Variance Capital Newsletter

	Print		Learning to Love “Frontier Beta” and Why Small is Beautiful		There is value in the bank loan market.		The impact of the US slowdown on its trading partners.		The pricing of portfolio insurance products
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	Allocating to Hedge Funds: Learning to Love “Frontier Beta” and Why Small is Beautiful
	Scott C. Johnston is a Managing Partner of Belstar Group, an emerging provider of alternative investment products headquartered in New York. He has spent the last 11 years in the hedge fund industry, and has also served as an Adjunct Professor of Finance at Yale. A relatively high level of dysfunction has crept in to the Fund-of-Funds industry. As the industry has boomed, it has grown from its entrepreneurial stage to sclerosis in less than ten years. The hedge fund world has been dynamically evolving, but the FoFs world has not kept apace. At our firm, we sat down a year ago and identified a number of opportunities that we thought the industry was missing, two of which we will highlight here: frontier beta and emerging managers. U.S. endowments have led a revolution in the field of asset allocation theory over the last twenty years. Yale’s David Swensen has pushed the intellectual boundaries more than any, and the school has reaped the rewards of 17% compound returns since the mid-eighties. Remarkably, Yale has had no losing years, even in 2002 when the stock market lost 23%. This was accomplished not by being “hedged,” but by being diversified. The insight here was that diversification is often a better hedge than hedging is. In short, hedging costs money, while diversification does not. The question for us became how to fit this approach into the somewhat more constrained world, liquidity wise, of hedge funds. The answer, for us, is something we decided needed a name, so we call it “frontier beta.” Allow me to back up a bit. Why does anyone buy a hedge fund in the first place? The answer is to find a stream of returns that is poorly correlated to other, more conventional assets like stocks. Hedge funds traditionally provided this by delivering pure alpha, which is generated by running a perfectly hedged book, or close to it. This way performance is theoretically unaffected by prevailing market winds. So the game, for allocators, was simply to go out and find alpha generators, portable alpha players, in particular (those separating cheap, conventional beta from more expensive, pure alpha), do this by the billions. Ah, but it is not so simple. Alpha can be fleeting and enormously difficult to produce - sometimes it can be the product of market conditions that become favorable to the manager’s strategy - other times, what looks like alpha can be merely luck. Alpha is, by definition, zero-sum, and the middle of the alpha see-saw is arguably LIBOR (what managers make on their collateral balances). Thus, a manager with zero skill earns currently around 5%. Think of this as the starting point from which managers add or subtract skill/return. The problem with this model – searching for pure alpha – is that it leaves out a whole sub-stratum of hedge funds, ones that have beta, but a different kind of beta. Most investors think of beta as the stock or bond markets, but every market has its own beta. Gold, real estate, art – even wine has a beta (I refer you to the Live-Ex 100 Wine Index). Often, these markets have little correlation to conventional markets. So if the whole purpose of allocating to hedge funds is to find poorly correlated sources of returns, wouldn’t going long these markets, i.e. accepting their betas, give you what you wanted from alpha in the first place? In short, yes, but the real kicker is that the “zero skill” starting point can be hundreds of basis points higher. Meaning, if our frontier beta managers simply coast with their respective market betas, we still get high, non-correlated returns. If they add skill, it is the proverbial cherry on top. It might be useful to offer an example. We have an investment in a fund that owns debt linked to diversified insurance risk through Insurance Linked Securities (ILS). Returns vary with world-wide property & casualty claims, as well as life claims. These claims are not correlated in any way to stocks or bonds, so ILS satisfy the alpha requirement. Our manager is 100% long, meaning they’re not a traditional hedge fund in any sense; the primary source of their returns is ILS beta. But here’s the best part: the market beta, our zero-skill starting point, is north of 10%. Think of the margin for error we have picking managers like these as opposed to pure alpha-generators. Our zero-skill point is over 5% higher! Lest you be tempted to think that these markets are “gimmicky,” they are not. Often, these funds are performing roles traditionally filled by large institutions like banks and insurance companies, but they are doing so with more flexibility and intellectual wattage. In other cases, like pollution credit trading, these are new markets altogether. In all cases, though, these are real, growing hedge fund asset classes. Never before have hedge funds been expanding faster into new territories than now. Among the newer strategies are: Real estate derivatives; Shipping; Weather derivatives; Niche, asset-backed lending (entertainment, trucking franchise); Pollution credit trading; and Insurance. Another big return driver in the hedge fund selection process is the focus on emerging managers. Consider this: 95% of hedge funds are classified as “emerging,” either by AUM or age. That is an eye-opening statistic. Limiting oneself, as most FoFs do, to 5% of the available universe, is wildly suboptimal. The simple fact is that small hedge funds outperform. Lots of research has been done on this, and the data say that there is a 300-400 b.p. per annum advantage in being small. And as the industry becomes institutionalized, with all the large flows going to the mega-managers, this gap may widen still. Consider, though, that smaller managers… can be more nimble; can execute on their “best ideas” only; have a hunger for validation and wealth (not having achieved it yet); and actually want to achieve 20% returns. Less well known is that hedge fund performance also diminishes significantly with age: Source: Lazard, TASS/Tremont and HFR. Large FoFs can’t invest in emerging hedge funds because their sheer size requires handing out money in nine-figure chunks. Multi-billion dollar FoFs can really only consider hedge funds of similar girth. Notice that above I said, somewhat provocatively, that smaller hedge funds actually want to make 20% returns. Am I suggesting that larger funds aren’t? Yes, I am! To understand why, you just have to understand their incentives. As hedge funds grow, their client bases become more institutional. Institutions, such as pension plans, have an overly risk averse approach to hedge fund investing. Often, they are executing on portable alpha. Without going into detail, such strategies target LIBOR plus 300-400 basis points. Right now, that’s 7-8%. These investors don’t care for volatility either, so a manager with 8% returns and low volatility is ideal. So hedge fund managers give the market what it wants. Gone are the swashbuckling days of Soros and Robertson when 25% was the goal. This might seem counter-productive, fee-wise, but 2 & 20 on an 8% return at a $5 billion fund is $180 million in fees a year. No one’s giving up their beach house in East Hampton or St. Tropez, just yet. Notice our two themes, frontier beta and emerging managers, merge nicely: funds specializing in frontier beta markets are almost exclusively small. In fact, they couldn’t be otherwise because newer markets are always more modestly sized at the outset. But this is where the inefficiencies will always be the greatest, so it is where we will always focus. Five years from now the list will likely look quite different. Our Belstar Multi-Strategy Fund was started only one year ago, but thus far the performance suggests our ideas are bearing fruit: year-to-date through November we are up 17.4%, with 5% volatility, while the average FoFs is up 9.2%. For more information about Belstar Group, please contact Axel L. Tenvik on tenvik@belstargroup.com Variance Capital Management does not recommend or distribute any of Belstar Group's products.

