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Enter the Dragon 2012

August 4, 2012 1 comment

This article was first published in B Beyond 2012/1 (page 88) by BB Publications – a niche publisher catering for the global HNW and UHNW community. http://bbpublications.org/

The S&P 500 index ended 2011 relatively unchanged despite a year of high volatility driven by the European Sovereign Debt Crisis and the pertinent risk of double dip recession. During the year, the markets witnessed the major impacts of the Arab Spring, the Japanese earthquake, the downgrading of the US credit rating and the risk of a Eurozone country defaulting on its debt obligations – none of which were ‘predicted’ by Wall Street analysts at the beginning of the year.

The future is much harder to predict than Wall Street would have us believe. As Nassim Taleb remarked: “To prophesize, don’t add anything to the future; just figure out and eliminate what will not survive.” This Popperian view, that all investment hypotheses are provisionally accepted until proven wrong, may not seem comforting to investors.  Nonetheless, it has not stopped the influx of money flowing into hedge funds.

Hedge funds on average lost 4.83% in 2011 despite amassing a record $2.04 trillion in total capital under management during the first quarter of 2011. The industry – which caters to wealthy and institutional investors chasing higher returns for bigger fees – appears to be licking its wounds as fund managers finished the year in the red. The hedge fund industry – which prides itself on outperforming the market – has failed to live up to expectations and delivered one of their worst annual performances last year. As 2012 – the year of the Water Dragon according to Chinese Zodiac – rolls on, can the industry reverse its fortune?

Renewed optimism in Europe’s ability to solve its debt problems and the U.S. economic recovery has led analysts to expect a brighter 2012 with hedge funds gearing up on riskier bets. The question then remains: Why are the so-called ‘Wall Street analysts’ invariably wrong?

Despite their relatively poor record in making financial predictions, it seems to be a staple publication for analysts each year. From a non-deterministic worldview, the future is unpredictable; therefore, a successful investment manager should be able to change his views as events that either confirm or refute his investment hypothesis unfold. Making a public prognostication in the form of a financial prediction begins a very slippery slope towards intellectual materialism. Subsequently changing one’s view would be tantamount to admitting that the former was, in fact, erroneous. Making erroneous financial calls reflects badly on an investment manager. This agency problem may manifest itself when the manager seeks out confirmatory evidence for his earlier thesis and subconsciously filters out contradictory evidence. Such intellectual materialism is a highway to financial ruins. Perhaps money managers should refrain from making explicit public commentary on financial markets for this very reason. It frees them from the shackles of having to defend their views and allows an unfettered approach towards investing. This separation is exemplified further in the financial service industry’s highly regulated relationship with its research divisions, requiring a Chinese wall between public and private functions.

So then, why are analysts’ predictions invariably wrong? To borrow from quantum physics’ Totalitarian Principle which states “everything not forbidden is compulsory” – it is not possible to envisage or even model the future states of all permissible events that can occur and affect the markets. This is akin to the adage commonly referred to as Murphy’s Law that is typically stated: “anything that can go wrong will go wrong”. The job of a money manager is therefore not just to react to such events but to be perceptive. George Soros famously remarked that “it’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong”. As the collective action of investors translates to the ebb and flow of the financial markets, the investment manager’s job is to remain one step ahead of the crowd. There is no point in being right one year in advance as the financial markets can remain irrational longer than one can remain solvent.

The hedge fund industry’s performance for 2011 is an egregious example of ‘smart money’ getting it wrong. The industry as a whole underperformed the broader market. This is an industry that hires the best and the brightest minds armed with MBAs and often wielding PhDs from the top business schools in the world. Compensation in this industry is second to none. Hedge funds understood what politicians have long understood – that there is no shame in buying success. The industry goes to great length to justify its compensation and management fees. Can this be one of the reasons as to why the asset management industry continues to churn out financial predications, the majority of which are often not worth the paper they are printed on? After all, the industry that pours millions into its research departments ought to be seen as making informed investment decisions based on well-researched ideas. A simple flick through previous years’ financial predictions and their propensity to come to pass will reveal dismal statistics. Nonetheless, the media’s deep-seated fascination for financial predications continues to contribute to the proliferation of analyst recommendations aimed at investors.

Ask any economist or analyst how precise their estimates are, their response will be that such predictions help guide decision-making in investments more satisfactorily than it would be otherwise. That however inaccurately or irresponsibly their predictions may help shape investment decision, it does so better than astrology. However mindless the culture of prophesying, it is more attractive than disremembering. And however deceptive the idea of an analyst’s estimate, it is more believable than that of a coin toss.

