Mythbusting: Emerging Market High Yield Bond Risk

Friday, August 3rd, 2012

by Del Stafford, iShares

Emerging market high yield bonds – about as risky as an asset class can get, right? After all, emerging markets are known for carrying a significant amount of risk, and high yield bonds are one of the more speculative sectors within fixed income. Put the two together, and aren’t you doubling down on risk? I thought the same myself before researching this very topic, but to my surprise I found that is not [always/necessarily] the case.

First, most investable emerging market high yield indices contain bonds that are issued in US dollars (USD), so with these indices there isn’t additional risk from owning other currencies. Also, emerging market high yield generally includes sovereign bonds (issued by a government) and quasi-sovereign bonds (issued by an agency backed by a government), while US high yield generally only includes corporate bonds.

Corporate bonds are typically viewed as riskier than government bonds, even when they have the same credit quality rating. In times of market volatility and stress, you can see that play out in what is commonly referred to as a “flight to quality”. For example, we saw this happen during the credit crisis of 2008 when the market largely sold out of corporate bonds and bought US Treasuries.

The sovereign and quasi-sovereign exposure in emerging market high yield caused it to behave differently from other risk assets during 2007-2009. The below chart shows correlations of emerging market high yield (Barclays EM High Yield Index), US corporate high yield (Barclays US Corporate High Yield Index), emerging market equities (MSCI Emerging Markets Index) and developed international equities (MSCI EAFE Index) to US equities (S&P 500 Index) during this time period. You can see that developed international equities, emerging market equities, and US high yield increased in correlation but emerging market high yield decreased in correlation.

In addition, when you look at historical volatility in the below chart, emerging market high yield has experienced comparable levels of risk to US high yield over the past seven years.

Now, the intent here isn’t to say that emerging market high yield bonds are for everyone, but rather to challenge investor assumptions about the investment’s risk profile. Investors interested in emerging market high yield debt should still consider whether it suits their portfolio needs (Matt Tucker’s recent post may be helpful).

Source: Markov Processes International (MPI)

Del Stafford, CFA is the iShares Head of Product & Investment Consulting and a regular contributor to the iShares Blog. You can find more of his posts here.
Correlation is a statistical measure that captures the degree of the historical relationship between the returns of a pair of investments or indexes.

Correlation ranges between +1 and -1. A correlation of +1 indicates returns moved in tandem, -1 indicates returns moved in opposite directions, and 0 indicates no correlation.

Standard deviation is the statistical measure of the degree to which an individual value in a probability distribution tends to vary from the mean of the distribution. It is widely applied in modern portfolio theory, where the past performance of securities is used to determine the range of possible future performance, and a probability is attached to each performance.

Bonds and bond funds will decrease in value as interest rates rise. High yield securities may be more volatile, be subject to greater levels of credit or default risk, and may be less liquid and more difficult to sell at an advantageous time or price to value than higher-rated securities of similar maturity.

Copyright © iShares

Tags: asset class, Barclays, Corporate Bonds, Correlation, Correlations, Credit Crisis, Credit Quality, Emerging Market, Emerging Markets, Fixed Income, Government Bonds, High Yield Bond, High Yield Bonds, International Equities, Ishares, Market Volatility, Markets Index, Sovereign Bonds, Time Period, Treasuries
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What History Suggests About the Future of Stocks

Thursday, August 2nd, 2012

by Seth Masters, Chief Investment Officer, AllianceBernstein

Some experts today argue that the world has entered a “New Normal” condition in which stocks have permanently lost their return edge. We’ve heard this before. It was wrong then, and we think it’s wrong now, too.

In 1979, BusinessWeek published a cover story famously called “The Death of Equities.” Then, like now, stock market returns had lagged 10-year Treasury returns for a decade, although for somewhat different reasons.

Stock returns had been dragged down by the bursting of a bubble (the Nifty Fifty) and bleak economic conditions. OPEC had unleashed its second oil-price shock in five years. The so-called misery index—the sum of the unemployment and inflation rates—was 20% in the US, double its level today (because inflation is now very low). And corporate profits were very weak (today, they are very strong).

BusinessWeek was capturing widespread sentiment about the economic and market outlook. Nonetheless, stocks handily beat bonds over the 10 years starting in 1979.

As the ubiquitous legal disclosure says, past performance does not guarantee future returns. Indeed, performance often reverses sharply.

Between 1901 and the onset of the recent credit crisis, there have been 11 10-year rolling periods in which bonds beat stocks, all of them coinciding with the Great Depression or the stagflation of the 1970s. And after each and every one of them, stocks beat bonds for 10 years—on average, by 5.8%, as the Display below shows.

Because we are human, we all tend to expect the future to resemble the recent past—to become “anchored” in our recent experience. It takes guts to buck the trend. But at a September 1983 client conference, we cited good fundamental reasons in making “The Case for the 2,000 Dow.” The Dow Jones Industrial Average was then slightly below 1,300. It reached 2,000 in January 1987, about three-and-a-half years later.

Today, our median annual return projections for global and US stocks are about 8% over the next 10 years, far ahead of our projected 2% median return for 10-year Treasuries. At that rate, the Dow could hit 20,000 in five to 10 years. In the same time frame, the S&P 500, a more representative index, could hit 2,000. (It’s now around 1,300.)

Our projected stock returns may sound optimistic. They’re not. They are well below the long-term average for US and global equities, and are based on conservative assumptions about economic and market conditions.

Still, many pundits argue that stocks today are overpriced. My next blog post will assess stock valuations.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Seth J. Masters is Chief Investment Officer for Asset Allocation at AllianceBernstein and Chief Investment Officer of Bernstein Global Wealth Management, a unit of AllianceBernstein.

Tags: Businessweek, Chief Investment Officer, Corporate Profits, Credit Crisis, Different Reasons, Dow Jones, Dow Jones Industrial, Dow Jones Industrial Average, Fundamental Reasons, Future Returns, Great Depression, Inflation Rates, Legal Disclosure, Market Outlook, Misery Index, Oil Price Shock, stagflation, Stock Market Returns, Stock Returns, Stocks Bonds
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May Rout Leads to June Rally (Edwards)

Sunday, June 10th, 2012

On April 6th, just after US stocks touched a high for the year and climbed to within 10% of the all-time high set back in October 2007, we wrote:

“The market will do one of three things over the rest of the year:

Trade flat for the next 9 months – not likely.
Surge into a “buying panic” as investors finally jump back into stocks, which would leave the market up 20% or more by year end.
Plummet as some exogenous event (like last year’s Japanese tsunami or the Greek credit crisis) cause investors to retreat to cash once again.”

We got three “exogenous events” in May:

• Greek credit crisis resumed, with Greece likely to exit the Eurozone this summer.
• JP Morgan Chase lost $3 billion on Credit Default Swap trading.
• The FaceBook “FacePlant”.

And on June 1st, the Labor department reported a minimal gain in jobs, which has economists worried anew about the United States returning to recession.

So from the high on April 2, to the low on June 1st, US stocks sank 9.9%. Unfortunately, human nature focuses more on losses than on gains. Stocks remain 81% above the March 9, 2009 low, and 18% above the October 3rd low. But as we saw today (best one day return of the year,) universal bearishness tend to lead to outsize upside returns.

Many, many questions from our clients:

What is going on with Europe?

As we have said many times, the Europeans spent 30 years building to the current situation, and it will take at least a decade to straighten things out. The situation in Greece is the “canary in the coal mine.” Greece is an artificial country cobbled together by the US and Great Britain at the end of World War II to prevent the Soviets from getting warm water naval ports on the Mediterranean. As of 2010, Greece had about the same GDP as Maryland, now probably 20% less. The country has three important industries: agriculture, tourism and shipping. These industries did not generate enough cash flow to purchase what Greeks wanted to buy, namely, German cars and dishwashers. Germans were anxious to keep exports booming, so helpful French and Italian banks stepped in to lend money so that Greeks could buy German exports (and build super-highways and other modern infrastructure.) The bankers felt confident in making loans despite the Greek national tendency to not pay taxes because a.) the loans were denoted in Euros, not some trashy third world currency like the Drachma and b.) scores of hedge funds were willing to write Credit Default Swaps on Greek debt (more on CDS below.) The bankers did not consider that their purchase of CDS did not eliminate their risk in buying Greek debt. It only transferred that risk from a junky country to junky hedge funds, which, as history has shown, tend to close shop when a payment is owed.

Over the last two years, bankers, governments, hedge funds and the Greek people have played “hot potato” as to who ultimately takes the loss on tens of billions in Greek debt. Thus, time and again a “deal” is declared, which is replaced by another deal a few months later, and another and another. The latest deal will most likely be rejected by a new Greek Parliament elected June 17th, 2012 and Greece will exit (or be forced out of the Euro.) 50% of young Greeks will emigrate over the next 3 years as unemployment remains in the +20% range.

The real threat is that Spain (the 12 largest economy in the world, ahead of Texas but behind California) goes next.

Is Greece the next Lehman Brothers?

No – two distinctions:

Lehman was central to the world banking system, Greece is peripheral to the Eurozone. When Lehman failed so did AIG. Merrill Lynch, Morgan Stanley, Goldman Sachs, Barclays Bank and Deutche Bank were right behind. Only a miraculous intervention by the US Treasury and Federal Reserve to payoff AIG’s liabilities in CDS (there’s that word again!) saved the day. As of now,

Greek debt has already been written down by 75%.

Lehman was there Friday afternoon and gone Sunday afternoon, leaving its counterparties no time to react. Is there any investment manager in the world who hasn’t expected to Greece to fail for a year now?

What is a Credit Default Swap?

Once upon a time, managers of bond portfolios believed it was their job to adequately evaluate the credit quality of their bond investments and diversify accordingly. Then, in the mid 1990′s, JP

Morgan bankers created a nifty bond put option. In the event that an issue failed, the writer of the put option would pay the buyer of the put option the difference between the issue price (par) of the bond and any residual value of the bond.

