Vertical Pulse

Hedge Fund Strategies

Just some points for you hedge fund investors out there. From our poll results and discussions with professionals, these are some of the hedge fund strategies to keep an eye on in 2008.

Distressed debt hedge funds are preparing for a new wave of business failures to occur in 2008 as the credit crunch forces highly leveraged companies to default on $35 billion-worth of debt.

Emerging markets is the top-performing strategy among hedge funds in 2007. As of September it is still far and away the best strategy; at 15.02%, its return clocked in at more than twice the next-best strategy.

The S&P Fund Service's fund of hedge funds directory found that fund of funds had a great first half of 2007 with generally positive returns all round. It also found that the best performing fund of funds were those biased toward equity-related strategies such as special situations, merger arbitrage and long/short equity hedge.

The CISDM Global Macro Index showed that year-to-date, August, global macro strategies yielded a 7.78% rate of return. Through most the summer, in terms of rate of return, global macro strategies outperformed other hedge fund strategies 2.37% to -0.29%.

According to the Barclay Equity Long/Short Index, the Equity Long/Short strategy produced solid returns for the last four years: A 15.81% ROI in 2003; 6.56% ROI in 2004; 11.47% ROI in 2005; 8.04% ROI in 2006; and thus far a 5.69% ROI in Q2 2007.

These are some of the issues that will be discussed at IncreMental Advantage's Jan. 22 hedge fund strategies conference. For more information, please visit www.incrementaladvantage.com. 

Free Trade And GM

Here at Vertical Pulse, we usually focus on Wall Street matters. Today, we look to shift our focus on public policy matters, because in the end, it affects Wall Street and Main Street. Last night CNN editorialized Washington's "so-called free trade policies" implying that it was a detriment to American manufacturing workers, who have lost three million jobs to cheap overseas labor markets, i.e. China. The protectionism bug has crawled back into Washington recently, and is now swarming national debate over free-trade policies, which up until recently have enjoyed many decades of support from both Democrats and Republicans. It's as American as apple pie.

"While it is true that the number of workers employed in the U.S. manufacturing sector declined by about 2.8 million between 2000 and 2003, the fact is that job attrition in the sector reverted to its much more modest, decades-long rate of decline after 2003. Since 2003, the sector has shed about 300,000 jobs," wrote Daniel Ikenson, of the Cato Institute, in an article that appeared in the Chicago Tribune. "But declining employment in a sector that is producing record output is hardly credible evidence of doom. In fact, the two indicators taken together are evidence of soaring labor productivity, which is the source of long-term increases in living standards. With the national unemployment rate at 4.5 percent, 1.8 million net new jobs created on average every year since 1980, U.S. plants producing record output, and manufacturing companies earning record profits, what is so troubling about the loss of manufacturing jobs?"

Usually, unions, such as the UAW, beat their chests about how unfair free-trade policies affect its declining membership. They lobby policymakers to construct barriers to entry for obvious reasons. However, with the latest tentative agreement on a new national contract for about 74,000 U.S. auto workers between the UAW and GM, it might be in organized labor's favor to support free trade policies, especially ones lingering in Congress for approval, such as the Korean, Colombian, and Peruvian deals. The Wall Street Journal reported "In effect, the new agreement allows GM to cap and move off its books to an independent trust a more than $50 billion debt owed to the UAW for retiree health care that the company cannot pay and remain viable. ... For GM, restructuring the UAW health care legacy burden should help free the company to pursue Mr. Wagoner's strategy of accelerating growth outside the U.S."

With GM's agenda of international growth, those free trade deals that provide quality access to a growing middle class in Asia, would surely help him, GM's stock, shareholders, and most of all, GM's rank and file workers. Question is, are politicians bold enough to communicate those facts to their special interest friends and voters? I'm not betting on it any time soon.

Reason For Hard Times

So, here we are again. At the beginning of a bust period in the typical boom/bust economic cycle. Lots of ordinary people are fretting if they can continue to pay the mortgage. Workers are concerned about their jobs if a recession does indeed come. Economists are worried about the ever weakening dollar and the many effects it will have around the world. Everybody is concerned about oil and other commodities maintaining their skyward cost projections, which in part stems from the weak dollar. The struggling dollar was made weaker by the recent Fed rate cut, which Mr. Bernanke decided to do in an attempt to resuscitate financial markets after they took a pounding from the sub-prime crisis. Lots to worry about. In such times politicians pounce on the opportunity to spew populist rhetoric to win votes. With the elections next year, this economic bust probably came at the worst possible time.

