Tag Archives: hedge funds

commodities trading and margin: why volatility now?

May 17, 2011 By in emerging markets, hedge funds, Margin, Recent Market Action, Technical Analysis, Trading Tags: , , , , , , , , , , , , , Leave a comment

commodities vs. stocks

Early in my career internationally, my boss gave me the assignment of studying the palm oil and soybean markets as a step in taking over responsibility for investing in the publicly traded plantation companies in Malaysia.  One of my first stops was a visit to the head of commodities trading for Merrill Lynch in Chicago.

It was like stepping into a parallel universe.

As an equity investor, I talked about remaining calm, not acting hastily and doing thorough research.  He talked about being in tune with the rhythm of the markets, reading the charts, developing good instincts, making decisions on gut feel and having lightning reflexes.  I spoke about hiring professional researchers; he said he looked for good high school or college athletes, regardless of academic accomplishment.

margin differences

Why the difference in outlook?  It may have something to do with the difference between dealing with global demand for natural raw materials vs. the actions of managers in highly complex, but focused, corporations.  But I think it has mostly to do with the, by equity standards, extraordinarily high levels of margin leverage that commodities market participants routinely employ in their investing/speculating.  It’s cold comfort to have the long-term trend absolutely correct but to be wiped out by a 10% price fluctuation in the wrong direction later on this week.

other quirks (from an equity investor point of view)

Two other characteristics of commodities trading to note:

–exchanges typically set the margin rules

–exchanges also typically set maximum daily price movements, both up and down, for a given commodity.  One consequence of this is that there are days when the price moves to the upper/lower limit without any sellers/buyers appearing.  In this case, the market can close for the day at limit up/down, but no trade.  So you can be “trapped” in a position you want to liquidate but can’t.  Another reason to act fast on new short-term developments.

greater interest in commodities

In recent years, there’s been a lot more interest in commodities than previously.  I see several reasons for this:

–the rapid economic advancement of countries like China and India, with large populations and at a stage of development where they use increasingly large amounts of farming and mining commodities.

–the rise of hedge funds, many of which are run by traders who are familiar with commodities and who are more comfortable “reading” charts than researching companies.

–the development of exchange-traded funds based on commodities, which give individuals easy access to commodity investing they didn’t have before

–the end to almost two decades of gigantic, price-depressing overcapacity in most mineral commodities created by overdevelopment in the late 1970s- early 1980s

–the increasing complexity of finance and the concomitant development of financial derivatives.

what’s going on now?

Why the sharp recent decline in mining and food commodities?

As I mentioned in my post yesterday on margin in general, a margin call can happen in two ways:

–either the value of your account can fall below the minimum margin level, or

–the market regulators can raise margin requirements.

margin requirements rising

The second hit the commodities markets late last month.  As the New York Times reported recently, that’s when officials at the CME (Chicago Mercantile Exchange) became concerned about the near doubling in the price of silver over the prior half-year.  The CME  immediately increased in the margin requirement for silver contracts.   When that had no immediate effect on the silver price, the exchange announced a series of increases that would rapidly bring the first-day margin needed to support each contract to $21,000+.

Each silver contract is for 5,000 ounces, or about $235,000 at a $47/oz. price.  Prior to these actions, the required first-day margin was $12,000-, meaning a market participant could leverage himself by 20x in buying silver.  (Actually, the allowed leverage was higher, since maintenance margin is lower than first-day, and because exchange members are permitted to use more leverage than speculators.)

Silver now trades for $34/oz., a decline of almost 30%, mos of the fall occurring in the first week after margin requirements were changed.

Other commodities have followed suit, though not to the extent of the decline in silver, as regulators have lifted margin requirements for them as well.

why act now?

Maybe the CME is just doing its regulatory duty.  A cynical person might speculate–à la the Hunt brothers–that pressure came from exchange members on the losing side of the trade.  Another (better, I think) guess is that there was pressure from Washington, where a new regulatory framework for commodity trading is now being developed.