Tags: 9 Months, Agriculture Tourism, Coal Mine, Credit Crisis, Credit Default Swap, Dishwashers, Eurozone, Exogenous Event, Exogenous Events, Faceplant, German Cars, Greeks, Human Nature, Jp Morgan, Jp Morgan Chase, Labor Department, Plummet, Rout, Soviets, Warm Water, World War Ii
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Panic Is Not a Strategy—Nor Is Greed (Sonders)

Monday, May 14th, 2012

Panic Is Not a Strategy—Nor Is Greed

Updated May 10, 2012
by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.

Key Points

• Originally publishing in 2008, it’s time for a refresher about the perils of panic.
• Asset allocation, diversification and rebalancing are as close to a “free lunch” as you can get as an investor.
• In a world where time horizons have shrunk precipitously, think longer-term.

If markets are good at one thing, it’s reminding investors that they don’t go up uninterrupted forever. We witnessed several bruising corrections in 2011 before the market’s strong rally between October 2011 and April 2012. As the chart “Fear Spikes Again” below illustrates, the CBOE Volatility Index® has picked up again, but remains below the unparalleled heights of the 2008 credit crisis and the more-recent elevation in 2011.

Fear Up, But Well Down From Highs

Source: FactSet, as of April 20, 2012. The CBOE Volatility Index (“VIX”) is a registered trademark of the Chicago Board Options Exchange. The VIX Index shows the market’s expectation of 30-day volatility. For more information on the VIX, visit www.cboe.com/micro/vix/

We’re always quick to remind investors that neither panic nor greed is an investment strategy, and that the best foundation to help protect a portfolio against the unpredictable is having—and sticking with—a long-term strategic asset allocation plan.

Mindset matters: strategic trumps tactical

In reality, investors should rarely, if ever, react to a dramatic short-term move in the market. As intriguing as it may seem to try to catch bottoms and get out at tops in order to reap big profits (or so you think), the “tactical” (or shorter-term) approach to investing has its limitations … and its risks.

We believe it’s the “strategic” asset allocation decision—and the ability to stick with it through the discipline of rebalancing—that will ultimately reap the greatest rewards. These decisions are not a function of short-term market gyrations or forecasts (mine, yours or anyone else’s), but are tied to your risk tolerance and long-term goals. Developing and maintaining the right long-term asset mix is by far the most important set of decisions a client will ever make.

Never before has information about the global economy and markets been more readily available and disseminated. As a result, global markets have become very interconnected. In turn, our reaction mechanisms have kicked in, and investor time horizons have shortened dramatically—but not necessarily to our advantage. Yes, the long term is really just a series of short-term events, but it’s how we react to them that decides our ultimate fate as investors.

Asset allocation and diversification: investors’ “free lunch”

One of the most important areas where Schwab offers advice is the development of a long-term strategic asset allocation plan. Many investors assume that their position along the risk spectrum from conservative to aggressive is largely based on their age and time horizon. But a more important factor is their risk tolerance. Also important is judging the difference between an investor’s financial risk tolerance (their ability to financially withstand volatile markets) and their emotional risk tolerance—a spread that’s often quite wide and only acknowledged during tumultuous market environments.

I’ve known plenty of older investors who thrive on the risk associated with an aggressive investment stance. I’ve also known plenty of young investors who can’t stomach any losses. Too often, investors use a rearview mirror to make their investing decisions, by looking at past performance as a guide to future results. A mirror is a valuable tool but only when turned on yourself to judge your own circumstances—tolerance for risk, time horizon, income needs, etc. As I’ve often said, there are very few free lunches in investing. Asset allocation, diversification and periodic rebalancing are as close as you get.

Risk tolerance: Know what you can stomach

In the chart “Schwab’s Strategic Asset Allocation Models” below, you’ll see our long-term recommendations regarding different asset classes for three types of investors: conservative, moderate and aggressive.¹ Note the vast differences in allocations to riskier asset classes, including international equity, as you move up the risk spectrum.

Clearly, over the long term, given the better performance by the riskier asset classes, a more aggressive allocation has historically reaped higher rewards in terms of returns. But there is a dark side to an aggressive posture’s higher returns—the risk taken in getting there.

Tags: Allocation Plan, Cboe Volatility Index, Charles Schwab, Chicago Board Options, Chicago Board Options Exchange, Chief Investment Strategist, Credit Crisis, Diversification, Free Lunch, Greed, Investment Strategy, Liz Ann, Perils, Rewa, Senior Vice President, Strategic Asset Allocation, Term Approach, Time Horizons, Unparalleled Heights, Vix Index, Volatility Index Vix
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Q2 Markets: Don’t Expect Smooth Sailing

Wednesday, April 18th, 2012

by Russ Koesterich, iShares

After a disappointing, frustrating and, at times, terrifying 2011, patient investors were rewarded with a stellar start to 2012. In the first quarter, equity markets banked a performance that would have been respectable for the full year. Developed markets gained nearly 11%, while emerging markets advanced more than 13%. However, equity markets have lost some steam in recent days, and now many investors are wondering if there’s anything to look forward to in the second quarter.

The good news is that even after the rally, valuations still appear reasonable. Developed markets are currently trading at around 14x earnings, no longer a screaming bargain but below historic averages. Emerging markets, meanwhile, are even cheaper, trading at less than 12x trailing earnings. In addition, inflationary pressures remain well contained and while last Friday’s disappointing employment report reminded everyone that the recovery will continue to be slow and uneven, both the US and global economies are stabilizing.

That said, I don’t expect markets in the second quarter to be all smooth sailing. While markets can still move higher, gains are likely to be predicated on earnings growth, which in turn will depend on further improvement in the global economy. And even if the economy continues to stabilize, we’re unlikely to see another round of quantitative easing until at least July as the Fed’s Operation Twist is set to continue through June.

Without the sedative of easier monetary policy, markets are likely to be more volatile. I expect volatility to be in the high teens to low 20s, above the mid-teen levels that characterized the first quarter. In fact, it’s probably fair to say that the first quarter rally was more a function of continuing, and arguably intensifying, central bank generosity rather than a reflection of fundamentals experiencing a complete turnaround.

Given this environment, as the second quarter kicks off, investors should consider repositioning their portfolios to access international equity income, prepare for more volatility and shift into investment grade credit.

As I’ve mentioned before, in an environment of slow growth and more volatility, higher income stocks are more likely to outperform. However, such stocks currently look expensive in the United States, meaning investors may want to cast a wider net to get their dividend exposure through vehicles such as the iShares Dow Jones International Select Dividend Index Fund (NYSEARCA: IDV) and the iShares Emerging Markets Dividend Index Fund (NYSEARCA: DVYE).

In addition, as the market becomes more volatile, investors may want to consider equity funds that employ a minimum volatility methodology that can potentially help insulate portfolios from wild market swings. Such funds typically hold lower-beta stocks than similar, cap-weighted benchmarks and have historically produced higher risk-adjusted returns over the long-term.

Finally, as I wrote earlier this month, while high yield can still offer a good coupon, investment grade debt, accessible through the iShares iBoxx $ Investment Grade Corporate Bond Fund (NYSEARCA: LQD), looks cheaper and should hold up better during a more volatile quarter.

Source: Bloomberg

The author is long LQD and IDV

International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. There is no guarantee that dividends will be paid.

Minimum volatility funds may experience more than minimum volatility as there is no guarantee that the underlying index’s strategy of seeking to lower volatility will be successful.

Bonds and bond funds will decrease in value as interest rates rise.

Past performance does not guarantee future results.

Tags: Asset Allocation, Columbia Management, Credit Crisis, Diversification, Earnings Growth, Emerging Markets, Employment Report, Financial Situation, First Quarter, Generosity, Global Economies, Global Economy, Inflationary Pressures, Investment Advisers, Investment Mix, Iranian Hostage Crisis, Ishares, Last Friday, Market Crash Of 1987, Market Fluctuations, Monetary Policy, Ned Davis Research, Patient Investors, Portfolio Holdings, Q2, Quarter Rally, Rebalancing, Reflection, Risk And Reward, Risk Tolerance, Russ, Second Quarter, Sedative, Smooth Sailing, Stock Market Crash, Stock Market Crash Of 1987, Substantial Market, Time Horizon, Turnaround, Valuations, Volatility, Weather Market
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Where’s the Beef for Gold Equities?

Sunday, April 15th, 2012

Where’s the Beef for Gold Equities?

By Frank Holmes, CEO and Chief Investment Officer, U.S. Global Investors

Gold bulls have plenty of room to graze in the stockyard these days as the investing herd migrated to other assets during the market’s steep climb in 2012. For the fourth time in the past year, gold bears outnumbered the bulls in Bloomberg’s weekly Gold Bull/Bear Sentiment Survey. In fact, the bears had the bulls outnumbered by almost 2-to-1.

Today’s growing sloth of gold bears is a “buy” signal for contrarian investors like us at U.S. Global. Research from the gold team at Canaccord Genuity found that gold rallied about 10 percent on average during the month following each of these sentiment “cross-overs.” This historical increase means that gold could potentially rally to the “high $1,700’s per ounce,” which Canaccord believes “would breathe some new life into the gold equities.”

After a year of neglect from investors who favored bullion, gold equities need resuscitation. Going back to April of last year, gold stocks have been undervalued compared to bullion. I discussed this disconnect back in June 2011 (Will Gold Equity Investors Strike Gold?) and again in August (Valuation Gap Makes Gold Miners Attractive, but All Miners Aren’t Created Equal).

This trend has been accelerating recently: At the end of March, the spread between the NYSE Arca Gold Miners Index and gold bullion was at the same extreme level it was during the 2008 credit crisis despite a much rosier global economic outlook. Going back the full decade of gold’s bull run, this is quite a rare event.

It hasn’t been a complete drought for gold equity investors though, as there have been occasional spurts of relief over the past year. From the beginning of 2011 through the middle of the year, the S&P/TSX Global Gold Index declined by 14 percent. The index then quickly reversed course upward during the market’s volatile period last fall. Now, the index has been declining for four months now, dropping 28 percent, while gold bullion has only fallen 9 percent over that same time period, says Canaccord.