While there are many culprits for the recent financial and economic downturn, perhaps the biggest suspects are Wall Street and those who implement public policy. Ray Carey, former CEO of ADT, Inc., and author, wrote about Wall Street speculators and finance law in his book, "Democratic Capitalism." In parts of his book he examines the Wall Street machine that lends hefty amounts of money to hedge funds and other "leveraged speculators," which in conjunction with flawed public policies (volatile currencies and derivatives to name a few), are the agents of boom and bust economic cycles. He wrote:

"Adam Smith specified that the success of free markets depends on money that is ample, low-cost, non-volatile, and patient. Smith also warned that speculators would deflect capital away from growth, and make money scarce, high-cost, volatile, and impatient. Smith defined the mission of finance capitalism as helping companies grow, offering advice, and lending money that meets Smith's criterion of neutrality while avoiding damage from speculators."

Mr. Carey continues about flaws in Wall Street's short term outlooks and public policy:

"The ultra-capitalistic distribution of surplus for short-term personal gain is stock buy-backs and non-strategic acquisitions. Why, then, do tax laws favor stock buy-backs and non-strategic acquisitions? Too many hints have already been provided: The answer is that public policy is determined not for the general welfare but based on the lobby power of Wall Street."

"The United States government ... escalated the traditional impediment of wealth concentration into a dominant influence that damages both economic and social opportunities. An extraordinary volatility in international currency and interest rates resulted from the American government's floating the dollar in 1971 without an alternative stabilizing mechanism or control of speculation with borrowed money. This was followed in 1974 by a further U.S. government action that coupled the excessive volatility with excessive liquidity. A new law, ERISA, required present funding of future pension benefits and effectively took about $100 billion a year out of the economy and delivered most of it to the stock market with only a part of that sum recycled into the economy. In addition to the volatile and impatient money that these mistakes caused, the government in the last quarter of the 20th century compounded the problem by deregulating finance capitalism at the same time it was abrogating the market disciplines upon which free markets depend."

I don't mean to attack hedge funds, private equity, or other financiers, that is not my intention. However, government and business leaders need to take a hard look at current laws, taxes, and regulation that impact people's daily lives. To point the finger at someone else or turn a blind eye to the problem means one is unfit for duty.

Top Hedge Fund Strategies In 2008? You Decide

Preliminary results from IncreMental Advantage's survey, which asks participants what they think will be the top performing hedge fund strategies in 2008, has found that about 58% of the people think "distressed securities" investing will be the top strategy. Emerging markets is in second at about 41% and the classic long/short equity strategy has thus far received 25% coming in at third place. To cast your vote in one-question survey, click here.

The Barclay Hedge Fund Index is down 1.38% for the month of August (2,289 hedge funds reported), which was a time of turbulence in global markets. Comparing the strategies our participants selected with the Barclay indice, its emerging market index was down 2.58%, distressed securities index was down 0.70%, and equity long/short index was down 1.17% for August. The biggest winner was healthcare & biotechnology index, up 1.85%. The biggest loss was found in the Pacific rim equities index, down 3.04%.

In this month's Accredited Investor, it reports the hedge fund strategies that suffered the most from August's market volatility were credit funds, quants/systematic, and equity long/short strategies.

Despite the pummelling emerging market strategies took last month the prospects for Asia, Eastern Europe, and the Middle East still remain upbeat among analysts. One of Accredited Investor's reporters wrote that hedge fund managers' believe because of the U.S.'s problems in the credit markets, many global, multi-strategy, and long/short funds are looking to Asia for promising returns.

"What has definitely happened, given the turmoil in the U.S., is that global and multi-strategy funds are looking to Asia as an island of stability," Nick Lord, a principal with executive search firm Heidrick & Struggles, told Accredited Investor. Not only are hedge funds eyeing Asia, but prime brokerages are looking to locate to Singapore since Hong Kong is a saturated market. "Singapore is the new hot spot since firms are well established in Hong Kong. Merrill Lynch and Citigroup have already put in embryonic prime services teams, ... (and) both Morgan Stanley and Barclays Capital are thought to be next in line to set up in the Asian city-state," Accredited Investor reports.