	Liquidity and value are two very different things.
	Multi-strategy managers I have spoken to recently feel bank loans are the cheapest asset class in the market by far. Clearly if they found some papers attractive in June ahead of the market’s 6 sigma correction (an event akin to the 1929 correction in stocks), they’re clearly going to love pricing at these levels. It’s unfortunately not that simple and reminds me of Antoine de Saint-Exupery’s Little Prince and his rose. Alone on his asteroid, his flower was unique, he was mesmerized by it, he even loved it. Back on earth, he enters a garden where thousands of roses are growing and was unable to appreciate a single one. There is clear value in uniqueness and if any of the current senior names in the LCDX were trading at these levels on their own they would be on everyone’s buy list. Admittedly, the rules have changed since the first half of 2007. The bank loan market is marked to liquidity at present - and not marked to value - making it very hard to be aggressive for anyone interested in this paper. Even though bank loans are cheap, the market is sloppy. The average bid in the US leveraged loan index has come down below its August levels. The European markets have exhibited the same performance. There are clear headwinds faced by the markets which justify current pricing: Lack of liquidity provided by dealers; Hedge funds who own most of the paper have a very weak hand; High yield investors who were recent players in the bank loan market were chasing coupons and as LIBOR collapsed found themselves squeezed out of the market; Deleveraging; News flow from investment banks that is affecting market confidence; uncertain economic outlook driven by a consumer faced with lower house prices; higher energy costs; and much reduced access to credit. In essence, it boils down to the huge overhang in Level 3 loans and the market’s inability to price the paper. The end result of this cycle is that prices are determined by liquidity issues, not by fundamentals. The value players have by and large been scared away. Once the dust settles and the highly leveraged players have disappeared, everything moves back to normal, where "normal" means that prices are determined more by value again. There is clear confusion between the liquidity-driven marks with the value-based marks, and in doing so are making things look even worse than they are. Beyond bank loans, the overall numbers affecting credits whose markets have dried up completely have been staggering: MORGAN STANLEY (NYSE: MS) -----> $88.21B as of August 31st GOLDMAN SACHS (NYSE: GS) ------> $72.05B as of August LEHMAN BROTHERS (NYSE: LEH) ---> $34.68B as of August 31st BEAR STEARNS (NYSE: BSC) --------> $20.25B as of August 31st CITIGROUP (NYSE: C) --------------> $134.84B as of September 30th MERRILL LYNCH (NYSE: MER) ------> $15.39B as of September 28th BANK OF AMERICA (NYSE: BAC) ----> $21.64B as of June 30th ---------------------------------------------------------------------- TOTAL = $387.06 Billion of Level 3 Assets Known So Far Source: FACTBOX Clearly, the write downs on these portfolios haven’t come close to that amount acting as a sword of Damocles on any investor’s intentions. On the other hand, it’s important to note that these are not losses, they are the total assets deemed by the company to fit into the category of un-tradable assets because not enough liquidity exists in the marketplace to get a true price value on the securities; so instead of marking them to market they are marking the asset values to models. In other words, the firms use these in-house valuation models to put a price tag on what these assets might be worth if they could be traded. Needless to say, you can see the problem with certainty here and why future write downs and losses are likely as the secondary mortgage markets continue to be seized up. Banks may have more to go on the downside, dragging the leveraged loan market with them. As a consummate contrarian, I’m not a big fan of jumping on this “bank-beating bandwagon” as it has already mostly played out. If past bust ups are any reference though (i.e. the S&L crisis), money centres, investment banks and commercial banks come into buying territory at around 1 times book value. We’re not there yet by any stretch. The recent E-trade transaction hasn’t helped to alleviate any of these concerns. Some see the sale of its Level 3 positions for pennies on the dollar, as representation of where value actually lies. “I have seen a number of sources extrapolate the E-Trade transaction, asking what would happen if all the Level 3 positions of banks and investment banks were to be remarked based on this transaction” claims Rick Bookstaber in one of his recent notes and goes on to add “This seems to be a variation on the game that started a month or so ago of assessing the prospects of a bank staying in business based on the ratio of Level 3 assets to capital. I think this is an exercise that is alarmist. Level 3 positions are not all sub-prime or even all CDO. There may be Level 3 positions that are good as gold, but simply do not have comparables or models that can provide adequate marking. And it is no surprise that these institutions are highly leveraged - they typically might have a balance sheet that is twenty times their capital. So with that sort of leverage, and with the sorts of businesses they are in (remember, they tend to make markets in things that you can't just run out and buy on an exchange), it is not surprising to me that they will have Level 3 assets that are greater than their capital. But again, "Level 3" does not mean worthless. Even the sub prime mortgages have hard assets and homes (whose values are falling admittedly) to back them up. I’m certainly not trying to call a bottom: value is a very subjective criterion. On the other hand, a senior secured 1st lien bank loan trading at 90, with a 10% coupon and a “worse case scenario” 80% recovery value has to represent value at some point. Even if the company were to go bankrupt, investors would be in the money in 12 months. Simply stated, liquidity and value are two completely different things. For investors who have the ability to weather the storm, there is some value here and what will finally matter is the mark to value.




