Arc Notes

Day One – 5/11/09

The three day Global Absolute Return Congress held in San Francisco is organized along three main themes: 1. Global environment, 2. Economics theme 3. Absolute return theme. Much of this three-day conference in San Francisco focused on the “tectonic shifts” going on the global economy. Unlike previous versions of this particular conference, this new left-coast edition featured several economists specializing in the global economy - particularly in Asian economies. From Nobel Laureate Michael Spence (chairman of the Independent Commission on Growth and Development) to academic and author Richard Koo (author of a recent book on what the US can learn from Japan’s lost decade) to this morning’s opening speaker Stephen Krasner, former Director for Governance and Development at the National Security Council. As much as these macro-economic issues seemed to engage the sensibilities of the hedge fund managers and institutional investors in the room, one question was never far from the surface: so what? How would these “tectonic shifts” affect the investment portfolios of the foundations, endowments, pensions, insurance companies and hedge funds who make the pilgrimage to Boston and San Francisco every six months for this gathering? One obvious answer is that these macroeconomic dislocations could lead to opportunities for global macro, currency and emerging markets hedge funds. But from Vanguard shows that emerging markets may still be all about beta, not all about alpha. Placing the Economic Crisis in Context – Barry Eichengreen (UC Berkeley)  

Markets globally have fallen further than during the Depression. The Fed is cutting interest rates faster and money supplies are growing faster today. − The downward trend is in place globally

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Fiscal policy is also being used more aggressively. Conclusion is that the economy is “getting worse more slowly” – not getting better yet. − Weak support from bank lending − Fiscal stimulus can replace only 2% of the 6% GDP gap left by the decline in private spending

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The “policy mix” is not supportive of investing. Dependence on China for global growth is unhealthy. The decline in U.S. consumer spending hurts the global economy more than the rise in Chinese GDP helps it. The Obama Administration’s attempts to boost confidence have the ability to reinforce the positive trends – but could also backfire.

Re-inventing the Financial Wheel – Harry Markowitz (UC San Diego)      

The recent stock market decline was a 1-in-40 year event, not a black swan. Investors should have planned for the possibility. Acknowledged that various asset classes exhibited greater than normal correlation, but less than 1. Behavior of crowds is persistent The market is a leading economic indicator, so it makes sense that the market is rallying in advance of improvement in the economy. Mean-variance optimization was intended to use forward-looking, not backwardlooking, returns. A rising equity price since the 1980s implied lower risk premium going forward.

Roger Ibbotson, founder of Ibbotson Associates and Yale professor was the in the anchor position for this “no-media” event. In many ways, it was an appropriate book-end to my interview with Harry Markowitz that helped kick things off on Monday morning. Ibbotson, like Markowitz, is skeptical of active management - at least in aggregate across all mutual funds. He said that before the 90’s, mutual funds seemed to produce some alpha, but since then…no way. Hedge funds are a different story however. Ibbotson’s wildly popular 2006 paper with Peng Chen) shows positive alpha even after fees are taken into account. As a hedge fund manager, the self-described “geek” told the audience that he remains convinced that alpha-centric investing (particularly quant investing) still works. After a year that battered both hedge fund managers and institutional investors that was message everyone wanted to hear. Diversification Strategies – Panel    

Diversification by risk factor can be more useful than by asset class – but it may be difficult to explain risk factor optimization to investment committees. Diversification by counterparty, firm also important. Some panelists have de-risked at the margin. Most participants did not have exposure to managed futures, which did well in ’08.

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The panelists had a combination of fund of funds and direct allocations to hedge funds. Those with FOF exposure were reducing it at the margin. Idea sharing was one of the perceived benefits to allocating to FOFs. The panelists are prioritizing liquidity. Those who did not already have a strategic allocation to cash were loath to create one now given that Treasuries are overpriced and that liquidity is available via other income producing assets.