Distressed securities investors will definitely shrug off August's performance and look to the near future, which is certain to experience an uptick in corporate defaults and bankruptcy filings. Citadel Investment Group LLC, the $16 billion Chicago-based alternative investment firm, is making moves in the distressed security realm buying up such portfolios at 40 cents on the dollar. Citadel also acquired the credit book of Sowood Capital Management LP just when the fund defaulted. According to Hedgeworld.com, "the firm is considered one of the best, and as such, is unlikely to run out of cash from its investors. Citadel is known for using its large cash reserves judiciously and at opportune times, making distressed and contrarian investments that end up paying off."

In the same Hedgeworld.com story it is reported that Citadel is now considering going public. Though outsiders remain uncertain why the firm would file an IPO in troublesome markets, sources in the story speculated that the giant alternative investment firm could go public because of timing (the fall is when the IPO market wakes from its mid-August to mid-September slumber. Plus, Citadel has had a few good quarters behind it, which would generate excitement over its IPO) and for its managers to "monetize their equity interests."

Regarding other event driven strategies, The Wall Street Journal ran a front-page story today about activist hedge fund manager Christopher Hohn, of Children's Investment Fund.

These are some of the issues that will be discussed at IncreMental Advantage's January Top Hedge Fund Strategies in 2008 Conference. For more information, please visit www.incrementaladvantage.com.

Due Diligence and Trade Secrets

A lot of interesting points came out of our Intellectual Property Finance and Valuation Conference today. One pertains to due diligence checklists for any application: The problem with checklists is that the other party will try to design around the checklists.

Another interesting point was that the Brazilian government decided that it would translate massive volumes of the patents filed in the US, Europe and Japan in order to steal the intellectual property. This turned out to be a massive failure since the Brazilians did not have the know-how to make the underlying technology work.

Separately, as Phillip Goldstein from Bulldog Investors said, "the government puts too high a premium on investor confidence in the financial markets. When someone loses money on a stock investment, it isn't because he lacked confidence in the investment."

Are Quants Recovering From Terrible August Performance?

Credit Suisse Index Co., Inc., today said that equity market neutral hedge funds have recovered 1.2% from the worst drawdown in August. "Extreme market turmoil during the first two weeks of August led to a technical sell-off, sudden spike in volatility and a subsequent drop in performance for equity market neutral funds" according to Oliver Schupp, president, Credit Suisse Index Co., Inc. "Despite the downfall, many managers believe the sell-off was due to massive deleveraging and cash-raising activities. Cautious optimism has now returned as liquidity infusions take effect and investor fears have calmed. As the flow of redemptions has been stemmed, an upward trend in performance has taken place in the Credit Suisse/Tremont Equity Market Neutral Sector Invest Index."

Meanwhile a hedge fund run by Goldman Sachs recorded its worst monthly performance in its 12-year history in August. CNNMoney.com reported that Goldman's Global Alpha hedge fund fell 22.7 percent last month. The Wall Street Journal reported that one investor "described the losses as 'shocking' that they could have lost money 'across so many different strategies.' Like the Global Alpha fund, some funds that use a "quantitative," or "quant," strategy, of using models to set strategies and computers to carry them out got clobbered in August when many of the funds wound up having to sell similar investments at the same time, driving prices down. 

Also, Financial News ran a story today about how fund of hedge fund managers are worrying about "liquidity mismatch." Additionally, Moneycontrol.com published an interview yesterday with Mehraj Mattoo, a hedge fund manager with Commerzbank, who discusses why 200 emerging market oriented hedge funds are investing in India.

Again, IncreMental Advantage is interested in what you think will be the top performing hedge fund strategies in 2008. To cast your vote in our one-question survey click here.

To get more information about IncreMental Advantage's Oct. 16 Hedge Fund Due Diligence Conference or January's Top Performing Hedge Fund Strategies in 2008 Conference, please visit www.incrementaladvantage.com.