Believe it or not, the four-month selloff is a bullish sign for gold stocks. If you expand your time horizon, you’ll see each dip has been a turning point for gold stocks. Canaccord says that, “sector weakness (less than one year) in the gold equities over the last six years has typically ended with “V” shaped corrections to the upside.” Gold investors must be quick to “buy on the dips” since these sharp V-shaped corrections have been frequent.

The Stampede to Buy Undervalued Gold Miners

If you plan on shopping for bargains in the gold miner department, you’re going to have to fight a crowd. Numerous global investors have been pounding the table for gold stocks, including Dr. Marc Faber who said “gold shares have become extremely oversold and could rebound in the next few days” in his April market commentary and Global Portfolio Strategist Don Coxe, who reiterated that gold equities are undervalued compared to the precious metal on his weekly conference call today.
Another big buyer has been the miners themselves. Mergers and acquisitions in the mining sector have been at an all-time high over the past two years. Large gold miners such as Barrick, Goldcorp and Kinross have been taking advantage of these cheap valuations by snatching up small miners with proven deposits.

And they’ve been willing to pay a premium too. According to Desjardins Capital Markets, over 2010 and 2011, a total of 26 mergers and acquisitions have taken place to the tune of more than $30 billion. In this time period, the buyout or purchasing premium has averaged more than 40 percent.

Desjardins says the M&A trend in the gold sector should continue, given “growing cash hoards and a lack of new discoveries” of the precious metal. As one example of this ongoing worldwide trend, Bloomberg News reported today that, “Chinese gold producers are vying for domestic and overseas mining resources,” with two companies competing for two different gold mining companies located in the eastern province of Shandong.

Big miners have historically purchased the known assets of their rivals as a way to increase reserves rather than deal with the heartache and headache of drilling core samples and filling out permit applications. Large-scale gold production is a complex and costly process involving digging, transporting, crushing and chemically treating massive quantities of rock to get at small amounts of gold. In fact, a commercially viable deposit could contain just a tiny fraction of an ounce of gold for every ton of mined rock. If you’re curious about this phenomenon and want to learn more, check out my book The Goldwatcher: Demystifying Gold Investing where I go into greater detail.

With the signals there for a bounce and stocks undervalued, what’s stopping investors from buying gold equities? One reason could be margin pressure. Rising energy costs, reduced supply and currency swings can quickly erase a gold company’s margin. It takes a great deal of diesel fuel to run the shovels and dump trucks that haul ore to the mill for processing and rising energy costs can affect the profitability of a mine substantially. These variables are the project’s cash costs, or how much capital must be spent to pull an ounce of gold out of the ground.

From the first quarter of 2008 through the third quarter of 2011, the global average cash cost has been rising for miners at a rate of about 8 percent year-over-year. Desjardins says costs will “likely remain under pressure, especially on the energy and labor fronts.”

However, as Desjardins points out, at the level that gold is at now, “most producers will be generating significant cash flow and earnings,” using this cash to fund takeovers, build out development pipelines and pay higher dividends.
Another barrier for investors could be perceived volatility. On Bloomberg Radio, I explained to host Kathleen Hays how gold’s 12-month rolling volatility is very different from the way it’s perceived. While the normal volatility for the S&P 500 Index is up or down 19 percent over a 12-month period, it’s only 13 percent for gold bullion.

My friend and CIBC analyst, Barry Cooper heard my Bloomberg interview and emailed me the chart below showing how the TSX Global Gold Index ETF/Gold Price Ratio has historically been negatively correlated with gold’s volatility. Two times over the past four years, when gold price volatility was falling, it was generally associated with rising valuations of the TSX Global Gold Index ETF. Today it’s a different story: Gold’s volatility and value are both going down. According to Barry, “either we are in a totally new regime for gold shares or something has to give.”

The cold shoulder from investors has also given way to a promising trend in the gold space—growing dividend payouts. We believe this is one can’t-miss trend. We’ve been paying close attention to this as it has developed over the past few years, because through monthly or quarterly dividends, investors can receive income while they wait for share prices to appreciate. To capture the income potential, we’ve adjusted the portfolios of USERX and UNWPX to hold some of these dividend-payers. Many of these holdings pay a monthly dividend that is higher than the two-year government note, have rich balance sheets and receive royalties from all over the world on their gold mines.

We encourage investors to think contrarian: Eat up all you can while the pasture is wide open, because as the chart above shows, when gold equities reverse, it happens quickly.

Tags: Bullion Gold, Chief Investment Officer, Contrarian Investors, Credit Crisis, Equity Investors, Extreme Level, Frank Holmes, Global Economic Outlook, Global Gold, Gold Bullion, Gold Bulls, Gold Equities, Gold Equity, Gold Index, Gold Miners, gold stocks, Gold Team, Nyse Arca, Strike Gold, U S Global Investors, Volatile Period
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The Oil Conundrum Explained

Friday, March 23rd, 2012

Submitted by Brandon Smith of Alt Market

The Oil Conundrum Explained

Oil as a commodity has always been a highly valuable early warning indicator of economic instability.  Every conceivable element of our financial system depends on the price of energy, from fabrication, to production, to shipping, to the consumer’s very ability to travel and make purchases.  High energy prices derail healthy economies and completely decimate systems already on the verge of collapse.  Oil affects everything.

This is why oil markets also tend to be the most misrepresented in the mainstream financial media.  With so much at stake over the price of petroleum, and the cost steadily climbing over the past year returning to disastrous levels last seen in 2008, the American public will soon be looking for someone to blame, and you can bet the MSM will do its utmost to ensure that blame is focused in the wrong direction.  While there are, indeed, multiple reasons for the current high costs of oil, the primary culprits are obscured by considerable disinformation…

The most prominent but false conclusions on the expanding value of oil are centered on assertions that supply is decreasing dramatically, while demand is increasing dramatically.  Neither of these claims is true…

The supply side of the oil equation is the absolute last factor that we should be worried about at this point.  In fact, global oil use since the credit crisis of 2008 has tumbled dramatically.  This decline accelerated at the end of 2011 and the beginning of 2012 all while oil prices rose:

http://www.energyasia.com/public-stories/markets-world-oil-demand-fell-3…

In its February Oil Market Report, the International Energy Agency (IEA) forecast a reduction in the growth of demand into the Spring of 2012, despite reports from the mainstream media that oil prices were spiking due to “recovery” and “high demand”.  Simultaneously, the IEA reported that petroleum inventories rose to the highest levels since October, 2008:

http://omrpublic.iea.org/currentissues/full.pdf

The Baltic Dry Index, which measures global shipping rates and the demand for freight in general, has fallen off a cliff in recent months, hovering near historic lows and signaling a sharp decline in world demand for raw materials used in production.  A fall in the BDI has on multiple occasions in the past been a predictive indicator of stock market chaos, including that which struck in 2008 and 2009.  A sharply lower BDI means low global demand, which should, traditionally, mean decreasing prices:

http://investmenttools.com/futures/bdi_baltic_dry_index.htm

So, supply is high across the board, inventories are stocked, and demand is weak.  By all common market logic, gasoline prices should be plummeting, and far more Americans should be smiling at the pump.  Of course, this is not the case.  Prices continue to rise despite deflationary elements, meaning, there must be some other factors at work here causing inflation in prices.

Ironically, stock market activity in the Dow has now come under threat from this inflationary trend in oil.  Rising energy costs have essentially put a cap on the epic explosion of equities, and many mainstream analysts now lament over this Catch-22.  The problem is that these investors and pundits are operating on the assumption that the Dow bull market is legitimate, and that the rally in oil is somehow an extension of a “healthier economy”.  This version of reality, I’m afraid, is about as far from the truth as one can stretch…

In the candy coated world of Obamanomics, high priced stocks are a valid signal of economic growth, and oil is rising due to demand which extends from this growth.  In the real world, stock values are completely fabricated, especially in light of record low trade volume over the past several months:

http://money.cnn.com/2012/01/19/markets/trading_volume/index.htm

Low trade volume means very few investors are currently participating in active trade.  This lack of investment interest in the markets allows big players (such as international bankers) to use their massive capital to swing stocks whichever way they choose, even to the point of creating false market rallies.  Throw in the fact that the private Federal Reserve (along with helpful hands-off approach by our government) has been constantly infusing these banks with fiat printed from thin air, and one can hardly take the current ascension of the Dow or the S&P very seriously.

Another issue which should be stressed is the renewed tensions in the Middle East, namely, the very distinct possibility of an Israeli or U.S. strike in Iran, and the possibility of NATO involvement in Syria (which has extensive ties to Russia and Iran).  Certainly, this is a tangible danger that would have unimaginable consequences in global oil markets.  However, the threat of growing war in the Middle East is in no way a new one, and has been ever present for the past decade.  It hardly explains why despite hollow demand and extreme supply, the price per barrel of oil has been an unstoppable rising tide.  Attempts by Saudi Arabia to reverse inflationary trends by promising increased production in the wake of Iran turmoil has so far been ineffective.

Simultaneously, large oil reserves have been discovered off the coast of Greece:

http://www.balkanalysis.com/greece/2010/12/08/greek-companies-step-up-offshore-oil-exploration-large-reserves-possible/

Off the coast of Ireland:

http://www.independent.ie/national-news/ireland-on-the-verge-of-an-oil-and-gas-bonanza-679889.html

Massive fields in Mongolia have been uncovered:

http://www.chinadaily.com.cn/bizchina/2009-08/08/content_8544985.htm

And of course, the vast shale oil fields in North Dakota and Montana are finally being tapped:

http://www.mtpioneer.com/archive-July-oil-reserves.htm

Oil supply has been ample and large oil reserves are being discovered yearly.  Speculation would be the next obvious assumed culprit, and there are certainly some signals of such activity.  Oil speculators traditionally use the forced accumulation of oil inventories to reduce market supply and artificially increase prices.  Inventories have indeed been high.  However, as previously stated, demand for oil has been static or fallen in most countries around the world since 2008, and there has been NO petroleum shortages due to manipulated markets.  In fact, there have been no petroleum shortages period.  Speculation has the potential to cause sharp but short term shifts in markets, but one must take into account the long term trend of a particular commodity to understand the root cause of its increasing or decreasing value.  Again, inadequate supply is NOT the trigger for the ongoing oil price problem, whether by threat of war, or by reduction through speculation.

