Wednesday, 30 December 2009

Chart of the Week – Bond Mutual Fund Flows

I often write about the US stock market for a number of reasons. I have been a professional investor investing in that market. The US market is the largest and most developed in the world. The US stock market usually sets the tone and the pace for other markets – correlations are very high between other equity markets and the US equity market. The expression "if New York sneezes London catches a cold" is a truism that could be applied to most markets. Since the globalisation of US portfolio flows first by Capital International and Fidelity and then by US hedge funds the sectoral out and under -performance within stock markets have become global phenomena. Plus the ready availability of data and a long history of data collection and analysis allow investors to use tools based on American market phenomena that should work elsewhere, but if not the market-level call will still prevail. So looking at and analysing the American stockmarket is looking at the world of equities on a week-to-week or month-to-month basis.

I often have a "fact of the week" and "chart of the week". This week's chart is below and comes courtesy of Citigroup's research. It shows US mutual fund flows over the last five years.

This year the stock market has been about bear psychology in the first quarter, and since then about liquidity. I believe in Marshallian K, so to me the rally was mostly explicable by the enormous money creation and liquidity creation we saw in the last 18 months being channelled into financial assets because the real economy could only use it up with a lag. The US economy has started to grow, so towards the end of the year the rate of gain in stocks tailed off, as the real economy started to use the money that was created a year ago.

So having a rally in 2009 was not a surprise. The scale of the rally did surprise me but should not have done – the historical precedent of the Great Crash had an analogous rally – also a 50% retracement, and up around 50% from the low. One of the reasons that I thought that the rally might be significantly smaller was the psychology of investors. The Coppock indicator is based on recovery from trauma. In my mind the Coppock indicator is of limited use. Indeed it is only useful for non-professional investors – it is lagging and confirms only buy signals, but does tell long-term investors that a market is safe. The Coppock indicator is based on 11 and 14 month moving averages. I has assumed that we would have a limited recovery because it just takes longer than a few months to get over the trauma of what happened in the 2H of 2008. It turned out that the balancing item of liquidity provision was so huge that it overwhelmed the psychological imperative in 2009.

I think the chart of US mutual fund flows from the Investment Company Institute tells us a lot about the state of psychology of the US individual investor, and to some extent about the psychology of all investors in equities. We are still very much in the mode of "it is the return of my money that is important rather than the return on my money". I first heard the expression that "cash was trash" in the early '90s. At that point a bull market was still in gear, the bail-out of S&L s had taken place and returns on cash were derisory by the standard of recent decades. There was a compulsion to put money into stocks and other financial assets because there was nowhere else to go. The events of 2008, and the money market fund scandals, and the level of trust in banks all reinforce staying out of money market funds and other cash proxies to a degree. Sales of domestic equity mutual funds have been minimal this year. The positive flows to equities such as they were went into overseas equity mutual funds, as if Main Street didn't want to give its money to Wall Street. Almost by default US mutual fund investors have moved out on the steep yield curve and bought bond funds. Over the last 18 months more money has been put into bond funds than was taken out of US equity mutual funds.

So the current state of psychology of US investors is keep me out of Wall Street, I want the return of my cash, and I can only trust Uncle Sam with my money at the moment, thank you.

The equity market low was mid-March 2009. Eleven months on from there is February 2010. If the trauma of the Credit Crunch of 2008 is mitigated in the period around March-to-May 2010, where will US and other investors put their capital then? Cash will still be trash: even if the Fed raise rates it won't be by much. So a big question for next year, maybe even THE big question for next year is whither inflation, government borrowings and bond yields?

Two prominent hedge fund managers are making big bets on U.S. Treasury yields.

John Paulson’s Paulson & Co. has begun shorting U.S. government bonds, believing that inflation will lead to higher yields, which will drive down the price of the securities, the Financial Times reports. “It will be difficult for the government to withdraw the economic stimulus,” Paulson said in a recent speech. “An increase in the monetary base leads to an increase in the money supply, which leads to inflation.” According to the FT, another major hedge fund, TPG-Axon Capital Management, is also betting on rising yields.

Thursday, 24 December 2009

A Creative Way to Build a Hedge Fund Brand Name – Broadwalk Asset Management

I was listening to trader trainer Michael Martin interview Jim Rogers on his excellent website (, and I heard Jimmy Rogers say that investors should stay with what they know and are interested in. In working with portfolio managers I often ask them which sectors or types of stock they are good at investing in, and which they can't seem to get right. It may be they can't read retailers, or always seem to mis-time growth stocks, but it is very important to eliminate what you are not good at as a trader or investor. I think of it as playing defence to some extent – by eliminating a repeated error, and focussing on what you are provenly good at your returns have to improve.