New Opportunities - Phil Falcone, Harbinger Capital    

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2009 has already been a year of record defaults – 59 companies, $106 billion. High level of fallen angels – stressed/distressed investment grade are a big opportunity set. Paying more attention currently to coupon and maturity, holding company vs. operating company nuances. Have moved up in the capital structure to control volatility. − DIP loans in the middle market − Trade claims − Bank debt, especially in oil services sector – need to be careful of covenants to avoid “high yield in drag.” “Scarcity assets” have greater certainty of emerging from bankruptcy as going concerns rather than going into liquidation.

Credit Environment:

• Credit is an area where many endowments would look at the opportunities within. However, it is very complex and difficult to invest and conduct proper due diligence unless we understand how this credit/distressed cycle is different. The former credit cycle from 2001-2004 is characterized by fraud, a complement crisis of confidence in accounting and management, California electricity crisis and telecom meltdown. The macro environment provided cheap readily available credit and equity financing facilitated recapitalization, often without requisite operational restructuring. In the ongoing pursuit of growth opportunities, strategic buyers of post reorganization companies come in to complete the cycle. • The post 2008 credit cycle has largely driven by the near collapse of the global financial system and deleveraging across the entire investment community.

Companies will not have the benefit of exiting Chapter 11 in a secular bull market. Instead, companies will be emerging in the face of a synchronized global slowdown. Companies have far less access to capital as both DIP and exit financing is relatively difficult to come by and will come at a high costs.

Systematic Risk and Hedge Fund by Professor Andrew Lo (MIT) • Professor Andrew Lo of MIT presents trend following and herd mentality in hedge fund investment is very risky. Based upon his adaptive hypothesis derived from evolution theory, Alpha will mutate into Beta in a short period of time (2 to 3 years). The conference attendees also singled out Bridgewater All Weather and Brevan Howard as actual example of money chasing hot funds. Based upon Andrew Lo’s analysis, a significant portion of hedge fund time bombs are managers who are exposed to risk factors which happen to have low volatility during the period of analysis. By highlighting nonlinearities (changes in correlation) and return smoothing, hidden risks can be identified with appropriate methods. Time bombs are a critical source of hidden risk particularly in a period of low volatility such as the one from 2003-2007. • By deploying a network diagram of correlations among 13 CS/Tremont hedge fund indexes over two sub-periods (1994-2000 and 2001-2008), hedge funds demonstrated a significant increase in the absolute correlations in the more recent period (2001-2008), the hedge fund industry has clearly become more connected. Thus, the diversification benefits by investing in alternative assets has been compromised significantly. • There is also much more focus on risks taken by hedge fund managers, the difference between risk measurement and risk management. What is the action to take from the various risk measures and as most risk measures focus on end-ofperiod measure, how about the drawdown risk experience during the interval?

Risk, leverage, and liquidity management panel 

Panelists generally agreed that the days of hedge funds run by “two guys in a garage” were over. − Ability to get credit lines, leverage limited − Errors in compliance, etc. are costly!

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Capital adequacy (assets vs. liabilities) is key. Evaluate counterparty risk. − Multiple prime brokers are a must − Write CDS on large counterparties?

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Operational risk includes areas such as compliance, IT, HR, disaster recovery, and settlement/reporting. − The panelists preferred to see minimal outsourcing.

Skill Set Investing – George Main, DGAM Fund of Funds  

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“Adjacency risk problem” – investing alongside short-term investors hurts longterm investors. Investors are no longer “tenants” but rather perceive their relationships with managers as long-term and expect to participate in setting terms that align their interests. − Labor-intensive process Speaker argued that large, global, diversified funds and small, monoline firms that specialize in a particular market segment would be the survivors.

Fee Structures Panel    

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Panelists argued that hedge funds’ improperly aligned fee structures creates left tail risk. Neither panelist believed that negotiating fees was possible only with second-tier managers. Look to customize terms to match investor’s needs. Improve alignment by extending time horizon over which incentive fees are collected. − Tax law changes are making it more difficult to structure this. Separate accounts allow infinite customization. Key not to reduce fees to the point where managers are inspired to become asset gatherers. − Can dis-incent managers from raising money by reducing fees over a certain AUM level.