This schizophrenic disconnection between the stock market, and oil, and true supply and demand, is, though, a symptom of one very disturbing illness lurking in the backwaters of the U.S. fiscal bloodstream; dollar devaluation.

We all understand that the Federal Reserve has been engaged in non-stop quantitative easing measures in one form or another since 2008.  We don’t know exactly how much fiat the Fed has printed in that time, and won’t know until a full and comprehensive audit is finally enacted, but we do know that the amount is at the very least in the tens of trillions (be sure to check out page 131 of the GAO report below to find their breakdown of Fed QE activities.  This is just the money printing that has been ADMITTED TO, in excess of $16 trillion):

http://www.gao.gov/assets/330/321506.pdf

The dollar is being thoroughly squashed.  Why is this not showing in the dollar forex index?  The dollar index is yet another example of a useless market indicator, being that it measures dollar value relative to a basket of world fiat currencies, ALL of which also happen to be in decline.  That is to say, the dollar appears to be vibrant, as long as you compare it to similarly worthless paper currencies that are being degraded in tandem with the greenback.  Once you begin to compare the dollar to commodities, however, it soon shows its inherent weakness.

The dollar’s only saving grace has long been its status as the world reserve currency and its use as the primary trade mechanism for oil.  This, however, is changing.

Bilateral trade agreements between China, Russia, Japan, India, and other countries, especially those within the ASEAN trading bloc, are slowly but surely removing the dollar from the game as these nations begin to replace trade using other currencies, including the Yuan.  I believe commodities, especially oil, have been reflecting this trend for quite some time.  The consequences of the dollar’s ties to oil are detrimental to all nations that consume petroleum, and they are clearly moving to insulate themselves from further devaluation.

Even after the release of strategic oil reserves back in the summer of 2011 in an effort to dilute prices, and the announcement of an even larger possible release of reserves this month, oil has not strayed far from the $100 per barrel mark.  High Brent crude price have held for years, even after numerous promises from government and media entities admonishing what they called “speculation”, and promises of a return to lower energy costs.  Not long ago, $100 per barrel oil was an outlandish premise.  Today, it is commonplace, and some even consider it “affordable” compared to what we may be facing in the near future, all thanks to the steady deconstruction of the last pillar of the U.S. economy; the dollar, and its world reserve label.

Ultimately, no matter how manipulated and overindulged the stock market becomes, no matter how many fiat dollars are injected to prop up our failing system, the price of oil is the great game changer.  As inflation is reflected in its price, and energy costs burn out of control, the Dow will begin to fall, regardless of any low volume or quantitative easing.  In all likelihood, this conundrum will be blamed on as many scapegoats as are available at the moment, including Iran, or China, or Russia, or Japan, etc.  Each and every American, and especially those involved in tracking the economy, will have to remind themselves and the public that at bottom, it was the Federal Reserve that created the conditions by which we suffer, including currency devaluation and high oil prices, NOT some foreign enemy.

The one positive element of this entire disaster (if one can call anything “positive” in this mess), is the manner in which the high price of oil tends to dash away the illusions of the common citizen.  It is an issue they simply cannot ignore, because it affects every aspect of their lives in minute detail.  Costly energy awakens the otherwise ignorant, and forces them to see the many dangers lurking on the horizon.  Hopefully, this awakening will not be too little too late…

Tags: Assertions, Brandon Smith, Commodities, Commodity, Conundrum, Credit Crisis, Culprits, Disinformation, Economic Instability, Energy Prices, False Conclusions, Global Oil, Iea, International Energy Agency, Inventories, Mainstream Media, Markets World, Oil Market Report, Oil Markets, Oil Prices, Russia, World Oil Demand, Wrong Direction
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Stocks: More Room to Run

Tuesday, March 20th, 2012

March 19, 2012

Stocks Rise to New Cyclical Highs

Equity markets around the world continued to advance last week, again thanks to continued improvements in economic growth and an overall sense that macro risks have been receding. In the United States, stocks rose to new post-credit-crisis highs, with the Dow Jones Industrial Average advancing 2.4% to 13,232, the S&P 500 Index rising 2.4% to 1,404 and the Nasdaq Composite gaining 2.2% to end the week at 3,055.

At the same time, bond prices sank as yields moved sharply higher, with the yield on the 10-year Treasury jumping to close to 2.3% after trading at around 2.0% for several months. Meanwhile, oil and gasoline prices rose again, gold prices fell and the US dollar gained some strength.

Economic Growth Shouldn’t Be Derailed by Higher Oil Prices

As we have been saying for the past several weeks, it appears the US economy is improving to the point that it is entering a self-sustaining cycle, helped in large part by advances in the labor market. We have recently been seeing improvements in retail sales (with January’s figures up by 1.1%) and we are expecting that gains in employment will translate into faster income appreciation and additional consumption. One cautionary note is that jobless claims have stopped falling in recent weeks, which suggests that the future pace of jobs growth may be more subdued than we have seen in the past few months. It is possible that the warm winter weather may have skewed jobs growth to the upside.

At the beginning of the year, two of the main risks to global economic growth appeared to be the ongoing European credit crisis and the possibility of a hard landing in China. While those risks seem to have receded since that point, a new one has emerged: rising oil prices. Since December, oil prices have advanced by roughly $20 per barrel. Our assessment is that roughly half of that comes from growing optimism about the prospects for global growth as well as some supply shortfalls. The other half can be attributed to the risk premium coming from noise in the Middle East and concerns about Iran. Quantifying the exact impact of the “Iran premium” is extremely difficult since there is a near-limitless range of possible developments that could impact oil prices. The worst-case scenario would be for some sort of military conflict that could disrupt the flow of oil through the Straits of Hormuz, but at this point that seems unlikely.

In any case, it is important to remember that the current run up in oil prices is still only about half of what occurred around this point last year, and at present we do not believe oil prices have risen to the point that they represent a significant threat to the pace of global growth.

Treasury Yields Rise: What Does It Mean for Stocks?

An additional development that drew attention last week was the dramatic rise in Treasury yields. The rise in yields came at the same time that the Federal Reserve held its regular interest rate policy meeting. At that meeting, the Fed confirmed that economic growth is clearly not weakening and may be strengthening, and the central bankers retained their commitment to keeping rates low for the foreseeable future. At this point, markets appear to be signaling that an additional round of quantitative easing is not in the cards, which (along with improved growth) helps explain the advance in yields.

The selloff in bonds does raise the question of how much further it can go before higher yields represent a threat to equity markets. In our view, current macro conditions warrant additional increases in yields. We believe a fair value for the 10-year Treasury is currently around 2.5% or higher. It is important to remember that before last week, we saw several months of improved economic data without a corresponding rise in yields, so in many respects, last week’s moves represent a sort of “catch-up” effect for the bond market. We believe the current trend of rising yields signals an acknowledgement of growing optimism around the economy and, as such, is a positive for stocks.

Stocks Likely to Grind Higher From Here

While it is important to remain cognizant of the risks facing the markets, our overall view toward stocks remains constructive. Since the current rally began last autumn, we have seen some market pullbacks, but they have been brief and shallow, likely because many investors remain underweight equities and have been using pullbacks to buy on price dips. Now that bond prices are falling, we believe investors as a whole will finally begin to move out of Treasuries and into stocks. As such, as long as the macro fundamentals remain reasonably good, we believe equities should grind higher from here.

About Bob Doll

Bob Doll is Chief Equity Strategist for Fundamental Equities at BlackRock^® a premier provider of global investment management, risk management and advisory services. Mr. Doll is also Lead Portfolio Manager of BlackRock’s Large Cap Series Funds. Prior to joining the firm, Mr. Doll was President and Chief Investment Officer at Merrill Lynch Investment Managers.

You should consider the investment objectives, risks, charges and expenses of any fund carefully before investing. The funds’ prospectuses and, if available, the summary prospectuses contain this and other information about the funds, and are available, along with information on other BlackRock funds by calling 800-882-0052. The prospectus and, if available, the summary prospectuses should be read carefully before investing.

The information on this web site is intended for U.S. residents only. The information provided does not constitute a solicitation of an offer to buy, or an offer to sell securities in any jurisdiction to any person to whom it is not lawful to make such an offer.

Sources: BlackRock, Bank Credit Analyst. This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of March 19, 2012, and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. Investment involves risks. International investing involves additional risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. The two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

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Tags: Bond Prices, Cautionary Note, Credit Crisis, Cyclical Highs, Dow Jones, Dow Jones Industrial, Dow Jones Industrial Average, Gasoline Prices, Global Economic Growth, Global Growth, Gold Prices, Jobless Claims, March 19, Nasdaq Composite, Optimism, Prospects, Retail Sales, Rising Oil Prices, Supply Shortfalls, Warm Winter Weather
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Market Update: A Real Recovery, or a False Start?

Friday, March 16th, 2012

The Dow has hit its highest level in years, loan rates are at record lows and the U.S. economy appears to be gaining momentum. Even the housing market is starting to look inviting. But is this a real recovery — or a false start like last year’s? Wharton finance professor Jeremy Siegel and Scott Richard, a Wharton practice professor of finance, think the economy is showing signs of a true rebound and predict that stocks should do well in the next 12 months. But bonds, they warn, are in dangerous waters, and economic growth will be in jeopardy if oil prices keep rising and the European credit crisis worsens.

An edited transcript of the conversation follows:

Knowledge@Wharton: Let’s start with you, Professor Siegel. Looking at the signs of the economy, it does seem like things are improving. On the other hand, we had somewhat of a false start a year ago, and I think a lot of people were burned by that. So, should we believe there is an improvement, or should we not believe it?