	Pro value, anti bubble. The impact of the US slowdown on its trading partners.
	Most technical indicators suggest we have entered a bear trend in Asian equities. The Hang Seng broke through its November lows with Hong Kong and H shares breaking through their 100 day moving averages a fortnight ago. There’s a buyer’s strike in Asia. Contrary to conventional wisdom I suspect the brunt of America’s sub prime debacle will not fall on the US itself, but rather on its major trading partners. Recent economic data seems to support this with Q3 GDP figures on the rise pushed by exports. A notable improvement in exports is offsetting a slowdown elsewhere in the economy. Thanks to globalization, economic benefits and damages are distributed and transmitted among the world’s major economic blocks. In the last half decaed, America’s property boom benefited its trading partners far more than America itself. Rising property prices in the US has led to excess consumption, which in turn resulted in a record trade deficit. Emerging market countries such as China benefited handsomely from the “leakage” in US GDP. Now the pendulum has swung the other way. The reversal of this dynamic could lead to great economic damage to America’s major trading partners. The present record low US dollar exchange rate, coupled with weakened domestic consumer demand in the US, are just the tolls to facilitate continued improvement in US net exports at the expense of Europe and Asia. While America’s improving net exports should substantially offset most of the weakness in consumption – with aggregate impact relatively small- the trading partners have no similar “economic edge” and the impact on them may in fact be significantly more negative than current market perception. If the current global financial crisis reminds us of anything it is that: All bubbles do bust; and The multiplier effect of post-bubble damage is significant and consequences are hard to contain. America’s real estate market was not the only bubble prevailing in this decade. Asia has several of its own which are both wider in scope and bigger in magnitude. Amidst of what appears to be a real start in global re-balancing, centered around sustained improvement in the US balance of payments, it is hard to imagine the “frothy” markets of the emerging economies will stand immune to on-going global challenges, especially as transmitted through a large and open economy as the US. Indeed, a delayed coupling creates the mirage of de-coupling but they are not the same. If anything, de-coupling may occur in the exact opposite way most bulls on emerging economies see it. Market technicals of the bubble markets in Asia since November have suggested a possible start of a bear trend; technicals of value markets are quietly showing strength.

