Pretty much all risky assets have been on a rampage since the March lows. The riskier the asset, the stronger the rise it seems. Sentiment readings in US stocks have been registering highs; yet momentum and breadth have been waning. Everyone (and his neighbor) is bearish on the dollar. And gold, the great inflation hedge, is displayed proudly and prominently as a core holding, as if not being a believer would get you stoned in the village square.
Speculation is in the air…except it’s not spring, it’s autumn, and autumn brings with it a hint of the frosty winter to come. Investor psychology feels eerily reminiscent of 2007, but now it is being driven by a palpable feeling of anxiety that was missing then. This time around, it seems to touch on desperation rather than euphoria.
My guess is that we are at a turning point. A decline in risky assets led by a rising dollar would signal a major turn. Inflation is for the future; deflation is now. Are we prepared for a market downturn? Are our expectations too rosy? What if the world’s problems have not gone away? Nouriel Roubini, the famed economist that saw the crash coming, believes that we are in “the mother of all carry trades”.
Hedge funds are up this year, up strongly. A well-managed, diversified portfolio of hedge funds has also done well. If we continue on the current path, returns will be in the upper teens for the year. But many managers may have too much beta on if the markets make a volte face. Martin Hughes of Toscafund believes that stocks have embarked on a long-term bull market. He may be right. Or maybe not. Being wrong in a speculative market environment has a much higher consequence than missing the start of a new multi-year bull market. Last year showed that trying to find an exit during a stampede is not where you want to be.
Hedge funds have the tools to make money in both rising and declining markets. This is pretty well understood. However, all managers are not equal. This can be seen in the huge dispersion in returns during last year’s rout; some managers performed admirably well whereas others suffered from the triple-whammy of overly long beta and leverage on crowded (read illiquid) trades. Some of these managers have maintained and, in some cases added, risk in the hope of catching up to their high water mark. This is worriesome.
Looking back at 1999, hedge funds had a banner year following the emerging market crisis of 1997-1998 which imploded most of the bank proprietary trading desks and brought down Long Term Capital Management. 1998 was but a mere echo of what happened in 2008, but it’s a good place to seek out some insights.
The broad hedge fund industry (as measured by the HFR Fund Weighted Composite Index) netted some solid returns in 1999. Security prices were broadly dislocated following the near collapse of the financial system the year before which had led Greenspan to aggressively lower the Fed Funds rate in three consecutive rat-tat-tat machine gun bursts. We were told we were so near a global collapse back then; if only we could see 10 years forward into the future to catch a glimpse of a real crisis. The outcome of this sharp interest rate boost was a V-shaped reversal in global equity markets.
Competition had also been substantially reduced as banks had to reel in their prop desks in response to significant losses primarily in the fixed income markets and specifically in emerging market bonds and currencies. The blow off rally in equity markets in the fourth quarter of 1999 was a fitting tribute to the speculative excesses of the 90’s and its imbedded high tech froth. Hedge funds certainly partook of the electric Kool-Aid that year but in 2000, when the tech bomb finally exploded, they managed to not just sidestep the crater but to hold on to their prior gains (see chart above). Certainly there were many hedge funds that performed poorly and some which wound up going extinct, but as an industry, overall hedge fund performance not only came through as promised in all those marketing pitch books but proved far beyond that of equities and bonds (Treasuries notwithstanding). This success led to a flood of assets that came from beleaguered institutional investors seeking shelter from the fallout.
The latter part of 2009 and into 2010 could provide another test for the hedge fund industry. Will managers have learned from the mistakes they made in 2008? My sense is that for the most part, the veterans are well prepared recognizing that there remain many problems that have yet to surface and sensing the speculative urges that have once again started flowing after the quieter summer months. Managers that have held on to the risk in their books in an attempt to reach an old high water mark or, having passed it, are looking to prove that 2008 was just an aberration, may find that the history does indeed rhyme. |