“Financial Markets 2020”: an IBM study of the investment management industry

April 7, 2011 By in Getting financial advice, hedge funds, Industry Analysis, Investment firms, Where are the customers' yachts? Tags: , , , , , 4 Comments

the survey

Talk about ugly.

In the April 4th issue  of FTfm, its review of the fund management industry, the Financial Times outlines the conclusions of an as yet unpublished study by IBM of the investment management industry, Financial Markets 2020.

the findings

FM2000’s bottom line?  …the worldwide investment management industry loses US$1.3 trillion of its clients’ money every year.  That’s over $100 million during the time it takes a fast reader to reach this point in the post.  Wow!!

The main offenders?  Here they are, in order of the magnitude of client losses:

—$459 billion        credit rating agencies and sell-side research, because the analysis is weak

—$300 billion        fees paid to underperforming portfolio managers

—$250 billion        fees paid for advisory services that underachieve

—$213 billion         excess expenses caused by investment managers’ organizational inefficiency

—$51 billion           fees paid to underperforming hedge funds.

the conclusions

IBM argues that clients are gradually waking up and smelling the coffee  …and firing the offending service providers, as they work out how bad the performance has been.  The computer giant thinks upward of a third of the people involved in today’s fund management industry will be gone before clients are through with their housecleaning.  Among sell-side researchers and credit rating agency analysts, the winnowing will remove closer to half.

my thoughts

First of all, I haven’t seen the study.  I’m assuming that it’s being accurately portrayed in the FT.

In the nitpicking department, the data seem to have come from an internet survey.  If so, its conclusions represent the input of the respondents, and may not be representative of the views of clients as a whole.   In addition, the numbers are overly (maybe “ludicrously” would be a better word) precise, suggesting inexperience on the part of the IBM Institute for Business Value, which wrote the report.  The assertion that credit rating agencies et al lose their clients $459 billion a year implies the figure is not $458 billion or $460 billion.  How could IBM possibly be confident that this is right?

The general direction of the report is doubtless correct, though.  Early in my career as an investor, I remember reading the famous comment by Charles Ellis, the founder of Greenwich Associates, a pension consulting firm, that the average portfolio manager is just that–average.  At the time, I was offended.  Thirty years later, I’d be tempted to amend it to read that the average portfolio manager is just that–a little below average. The credit rating agencies have been notorious for as long as I’ve been in the business for being behind the curve.  And everyone knows, or should know, that brokers make their money by having you trade with them, not by having you achieve superior returns.

I think IBM’s idea that clients will quickly take the axe to many of their investment service providers is much too simplistic.  Yes, chronic underperformance is a big issue.  But there seem to me to be three factors IBM overlooks:

1.  The head of virtually every investment management organization is a highly polished marketer, not an investor.  A big reason for this is that investment firms are not only in the business of selling performance, they also sell intangibles–like feelings of prestige, exclusivity, reliability, safety–especially to individuals.   Some people will hire a hedge fund manager instead of buying a Vanguard index fund (which will likely provide superior returns) for the same reason they buy an $8000 Hermès leather handbag instead of a $50 nylon equivalent, or a $150,000 Porsche instead of a $30,000 Subaru Impreza.  It’s to exhibit their wealth.  Having your yearly performance review in a major city, with dinner and a show and your favorite flowers in the hotel suite your manager provides may be just as important as the performance figures–maybe more so.

2.  Companies typically don’t want to manage their employees pensions money in-house for legal reasons.  Hiring a pension consultant and a series of specialist third-party managers transfers responsibility to them.  Doing so acts as a form of insurance.

3.  Suppose you go ahead and fire all your investment advisors.  What do you do then?  What do you substitute for them?  Maybe losing a trillion dollars a year is good in comparison with the alternatives.

G-7 intervention to stop the yen’s rise: will it work?

