Where is Alpha and the Omega?

If one is to believe in the mean variance framework, hedge funds are an amazing addition to a portfolio and tend on average to deliver similar returns to those of stock markets with considerably less risk as defined by the standard deviation. The reality however is quite different. Various strategies in the hedge fund world are highly leptokurtic and are subject to considerable left tail risk. 

Once you begin to incorporate the higher moments of the return distribution in your optimization toolkit, you begin to get the whole picture. If you perform various multi factor regressions on hedge fund returns, you begin to realize that the alpha you were seeking is mostly made up of repackaged Beta being sold to you at alpha prices.

The roller coaster ride in the US stock market over the past two months has been a story about the crisis of the hedge fund industry as well. In fact this once upon a time 1.7 trillion dollar loosely regulated business is expected to be worth less than half that by the end of June 2009. It is panic selling by hedge funds that has largely been responsible for the downward spiral of US stock markets in October. Of course naked shorting did not help matters either. All the printing of dollars and euros will create another headache. 

The hedge fund story can be summed up as follows: Whatever money was made by hedge funds from January to August 2008 can be mostly attributable to small cap investing in commodities and alternative energy related companies. These funds then took short positions on the stock market index and were able to generate substantial alpha when the commodities story was still on. Other hedge fund strategies such as convertible arbitrage and distressed securities arbitrage have not been working too well as credit spreads have continued to widen, and margin requirements on highly levered portfolios have certainly made many a fund disappear.

When the Baltic Sea Dry Index fell below important resistance levels signaling the end of the commodities play, the hedge funds were sitting ducks. When the fund managers saw the widening of credit spreads and end of the commodities play, they began to redeem as if there was no tomorrow. This forced various hedge funds to sell their already loosing positions on small cap stocks. Hedge fund managers had to prevent further losses and increased their short exposure on various market indices which pushed the entire market down on small volume making the month of October one of the worst months on record.This shorting did not work because the diversified market indices had more solid and stable consumer staple and large cap stocks than the hedge funds did and they still lost money. 

What do you do when you are a hedge fund that loses money? You short the market index futures some more! Market neutral hedge funds (computerized hedge funds that trade based on various trading algorithms which are in themselves econometrically derived) could no longer make any money because stock markets were no longer behaving on fundamentals, but on panic. 

Many hedge funds have liquidated and disappeared. That is why you see the Dow Jones going up by 400 points until 2.45pm on a typical day and down 600 points after the last minute hedge funds have to sell stocks in order to meet redemption requirements. The US economy has not helped matters for the poor hedge fund manager. The US Treasury’s flip flop on buying bad bank assets can only make matters worse.

Here is the story on that. You have 700 billion dollars, half of which is being spent on directly recapitalizing banks via the preferred shares buy route and another half which was meant to buy bad debt. The problem is that all the money you have been giving banks (with the first half) is not being lent to consumers and small businesses thereby hurting the economy even more. Many problems are popping up everywhere, banks do not still trust each other in the US despite implicit guarantees by the central bank on various instruments and the US auto industry is nearly bankrupt because it cannot get access to short term financing anymore. It is becoming increasingly difficult to get small time loans and even credit cards and so the Treasury finds itself in a situation where 700 billion dollars is looking mighty small from its stand point.

The private sector is delivering and does not want to play at this point. The Federal Reserve has already made some 2 trillion dollars worth of emergency loans and has an awfully interesting balance sheet for it and only God knows where the money for this endless spiral of bailouts will come from. Suffice to say, a lot of dollars are being printed these days.

Latest projections indicate that the world economy is expected to slow down dramatically and grow by a mere 1.8-2.4% in 2009 and projections for eventual economic recovery are being continuously pushed back. The world is only now expected to recover in a very moderate fashion in late 2010. Growth in emerging market economies is expected to slow down towards the 5.5-6.5% range, nearly a 30% drop in growth. In the medium term, demand for commodities is not expected to pick up. Oil prices are expected to remain within the 50-80 dollar range over the next 12 months. There is no threat of food and commodities based inflation in the short to medium term although all this printing of dollars and euros will create another headache in the longer term.Inflation forecast at between 5.5% and 7% by December 2009.

This brings me to the much hyped and loved Keynesian economic theories that Mauritian policy makers love to adhere to. I do not blame them: in the 1960s and 1970s, the last time many of them went to school, Keynesian economics was still in fashion. The Great Inflation refers to the period when U.S. inflation rose from negligible levels in the mid-1960s to double digits in the early 1980s. Though the episode scarred a generation, the memory of the fire has evaded Mauritian policy makers for the past decade.    To be continued

By Sameer Sharma

Sameer Sharma is a Canada-based financial
analyst.