	The pricing of portfolio insurance products
	For those who have been following our risk overlay strategies, the obvious question is what to do next. Clearly, some of the ideas we had early 2007 worked out well but unfortunately have moved up to a new and wider price range. The environment is clearly bifurcated between the rising probability of a US recession, or the return of the “white swan” due to Central Banks reflationary success and/or SWF saving the Western Financial Institutions and markets. Based on these new challenges, we can articulate tested paths for a worse case scenario: $JPY volatility. Historically the unwind of emerging markets is best protected by buying variance (both spot and forward) on the $JPY (see next article on the risks of the bubble bursting in Chinese equity markets). At its lows, spot variance traded at 7+ until the summer and jumped into the 14+ range in August and November of this year. The rationale is quite simple: as risky assets capitulate, the carry trade is unwound quite quickly (or Japanese investors repatriate assets back into their country) leading to a spike in the volatility of the $JPY. Near term, the Fed’s Term Auction Facility (TAF) has had some effect on liquidity and with the holidays we’ve seen some stability in the appetite for risk. 3 month in 3 months forward volatility swaps on the JPY are back to 9% with a downside risk of ca.1+ vega (down to 8 vegas) with upside back to 14+/- in the event the current correction has a third leg down ( as the last time around the Yen went down to 108 to the US dollar; it is now trading at the 114 handle. Some forecast on Wall Street see the Yen as low as 103 in 2008. SPX and HSI variance swaps. We’re clearly in a zone where we can re- examine entering this product. The VIX is under 20 and any forward variance trading below 20 would be interesting (it’s around the 22% mark at present). For those who feel there can be a January rally (in my view a bear market rally) they may want to wait until re-encounter the 18 vega range. Philippe Gazil who runs these platforms for Variance Capital does not feel we’re heading back to where we were in March/April of this year (i.e. around 14 vegas for 12 months protection), and instead suggests it makes sense to start building a position here as the new range for SP500 in his view is 20 to 30, unless we enter a recession. On the Hang Seng, he feels that since forward variance is strongly inverted between the 6th and 12th month, protection benefits a roll-up on the curve (removing any downside at such an elevated P/E). Credit indices. The story for these products is predicated mainly on how far investors feel the correction in US growth will go. At present, most indicators are trading mid range. The Itraxx Europe (series 8) is trading at 51 with a high of 62.5 and a low of 45. The Asian ex-Japan version went to 173 from lows of 36 and is trading at 144. It went up 75bps in the last 3 months. They represent an average pricing scenario which means they forecast a 50/50 chance a recession is underway in the US. For anyone who ascribes to Bill Gross’s view the chances of a recession are much higher, there may be another 30 to 40 bps in there easily. The grey line on the graph below represents an investment grade index (CDX.NA IG S8) which incorporates home builders, monoline insurers and comprised more or less of 40% of companies exposed to the US consumer. As you can see, the line is still higher than the August peaks, in spite of banks and brokers’ spreads having recently compressed. The spread could very easily go above 100 if the probabilities of a recession go above 60 to 70%. Credit Default Swaps on the Investment Banks. Goldman CDS senior 5 year CDS are trading at 68 which is not cheap in absolute terms (see graph below) and is trading at 50% more than the commercial banks. This makes sense as these institutions have access to Central Bank’s financing in their role of depository banks which is not readily available to Investment Banks. On the other hand, it’s hard to imagine that even Goldman Sachs (who are priced for perfection I may add), whilst being on the front lines for most capital markets products, won’t give way at all during the difficult markets of 2008. The pricing of portfolio insurance products.

