Empirical studies seem to show younger more nimble funds outperform their larger peers and that hedge fund performance seems to diminish with Assets Under Management (AUM). One of our past contributors in an article on the life cycle of hedge funds claimed hedge fund performance demonstrates a concave relationship to AUM. This relationship is the origin of the concept of an optimal level of AUM which maximizes returns.

Chart 1: Illustrative returns versus AUM for all hedge fund strategies

To take the edge off the law of diminishing returns and its impact on the NAV, Arundel created the Emerging Managers Fund (AEM). “It was launched to seed and invest with early-stage managers in exchange for a portion of the economics. It’s a way for us to create a product that is “long the industry” whereby investors can access better performing and smaller funds whilst participating in the asset management company’s revenue stream as the assets grow (and returns ultimately diminish)”.
Originally launched in December 2004 with $60 million, the fund currently has investments in Alladin Fusion, a relative value credit fund, Park Town, a UK long/short fund launched by former Merrill Lynch alumni, and the recently backed Hedge Vision, a long/short Japan fund and RPMH a directional Global Macro Fund . Over time we would like the product to look like a multi-strategy fund or what you can see with the investable indices. Arundel would like to keep its 50/50 exposure to the equity and fixed income (including credit) markets.

Early managers do comprise some operational risk though which Arundel try to alleviate through this diversified product. Arundel’s value proposition here is to help young managers build experience running a hedge fund. Some will have never managed both long and short positions before whilst former prop traders have to adjust their management style away from flow orders. They must also understand how important it is to maximize performance in the first years without risking the fund’s viability by implementing “hero” type trades. A delicate balancing act, Mike Hodges, Paul Ross, Cambiz Alikhani and Paul Mack who are all part of the fund's investment committee, try to manage actively.
Unlike the five other Arundel funds of funds, this product is only 51% owned by Arundel, with 49% owned by five initial  investors - Arundel makes two types of early-stage investments, namely day-one seeding, and what is known as accelerator capital. The very rough measure of stake taken is 1% each, worth roughly $1 million, but Paul Ross specifies that this varies depending on how long the capital is locked in for.
“Again, investors benefit from the returns of the seeded funds, additional performance from the seeding economic interest, the growth of AEM as a business, as well as a trailing revenue stream from the original investments after the seeding period.” concludes Ross.

Breaking the Rules? The most difficult markets in which to operate are certainly the currency markets.
The reason is fairly simple: both the stock and the bond markets are positive-sum games. In other words, “buy and hold” strategies tend to deliver returns over time. But the FX markets operate a zero-sum game. Over the long-term, there is no such thing as an FX position giving a structurally positive return. In
good economic theory, and in reality, the difference in exchange rates will always
be compensated over time by a difference in interest rates.
Let’s check this with the world’s two largest currencies: the US$ & Euro (in order to do our computations, we resurrected the DM). Here are the results

The top chart shows the DM/US$ exchange rate, rising structurally since 1977. The green line in the middle is the least square trend. From 1977 to today, the DM (since 2000 represented by the Euro) has moved from a little above 40 cents to around 67 cents. So being long the DM and short the US$ must have been a good idea? Actually, it wasn’t!

The bottom chart shows the same exchange rate, but this time adjusted for the differences in short rates between the two currencies. And the results are obvious: there is now no trend. The dotted line (the trend for the adjusted exchange rate) is flat and exactly on the average for the period (last thirty years). So FX markets are mightily efficient, and outsmarting them is no simple task.
For those who seek to do so, it pays to remember three rules:
1. It usually pays to favour the currency with the higher short rates.
2. When one is two standard deviations on any side of the trend (the green dotted line), one should have very strong reasons not to play the “return to the mean”. Indeed, one would have to expect the markets to stop being efficient.
3. If the “cheaper” currency is also offering higher short rates, then it’s practically
a slam dunk!
As of today, the US dollar is offering a higher rate and is almost at two standard deviations from the horizontal trend. Simultaneously, everyone and their dog has been bearish on the US$ dollar for the last three years, and as the reader can see, for the last three years, the US$/DM adjusted exchange rate has been busy going nowhere. Since most operators always talk their books, the inescapable conclusion is that the world must be extremely long the DM (Euro) and extremely short the US$. But being long the Euro today would break all.