March 18, 2011 By in Balance of Payments, comparative advantage, currency effects, Current Market Thoughts, J-curve, Japanese development, Purchasing power parity (PPP) Tags: , , , , , , , , , Leave a comment

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Please take my survey.  Thanks to everyone who has done so already.  If you haven’t yet, I’d appreciate it if you’d do so.  It’s brief, anonymous and will help me focus future posts.

PSI reader survey.

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Will G-7 intervention work?

Yesterday, the G-7 group of major industrial countries announced plans for coordinated intervention in the foreign exchange markets in order to halt the rise of the yen against the currencies of other developed nations.  In the wake of last week’s earthquake and tsunamis, the yen had risen by about 5% against the dollar.  Will the G-7 be successful?

The short answer is “…most likely, no.”

How so?

The main reason is that the major international commercial banks, who are the main forces in the global currency markets, are far larger and have greater financial resources than national governments do.  That might not have been true twenty-five or thirty years ago, but it is today.  Even the G-7 nations acting together don’t have the financial firepower to oppose a concerted move by the banks.  In the past, it hasn’t helped either that governments have typically tried to defend currency values that were politically attractive but economically unsound.

Japan the most skillful government player

I’ve been watching the currency markets as a global investor for over twenty-five years.  Over that time, the country that, to my mind, has the best record in influencing the direction of its currency is the Japan.  Understanding it can’t oppose the banks directly, it has waited until a wave of speculation has almost exhausted itself and then applied enough pressure to send the yen in the opposite direction.

Japan’s present stance is a curious one, though.  The current administration in Tokyo, the Democratic Party of Japan, came into office with the intention of reversing the long-standing (and very outdated) policy of the Liberal Democratic Party of always aiming to weaken the yen in order to help the prospects of export-oriented industries.  Nevertheless, when the original DPJ finance minister tried to enforce the new policy, he was replaced with someone more willing to cater to the Keidanren.  The new minister immediately began selling the yen in what I saw as simply a wasteful attempt to establish his pro-industry bona fides.  That was Naoto Kan, who is now the prime minister.  Who knows what he’ll do now.

A second curious aspect of the situation today is that there’s no good reason for the yen to be a strong currency.  The country’s workforce is shrinking.  The government is ineffective and heavily in debt.  The budget is in deficit.  And the country hasn’t shown any real growth in over twenty years.  Japan’s most “positive” feature  vs. the euro or the dollar is that it’s a known quantity and has less near-term potential for negative economic developments than the EU or the US.

Why has the yen been rising, then?  After the Kobe earthquake in 1995, Japan repatriated large amounts of money invested abroad.  Insurance companies needed funds to pay claims.  Parties–individual or corporate–who had no third-party insurance needed money to rebuild.  this activity drove the yen up by about 20% against the dollar in the months following the earthquake.  It’s probably too soon for this to be happening again.  The yen probably started to rise early this week as speculators began to bet the same thing would happen again.

Interestingly, the yen gave back almost all its gains as soon as the G-7 announced its plans and Tokyo was seen selling the yen aggressively in the currency markets.  To me, this suggests that the big players in the market haven’t decided what to do yet.  In the end, though, it will be the banks, not the G-7, that decide whether the yen strengthens or not.

investment implications

What’s the significance of a rise in the yen for investors?

An appreciating currency has two effects:

–it slows economic growth in local currency terms, and

–it reorients what economic energy there is–away from export-oriented industries, and toward domestic-oriented firms and importers.

If you were investing in Japan and thought the yen would rise, you would overweight domestic firms and underweight exporters and other companies with large foreign-currency exposure.  But the most sensible thing for most people to do, as I suggested a couple of days ago, is just to stay away.  (I own two social networking stocks in Japan, DeNA and its smaller competitor, Gree.  For now, I’m keeping them both.  These are youth-culture special situation stocks that are growing very fast, so I think they’ll be relatively unaffected by problems in the overall economy.  But I wouldn’t advise anyone to follow my lead.)

pension consultants and placement agents: the CalPERS report

March 17, 2011 By in Getting financial advice, hedge funds, Investment firms, Private equity Tags: , , , , , Leave a comment

the situation

Imagine you’re a global equity portfolio manager.  You have a top quartile record over virtually any period during the prior ten years.  In fact, there’s no one in the US, and only one in the EU, who can equal or better your numbers.  You have presentation skills polished by intense preparation by experts both inside and outside your firm, as well as your many hours of practice.