Jeremy Siegel: [Last year,] it was a head fake. Things were going up in April…. I think things are far more real now. The employment numbers are much better; the private payroll expansion is much better. Remember, [last year we had] the tsunami and earthquake in Japan. And then Europe got much worse. We can talk about Europe later. No one can say that couldn’t flare up again, but there have been a lot of measures taken that have stifled the recovery that was proceeding at the beginning of this year.

Take a look at even home building, because that has been the most depressed area. [Figures from the] National Association of Home Builders are suddenly moving up. That was dead last year. In today’s Wall Street Journal, I saw an article about a revival of real estate in Phoenix…. It was one of the worst [areas,] and all of a sudden they see a recovery there. So, I think these green shoots are much stronger now than what we had a year ago.

Scott Richard: I completely agree with that. We are in the beginning of a serious recovery, both in jobs and in output. And I expect stock prices and bond prices will react accordingly, with the bond market going up in yield and down in price.

Knowledge@Wharton: But you think it’s more solid this time than it was a year ago?

Richard: Absolutely.

Knowledge@Wharton: Well, let’s zero in on the stock market for starters and then we’ll talk about the bond market. Professor Siegel, we’ve talked a number of times about the gears and levers inside the market that you look at to see what’s going on — things like price-to-earnings (PE) ratios and that sort of thing. What are you looking at now?

Siegel: I think … the two things that are important are cash flows and the discount rate — which for stocks are earnings, basically, and the interest rate environment in which you find those earnings. It was very favorable last year. Actually, it is more favorable, to me, this year because interest rates are a lot lower now — especially those long-term interest rates — than they were a year ago. So the PE ratio is about the same as a year ago: 12 to 13, as we had last year.

Knowledge@Wharton: That’s forward looking?

Siegel: Yes, that’s the forward looking in the next 12 to 13 months, which is lower than the long run average of 15, and in [what is] in some ways a record low interest rate environment. So the question is, [what about] those alternatives out there that are not attractive at all. A lot of people tell me nowadays, “Well, Jeremy there’s not just bonds out there. There’s all these other assets that they talk about, and commodities and private equity and venture capital and all the rest.”

But you shouldn’t be fooled. I’m sure that Scott will agree that fixed income is still the biggest asset class that you have to compare [these alternatives] to. They’re not on all equal footing in terms of size. Fixed income is the big comparison there, and the comparison is, I think, extraordinarily favorable.

Knowledge@Wharton: So with PE ratios low, the risk level of stocks looks relatively low, and you can make nothing in bonds or anywhere else.

Siegel: Of course when I say risk level in stocks, I mean they could go lower. The bears like to point out, “Well, Jeremy, we had PE ratios of seven and eight back in the late 1970s and 1980s.” And I say, “Yeah, and that’s when interest rates were 15% and 20% and there was a lot of competition there.” There isn’t any competition. So to see a PE ratio of 13 in an extraordinarily low interest rate environment is really extraordinary.

Knowledge@Wharton: And that’s a positive sign?

Siegel: Extraordinarily positive going forward. I think people are beginning to put their toes in the water and buy a little.

Knowledge@Wharton: Given what the market has done over the last few years, would it be a good period to look back at to compare how stocks are doing?

Siegel: Well, I actually think that this period is not unlike the 1950s. In the mid-1950s, we had very low interest rates and low valuation of stocks. People were very frightened then. They still had memories of the Great Depression and the tremendous stock collapses that happened. They didn’t believe the post-war recovery was real because so many economists were talking about a relapse into another depression. The fear was there. And if you remember, that was one of the best times to start accumulating stocks and one of the worst times to start buying bonds.

Knowledge@Wharton: So it would be risky to be sitting on the sidelines now?

Siegel: I think you’re missing out on great values in stocks, even in terms of the dividend yield. This is the first time since the 1950s that the dividend yield on the S&P 500 has been higher than the 10-year government bond. And stocks have growth and inflation hedge properties that the bonds don’t have. If you want the inflation hedge properties in the bonds and you go to TIPS (Treasury Inflation-Protected Securities), their yields are negative — incredibly so, in my opinion. So there’s really no yield there at all. So again, stocks are really the only real game in town for yield going forward.

Knowledge@Wharton: So a person who is, say, in or near retirement, should really consider dividends as a source?

Siegel: Good blue chip dividend paying stocks, low PE dividend paying stocks — I think that’s going to be your best answer.

Knowledge@Wharton: I know some of the telephone stocks are paying over 5% these days.

Siegel: I wouldn’t stay with any one or two. I would try to be as diversified as possible. I don’t pick sectors or stocks, but if you are diversified towards a value portfolio that is dividend tilted and dividend weighted, I think that will perform very well going forward.

Knowledge@Wharton: For people who look back or read the stories about “the lost decade” — not referring to Japan but referring to the U.S. stock market — would that be too short a perspective or a misleading perspective?

Siegel: Well, remember, we started that [so-called] “lost decade” in 2000, with a PE ratio of 30 on the market in March of that year. When you start with 30, you’re not going to have a decade. Japan started in 1989 with a 90 PE, and they did not have a good 30 years after that…. People say, “Can’t this next decade be lost?” And I say, “Not starting from these PE ratios.”

Richard: There’s one other class you might want to look at, which is real estate. Clearly, cash is absurd with single digit yields — I mean, in basis points, 10, 12, basis points. And then bonds: I don’t understand why anybody in their right mind wants to lend the U.S. government money for 10 years at under 2%. It makes no sense to me at all. So if you rule out cash, you rule out bonds, stocks are very attractive, as Jeremy said. But real estate also has a lot of attractive attributes right now.

Knowledge@Wharton: You’re referring to real estate investment trusts (REITs)? Or actually going out and buying an investment property?

Richard: Either one, especially if you have the nerve [to invest] in some of the sand states where things have really been crushed. The rental markets already are reflecting this: Rents are up nationwide. But we’ve never seen more affordable prices on single family housing since the records have been kept. Between the low mortgage rates and the low prices, this is the best opportunity we have seen in 40 years.

Knowledge@Wharton: Talking about real estate, when people are considering their own home, they’ve historically been told, “Well, you’ve got to stick around for four or five years to break even, given the cost of buying and selling, title insurance, things like that.” If one were considering an investment property, how long a holding period would they have to commit to, do you think, at minimum?

Richard: Depends on the market, of course.

Knowledge@Wharton: But it’s not a six month, flip-buy-and-flip kind of market?

Richard: Never. For the one who occupies a consumption good, it’s not an investment. If you’re not collecting rent, it’s not an investment; you are consuming the house property. And as for rental properties, that’s just a straight forward present value calculation. How much is the rent I can collect versus the cost of carrying the house — the principal and interest, the insurance and the taxes. And I think that you’d have to be fairly foolish,, as we’ve all learned, to invest on the capital gain that you’re planning to get out of that house.

Siegel: I do agree with Scott here. But the REIT index has totally bounced back. It’s within, I think, 10% or 15% of the high that it reached before the crisis.

Richard: So is the stock market.

Siegel: And the stock market is also within that. In some of these individualpropertiesyou’re talking about, I do agree the affordability index is at a record high. And U.S. real estate is unbelievably cheap on an international basis as well. So again, the REITs themselves have gotten a good bounce. I still think they are probably okay as an investment. But if you can get into the rentals in particular places, I think you might score very well.

Knowledge@Wharton: But again, that’s a multi-year proposition.

Siegel: That’s multi-year. It requires a little bit more specialty in terms of being able to do that.

Richard: And no liquidity. There’s no liquidity there, as opposed to stocks.

Knowledge@Wharton: Professor Siegel, you mentioned the foreign markets in real estate, and there are also of course foreign markets in stocks. In the past, you’ve been quite a strong advocate of people having pretty substantial holdings in international stocks. How have things changed? Is that still a good idea?

Siegel: I think it’s still an excellent idea. There was more growth abroad…. Countries such as Japan and [those in] Europe have moved into a slow growth period to be sure. But the emerging markets have bounced back. And not only have they bounced back, but their valuations for rapidly growing countries and firms are still extremely reasonable. I was just looking at the Shanghai composite selling 10 to 11 times this year’s projected earnings. And even with the comedown of the squeeze in the Chinese market, Hong Kong is around 12, and Singapore is at 15. They’re all 15 to 16, which I think are very good valuations.

People say, “Are these emerging markets for real?” I think we definitely know the answer is “yes,” because we had the biggest economic shock in 2008-2009 since the Great Depression in the 1930s. If it was going to knock anyone out, it would have been the emerging markets. They’ve come back much stronger than any of the developed markets in terms of their economies. Some of their stock markets are not quite back, but their economies are now well over the peak of what they were in 2007.

Richard: I have data since 1972 looking at corporate values, including both the stocks plus the corporate bonds. That’s grown about 1% faster than nominal GDP…. [One reason] is we are participating in a global expansion.

The U.S. companies themselves, without diversifying globally, give you global diversification. Now, clearly they can’t keep growing 1% faster than the economy, or they become the economy. Sooner or later, they are going to have to level off and grow at the rate of the economy. But I don’t see that happening, myself, in the short run because of the increasing and continuing globalization.

Siegel: I definitely agree. People look at the ratio of stock market value to GDP. It’s not appropriate anymore. I mean, 45% of the profits of the S&P 500 are now coming from abroad. So, you need to look at world GDP, which is growing faster than U.S. GDP. That is, I think, the most important criteria, and why I think that divergence can go on for an awfully long time.

Knowledge@Wharton: Before we switch from stocks to bonds, I just want to ask one last question, which is what worries you the most? If something were to derail all of this, what would it be?

Siegel: I’m not happy about rising oil prices…. Any sort of war in the Gulf that could send oil up to $250 a barrel is obviously a threat out there. A longer-term threat is — and I don’t see this happening — if the emerging markets stop growing. Political things [could happen], and the growth of the emerging markets is very important for us economically. They are the new middle class that is going to be buying so many of the goods as the baby boom population retires over the next 20 years. And they’re going to be the demanders of goods and grow much bigger than the middle classes that now exist in Europe and the United States. If something disrupts their growth, that’s a longer-term issue. I don’t see that happening. Short run, it is probably the oil question and war or attacks on Iran.