There may be an element of ego involved – it may seem a sign of weakness on the part of a money manager to leave out a sector or type of stock from their universe. But investors, and ultimately the manager, will only be interested in the scale of returns achieved. So my conviction is to put the ego to one side, check the data, and eliminate areas of weakness. For example I worked with a manager who occasionally dabbled in the financial sector, but whose major strength was in consumer-related sectors. Analysis showed that the hit rate (percentage winning trades) was a lot lower in financial stocks than in other sectors, and I advised leaving the financials alone. Losses in the financial positions were slightly larger than those typically tolerated. If anything the stop-losses should have been tighter and positions sized smaller initially.

The ultimate specialism is sector funds, a strategy area I hope to return to shortly in more detail. In Europe we have begun to be used to hedge funds specialising in sectors, though they are a well established and successful phenomenon of the US hedge fund industry. Investor interest in sector hedge funds should be strong – the return data suggests they can offer enhanced return and lower correlation with markets if the funds have an appropriate framework for portfolio structure. The evidence for this contention is stronger at the manager level than at the index level - there is scope to add a lot of value to a portfolio hedge funds through manager selection in sector funds.

I came across an unusual sector fund this month. The Broadwalk Select Services Fund, run by Charlie Cottam, is Europe's first "Services" sector focused fund. The Fund has been going since June last year, and it has been going rather well. Most hedge funds made money in the first half of 2008 and lost more than their first half gains in the second half of the year. The Broadwalk Select Services Fund was up 1.3% over the last seven months of 2008 through putting in four down months and three up months. Obviously the average up-month in 2008 was bigger than the average down-month!

Charlie Cottam preserved capital well in the first few months of this year, and did better thereafter: through the end of November the Fund is up 44% for the year. The relevant market index for the fund is the FT-All Share Index (the Fund concentrates on UK companies), and that benchmark was down in four months of 2009, and the Fund managed by Broadwalk Asset Management was down in only one of those months. Over the whole life of the Fund the FT-All share has been down 14.6%. According to the manager he didn't get properly invested until February/March of this year, but once he did he made excellent returns through stock selection – the net is now about 80%, and the fund is concentrated (large position size).

The manager of the Fund claims two forms of competitive edge: better information and original analysis. The original analysis comes from Cottam's experience on the sell-side. As a chartered accountant himself he sees accounting issues not well understood by those analysing the service sector specifically. He may have a point as there are few sell-side analysts in the sector with similar tenure as an analyst. The manager himself sees an advantage in his ability to use his been-through-the-cycle experience to turn around his conception on a company and stock quickly – he can grab an emerging opportunity at the time when other analysts are getting out their apocryphal pen to write a research note.

Cottam is an experienced sell-side analyst, and in that may be a true edge as he was company broker to 33 UK corporates. This unique arrangement for UK quoted companies – a corporate brokership for each quoted company – gives the appointed broker a privileged position in terms of access to management. Cottam has kept his company network intact as he has moved to the buy side. His management contacts and experience of individual management teams based on their historic behavior helps Cottam to spot the early warning signs of change in outlook for companies and sectors. His sell side experience enables him to understand the flow information on stocks and their relative positioning in the market.

So Charlie Cottam uses his deep experience in service companies to extract alpha – staying with what he knows and is interested in. He has also taken steps to reinforce his edge by keeping senior management engaged with Broadwalk – last year he initiated the Broadwalk Business Services Awards. This is the second year of the Broadwalk Business Services awards to recognise outstanding achievements by quoted companies in the business services sectors. The UK often leads the world in business services -it is one of the less well-known success stories of the economy, and these awards are a step towards raising its profile. The categories and 2009 winners are: Company of the year (Aggreko), CEO of the year (Nick Buckles, G4S), Chairman of the year (John Peace, Experian), Deal of the year (Balfour Beatty - Parsons Brinkerhoff), Small company of the year (Hargreaves Services), and Entrepreneur of the year (Michael O'Leary, Ryanair).

I think this is a terrific example of creative thinking by a hedge fund manager, and Charlie Cottam's entrepreneurialism and unusual means of brand building are to be commended.

Wednesday, 23 December 2009

Inferences from a List of Larger Hedge Funds

Looking through Barron's Market Lab I came across a table of the biggest hedge funds in their univese. There are nearly 1100 single manager hedge funds listed in the newspaper. As is typical in the analysis of hedge funds it may not definitively contain the biggest hedge funds – even the most comprehensive databases may be missing nearly 40% of the largest hedge funds in the top 100 I was told recently – but still it makes interesting reading.