As for my financial predictions for 2012, it will take a leaf out of Chinese astrology. The year of the Water Dragon may bring more economic trouble in the year ahead. According to Chinese Feng Shui, the economy is very much affected by the five elements in Chinese astrology (wood, fire, earth, metal and water). In the Chinese calendar, the fire element will generate optimism and happiness. Therefore, if the financial market represents the collective optimism of investors, it should rally with the fire element.  The water element is the opposite and it represents fear in the five-element system. Happy 2012 – the year of the Water Dragon!

 

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Interview with David Rosier – CEO of Thurleigh Investment Managers

January 15, 2012 Leave a comment

The S&P 500 index ended 2011 relatively unchanged, despite a year of high volatility driven by the European Sovereign Debt Crisis and the pertinent risk of double dip recession. During the year, the markets witnessed the major impacts of the Arab Spring, Japanese earthquake, downgrade of the US credit rating and the risk of a Eurozone country defaulting on its debt obligations – none of which was ‘predicted’ by Wall Street analysts in the beginning of the year.

The future is a lot harder to predict than Wall Street would have us believe. As Nassim Taleb remarked, “To prophesize, don’t add anything to the future; just figure out and eliminate what will not survive.” This Popperian view that all investment hypotheses are provisionally accepted until proven wrong may not seem comforting to investors. Nonetheless, it has not stopped the influx of money flowing into hedge funds.

Hedge funds on average lost 4.83% in 2011 despite amassing a record $2.04 trillion in total capital under management in the first quarter of 2011. The industry – which caters to wealthy and institutional investors chasing higher returns for bigger fees – appears to be licking its wounds as fund managers finished the year in the red. The hedge fund industry, which prides itself on outperforming the market, has failed to live up to expectations and delivered one of its worst annual performances last year. As 2012 – the year of the black dragon according to Chinese Zodiac – rolls on, can the industry reverse its fortunes?

B Beyond caught up with David Rosier, CEO and co-founder of Thurleigh Investment Managers.

David Rosier and Charles MacKinnon, founders of Thurleigh Investment Managers, are a rare breed of investment managers who have skin in the game. David and Charles stress the importance of ‘eating your own cooking’ and have their own personal wealth invested alongside their clients.

BB In your view, what is driving the current market conditions?

DR At the moment, there is greed and there is fear. There is greed because you are leaving your money on deposit and earning next to nothing and there is fear because the markets have become so volatile. It is a ‘risk on risk off’ mentality. The flight to safety, or what investors perceive as safe investments, has been driving this ’bubble’ in the gilt-edge securities. I mean, it’s mad to buy 10-year gilts yielding less than 3% when inflation is 5%.

BB Has this affected your strategy?

DR The way we implement our strategy hasn’t changed. We have always focused on asset allocation and academic research has shown that 90% of portfolio returns can be attributed to asset allocation rather than stock selection. We have always invested in a mixture of index funds, ETF and absolute return funds. We believe that by active asset allocation it is possible to capture short-term cyclical opportunities to enhance the returns without increasing risk. I’d say the main change is we no longer invest in hedge funds with the exception of a few CTAs (Commodities Trading Advisors). People got very frightened in 2008.

BB Why do you no longer invest in hedge funds?

DR We no longer invest in hedge funds for two reasons: liquidity and control. Firstly, our clients wanted liquidity. After the credit crunch, our clients would ring us up and ask ‘how soon could we liquidate our portfolio?’, not necessarily doing it, but just the comfort to know they could turn it into cash. Secondly, when you invest in hedge funds, you lose the element of control. In early 2007, we put orders on to sell the hedge funds, but when we wanted the cash to invest – when markets had fallen – we couldn’t get the cash. It’s not that we don’t think there are some good hedge fund managers out there. The structure or the lack of liquidity is something that neither our clients nor we can take. Also, the UCITS III funds can essentially do what hedge funds do with slightly more onerous restrictions. With a UCITS III fund, you can get similar investment policies with the added benefit of daily dealings.

BB Can you tell us about your investment strategy and has that changed recently?

DR We have four core strategies based on volatility. The very low risk strategy has a maximum volatility of 4%, the low risk is 6%, medium is 8% and the high risk is 12%. Our strategies have not changed as we actively manage them to the desired risk levels. We are constantly checking our proprietary risk models to ensure our strategies run to a certain volatility level.

BB Any thoughts on the European Debt Crisis?

