not simply a luxury but a necessity. The purpose of this article is to start to lay out exactly such a framework, which we have evolved over almost a decade of implementation.

Defining a hedge mandate

As discussed in much detail elsewhere1,  a small set of inputs or guidelines is the natural starting point for defining a tail hedge mandate. In our view, the minimal set consists of the following:

1. Exposures
2. Attachment
3. Cost
4. Basis risk

The first step is quantifying exposures. Our analysis of the long-term history of many different types of assets shows that a small set of risk factors drives the returns of these assets. The two major secular exposures are the equity beta and the interest rate or duration exposure. In addition, over cyclical periods, factors like liquidity, currency exposure, momentum and monetary policy also play important and significant roles. In our practice, we first try to quantify the exposures of each underlying portfolio to these key factors, both for normal and stressed periods. Interestingly, both our research and the work of others show that even very diversified portfolios exhibit similar exposures to the key risk factors, with equity beta as the dominant risk exposure.

The second step is to define what we have called the “attachment” level (taking a term from the reinsurance industry). The closer the attachment level is to the current value of the portfolio, the higher one should expect the cost of the tail risk program. Generally, we believe that broadly diversified portfolios should have an attachment level anywhere from 10% to 15% below the current portfolio value.

This brings us to the important question of cost. We generally do not believe that tail hedging can be done efficiently in a perfectly costless manner over short-term horizons. Yes, there are structures (especially exotics) that purport to reduce the cost, or in many cases even eliminate the cost, but usually they consist of embedded sales of options that one would frequently rather not sell. Instead of this hidden discount, we believe that an explicit cost target is essential both to thinking of tail risk management as an asset allocation decision and as a commitment that one can continue to support in periods where fat tail events do not occur. Because of the natural difficulty in forecasting the time and form of the next tail event, we believe that tail hedging is an “always on” part of any risky investment portfolio. Our empirical and theoretical research validates the belief that over longer periods (three to five years), tail hedging is generally self-financing when one accounts for both the ability to tilt portfolios more aggressively and following a systematic approach to rebalancing in the presence of such hedges.

Finally, one has some freedom to replace what might be expensive direct hedges with relatively cheaper indirect hedges, taking advantage of the tendency for correlations to increase, especially when extreme events happen. This cheapening comes with a trade-off, that the indirect hedges will not perform as well as the direct hedges conditional on the extreme event happening. To quantify this basis risk, we specify a level of confidence within which the likely outcomes of the actual portfolio are likely to fall relative to the direct hedge through simulations. The performance of a particular hedge program should be quantified in terms of the trade-off between basis risk and cost savings relative to a low- or no-basis-risk benchmark.

Creating a proper index

Once the framework for proper tail hedge construction is defined, the task of creating a proper index becomes relatively straightforward. If the benchmark is equity beta, we can use the most liquid traded market sectors that carry the key risk factor exposures to start with a shortlist of potential benchmark constituents. For instance, it would make sense to use S&P 500 Index options close to the maturity of the hedge mandate as a reference instrument, since by definition this index has an equity beta of 1 to itself (one can choose another equity index for this reference, e.g., the MSCI World, if that is the index of reference for the underlying portfolio). If the reference portfolio is a blend of equity beta and fixed income – for instance, something like the MSCI World Index combined with the Barclays Aggregate Bond Index – then the tail hedge will be a blend of the best equity beta and duration hedges for this combination. The best reference market instruments will therefore be options on the equity and bond indexes. But since options on bond indexes are not very liquid, it makes sense to select options on tradable markets such as Treasury futures for index construction. Also, note that tail options on a portfolio are not the same as the sum of options on the individual constituents, so adjustments for the correlations of the underlying constituents need to be made.

Once the proper sectors are identified, the next step is to set a “strike” for the portfolio of reference market options. As an example, if the attachment level for an overall 60% equity, 40% bond portfolio is set at 85% (i.e., 15% out of the money for the whole portfolio), then assuming that the bond part remains static, the reference equity option strike is 15%/0.60 = 25%. So the natural strike of the reference equity option is 25% out of the money. One can proceed in a similar manner for the other underlying risks as a crude starting point.

The advantage of constructing the basket of reference securities in such a way is that they can be monitored in real time. Options-based tail hedges have various “Greeks,” such as time-decay, gamma, vega, theta, etc., which are very dynamic and have to be actively monitored and traded. The value added by an investment manager is proportional to how the actual portfolio of hedges behaves over time relative to the theoretical benchmark. It also solves the problem of behavioral aversion to cost. Once the actual hedge cost and time decay is put relative to the cost of a theoretical hedge, it is much easier to commit to the cost as a long-term asset allocation decision and to compare this cost versus the implied cost of de-risking or buying government bonds. The important point is that all types of tail hedging cost something, and this includes de-risking and moving to cash. The process of going through the relative value comparison of different types of hedges allows the investor to anchor the tail-hedging analysis to something realistic.