Richard: I think this is going to be the century of wealth creation. You have two billion people in the last 20 years who have come out of abject poverty into the cash economy and huge growth in the middle class in India and China. That’s nothing but good news. I don’t see anything that will cause that to derail, unless their governments adopt very bad policies. A government can always do that, and then there’s nothing you can do about it. But both the Indian and the Chinese governments seem to have … embraced market economies, and we should see quite a bit of growth continuing out of those countries.

Knowledge@Wharton: Let’s talk about bonds a little bit and the interest rates. It just seems like it’s been years that we’ve been saying, “Well, interest rates are more likely to go up than down.” Have we ever seen a period where rates have been so low for so long?

Richard: Not since the great depression….  We’ve seen low rates … but never cash this low, fed funds this low, for this long. And Fed chairman [Ben] Bernanke has announced that he intends to keep it there through 2014. The markets seem to be buying this.

Knowledge@Wharton: That was quite a remarkable announcement, very unprecedented. How did the markets react? Has it calmed them down? Are they just ignoring it?

Richard: I think nobody in the markets ignores the Fed. They are the 800-pound gorilla.Long [-term] rates are just averages of short [-term] rates. So you have to be looking at the Fed. Now of course the Fed has much, much more control of the front end of the yield curve than they do over the long end. So the reaction in the market is that we have very steep yield curves. The rates are not all that high, but the curve is very steep. And the forward rates are even steeper….

As the economy strengthens in the coming years, the Fed is going to be holding down the front end of the curve. The only way the curve can go is to move up, is to steepen. And that’s what the forward rates look like. That’s what I expect will happen. Whether the Fed changes its mind and then eases before the end of 2014, I think will … depend on what happens to the unemployment rate and inflation….

[As for inflation,] they may have printed a lot of money. I don’t know whether they’re going to be able to reel it back in time to [prevent] inflation. In past years when the economy was stronger, if they had printed anything like this amount of money — this huge easing they’ have gone through in the last few years — people would be very worried about inflation.

Knowledge@Wharton: So does it look like rates will come up in the next few years?

Richard: In my view. And that’s what the market’s forecasting as well.

Knowledge@Wharton: I’d like to just note that it’s always difficult for laymen to remember this relationship between the interest rates and bond prices, and how a rising rate can cost you money if you’ve bought a bond earlier that pays less. That’s a danger for people who are looking at bond mutual funds and think they are safe. How would you gauge that danger these days?

Richard: You can buy bond mutual funds in all sorts of flavors. [For example,] you can go for the money market fund, which probably is safe.

Siegel: But yields zero.

Richard: Yields zero. Well, no free lunch. [There are also] short bond funds which are yielding something like 1% and are relatively immune to interest rate movements. And then you can go on out to longer bond funds, five years, where what you say is very true. When yields go up, eventually these funds are going to suffer. Offsetting it will be some spread tightening as the economy recovers. The corporate spreads are not all that wide right now, nor are mortgages.

Knowledge@Wharton: So, should the investor who wants a portion of their portfolio in bonds assume that this is going to even out over time — the turnover in the fund will get new, higher yielding bonds, and it won’t matter? Or should they be worried about it?

Richard: I would expect to earn your yield right now. I don’t think you’re going to get some coupon, and I expect capital losses to come in against the coupon. So that’s what I mean by earn your yield; if you hold it to maturity, that’s about the best you’re going to do.

Knowledge@Wharton: Should be wary of the bond market right now?

Richard: I would be very wary of it, and I would not be a bond buyer at these yields. Like I said, why do you want to lend the U.S. government money for 10 years at 1.75 percent when they’re running trillion dollar deficits?

Knowledge@Wharton: Now of course we’re constantly hearing about the situation in Europe, the debt crisis in Europe. It’s a little bit mystifying to many of us how that affects us. We know vaguely everything’s interconnected. But how does it affect us? What’s sort of the mechanism in which troubles in Europe affect markets in the United States?

Richard: They’re a huge trading partner. And if they go through these serial defaults, like I liken it to a bank run. [After] Greece’s default, I imagine the market is going to turn its attention to Portugal next. Portuguese spreads are already very wide and have been widening. These [countries] are less worrisome because they are small [in terms of] GDP. But if they start to fall,  then the next one is Italy or Spain — and those are big and real. The joke about Italy is it’s too big to save. If its economy becomes compromised, these are people who buy a lot of goods and services from the United States. That’s going to hurt, that’s going to hurt everybody who exports, from farmers to manufacturers. So that’s the mechanism. Trade is really the mechanism.

Knowledge@Wharton: Do you feel that they’re getting a grip on this situation in Europe, or not?

Richard: Truthfully, no. I think that they’re moving in the right direction, but for a currency union to work, you need several things. We have a currency union in the United States. We have 50 states and one currency. We have a lot of labor mobility. That’s what makes our currency union work. They have very little labor mobility in Europe …. so they don’t really have a mechanism that’s going to allow huge differences in labor productivity across Europe to equilibrate. The normal way of doing that would be — for example, with Greece, they would have had a drachma. And the drachma would have fallen in value. Then everybody’s labor productivity per unit of currency would have worked out. So the euro would have stayed strong, the drachma would have weakened and the Greeks would have been competitive in the European market.

The same thing is true now of Portugal, Spain and Italy…. Their unit labor costs are very high compared to Germany’s, and they don’t have a mechanism for adjusting. That’s what worries me.

Knowledge@Wharton: Do you think that going to the euro was a mistake? Is that what all this is pointing to?

Richard: Going to the euro was perhaps not a mistake. What was a mistake was going to the euro without having a mechanism in place to make sure that unit labor costs across the eurozone were going to remain competitive…

Knowledge@Wharton: You mentioned that it would make no sense to lend the U.S. government money for earning nothing.

Richard: Well, I wouldn’t lend it to them.

Knowledge@Wharton: But there are other opportunities in the bond market. There are corporates or municipals and there are junk bonds, or “high yield,” as they like they say. Across that spectrum, what looks appealing or unappealing, or more dangerous or less so?

Richard: I don’t see anything awfully appealing in the bond market at all, across the whole sector. And that’s because I’m worried about rates going up. If you hedge out the rates, then the question becomes: Are any of the spreads attractive? Mortgage spreads are a little bit wide, not tremendously wide. Corporate spreads are a little bit wide, not tremendously wide. A lot of the value in corporations, if you had the nerve [to invest], was available a year ago. But they’ve tightened in a lot. So, I don’t see any real great values across the whole bond market.

Siegel: I tend to agree. Interest rates are going to go up. Again, they’re at zero on the short term. I personally do not think that Bernanke is going to be able to hold rates until 2014. I think the economy’s going to improve and/or inflation is going to increase enough that he’s going to have to pull the trigger on that.

A lot of people ask me, “What’s going to happen in the stock market?” I say that it will be a shock when that happens, but if you go through history, the early phases of fed tightening are not bad for the stock market. Stock rallies continue. It’s only at the end when they really squeeze — try to slow the economy that’s getting out of control in terms of inflation and resource utilization — that you really begin to see the bear market beginning. So I’m not saying that on the day when Bernanke says, “We’re now thinking of withdrawing the accommodation,” there will not be a short term shock there. And I consider that a buying opportunity because history shows us that often times stocks recover very quickly from that and continue on to the new highs as long as earnings are growing.

Remember, there are two things that affect the stock market — interest rates and earnings. The bond market is only the interest rates. If the economy’s going to be stronger, you’re going to do really well on the earnings side. That’s going to be able to bring the stock market up where bonds can’t go.

Richard: Some sectors of the bond market, like the banks, are very attractive right now. But that’s a view that the financial sector is healing and not going down the tubes.

Knowledge@Wharton: There’s one other sector I wanted to ask you about because of your background in the mortgage securities market, and that is, am I correct that the private securitization market is still pretty much dead?

Richard: Moribund, absolutely.

Knowledge@Wharton: And does that matter? Is there something else? I guess Freddie and Fannie have stepped in to fill that breach. Is it important that we have a private securitization market? And if it is, what will it take to get it going again?

Richard: Those are great questions. Fannie and Freddie can only securitize a loan up to a congressionally set ceiling… which under special circumstances is now up to about 6.25. But the actual ceiling is about $200,000 lower than that. And there’s a lot of political pressure to return it to the actual ceiling, to not make it a jumbo loan securitizer. There’s essentially no jumbo loan market. How important is that? Well, if you’re the average person who’s buying, the average home price in the United States is a couple hundred thousand dollars, and it’s not important at all because there are lots and lots of Fannie and Freddie conforming loans available. If you’re buying a jumbo loan or if you live in an expensive market like California or New York, it’s very important because you can’t buy a house — which means that the person trying to sell you the house can’t sell it to you. Even though rates are low, people can’t get the loans.

So what’s it going to take to get that going? I’m think you’re going to have to see house prices return to some strength so that the underlying collateral, the house price, looks good enough for people to be willing to lend against it. In the Wall Street days there was an expression, “Don’t catch a falling knife.” That’s what people look at the housing market as, a falling knife. Now we have some signs like Jeremy mentioned about Phoenix turning. And we may see other cities turning. But I believe that the mortgage lenders and the bond market are going to take a wait-and-see attitude. They’re not going to get in front of this.

Knowledge@Wharton: A year from now, what do you think things are going to look like in the economy and the markets that you’re following?

Siegel: Well, since I believe this recovery is real, we’re going to see a stronger economy. I think the stock market’s going to be higher — [maybe] 15%, or even more. We know one year projections are so uncertain. I think the interest rates on treasuries will be substantially higher. I think within a year, Bernanke’s going to have to bring forward the tightening date, and that announcement could very well be made in the next 12 months. And the rising economy, as Scott said, I think will stabilize the home price situation … [and] start lending in that market. We will be healing in the economic sense in the next 12 months.