The Breakdown in the Yen-Euro

Could this be because Japanese investors are now piling into EMU bonds?
What we have done between the Euro (DM) and the US$ on the previous page, we can do with the US$ versus the Yen. We find again the characteristics of an efficient market with one important difference: the Yen today is in a buy position against the US$. However, when we try to look at the Yen/Euro, the relationship breaks down.

Since the beginning of 2003, the Yen/DM exchange rate has moved completely out of any normal range. We are not two standard deviations away from the horizontal trend (at 80 on the graph), but instead at five sigma (at 130).
In other words, since 2000, the FX market between the DM (Euro) and the Yen has been a positive-sum game, which, according to economic theory, should not happen. But yet, it has...
The only explanation we find is that Japanese zombie investors (see Of Bonds and Zombies) have decided in their great wisdom to accumulate EMU bonds on the simple idea that historically the DM and the Yen were strong together when the US$ was weak, and vice versa. So why bother with high volatility in the US$ when one can buy into low volatility with the Euro? Into other words, the legendary Mrs. Watanabe has convinced herself that buying EMU bonds is similar to buying Yen bonds, but with yields of 4% instead of 1.5%. The intense buying of all these “substitute” to Yen bonds is probably responsible for the collapse of the Yen versus the Euro. And this collapse has comforted Mrs. Watanabe in her strategy; she has been getting, to her great surprise and delight, higher interest rates and a significant capital appreciation. So what started as a substitute has quickly become a very successful investment pursuit.

To our knowledge (and despite all the ink spent writing on the “Yen carry-trade”) this is not done on leverage, so the probability of a sharp set back is limited. If this analysis is right, then the main reason behind the extraordinary divergence between where the Yen is now and where it should be is due not to the actions of some central banks, but the investment policy followed very rationally by aging investors, desperately seeking yields. So how are the markets going to return to equilibrium (they always do)? Two possibilities:
1. The Yen goes up, which in today's world would imply probably the BOJ buying Yen and selling US$ (in reserves) to service the demand coming from Japanese investors to buy Euros. This is not very efficient.
2. The Euro starts to go down on some European problem. This is what we expected, but, to be fair, so far, the problems are nowhere to be seen.
As of today, the great winners of the massive capital flows out of Japan are European consumers and governments (it keeps rates low and the Euro high) and Japanese producers. At some point, this will have to reverse.

Changes in the Global Liquidity Environment?

This is somewhat worrying,as it equates to a tightening overall liquidity environment. Interestingly, however, foreign reserves held at the Fed are still rising fast.
As we write, there is increasingly little doubt that consumption in the US is slowing under the weight of a tightening in lending standards and a slowdown in housing. Consequently, and unsurprisingly, the US trade balance is improving.



Now while the improvement in the US current account situation will be good news for US headline GDP growth numbers, the improvement in the US trade situation is bad news for the global liquidity environment. After all, when the US current account improves, it means that the US is exporting less money to the rest of the world. This is why past improvements in the US trade deficit have typically led to liquidity squeezes (Mexico in 1995, Asia in 1997, Argentina in 2001…). When the US trade balance improves, someone, somewhere finds it hard to get their hands on US$’s and thus the more marginal borrower/guy running negative cash flows goes belly-up...

However, interestingly, while the US trade situation is “improving”, we are still seeing very healthy growth in central bank reserves. Given that central banks still have plenty of money coming into their coffers, it is hard to think that there is a shortage of US$’s outside of the US!

So how do we square this circle? How can the US be exporting less US$ this year than last year, while US$’s outside of the US are still growing at around 18% per annum? The only answer that we can come up with is that today, a large number of US$’s are being created outside of the US. Or, in other words, we are seeing a lot of US$ loans issued outside of the US. But why would people borrow in US$? The answer is obvious: people expect the US$ to fall…. Take China as an example: as we have shown in the past (see The Surprisingly Strong Chinese Reserves), reserve growth in China has, in recent years, far outpaced the trade surplus and foreign direct investment. In other words, China has been saving a lot more US$’s, than it has earned. Which can only mean one thing: someone in China is borrowing US$ and this is flowing into reserves. Now as long as the RMB stays undervalued, chances are that this someone will remain happy to put this trade on.

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