We should emphasize that the use of market-traded options is a simplification that works only if the underlying hedge objective is rather plain vanilla. If the objective is more complex, e.g., “hedge so that at no point in time the portfolio suffers a loss more than x percent,” the reference index security would have to be more of an exotic option such as a knock-in option. While these options are traded heavily in the over-the-counter markets, their prices are not as easily available as vanilla index options. More complex replicating option portfolios can be constructed to index these payoffs. Complexity vs. transparency is an important trade-off when it comes to tail hedging. We generally err toward simple portfolios and hence simple benchmarks to measure them against.

Measuring performance

For traditional indexes, the task of performance measurement is relatively straightforward. One can look at the returns of the actual portfolio versus the index and discern whether the decisions of the manager are adding or subtracting value. For tail risk hedging, the problem is only simple if all the hedges are relatively plain vanilla and the underlying instruments are liquid and replicate the portfolio without any basis risk. The moment the hedges become complicated, performance measurement takes a new twist. The reason simply is that the current price of the hedge does not reflect the potential it has for a large tail payoff, and since tail events are rare events, observation of a few nontail periods is not sufficient to identify the prospects of the tail hedge. Naively, a tail hedge could look like it is performing better than a reference index of securities by losing time value slower than the reference hedges, but this is most likely to offer less potential of payoff if there is a jump event in the market (if the option hedges have less time decay, they probably, though not necessarily, have less gamma as well). To compensate for this shortcoming of real-time performance measurement, we believe that tail hedges need to be evaluated on the basis of scenario analysis. By identifying scenarios of concern and shocking the underlying market factors at different horizons, one can evaluate the potential of these hedges to pay off in the situations that matter. Robust technology and sensible stress-testing systems are thus of paramount importance for this exercise.

Conclusions

While tail risk hedging is a new and critically important area of modern portfolio management practice, the relative newness of the area means standard frameworks for benchmarking such portfolios have not developed. In this article, we sketched the rudiments of benchmark construction that we have used. While much work remains to be done, we believe that standardization and benchmarking in this area will result in the same value added to investors as it has done in the areas of traditional equity and bond portfolio management. Most importantly, it will give end-users a means via which they can quantify the “distance” of a bespoke tail hedge portfolio versus an easily measurable index to evaluate the cost versus benefit trade-offs.

1. See, for example, V. Bhansali, “Tail Risk Management,” Journal of Portfolio Management, Winter 2008.

The products and services provided by PIMCO Canada Corp. may only be available in certain provinces or territories of Canada and only through dealers authorized for that purpose.

​Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Tail risk hedging may involve entering into financial derivatives that are expected to increase in value during the occurrence of tail events. Investing in a tail event instrument could lose all or a portion of its value even in a period of severe market stress. A tail event is unpredictable; therefore, investments in instruments tied to the occurrence of a tail event are speculative. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. 

There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.

This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.

© 2012, PIMCO.

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NYSE Short Interest Rises to 2012 Highs

Thursday, May 10th, 2012

On the surface, the fact that NYSE short interest was just reported today to have risen to 13.1 billion shares as of April 30 could be troubling for the bears, as this just happens to be the highest short interest number of 2012. Indeed, an increase in short interest into a centrally-planned market is always disturbing, as it opens up stocks to the kinds of baseless short covering melt ups that simply have some HFT algo going on a stop hunt as their source, that we have seen in the past several weeks. Naturally, it would be far easier to be short a market in which Ben Bernanke managed to eradicate all other bears, especially when considering that a year ago the Short Interest as of April 30 was virtually identical.

However, courtesy of some recent discoveries by Bloomberg, we now know that his very pedestrian way of looking at short exposure is simply naive, as it ignores all the synthetic means that hedge funds truly express their position these days, mostly in attempts to avoid observation, and to magnify their balance sheets in any way possible. In other words: epic abuse of leverage, but not simply on the books, but through repos, Total Return Swaps, and various other shadow “shadow” P&L enhancement techniques. To wit from Bloomberg:

Citadel Advisors LLC and Millennium Management LLC said their assets soared ninefold when tallied under a new rule that requires hedge funds to disclose investments financed through borrowings.

 

Citadel, run by Ken Griffin out of Chicago, reported $115.2 billion of regulatory assets in a March 30 filing with the U.S. Securities and Exchange Commission, compared with $12.6 billion of net assets. Millennium, founded by Israel Englander, disclosed comparable figures of $119 billion and $13.5 billion as of year-end.