Richard: The big unknown is the elections. We have a very, very big tax hike built in at the beginning of next year, [when] the rates return to the pre-Bush tax cut rates. If we’re split among Democrats and Republicans, it could be that it’s impossible to do anything about that, and I think that will not help. That will slow the recovery, [by adding] a big tax hike right in the middle of [it].

Siegel: But you know, I’ve always been saying that you’re not going to get an agreement until the elections…. As Scott said, if we go back to those [tax hikes], that will be a fiscal hit that [will derail] any recovery. So my feeling is at that particular point, this is our strength. These are our negotiating points. And they’re going to [have to] come to a deal.

Knowledge@Wharton: Okay, so we’re optimistic, but there are a lot of big “ifs” out there.

Richard: Well, whenever there’s an election year, there’s a big “if.”

Copyright © Knowledge @ Wharton

Tags: Credit Crisis, Dangerous Waters, Depressed Area, Earthquake In Japan, Employment Numbers, Finance Professor, Gaining Momentum, Housing Market, Jeopardy, Jeremy Siegel, Loan Rates, National Association Of Home Builders, Oil Prices, Practice Professor, Professor Jeremy, Professor Siegel, Record Lows, True Rebound, Wall Street Journal, Wharton
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Investors Losing Faith in Hedge Funds?

Friday, March 9th, 2012

 Nathan Vardi of Forbes reports, Investors Are Starting To Lose Faith In Hedge Funds:

For a long time, it seemed like nothing could diminish investor appetite for hedge funds. Even after the financial crisis embarrassed some of the industry’s most high-profile investors and caused the industry’s assets to tumble as hundreds of hedge fund closed in 2008, the hedge fund business quickly recovered. Last year the industry’s assets reached an all-time high of $2 trillion.

But 2011 turned out to be one of the hedge fund industry’s worst years ever. The average hedge fund fell by 5%. The average hedge fund specializing in equities fell by 8%. Hedge fund titans like billionaire John Paulson had a terrible year and lost massive amounts of money. At the same time, the S&P 500 returned a positive 2%. Evidence has started to emerge that some investors may have had enough.

According to research firms Barclays Hedge and TrimTabs, investors redeemed $15.2 billion from hedge funds in January, the highest outflow since the height of the credit crisis in January 2009.

This could only be the start of a river of outflows if hedge fund performance doesn’t improve soon. In January, hedge funds again trailed the U.S. stock market. The average hedge fund posted a positive return of 3.1%, underperforming the S&P 500, which returned 4.2% in January. Bank of America Merrill Lynch says that its investable hedge fund composite index was up 1.19% in February, yet still underperformed the S&P 500 by 2.87%.

“If hedge funds don’t deliver in aggregate this year, it is going to be a very real problem for the industry,” says Brad Balter, a Boston-based investment advisor who oversees just under $1 billion and farms out money to hedge funds. “2011 had a very volatile 3^rd quarter which hurt everyone, but if we go through another period of underperformance investors will question using them.”

FINalternatives also reports, Hedge fund redemptions , assets up in February:

Investors pulled $15.2 billion from hedge funds in January 2012, as overall industry assets climbed to $1.70 trillion from $1.68 trillion at end-2011.

According to BarclayHedge and TrimTabs Investment Research, hedge funds underperformed the S&P 500 by 110 basis points for the month.

“Hedge funds managed a 3.1% return in January after posting losses in seven out of the last eight months of 2011,” said Sol Waksman, founder and president of BarclayHedge. The benchmark S&P 500 Index returned 4.2% in January after outperforming the hedge fund industry for all of 2011.

“January marked the biggest monthly outflow since July 2009, when hedge funds redeemed $17.7 billion,” said Leon Mirochnik, an analyst at TrimTabs. “The hedge fund industry has experienced net outflows in four out of the last five months.”

Fixed income, multi-strategy, and merger arbitrage hedge funds are the only strategies to have seen net inflows since September 2011. Multi-strategy funds led, pulling in $2.6 billion in January. Mirochnik says investors seem to be “piling into strategies that can benefit from geopolitical uncertainty around the world.”

Funds of hedge funds underperformed their hedge fund counterparts by 140 bps, returning 1.7% in January and Mirochnik thinks FoF managers might have difficulty explaining “their layers of fees” to clients given that funds of funds have underperformed hedge funds by 200 bps over the past year.

In related news, hedge fund managers polled by TrimTabs/BarclayHedge remain bullish on U.S. securities, although the sentiment was less marked in February 2012 than in the previous month. Of the 105 hedge fund managers surveyed in the third week of February 2012, 40% were bullish on the S&P 500, compared to 45.4% in January. Bearish sentiment rose to 30.5% in February from 25.0% in January.

Nearly 30.0% of managers believe that U.S. equities will be the top-performing investment over the next three months. Gold came in second at nearly 23.0% followed by oil with 20.0%.

So what is going on? Are investors “losing faith” in hedge funds? Not exactly. They are simply becoming more aware that most hedge funds are full of it, charging 2% management fee and 20% performance fee for beta. And as we saw in 2011, most hedge funds had a a hard time even delivering beta, underperforming the market.

All this prompted Mindful Money to ask, Is this the end of the hedge fund manager?:

The headline that hedge fund bosses seem to have made a bit of cash in 2011 will hardly surprise many of the cynics who see them as more bogeymen of the financial services industry, alongside bankers. But these inflated pay-packets certainly seem counterintuitive at a time when many are predicting the end of the hedge fund manager altogether.

This Reuters piece, based on a Forbes survey showed that: “The top 40 highest-earning hedge fund managers took home a combined $13.2 billion… The top 10 hedge fund managers made more than $200 million each, while the lowest earning managers made $40 million each.”

But the report coincides with a Times article (paywall) predicting the end of an era for hedge fund managers: “Last year was a disaster for the $2 trillion hedge-fund industry. Desperately hoping for a recovery from the 2008 financial crisis, hedge funds actually lost investors 5 per cent in 2011, with some slipping as much as 50 per cent. Investors pulled millions of pounds out and hundreds of smaller hedge funds have closed.”

One analyst, who recently left a hedge fund, is quoted as saying: “The industry’s gone through cataclysmic change. There’s much more scrutiny. People are asked to work harder, in a more regulated environment, for less money. Everything’s more serious – you can’t send rude e-mails any more – it’s death by a thousand cuts.”

So how to explain these giant pay-packers? The Reuters article points to the fact that the more successful hedge funds are mopping up disillusioned investment bankers ahead of the imposition of the Volker rule, which seems to have benefited groups such as Europe’s Brevin Howard.

There certainly is more interest in alternatives. The most recent Morningstar fund flows survey showed that as risk appetite has increased, so has interest in alternatives: “Other broad asset classes also reversed the negative momentum of 2011′s second half. Funds in the allocation, alternatives, and commodities groups all enjoyed modest inflows in January.”

But this is benefiting some groups more than others. Man Group, the largest listed hedge fund managers has reversed a run of difficult performance: “Man said assets under management had risen to $59.5bn from $58.4bn at the end of December. Chief executive Peter Clarke told Reuters: If sentiment is maintained and performance continues, we’d expect it to translate into rising sales and net inflows. Man also held its dividend payment, which some analysts had suggested might be cut.”

The big money has tended to be made in the larger macro hedge funds, which have been able to use the market volatility to their advantage. The trouble is that the environment has exposed those hedge funds that are not doing anything very different to long-only managers and charging a lot more for it.

This Zerohedge article goes some way to exposing the lack of imagination in some hedge funds. It points to Goldman research into hedge funds, which demonstrates, among other points, that; “hedge fund returns are highly dependent on the performance of a few key stocks. The typical hedge fund has an average of 64% of its long equity assets invested in its 10 largest positions compared with 34% for the typical large-cap mutual fund, 18% for a small-cap mutual fund, 20% for the S&P 500 and just 2% for the Russell 2000 index.” Secondly, the Goldman research found: “Apple (AAPL) matters. One out of five long/short hedge funds has AAPL among its ten largest long positions and approximately 30% of hedge funds own at least one share of AAPL. When it ranks among the top ten holdings, AAPL represents an average of 8% of single-stock long equity exposure. In aggregate, hedge funds own only 4% of AAPL equity cap. The average hedge fund AAPL position equals 1.6%, given 70% of funds own no AAPL.”

As the Times piece points out, both markets and investors are getting smarter. The credit crisis exposed the limitations of the hedge fund industry and created a new scepticism about financial services generally: “In his book The Hedge Fund Mirage, industry insider Simon Lack calculated that between 1998 and 2010 hedge-fund managers earned an estimated $379 billion in fees, out of total investment gains of $449 billion. In other words, they took 84 per cent of the investment profits, leaving just 15 per cent for investors.” This may work in bullish times, but not when investors are short of cash and have Madoff in the back of their minds.

Weakening returns have also exposed the high fixed costs of some hedge funds: “While some larger hedge funds are still profitable, many smaller ones cannot afford the high Mayfair rents they took for granted until recently” says the article.

In other words, the hedge fund industry is the same as any other, the strong are getting stronger and the weak are falling away. The credit crunch has ensured that the hedge fund industry is becoming as Darwinist as any other.

The strong are getting stronger, able to attract talent because they have the big bucks to pay top managers, but it goes far beyond this.

According to the fifth annual global study released by SEI in collaboration with Greenwich Associates, with significant dollars poised to flow into hedge funds in 2012, managers must address investor transparency and liquidity concerns to take advantage of new funding opportunities:

The second report in the two-part series, entitled “The New Dynamics of Hedge Fund Competitiveness,” indicates a need for hedge fund managers to move beyond portfolio transparency to provide investors with consistent and insightful communications along with direct access to investment teams. Liquidity and the inability to control exit strategies have also emerged as key concerns for hedge fund investors.