Gavekal comment on the rise of the Chinese RMB.

During the holidays the Chinese RMB has continued to power ahead, rising another +0.7% over the past week (and almost half of those gains came this morning), now trading RMB7.3205/US$, the highest since the “depegging” of 2005. So far this year, the RMB has added +6.2% against the US$, which is almost double that of the +3.3% gain of 2006. Moreover, the market is clearly anticipating further appreciation. Indeed, the 12-month forwards are implying a +8.2% gain over the coming year. So why the recent run on the RMB?

* Aggressive inflationary pressures could spur a faster revaluation rate. As Milton Friedman would always point out, a central bank can control a) its exchange rate, b) its interest rate or c) its money supply growth rate. It cannot control all three. A few years ago, it made sense for China to control the exchange rate and interest rate and let the money supply growth rip. Back then, with the country flirting with deflation, a rapid growth of money supply was not a bad thing. Today, however, the situation has changed: asset prices have been rising very rapidly (something the government could afford to ignore when only equities were rising rapidly but can no longer afford to ignore now that the asset price inflation encompasses real estate) and inflation is creeping higher (November CPI rose to +6.9% YoY, the highest inflation rate since December 1996). So for a number of reasons, a policy change would make sense.

* The Chinese economy has weathered the past appreciation of the RMB surprisingly well. Despite the fact the RMB has gained more than +13% against the US$ since the 2005-depegging, the Chinese economy continues to accelerate. In fact, in November, Chinese exports jumped by +23% to a new record US$117.6 billion, highlighting that Chinese shipments have not been reined in by the stronger currency. In addition, the official profits of Chinese industrial companies rose by +36.7% in the 11 months of the year. All in all, it would seem as if the Chinese economy is strong enough to withstand further RMB appreciation.

* Chinese authorities have a history of making big policy changes during holidays. As such, if an imminent change of FX policy is in the cards, there is a high likelihood that it will be announced during/before the start of next year.

There is little doubt that RMB remains very undervalued, which, in turn, severely distorts the global economy. There is also little doubt that the RMB will continue to rise over the foreseeable future. Having said that, it is probably wise to remember that China’s policymaking tends to be rather gradual, and big abrupt changes are frowned upon. This is all the more true since visibility of the US economy remains poor. Indeed, if US economic activity rolls over hard, it is difficult to imagine a big move on the RMB. Nevertheless, this is a very important issue and it needs to be monitored closely over the near future.

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