Biggest Hedge Funds in Barron's Market Lab (all data as at end October 2009) 

In terms of strategy representation, and taking account that Barron's reports CTAs separately, there are a several points worth making:

  • Equity long-short is well represented, and it is striking that emerging market equity hedge funds make it to the list.
  • Managers running strategies in fixed income are represented by a credit fund and two mortgage-backed securities funds. Five or maybe more years ago some fixed income relative value funds would be amongst the largest individual hedge funds.
  • Global Macro remains a big strategy – three representatives of global macro present.
  • There is only one CB arb fund in the list – five years ago there would have been several big CB arb funds in such a list.
  • Event-driven funds are under-represented compared to the percentage of industry assets invested in them. Dedicated distressed bond funds are absent (pace universe bias). A couple of multi-strategy event-driven funds are large enough to get into this top 20.
  • It is striking to see a fund in what is considered a niche investment strategy making it to a list of very large funds. The Dexia Index Arbitrage Fund deals only on the most liquid equity markets, and the asset size is a reflection of both the (loyal) client base of the managers, Dexia, and the steady return profile of the Fund.

To generalise from a small sample (1100 self-selecting funds from a universe of maybe 6000 single manager hedge funds):

  • Amongst the very largest funds are multi-strategy funds running $3bn-plus of capital in a single fund structure. This reflects the industry trend towards multi-strategy replacing single-strategy funds in relative value investment strategies particularly.
  • Emerging market investing is now a permanent part of the range of strategies employed by investing institutions, and even after the yo-yo performance and redemptions of the last two years emerging market hedge funds can still rank amongst the largest funds.
  • Hedge funds investing outside the United States are amongst the largest. This particular ranking includes a European specialist (Odey European) and a UK specialist (Blackrock's UK Emerging Companies Fund) as well as emerging market funds. Asia investing is absent on a dedicated basis.

Tuesday, 22 December 2009

Quality Factors in Equity Hedge Fund Returns This Year

In 2008 one of the disappointments was the returns of market-neutral quantitatively-driven equity strategies. The difficulties were focused as much as anything else in the seemingly illogical behaviour of quality factors last year. I recently inquired to a senior researcher in equity quant about factor returns this year, and again quality factors have driven returns in unexpected ways. The behaviour of quality factors helps to explain equity hedge fund returns across different styles this year, and so I have included the following abstract from the research of this quant published at the beginning of this month:


Discerning the direction of the Quality trade remains the key issue for investors. Discussions of investors seeking to take money off the table heading into year-end and positioning themselves in a more defensive posture are not borne out by the behaviour of our Quality index.

Market Commentary

It has been a tough year for Quality. And it has been a tough year for stock picking. And these two facts are not unrelated. Indeed, over the past 9 to 10 months, the key to successful stock picking has been to understand the direction of the Quality trade.

The big news in the quantitative factor space, and really the market as whole, this month has been the underperformance of High Quality stocks relative to Low Quality Stocks. For the month, we saw High Quality stocks underperform Low Quality stocks by approximately 2.9%. For our quality index, this is a big move since, in general, our quality index runs at approximately 1/3rd the volatility of the Russell 1000. In other words, if our quality index were scaled to have the same volatility as the Russell 1000 index, we would have seen an approximately 8.5% down move in our Quality index this month. Clearly something is happening.

Backing up for a second: as most people are aware, the rally in the market that started around mid-to-late-July coincided with a very strong move upwards by low quality stocks. Specifically, we saw low quality names outperform high quality names by approximately 5.2%. Whereas the low quality junk rally in March was primarily focused around companies with distressed balance sheet and low stock prices, the July rally was much more broadly focused. Here we saw low quality companies of all stripes outperform. Companies with poor historical profitability outperformed. Companies with low quality of earnings (i.e. non-repeatable earnings) outperformed companies with high quality of earnings. And companies with low quality balance sheets outperformed those with high quality balance sheets. In short, the late summer rally was coincident with low quality stocks of all stripes outperforming.

Since that time, we have seen a reversal in quality and then this month a subsequent continuation of the low quality trend.

Now this stopped around September 16th as we headed into earnings season. From there to the end of October we saw High Quality outperform Low Quality stocks by approximately 4.5% as investors positioned their portfolio defensively and braced for what by all respects they feared would be a tough earnings season. Note, again these are large moves, if scaled to equivalent Russell 1000 vol, this would be a 13.5% move in a month and half.

This turned around again on October 28th, with another strong low quality rally emerging coincident with strong earnings announcements by banks, basic materials and commodity producers, consumer goods companies and REITs – in short, bellwether companies for any weakness in the recovery. As these decidedly good earnings numbers provided assurance of the recovery's continuation, investors took off defensive positions and piled back into the early stage cyclical recovery trade names. This trend has continued virtually unabated ever since, with the Quality index experiencing positive returns on only 6 of the 20 trading days last month (November). Discussions of investors seeking to take money off the table heading into year-end and positioning themselves in a more defensive posture are not borne out by the behaviour of our Quality index.