“Transparency has been the focus for managers in recent years, but we’re seeing clients look for increased personal interaction and dialogue. This Era of the Investor™ is pushing managers to look beyond standard expectations,” said Philip Masterson, Senior Vice President and Head of Business Development, Europe, for SEI’s Investment Manager Services division. “The environment is shifting and while managers are showing improvements in reporting, the study shows that portfolio transparency is simply not enough to satisfy investors anymore.”

Beyond communication, the survey shows that investors want greater detail in terms of security-level disclosure, including leverage detail, valuation methodology, and risk analytics. The study also showed that liquidity has emerged as a key area of concern among investors. Nearly a third of respondents (31 percent) cited ongoing liquidity risk among their biggest hedge fund investing worries, while “an inability to control exit strategy” was named by 46 percent of respondents.

“Evaluating and selecting fund managers has always been a top-of-mind concern for investors,” said Rodger Smith, Managing Director of Greenwich Associates. “What this study brought to light is that, as long as they can articulate their value proposition and differentiate themselves from their peers, there is a place for smaller and newer funds in institutional portfolios. In fact, one in five investors polled said they have no asset minimum requirements in order to invest, and while a majority of those surveyed said they seek hedge funds with a history of at least three years, roughly a quarter would consider less, and 14 percent would not eliminate a fund without a track record at all.”

Highlighting the increasing inability of investors to distinguish among strategies, 17 percent of respondents said manager selection is the single most important challenge facing hedge fund investors today. While 95 percent of respondents said clarity of investment philosophy is important or very important in the selection process, more than half of respondents (61 percent) said there are too many look-alike strategies in the hedge fund industry.

Given that challenge, more than half of respondents (51 percent) said hedge funds are too complex to evaluate without a consultant’s help. Respondents were decidedly mixed on the importance of brand in the selection process, while operations are clearly a critical aspect in selecting managers, with 80 percent of those polled agreeing that operational strength is a hallmark of an institutional-quality fund.

The white paper is published by the SEI Knowledge Partnership, which provides ongoing business intelligence and guidance to SEI’s investment manager clients. To request the full paper, visit http://www.seic.com/HedgeResearch2012.

Some consultants are working to address investors’ concerns over liquidity and transparency. Roger Kenyon, Senior VP at FIS Group, told me they have found a way to address the liquidity, transparency and investment concerns of investors looking to allocate to emerging hedge fund managers. Roger sent me these comments:

Investors have always been interested in investing in emerging hedge fund managers. No doubt this has been a natural inquisitiveness about anything new; the hope of discovering a spectacular talent; and also a possible morbid belief in discovering a future blow up. Research shows that new managers with limited assets to manage outperform more established managers.

Yet this has not prevented investors from introducing all sorts of preconditions that the manager must satisfy before investors will act. Even the definition of what constitutes an emerging manager seems to be unsettled. In the long-only area some investors define the category to be managers with assets below $2 Billion. Among hedge fund investors the cutoff seems to be $200 MM.

The difficulty in getting access to funding by emerging managers is primarily due to the fact that they do not share the same characteristics of established managers. This does not refer to their potential to produce skill based returns, but primarily to the absence of the support infrastructure of larger funds.

These structures usually provide investors with a sense of confidence that management is governed with features such as oversight, liquidity and transparency. Emerging managers would not be so classified if they were required to build up these capabilities before starting a business as the time and costs would be severe impediments.

Luckily, the market has responded to this gap and has addressed these infrastructure problems in a comprehensive manner. Emerging managers can now access all the institutional level back up required to produce accurate and timely valuations, counterparty controls, risk controls and limit monitoring. In this way the manager has the freedom to leverage his investment skills; and the investor can be confident in the investment decision because of the high level transparency.

The characteristics of these processes cannot be undervalued. They allow a smooth flow of information in periods agreed upon by both manager and investor. These periods can be daily or wider spaced. Each partner can communicate with each other as needed. Investors can view the information from a viewpoint chosen by the investor. No longer will the investor wait for the manager to an interpret performance. He will have seen the results and he will have been able to see whether they were within his investment framework.

Needless to say, both manager and investor can set benchmarks, allowable securities, risk controls, and general operating features that both feel comfortable with. With this capability in place, concerns about performance, strategy, strategy drift, use of cash, leverage, and tracking error and returns attribution can be analyzed rather than be an issue of uncertainty .

These types of facilities should provide investors to be more aggressive in sourcing, investing and having a positive returns experience with emerging managers. Investors will be able to continually tailor their allocations as required because they can be assured of being able to call on the liquidity conditions which were agreed.

Roger and I discussed how useless monthly “risk transparency” reports are and how investors who are looking to allocate to emerging managers are adopting this new approach to manage risk properly.

I cannot stress how important it is to look at emerging alpha talent, especially in this environment where there is a placebo effect of investing in large hedge funds. There is talent out there worth seeding but investors have to approach the seeding game a lot more intelligently.

Reuters reports that HSBC’s alternative asset management arm is scouring the market for promising new hedge fund managers, whose ranks are swelling ahead of the imposition of the Volcker rule, which cracks down on banks trading with their own money:

The rule could prove a boon for HSBC’s recently launched emerging manager programme as it is providing hedge fund managers across strategies such as long-short equity, distressed debt and trading funds.

“Several opportunities are arising from the Volcker rule. People are leaving the banks and launching their own funds,” Peter Rigg, head of HSBC’s alternative investment group told Reuters at a presentation in Zurich.

The Volcker rule, named after former Federal Reserve Chairman Paul Volcker, prohibits banks from trading with their own funds for profit, encouraging so-called proprietary traders to set up shop on their own.

U.S. regulators said on Wednesday they are unlikely to have the rule finalised by a July deadline, but many managers are still exiting banks ahead of when the ban is due to come into force.

Ex-Goldman Sachs stars like Pierre-Henri Flamand and Morgan Sze are among those to have already made the move.

Rigg said many managers perform best in the early years, when their funds are still small and they rely on strong returns to earn performance fees and draw in clients, rather than living off management fees levied on large asset bases.

He said HSBC’s $38 billion (23.8 billion pound) alternatives investment business can negotiate good fee discounts with these managers which it then passes on to its clients.

Rigg said HSBC’s funds of hedge funds were currently in “risk off” mode, meaning they are underweight strategies like long-short equities which rely more on market fundamentals than investor sentiment, while favouring strategies which look to profit from market trends, as well as smaller, nimble managers.

Tim Gascoigne, who was global head of portfolio management at HSBC Alternative Investments Limited, and who ran the $2.4 billion (1.5 billion pounds) GH fund of hedge funds left last month, after global banking group decided to merge its discretionary and advisory businesses.

Fund of funds are finding it increasingly tough to compete in an environment where investors are unwilling to pay an extra layer of fees. I happen to think that only the best funds of funds will survive the coming shakeout in the hedge fund industry, those that are able to add value in portfolio construction and identify new and existing talent.

And there are plenty of opportunities to seed emerging hedge funds. Bloomberg reports that Mike Stewart, who JPMorgan (JPM) Chase & Co. picked last year to oversee a unit of traders being moved out of its investment bank, has left to start a hedge fund.

Finally, Azam Ahmed of Dealbook wrote an excellent comment on Texas Teachers’ investment into Bridgewater. I quote the following:

If Bridgewater’s assets, and returns, continue to soar, the pension could do quite well. But if it has a string of bad years and investors withdraw their money, inflows could suffer.

“The investor has huge market risk,” said George J. Mazin, a partner at Dechert, a global law firm. “There have been a number of deals where investors bought high at the top of the market and in the next couple of years there was no growth and an attrition in assets.”

Such investments have been a mixed bag over the years.

Goldman Sachs, which started an in-house group to buy hedge fund stakes, has made some smart bets. Goldman’s Petershill fund bought a piece of Winton Capital in 2007 when the firm had less than $10 billion under management. Since then, its assets have swelled to nearly $29 billion, and performance has been strong, including a 6 percent return in 2011.

But Goldman has also had prominent losses. The Petershill fund bought a stake in Shumway Capital Partners not long before the firm’s founder decided to shut it down and return capital to investors. Another holding, Level Global Investors, was swept up in an insider trading investigation and decided to close shortly thereafter. Goldman lost big on its investment.

Morgan Stanley offers another cautionary tale. In 2006, it bought FrontPoint Partners, a hedge fund firm with $5.5 billion in assets. But soon, top managers started to leave. The relationship worsened when a FrontPoint manager was accused of insider trading in 2010.

In 2010, Morgan Stanley took a $193 million impairment charge related to FrontPoint. The bank sold its stake back to FrontPoint last year.

The deals can also prove treacherous for the hedge funds, as they try to navigate the relationships with their partners and their investors. An owner, like the Texas pension, may want fund assets to grow, because it means more money in hand. But an investor in the fund may want to keep a lid on the size, fearful that if the fund gets too large it will hurt performance.

I think Texas Teachers’ went overboard with this investment and time will prove me right. The landscape is changing in the hedge fund world. Investors fixated on the ‘old model’, chasing after the latest ‘superstar manager’, are going to be sorely disappointed. Those taking intelligent risks, changing without regret, will come out ahead.

Below, Bloomberg’s Dominic Chu reports that John Paulson lost 1.5 percent in February in one of his largest hedge funds, according to an investor update, paring this year’s gain and setting back efforts by the New York-based manager to recoup record losses in 2011. He speaks on Bloomberg Television’s “Inside Track.”

Also, Anita Nemes, Deutsche Bank AG’s London-based global head of capital introduction, talks about the outlook for the hedge-fund industry. Global hedge fund assets may rise 12 percent this year to a record $2.26 trillion as investors reduce cash and seek returns, according to an annual survey of investors by Deutsche Bank. Nemes speaks with Erik Schatzker and Stephanie Ruhle on Bloomberg Television’s “InsideTrack.”

Tags: Bank Of America, Billionaire, Composite Index, Credit Crisis, Forbes Reports, Fund Business, Hedge Fund Performance, Hedge Funds, Investment Advisor, John Paulson, Losing Faith, Massive Amounts, Merrill Lynch, Outflow, Rd Quarter, Redemptions, Terrible Year, Trimtabs, U S Stock Market, Vardi
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