DR As central banks continue to debauch their currencies, government bond yields do not offer a smart risk-reward profile. We think there is a distinct possibility the Eurozone area would fragment with either departures or some form of dual currency emerging (convertible euros and non-convertible euros) to enable the most indebted nations to reflate their economies. It is unlikely for the Eurozone to survive in its current form. Regardless of the outcome, there will be a wealth of investment opportunities that will arise out of the ashes of the Euro project.

BB Any insights on investing in 2012?

DR We think that the large growth economies of China, Brazil, South Korea and Taiwan will continue to grow, and their currencies and bond markets will continue to deepen and strengthen. Within the equity and the bond portfolios, we will continue to move them towards a higher yield profile. We currently have 20% of our bond portfolios exposed to high yield, and we anticipate growing this significantly at the expense of the strategic bond positions. Within equity portfolios, we anticipate altering the weighting of the indices and funds we use to increase the dividend yield significantly with a continued focus on global multinationals.

For more information on David Rosier or Thurleigh please check out: http://www.thurleigh.com

Asset Markets Formula Sheet

December 8, 2011 Leave a comment

Asset Markets – Formula (pdf)

Zynga IPO to raise $1 billion dollars

December 4, 2011 Leave a comment

Games maker Zynga is hoping to raise $1 billion in tough market conditions with an IPO price of $8.50-$10 – giving it a valuation of $7 billion.  Zynga is offfering 14% of its float or 100 million shares, which is higher than most tech companies.

Lead underwriters Morgan Stanley and Goldman Sachs have an additional option to sell 15 million shares. Like Groupon and LNKD, I expect downward pressure on the price when the cost of shorting becomes feasible. If you are one of the lucky few who got in early through private placement it may be time to cash out!

It’s worth noting that a fund raising in February this year valued the company at $10 billion.

I cannot for the life of me understand why any ‘ethical’ investor would invest in a company that generates the bulk of its profits from the sale of virtual goods. (We are NOT talking e-commerce here.) Does it play a socially benefiting role?? We need more clean tech or bio tech!!! Game makers like Rockstar, which makes the highly successful Grand Theft Auto series, actually make money from selling games! Virtual goods are on another level!  How productive?

Retail investors should ask themselves: “Can I live in my virtual farm in Farmville when Fannie Mae repossess my home??!?”

For a copy of their IPO prospectus click on the link below:

Zynga IPO Roadshow Prospectus

 

Zynga IPO Roadshow Prospectus

Sovereign Debt Crisis 101

December 3, 2011 2 comments

Commodities Investing: Demand, Supply and Speculation

July 24, 2011 2 comments

First published on BBeyond Magazine blog – an ultra niche publisher that caters exclusively for the global UNHW market and community: http://bbpublications.org/BBblogs/commodities-investing-demand-supply-and-speculation/

An unsophisticated forecaster uses statistics as a drunken man uses lampposts –
for support rather than for illumination.

– Andrew Lang

The price of a commodity is determined by demand and supply. At least that is what most of us are taught in ‘Economics 101’. The relationship between supply and demand forms the cornerstone of economic models. The most fundamental concept in economics – price – is therefore a reflection of supply and demand. Or is it? Ask anyone who has traded Brent Crude or Light Sweet Crude (WTI) oil contracts and they will tell you the oil market is driven as much by speculation and momentum as it is by demand and supply. To put it in perspective, the CFTC (Commodity Futures Trading Commission) recently revealed that almost 95% of US crude oil futures volume is generated by day trading and OPEC president Mohammad Aliabadi noted futures contract trade an astonishing 18 times higher than the volume of daily traded physical crude.

The world’s population currently stands at 6.93 billion (and counting). It is expected to surpass nine billion by 2050. As such, there has been a lot of brouhaha about our capacity to accommodate the rising demand. The rise of emerging economies like BRIC (Brazil, Russia, India, China) has pushed the prices of commodities to new highs. In the post-2007 credit crunch economic climate, despite the possibility of prolonged spells of slow growth in the developed world, demand is expected to be robust. Chinese GDP per capita alone more than doubled from $3600 in 2001 to $7600 in 2011 and is forecast to surpass $12,000 by 2016. This is a large demand explosion and the question is: How quickly can supply response to that? The prices of commodities will thus be determined using supply-side fundamentals.