…

 

In short sales, investors borrow assets to sell them in anticipation that they can be repurchased at a lower price later and they can pocket the difference. Hedging includes the purchase of offsetting positions to limit risk in a trade.

 

While some fund managers only gave information on their gross assets, 31 of the 50 largest also disclosed their net assets in a separate section known as the client brochure. For these advisers, gross assets of $949 billion were more than double their net assets of $422 billion.

 

That indicates hedge funds may be using as much leverage as they did prior to the 2008 financial crisis. On average, hedge funds held total assets that were double their net capital as recently as 2007, said Daniel Celeghin, a partner at Casey Quirk & Associates LLC, a Darien, Connecticut, adviser to asset managers.

 

Not all of the difference between net and gross assets may be explained by leverage, because the SEC’s gross number also includes proprietary stakes that money managers hold in their own funds as well as assets that don’t get charged a management fee. The SEC’s calculating method can lead to double counting of assets at funds, such as Citadel, that include multiple entities.

 

“If you are heavily levered, obviously that will result in you having a larger gross asset number,” said Gary Kaminsky, a principal in the business advisory services group at Rothstein Kass, a Roseland, New Jersey, accounting firm that audits hedge funds. That’s because, under the SEC approach, “all that matters is what’s on the asset side of the balance sheet,” Kaminsky said.

 

Hedge funds are relying less on margin loans from prime brokers, the securities firms that provide credit and facilitate trading, and more on repurchase agreements, leveraged exchange- traded funds, and derivatives such as total return swaps, according to Josh Galper, the managing principal at Finadium LLC, a Concord, Massachusetts, investment research and consulting firm.

 

“Leverage is down across the board from the perspective of borrowing from a prime broker,” Galper said in a telephone interview. “It’s tough to measure how much embedded leverage funds are using.”

In other words, while the chart above is useful generically, the reality is that a true picture of outright bullish or bearish appearance is now impossible to be gleaned courtesy of precisely the same synthetic instruments that nearly destroyed the financial system in the fall of 2008. Funds will do anything in their power to systematically boost their leverage at the gross level, while leaving their net leverage appear innocuous, and then spin how gross is not net, even as their Prime Brokers onboard all the risk: after all who bails them out if things go wrong? Why, you do.

And who benefits if they are right? Here’s who, together with an AUM breakdown based on the old and new methodology:

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Volatile or Not? (Tchir)

Sunday, April 22nd, 2012

From Peter Tchir of TF Market Advisors

Volatile or Not?

It is strange to start a weekly update and not be sure whether the week was volatile or not.  North American stock indices ranged from -0.4% for Nasdaq to 0.6% for the S&P.  Not much to look at there.

U.S. fixed income finished with small weekly gains.  The 10 year treasury was 2 bps better.  Fixed income ETF’s like TIP, TLT, LQD, HYG, JNK, and MUB all had small gains.  Even the CDS indices, IG18, and the underperforming HY18 saw some small spread tightening over the course of the week.

Looking at Europe and we start to see some more volatility and divergence.  The DAX was up 2.5% will the IBEX was down 2.9%.  Spanish bond yields were mixed to better on the week, but Italian yields were worse.  In a week of obvious attempts by governments and central banks and the IMF to calm markets, they had limited success with the smaller and more easily manipulated Spanish bond market, and failed in Italy.  One scary undertone developing in the market is the concern about France and the potential impact of the French election.  French 10 year yields moved 14 bps, and it wasn’t because the situation was improving, because German 10 year yields moved 3 tighter on the week.  Germany continues to have a flight to quality bid, but France, not so much.

Maybe it is the activity in Europe that made the markets feel more volatile than the weekly changes show.  Or maybe it was that the futures traded in an almost 3% range – from 1,359 to 1,390 with several 0.5% swings during the course of most days.  Market darling Apple isn’t helping calm the market either.  That can reverse on a moment’s notice, or a great earnings release, but the momentum that was dragging more and more hedge funds into the trade, is now working in reverse as stop losses are being triggered.

So often lately, the bulls are able to point to a decent tape in face of weak data and no stimulus, and this week ended with the opposite.  Bulls will be nervous that decent earnings and a mega-plan from the IMF failed to provide strength to the market.

So, it was a strange week that was more volatile than the weekly changes show, and where some real cracks are being exposed.

Politicians and the Markets

In a week where the Birkin wielding head of the IMF went from G-20 delegation to delegation asking for them to commit their taxpayer’s money to another illusory firewall, it is important to focus on what was accomplished and what wasn’t.