Lawsuits And The Sub-Prime/CDO Tragedy

Investors in Bear Stearns two bankrupt internal hedge funds - High Grade Structured Credit Strategies Master Fund and the High Grade Structured Credit Strategies Enhanced Leverage Master - are lining up behind their attorney, Steven Caruso, in preparation to take the investment bank to court in the coming weeks. The six individual and institutional investors that make up Mr. Caruso's clients, which held $1 million to $14 million in investments, claimed they were not told of material facts, such as the funds' performance, that would have kept them from investing or prompted them to pull out of the funds.

In addition to the law firm that Mr. Caruso works for, three other law firms have teamed up to represent clients that were former investors in the Bear Stearns hedge funds. All four firms include Aidikoff, Uhl & Bakhtiari; Maddox, Hargett & Caruso, P.C.; David P. Meyer & Associates Co., LPA; and Page Perry, LLC. The firms, which is really an association of attorneys, have also created a website entitled Bear Stearns Hedge Fund Litigation, which keeps track of news related to the sub-prime meltdown and, especially, how it relates to the Bear Stearns situation. The website also informs other former Bear Stearns hedge fund investors how then can get involved in the lawsuits.

There is plenty of blame to pass around regarding the sub-prime/CDO securities meltdown. A lot of politicians have been critical of the role rating agencies played when rating the CDOs. In short, the rating agencies, such as Moody's and Fitch, got compensated by the securities firms for giving their CDOs investment grade ratings and which allowed them to market their structured products. Basically, the rating agencies drove the CDO market.

Yesterday, on the sidelines of a conference I was running, an attendee who is in the structured finance industry, told me that after some of these lawsuits have worked their way through the courts and Congress has held enough hearings, a scandal, one that would overshadow Enron, would be discovered involving the rating agencies. Overblown, perhaps. But I think such a notion underlies Wall Street's jitters about the sub-prime/CDO market collapse.

On an unrelated note, I'm still looking for more participants to cast their vote in my hedge fund survey. It only takes a few seconds to answer the one question, which asks what do you think will be the top performing hedge fund strategies in 2008. Click here to cast your vote.

These are some of the issues that will be discussed at IncreMental Advantage's Oct. 16 Hedge Fund Due Diligence conference in NYC. For more information please visit www.incrementaladvantage.com.

Observations From Abroad

Regular readers have noticed my nearly three-week hiatus from posting entries on Vertical Pulse, which, to some, came at a bad time while me and my colleagues were closely following the news surrounding the "Sub-prime Summer." For the past couple of weeks the sub-prime fiasco has crept into the broader economy and now this nasty little credit crunch has crimped business around the globe.

Much to my delight, while all of this was going on I was exploring the cities and country-sides of Italy and France. I will not bore you (or make you jealous) with the details of all the sites, sounds, foods, and $5 cappuccinos I indulged myself with for 16 days. Instead, I will write about my observations of the dire economic conditions both Western European countries find themselves in.

My first five minutes in Rome I could already see the lack of investment in the once great city's buildings, infrastructure, environment, and most of all, its citizens. Aside from tourism and the businesses that feed off of it (restaurants, clothing, etc.) there is no commercial activity to speak of. I had the chance to talk to a handful of Italian college students in the Abruzzo Region, where all of them complained there are too few job prospects in Rome or Southern Italy. The youngsters ranged in majors from linguistics to mechanical engineering to marketing, but yet all of them had difficulty finding work. They said in order to find work one would have to head north, far from home, to Germany, France, or somewhere else like that to find a job.

Later, I was able to meet and talk to a well-to-do older gentlemen (through a translator) who is employed in management for a consortium of companies. He complained to me about how the Italian economy has suffered and that taxes are crushingly oppressive. Some of his relatives had to have their stock option investments managed in Poland, where the tax impact is much less than Italy's 40% tax on long-term capital gains. When I mentioned to him that in the U.S. there is only a 15% tax on such investments, his eyes lit up in disbelief. He remarked that he wished the government would either lower the tax or simplify the tax code.