In India, 60% of farmers’ produce spoils before it reaches the market. The problem therefore is not supply per se, but infrastructure (which constricts the supply chain).  New technologies can lower production costs while increasing the supply of the commodity. A technology is classified as ‘disruptive’ when it significantly lowers the supply-demand equilibrium price while it simultaneously causes a surge in production capacity. For example, the natural gas market was hit by a disruptive technology in the form of horizontal drilling. Each horizontal rig can surge production by 5-10x the previous capability of vertically drilled wells. In the past, natural gas needed to trade near $6–$7 per mmbtu (million British thermal unit) to encourage new production. Now natural gas is expected to remain under $5.50 per mmbtu for the foreseeable future. The key to successful commodities investing is to spot these disruptive technologies in the wings.

The ideas in this blog post stem from a panel discussion on Commodities Investing the author recently attended at JP Morgan, London. Chartered Alternative Investment Analyst Association sponsored the event.

 

 

If Hedge Funds are the good child of Capitalism, are Banking Institutions their Evil Twin?

July 12, 2011 25 comments

First published on BBeyond Magazine blog – an ultra niche publisher that caters exclusively for the global UNHW market and community: http://bbpublications.org/BBblogs/if-hedge-funds-are-the-good-child-of-capitalism-are-banking-institutions-their-evil-twin/

Give me control of a nation’s money supply, and I care not who makes its laws.

– Mayer Amschel Rothschild

Post-credit crisis, the spotlight was already trained on large ‘unregulated’ investment vehicles. Then we had the Bernie Madoff ponzi scandal. This was followed closely by one of the largest insider trading cases worthy of a Hollywood script – the Raj Rajaratnam Galleon case, which snared senior management from some of the most prestigious Wall Street and consultancy firms.

Main Street was hit with a triple whammy – reeling from the fact that taxpayers’ money is being used to bail out banks that took on too much risk, against a backdrop of the steepest recession since the Great Depression of the 1930s, which was further exacerbated by the unpopular war on two fronts. Obama said he did not run for president to bail out a bunch of fat cat bankers. A witch-hunt was inevitable.

The opaque nature of the hedge fund industry proved an easy target. In theory, hedge funds are just capitalist. They will tear a firm down if it makes money and build it back up if it makes even more. Capitalism at its very best – hedge funds help allocate capital more efficiently by punishing inefficient firms (through short-selling) and rewarding the well-managed ones (by purchasing their stocks). As part of a group of international private investors with a sizeable war chest measuring hundreds of billions, hedge funds can significantly affect global markets and the economies of nations. As such, hedge fund failures are often well documented as their strategies are laid bare for the ensuing media scrutiny.

Long Term Capital Management’s spectacular implosion destroyed $4.6 billion. Most of it belonged to the firm’s partners. Despite its trillion dollar off-balance sheet derivative positions (due to leverage), no taxpayers’ money was used to bail them out. Subsequent academic studies noted that the Fed’s intervention, despite its good intentions, was misguided and unnecessary as it set precedence for regulating hedge fund activity. The Fed may have helped shareholders and managers of LTCM to get a better deal than they would have otherwise obtained in a rescue effort that involved a consortium of Wall Street and international banks.

When Amaranth blew up in a $6 billon bet on natural gas that went bad, another hedge fund, Citadel, stepped in and took over Amaranth’s books. This time, the markets barely flinched. As Sebastian Mallaby, author of More Money than God, puts it: “hedge funds can be a fire-starter as well as a fire-fighter”.

The global financial system and banking institutions are so intertwined that recent events have shown some banks are clearly too big to fail. Hedge funds, on the other hand, are generally small enough to fail. When hedge funds blow up, taxpayers do not foot the bill. The same cannot be said for banking institutions.

During the recent credit crisis triggered by the bursting of the US housing bubble, two of the most hallowed investment banks on Wall Street converted to bank holding companies to take advantage of a lifeline from the Fed. The rest either went bankrupt, got taken over or got bailed out. Beyond the euphemisms, firms like Citigroup, JP Morgan, Wells Fargo, Bank of America, Goldman Sachs, Merill Lynch, and Morgan Stanley were bailed out by the American taxpayers through the Troubled Assets Relief Program (TARP).  In the UK, the Royal Bank of Scotland and Northern Rock ran into the arms of the British government. Northern Rock became the first bank in 150 years to suffer a bank run. Images of the public queuing up to withdraw their money from the branches were plastered on national newspapers and will forever be seared in the minds of Northern Rock’s customers.