Risk Management Panel 

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Preference for managed accounts, even commingled managed accounts, vs. investing in LP vehicles. − Allows greater customization of fees and terms. − As with the Fee Structures Panel, the panelists did not observe negative selection bias in negotiating this. Negotiate for transparency sufficient to hedge out risks . − Aggregating risk information is challenging. − Avoid collecting more information than is useful. Monitor staff turnover and organizational changes to offset key man risk. − Some panelists preferred to invest in funds run by a team to contain key man risk. Key question re: hedge fund risk management: Does the risk manager have enough power to stop a trade?

New Framework for Analyzing Risk - Andrew Lo (MIT)   

Traditional tools didn’t work in ’08. Hedge fund AUM has shrunk from its peak but remains at 2005 levels ($1.5 trillion). Hedge funds have compressed the process of turning alpha into beta. − As ideas transform from unique to novel to popular to common, correlations rise.

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Betas become more apparent as assets within a strategy proliferate and as technology facilitates the broader implementation of strategies such as stat arb. − Chart re: correlation between hedge fund asset classes shows boost in correlations from 2001-07 vs. 1994-2000. New framework: Adaptive Markets Hypothesis tries to reconcile efficient market hypothesis with observed market behavior. − Investors chase performance. − Managers follow investors into popular strategies (think distressed in ’08-‘09). How to diversify more effectively? − Acknowledge multiple risk factors/betas  equity/currency/etc. − Reduce or remove the long-only constraint. − Ignore value/growth distinction? − Diversify away from equities. − Hedge.

Day Two – 5/12/09 Lessons from Japan’s “Lost Decade” – Richard Koo  

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“Balance sheet recession” is the commonality between the two economies. House prices need to fall another 21% in the US to gain equilibrium with rentals. − Savings shortfall of $1.5 trillion would result if home prices declined to that extent. In Japan, GDP kept growing despite a huge loss of wealth. − Gov’t borrowed and spent funds on fiscal stimulus as companies paid down debt despite zero interest rates. Risk for the US is that reducing the deficit as companies clean up their balance sheets would create a prolonged recession. Japan reduced fiscal stimulus too quickly (twice) over the past 15 years and created a repeated rally/collapse dynamic. Dr. Richard Koo of Nomura Institute delivered a keynote speech on the “balance sheet recession”. Balance Sheet Recession argues that contrary to Wall Street belief, it is this massive shift in corporate behavior, instead of structural problems, that is the root cause of both the deflation and the non-performing loan problems that have troubled Japan for so long. It argues that when the causality runs from the corporate balance sheet problems to deflation and banking problems, a highly unconventional fiscal policy response is needed to stabilize the economy. After all, the last time anything similar has happened was the 1930s in the US.

He elaborate the reasons and the monetary policy implications of the Japan experience after the 1990 asset bubble collapse. The bigger point of interest is where the Japanese system had a leveraged corporate debt issue, the US has both a corporate and a personal debt issue. Therefore, what are the implications when we as a society start to pay off on this debt? He argued that if the Government changes their fiscal policy and starts to balance the budget, it will leads to a second wave of recession which will be much more severe than the first one. End Game of Financial Crisis – Professor ken Rogoff (Former Chief Economist of IMF) Professor Ken Rogoff of Harvard presented a speech on “what is the endgame of financial crisis?” His international evidence on severe banking crises suggests a far more cautious assessment than the greenshoot argument of economic recovery. The recessions that follow in the wake of big financial crises tend to last far longer than normal downturns, and to cause considerably more damage. If the United States follows the norm of recent crises, as it has until now, output may take four years to return to its pre-crisis level. Unemployment will continue to rise for three more years, reaching 11–12 percent in 2011.

At the same time, recent news on housing prices and the stock market is arguably a little better, mainly because there has been so much damage already. The typical fall in inflation-adjusted stock prices is 55 percent, a benchmark the U.S. has more or less achieved. The typical decline in housing prices is 36 percent. According to some indicators he presented, inflation-adjusted housing prices have already fallen roughly 30 percent. The bad news is that these down price cycles typically last for several years. So, even if the big hit on stocks and house prices has come already, the bottom might not be reached until the end of 2010, after which the inflation threat is both real and significant.