You visit a pension consultant in Connecticut.  You show him your numbers, make your presentation, and await his comments.

He has only two:

–your presentation skills are terrible.  Before he can recommend you to any clients, you must take a remedial course from his firm.  It costs $25,000.

–he’s not sure you know enough about foreign markets.  The only way he can gain the confidence he needs is if you subscribe to his firm’s international information service.  He shows you the latest copy.  It’s a worthless collection of news clippings–superficial, and weeks behind what your own information network provides.  It costs $50,000 a year.

Summary:  despite the fact your record is better than that of anyone he is currently recommending to clients (who are, incidentally, paying him large amounts of money to do manager searches for them), those clients will only hear your name if you agree to make an upfront payment (read: bribe) of $75,000 and agree to continuing payments of $50,000 a year.

We decline.

Welcome to the Realpolitik of pension consulting.

the CalPERS report

The consultant I’ve described lacks finesse.  It would be more common for a pension manager to agree buy analytic services from a consultant, who would examine the manager’s product offerings for their potential attractiveness to customers.  Paying the consultant to come to your offices and spend time digging through your products will not only give the consultant the knowledge of your products that might otherwise take five years of you visiting him to impart.  But it might engender a feeling of obligation as well.

The biggest weapon in the consultant’s arsenal, however, is his control over the types of products he will recommend that his client buy.  They will be all highly specialized, offering the maximum potential for the consultant to “add value” by applying asset allocation services to the individual pieces a given asset manager sells, thereby customizing a portfolio.

CalPERS wouldn’t see the sometimes seamy interaction between manager and pension consultant.  But that’s small potatoes compared with what the consultant earns by selling manager selection and asset allocation services.

None of this is mentioned in the just-released CalPERS investigative report on placement agents and consultant services.  In fact, the part about consultants is much like the amuse bouche in a five-course meal.  What the report says is this:

1.  Somehow, while it continued to pay pension consultants as neutral third-parties to find managers and monitor performance, CalPERS ended up hiring the same organizations as money managers, as well.  Talk about the fox guarding the chicken coop.

CalPERS has finally worked out that, in addition to not being a sound action from a fiduciary standpoint, this is a no-win situation for it.  If the performance is outstanding (and my casual reading suggests it isn’t), there’s still the blatant conflict of interest.  If it’s poor, there isn’t even a pragmatic justification for the breach of prudent behavior.

2.  The big issue in the report, though, is placement agents.  These are well-connected individuals who sold their privileged access to CalPERS management for tens of millions of dollars in fees paid by third-party money managers, some of whom gained CalPERS as a client.  This appears to have happened predominantly in CalPERS alternative investment and real estate areas.

The report of the investigation, lead by law firm Steptoe and Johnson, LLP, is a carefully crafted document.

The authors point out that they received “universal and unlimited cooperation”  only from CalPERS and its current employees, less than that from others.   Some relevant people, notably former CalPERS CEO Fred Vuenrostro and former board member Alfred Villalobos, refused to cooperate entirely (understandably, perhaps, in the case of the named individuals because the report notes both are defending themselves against charges brought by the California Attorney General).