One family I met with in Central Italy said it was extremely expensive to travel abroad. Their children, now in their college years, never have had the chance to visit Paris, which is similar to driving from New York City to Charleston, S.C. This is a middle class family in Italy, a supposed wealthy developed western nation. They found other goods and services too expensive that middle class families in America take for granted.

When I drove through the country-side I saw many, many dilapidated neighborhoods. While this is not true throughout the entire country (and I saw some beautiful neighborhoods and also met wealthy individuals) the proportion of rich to poor is lopsided in Italy in favor of the latter. Despite this, Italy is a gem to visit and the people are extremely friendly.

Regulation has also taken its toll on the business environment in Italy. When traveling on the Eurostar, operated by RailEurope, my reservations got mixed up. Navigating the Roman Terminal to correct the error was a nightmare. Lines were long, people agitated, and the service did not cater to the customer like here in the States. "Welcome to Italy," commented one Canadian man who stood in front of me in line after he overheard me complain. The airport was no better.

Returning home my luggage was delayed in Paris (connecting flight) and I did not receive it until three days after being in the U.S. When I was talking with one of Delta's baggage customer service representatives at JFK Airport he said Rome and Paris were some of the worst airports in the world with regards to baggage handling. "Everyone is a government worker over there," he said of the baggage crews. The representative had informed me that a week earlier before I left for my trip the baggage crews at the Roman airport had went on strike and allowed 50,000 pieces of luggage to pile up at the airport. That must have come with heavy price for the airlines, business, and tourists.

According to the Index of Economic Freedom 2007, Italy ranked 60th among 157 nation-states polled. There are a number of despotic regimes in the Middle East and underdeveloped nations in Africa and Caribbean that scored higher. The lesson here is that big government, especially Italian style, only impoverishes its citizenry and cripples entrepreneurship and business, choking off much needed investment in its people and resources.

The Best And Worst Hedge Funds In 2007

Yesterday, FINalternatives published the best and worst hedge fund performers thus far of 2007. "Hedge fund Tontine Associates finds itself atop a very undesirable list after posting a nearly 42% loss through the end of July. The Greenwich, Conn.-based hedge fund manager’s TFP Overseas Fund is the worst-performing fund tracked by HSBC Private Bank’s Alternative FundInvest Group in 2007," the article states. The best performing fund is Cayman Islands-based 788 Asset Management’s China Fund, which soared 61.43% through July 31.

Click here to see FINalternatives list (using information provided by HSBC Private Bank Alternative FundInvest Group) of the 20 best and 20 worst performing hedge funds. TFP Overseas uses a long/short equity strategy focusing on financial stocks while the 788 China Fund uses an equity-diversified strategy in the emerging Asian markets.

Speaking of hedge fund strategies, this January IncreMental Advantage will be hosting a conference that will focus exclusively on hedge fund strategies. Specifically, speakers will discuss the more potentially successful hedge fund strategies in 2008 and what investors need to know about those strategies. To share what you think will be the most successful fund strategies in 2008, click here to participate in our one-question survey. Participants will receive a $50 discount if they are interested in attending the conference.

For more information about IncreMental Advantage's conferences please visit www.incrementaladvantage.com.

Collateralizing Art is in Jeopardy

There was an interesting article in The Wall Street Journal last week. It dealt with the concern that the credit crunch may result in art collectors--who previously collateralized their art--having to pony up more capital or lose the credit that has been extended to them. The precedent for this can be found in the early 1990s, when there was a spate of defaults on art-backed loans triggered by a very serious correction in both the real-estate and art markets. People that are under water with their real estate loans are more likely to default on their art loans.

Some art loans are similar to reverse mortgages, as they allow borrowers to receive monthly payments against the value of their art, rather than selling it outright and taking a capital-gains tax hit.

Elsewhere, Americans are definitely more interested in art. For instance, Cincinnati's Contemporary Arts Center saw attendance rise 85% between 2002 and 2006. Also, according to the American Association of Museums, about 40% of U.S. museums have recently renovated, are currently undergoing renovations or are preparing for renovations.

These are some of the issues that will be discussed at IncreMental Advantage's Intelligently Purchasing and Selling Fine Art and Collectibles Conference that will take place in New York City on October 17. For more information, please visit www.incrementaladvantage.com or contact Neomi Barazani at neomi@incrementaladvantage.com.