Whilst Hedge Funds and Banking Institutions can both be guilty of gambling with OPM (other people’s money), the hedge fund captain is more likely to go down with the ship. Hedge funds go to great lengths to justify their management and performance fees in order to align their interest with that of their investors. Fund partners often (though not always) have a significant proportion of their personal wealth invested in their own funds. In banking, on the other hand, there is a clear dislocation between management incentives and accountability. With the benefit of hindsight, incredulously, the system is essentially rigged to encourage excessive risk taking. Couple that with deregulation and the repeal of the Glass-Steagall Act and we have ourselves a recipe for disaster. History has shown that given enough rope, some of us have a tendency to hang ourselves. The problem then arises when ‘some of us’ (that may hang ourselves i.e. banks) happen to possess enormous financial power by virtue of their control of other people’s money.

The recent credit crisis may have provided ammunition to opponents of the laissez-faire approach to managing economies. One of the basic tenets of the free-market capitalist approach is that firms should be allowed to fail. Like Social Darwinism, only the strong survive and the weak die out. On the other hand, ideas of socialism, while appealing, begin a slippery slope down into communism. The problem with capitalism is the inherent disparity of wealth that creates fault lines between the ‘haves and the have nots’. The problem with socialism is that it undoubtedly leads to ‘free riding and slacking’, or as Margaret Thatcher once said: “The problem with socialism is that eventually you run out of other people’s money [to spend]”. Recent financial events have drawn parallels with a common joke that begins:

A beautiful and shallow woman said to an intelligent and ugly man: “We should get married, so our children will be as beautiful as me and as smart as you”. The man replied: “What if our children turn out to be dumb like you and ugly like me?”

This worst of both worlds approach seems to caricaturize the recent tumultuous events of our financial markets post-2007. When we have ‘too big to fail’ in a supposedly capitalistic economy, we end up with the problems of capitalism (huge disparity of wealth) AND the problems of socialism (spending other people’s money) BUT with NONE of their benefits.

Thomas Jefferson, principal author of the Declaration of Independence and Founding Father of the United States of America, the last bastion of free-market capitalism once said that “banking institutions are more dangerous to our liberties than standing armies”.

What about hedge funds that take on excessive risk through high leverage and speculation? Hedge fund luminary George Soros is infamous for being “the Man Who Broke the Bank of England” when his currency trade forced the United Kingdom out of the Exchange Rate Mechanism (a precursor to the Euro). He netted $1bn by betting on the devaluation of the pound sterling in 1992. The total cost to British taxpayers by the botched attempt to prop up the pound was put at $6.1bn (£3.3bn). Subsequent information obtained through the Freedom of Information Act noted that “if the British government had maintained $24bn foreign currency reserves and the pound had fallen by the same amount, the UK would have made a £2.4bn profit on sterling’s devaluation”.

During the 1997 Asian financial crisis, former Malaysian prime minister Dr Mahatir Mohamad publicly criticized Soros as an ‘immoral financial speculator’ while Soros described Mahatir as a ‘menace to his country’ (Mahatir later accepted that Soros was not responsible for the 1997 Asian Financial Crisis). The crisis started in Thailand when the Thai baht collapsed. Thailand had already acquired a burden of foreign debt that effectively made the country bankrupt before the collapse of its currency. Soros defended his actions by saying “speculation could benefit poor societies if it serves as a signal, not a sledgehammer”. It is worth noting that Soros held back from an all-out attack on the Thai baht. In 1992, Soros sold $10bn worth of sterling at around 2.5x the firm’s capital. The $2bn Thai trade was only one-fifth of the firm’s capital. An all-out attack would have precipitated a crisis rather than encourage the Thai government to avoid one.

In the wake of the Thai baht devaluation, Soros funds gained about $750m whilst Thailand’s economic output plunged 17% and millions fell into poverty. Hedge funds were inevitably vilified. But in a larger context, the roots of the crisis stretched back several years where ‘hot money’ pushed the Thai economy into bubble territory. The Soros team had indeed led the short selling but the actions of hedge funds were in part vindicated when the crisis spilled over to other Asian countries that engaged in ‘crony capitalism’ like Indonesia and Malaysia. What is not usually cited is the fact that Soros lost $800m buying the rupiah as he wrongly believed the turmoil in Thailand had spilled over to neighboring Indonesia without justification. This essentially wiped out all the gains he made in Thailand.  President Suharto and his cronies who controlled Indonesia’s banks drove the country to a crisis, which resulted in his own downfall. Hedge funds may have triggered the avalanche, but it was the government officials who allowed snow to build up to such dangerous levels in the first place.

Hedge funds reap the rewards when they are right and pay the price when they are wrong. Banks reap the rewards when they are right but taxpayers pay the price when they (banks) are wrong. This case of ‘heads I win, tails you lose’ has played a key role in precipitating the recent capricious events resulting from the credit crunch.

 

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