What If? Panel (four professors, moderated by Andrew Lo)  

Panelists were disappointed to see the bank bailout impose such a huge burden on taxpayers. Fiscal stimulus “comes for lunch and stays for dinner” – i.e. is difficult to stop once it’s started. − Big, unpredictable government is the biggest risk.

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Disagreement re: the multiplier of fiscal stimulus on economic growth – across a very broad range, from 0.25x to 1.8x. − Takeaway was that projects themselves need to add value. − Balance between stimulating growth and inflicting burden of repayment on future generations. Population growth/immigration growth creates expansion. If current trend toward saving persists, there will be a $1 trillion gap in demand. Technology/energy stimulus. U.S. has the advantage of flexibility relative to other economies.

Strategic Asset Allocation Panel 

Panelists’ current focus includes: − Unconstrained managers, who can handle both equity and debt investments. − Cash and liquidity. − Portfolio de-risking.

Credit Opportunities – Frank Jordan, Goldentree 

Credit investments outside the largest, most liquid names are the better opportunity. − At $82, index of the 15 largest names prices in only a 6% default rate − Broader index trades at $72 (12% yield)

Credit Panel 

Attempting to align lockup structure with anticipated holding period. − Run overlays to offset undesired exposure during lockup?

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Do increasing levels of complexity across the industry favor larger funds? Extensive discussion of controlling fraud risk, adjacency risk, and monitoring overall exposure to credit.

Gates Panel 

More likely to occur in funds that have: high leverage, illiquid investments, mismatched assets and liabilities, or investors with different profiles commingled in one vehicle. − Greater focus on client mix going forward. 

We have always evaluated this as part of our due diligence.

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In response, investors can require separate accounts or impose higher performance hurdles for funds that can gate vs. those that can’t. Fee reduction if gates are imposed?

Funds should offer investors the option to continue holding illiquid positions, move them into a side pocket, or liquidate. Gated funds that continue making new investments are a problem. Does invoking a gate create a death spiral? − Key for funds to own up to the need to restructure. Funds with perpetual gates (“lines at the door”) are the biggest problem.

Day Three – 5/13/09 Future of Quantitative Alpha – Roger Ibbotsen  

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Style and sector selection are the chief drivers of returns among mutual funds. Predictability of returns – worst performers tend to stay worst, though good performers stay good with a lower degree of reliability (correcting for duration, credit, and equity beta). Overall beta of the hedge fund industry is 0.5. Bulk of returns historically have been beta. Their analysis corrects for survivorship bias – for funds that join the database later in their life, they do not include the prior return stream. Argument that quantitative management does a better job of dealing with the proliferation of information that is currently available (not sure this is compelling, since both quant and qualitative managers inevitably need to determine where to focus their efforts).

GAAI Meeting Returns Panel  

Key to be a provider of liquidity. Target higher in the capital structure makes sense if it is a U-shaped vs. a Vshaped recovery. − If a V-shaped recovery, buy equities.

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Balance between pursuing opportunities and ensuring sufficient liquidity. Want to take more risk when risk premia are higher. Credit portfolios are mismarked - should expect poor marks to “dribble in” over time.

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Loss of “smoothing” under FAS 157 will be very detrimental to some institutions. Some panelists were investing in corporate bonds, with varying degrees of hedging Some panelists thought investing in bad banks was compelling given the implicit put back to the government on bad assets.

Negotiating Terms Discussion       

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Need to ask. Need to be willing to pass if terms are not negotiable (difficult for managers in one’s existing portfolio!). MFN is insufficient – managers can circumvent it. Generally, managers in high demand are less likely to negotiate. Smaller funds are more flexible. Look for logical modifications, such as adding a LIBOR hurdle. Look for non-economic modifications, such as improved liquidity or the ability to rebalance, in addition to fee reductions. Managed accounts on commingled platforms provide many benefits: − greater liquidity and transparency − improved control/governance − cash efficiency (because of notional funding) − cross-margin benefits − reduced fraud risk Panelists cited approximately 20-50bp incremental cost – need to verify this. Difficulty of administration – should be less of an issue for managed account platforms.