As I read it, the report makes several, not entirely consistent, points about the attempts of several of CalPERS key alternative investment managers to buy influence through Villalobos and Vuenrostro:

a.  CalPERS lost no money (not relevant from an economic point of view, but likely a key point under state securities laws)

b.  the main operational failure was on the part of the board of directors in not reining Villalobos and Vuenrostro in, and in some cases, aiding their influence-peddling efforts; the staff of CalPERS consistently resisted unwarranted pressure from Vuenrostro to select certain managers or not negotiate fees diligently

c.  nevertheless, the report also cites the case of the former head of CalPERS’ alternative asset arm, who appears to have accepted inappropriate favors from Apollo Global Management, while CalPERS was negotiating to buy a stake in Apollo

d.  in addition, many of the third-party managers who paid a total of $180 million to placement agents, Apollo Global Management, in particular, remain among CalPERS’ “most trusted external managers.”

e.  again, despite the contention that the staff of CalPERS acted entirely appropriately, the report also says that four alternative asset managers, Apollo, relational, Ares and CIM, “agreed to a total of $215 million in fee reductions for CalPERS.”

my thoughts

At least this behavior is out in the open.

To me, the conclusions in the placement agent part of the report don’t add up.  It may be, however, that CalPERS is so deeply entwined with the alternative asset managers who paid placement agents all that money and who overcharged the agency by close to a quarter billion dollars that it isn’t able to extricate itself.  So it has decided to make the best of a bad situation.  We’ll probably find out more as pending lawsuits wend their way through the legal system.

Hedge funds are sweeping homes and offices for bugs

February 22, 2011 By in hedge funds, insider trading, Securities regulation, Trading Tags: , , , , , 1 Comment

security sweeps

…not the biological kind that infest beds, but listening devices.

According to the Financial Times, security firms in the New York City area are experiencing a surge in requests by hedge funds to have their offices and, in some cases, the homes of key firm members, swept for hidden surveillance devices.  This is apparently the hedge fund response to the continuing stream of arrests of industry employees on charges of insider trading.  In many cases, the SEC and FBI have cited, as justifications for the arrests, recordings of telephone calls they have made, in which the arrested parties either receive or solicit inside information that they subsequently trade on.

not so smart

This security sweep activity is more than a little crazy.  But it does illustrate two things, I think:

–the fact that the SEC/FBI tactic of making fresh arrests every few days instead of doing everything at once is having its desired effect of instilling fear into the hedge fund community, and

–it gives us some insight into the character of the management of at least some hedge funds–not that we necessarily needed this confirmation.

Why is it crazy?

First of all, the cases I’ve read about have involved a cooperating individual telephoning into hedge fund offices from, say, his home or the local FBI office and trying to get the recipient of the call to make incriminating statements.  In all these cases, the recording is done at the caller’s location.  A sweep for hidden spying devices, like in movies about the Cold War, would find nothing.

Second, legal wiretapping would be done from the telephone company premises, not from the hedge fund offices.  Same result–a sweep finds nothing.

Finally, the people who run security agencies are mostly former police officers, or FBI or Secret Service agents.  Part of their stock in trade is the cordial relations they maintain with their former colleagues.  It would be hard to believe that the FBI doesn’t have a complete list of the hedge funds who have called to have their offices swept (talk about dumb).

says something about the industry, though

At least part of this panicked reaction is hedge fund managers seeing what happens to assets under management when someone in a firm is accused of insider trading–the assets are immediately yanked by clients.  But it also shows the lack of organization, or the immaturity, of the firms in question.

what to do?

What should hedge funds be doing?  I have two observations–really three:

top management sets the tone

In any firm, all employees look to the top management for cues on what acceptable performance is.  If the boss signals that it’s ok to lie, cheat and steal to get performance, regular employees will likely respond by doing so.  Academic research suggests that a significant proportion of hedge funds do this–that they’re are willing to exaggerate their education, experience and performance to try to attract clients (look under my “hedge fund” tag for evidence).  In my mind, such firms are lost causes.

compliance training is key

In the SEC-regulated world, all investment professionals are required to have periodic training in compliance, that is, on the ins and outs of securities laws and the standards of conduct they require.  The fact of this training, and the care management takes in organizing and conducting it, goes a long way to set the ethical tone of a firm.  In fact, to my mind this is the fastest way for a top management to set standards for behavior.

bug sweeps send a bad message

What message does sweeping the office for bugs send to employees?  I don’t know exactly, but it certainly isn’t that the firm is highly ethical and has nothing to hide.