By all accounts, the IMF has received commitments to increase the “firewall” by some amount, possibly as much as $500 billion.  The politicians expect the markets to be excited about this “heroic” effort and the guarantee that no debt problem is too big that it can’t be solved with more debt.  In spite of the headlines, I’m being asked

How will the countries honor their commitments?
Where will the money come from?  Especially the European portion?
How would the money be used?  For countries?  For banks?
If commitments made in 2010 haven’t been approved, what good are these commitments?
What does this do to help the countries that are in trouble?  Why does the IMF think it is safe to lend when real investors won’t lend?
The list is long, but is also accurate.

The entire IMF Firewall is being run as though it was an election.  The leaders use the same slogans over and over.  They say the money is needed to avoid calamity.  They say the money will help.  No evidence of either is provided, but who needs evidence when you are just running a campaign.  So they campaigned, and in their view, they “won” the election, by getting these commitments.

That is the big disconnect.  Politicians are sitting around Washington convinced that they have won.  They fought a hard campaign to convince people that the Firewall was needed and would be good, and they got the job done.  What they haven’t done, is seen how the market will react.

Unlike a real election, the market doesn’t give the winner a free pass for a certain amount of time.  You haven’t won until the next election, you have merely won until the market tests your resolve.

That test will come quickly, quite likely this week.  Markets will likely put pressure on Spanish and Italian yields, and possibly French yields depending on the election results.  Nothing about the firewall changes a thing about the current situation these countries find themselves in.  That is the key.  If the firewall actually did something for these countries, we might be able to stage a strong rally, but the firewall doesn’t have an immediate impact.  The firewall just ensures that these countries can borrow more money.  That when the markets shut down on their ability to borrow, the IMF will lend to them.  Your best hope as a current lender, is to hope you own short enough dated bonds that the IMF is still being generous and lending to the country to pay you back, rather than having gone into PSI mode.

Spain and Italy need to reduce the current interest burden, the total debt, make long term adjustments that while technically austerity, can have minimal near term impact, and they need to embark on some growth policies.  A debt restructuring can accomplish the first two items.  Policy and some IMF money can help on the all important growth issue.  Without some form of PSI, the firewall at best will shift who countries owe money to, and at worst will discourage banks from lending to anyone other than sovereigns.

The markets will test the resolve of the EU, ECB, and IMF this week.  They will see how readily “commitments” turn into “actions”.  Once again, the smug victory speeches being made by the politicians are likely to look very wrong, and possibly before they have even finished their victory tour.

Last chance to QE?

I think we have one group within the Fed that is desperate to do QE and wants to do it now.  There is another group that believes the economy should be left alone, unless the data deteriorates significantly.  As we head towards the election in November, the hurdle of what constitutes “weak” economic data will increase.  Right now, Benyellen might be able to argue “only” 120,000 NFP jobs is enough to launch QE.  I don’t think they would have a chance of launching in August with NFP numbers like that.

So, Benyellen will push hard at this meeting.  I think they will still face too much resistance.  It is only one bad NFP number and 2 bad “initial claims” numbers.  Not enough for the last defenders of anything resembling a free market at the Fed.  Housing has been weak too, but again, permits were up, and although not bouncing, there does seem to be some stability returning to the housing market.

I don’t expect QE this week.  I think the statement will be slightly more dovish than the last one, but that is priced in as the market does often seem to take the “bad news” as good news path.  Realistically, the next meeting is the most likely one to see QE announced since it would only take a few more data items confirming recent ones to let Benyellen railroad the rest into one more round.

Earnings, just how good?

I was frustrated and disappointed with BAC and MS.  They aren’t the only ones (GS and C did accounted for things similarly), but for whatever reason, they caught my eye, and convince me that this is what is wrong with the market.

Last year, when DVA and FVO were big positives, those numbers were not only included in the headline, but in the case of Gorman at MS, were trumpeted as he pounded his chest that MS beat GS in Q3 2011.  The quality and wisdom of DVA accounting has been questionable at best and the FVO adjustments are staggering in the ratio of the magnitude of the amounts versus the amount of disclosure.

I would much rather have seen headline numbers consistent with 2011.  Then we could focus on how they did that quarter. What the business outlook is.  Instead, it looks like they are trying to trick the media and investors and make the story better than it is.  Investors aren’t stupid.  They will do the work.  They will figure out the differences in how Q3 2011 and Q1 2012 were reported.  Then, not only will they be disappointed with what the firms tried to trick them on, they will question what else is being done.  If you are willing to “massage” (sounds better than manipulate) the way you report each quarter’s earnings to make it seem the best, what else are you willing to “massage”?  Banks are opaque.  On 100’s of billions of assets, what’s a bp or two here or there?

All companies should lay it on the line.  Report what happened in the way they always do, then rely on themselves and their conference calls and good analysts to figure out the longer term picture.  Companies have to trust in the intelligence of investors and investors will have trust in the companies.

 

Copyright © TF Market Advisors

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