Perhaps the most surprising element to us was that the quality index has continued its downward march late last week even on the news coming out of Dubai, which instilled some measure of fear in the market. We would have expected a flight to quality on Friday as the story broke and world equity markets lurched down. But it didn't happen. Our Quality index continued to inch downward on Friday (-4 bps) and then again on Monday (-23 bps), as even geopolitical fears did not send investors fleeing to safety.

As we head into year-end, the pressing question is: do we anticipate a rally in Quality? Absent a high-impact geopolitical event, we see two scenarios under which the Quality rally can end. Namely, investors can become concerned about slowing growth and thereby move into a more defensive posture in their portfolios.

We believe the most likely cause of a pull-back in Quality is the likelihood that investors take money off the table from the strategy as valuation of low Quality stocks is no longer compelling. By most metrics that we use to judge, low quality stocks appear to be fairly to slightly richly priced.

Monday, 14 December 2009

Flows to Liquid and Branded FoFs or all FoFs? carried this story today:

Deutsche Bank’s Hedge Fund ETF Reaches $1 Billion Mark
December 14, 2009

The db x-trackers db Hedge Fund Index ETF has reached more than US$1 billion in assets under management since its launch in January of this year. The exchange traded fund that tracks the asset class via an index.

"The db x-trackers Hedge Fund Index ETF is the first of its kind to provide exposure to the performance of actual hedge funds. It is not a hedge fund replicator,” explains Stephane Farouze, global head of hedge fund derivatives at Deutsche Bank. “With the introduction of the ETF we have enabled investors to access an important portfolio component in a new way. Underlying the index is a diversified pool of hedge funds from the, transparent, risk-monitored and liquid Deutsche Bank X-markets Hedge Fund platform.”

Thorsten Michalik, head of db x-trackers at Deutsche Bank adds, "Besides investing into actual hedge funds, the intra-day liquidity is clearly a unique advantage of our Hedge Fund ETF - daily volumes of over 50 million Euros are not unusual. We’re aiming for the db x-trackers db Hedge Fund Index ETF to become the world’s most recognized product for transparent and liquid investments into Hedge Funds."

The db Hedge Fund Index is asset weighted to the hedge fund industry and linked to the range of hedge funds available on Deutsche Bank’s X-markets Hedge Fund Platform.

The db x-trackers db Hedge Fund Index ETF is available in US Dollars, British Pounds, Euro and Swiss Franc share classes and is now listed in the UK, Germany and Switzerland.

From Simon Kerr:
This story says something constructive, but is it constructive about the HF industry or Deutsche Bank? In isolation the story says somethings about the power of DB marketing of financial products. But Friday also saw Europe’s third largest hedge fund firm, BlueCrest Capital Management, announce that they had raised £101 million ($164.5 million) through a new share issuance for its BlueCrest AllBlue fund.The publically-listed BlueCrest AllBlue fund now manages approximately £440.3 million, and serves as a feeder fund for the BlueCrest's fund of hedge funds vehicle.

The confluence of the two stories gives a sense of something emerging - liquid forms of funds of hedge funds with some branding are attracting interest? The corollory should be net positive inflows to funds of hedge funds in general. If we don't see that in 4Q flow data, does that mean that the old form of fund of hedge funds really has peaked (as a proportion of the industry assets)?

Friday, 4 December 2009

Non-Confirmations Dissipated

Well, we are here again: another signal day near market highs on an index. The index is the NYSE Composite this time. The same short term sell signal came up on the COB 21st October on the S&P.

However, there is a different set-up:

*The market has been in a trading range for 3 weeks rather than running up and then giving a reversal signal. This gives a reversal signal less predictive success.

* You may recall that recently Bob Prechter was pointing out some non-confirmations - some indices were failing to hit new highs at the same time as the broader market indices. Apart from the AMEX, all the major indices have hit new highs since Prechter's comment, so those non-confirmations have gone. The DJ Transports and Utilities indices appear to be breaking out to the upside.

* There is not a clear non-confirmation on the advancing - declining issues indicator (second graphic). So breadth is in line with price at the broad index level.

* The market is going up with less short term thrust on each up-leg. Volume confirms this.

*Yesterday's down day was on the biggest volume for a month on NYSE trading. Was that a clean-out cathartic day? Even on the big volume down day there were a lot more new highs than new lows on the various stock exchanges.

The probabilities have shifted to less negative scenarios by market action over the last week or so. In particular the break outs to new rally highs by various industry sub-groups allows for some market leadership. The postive seasonal bias may kick in this month, particularly after a positive November. Some hedge funds are still gunning to make their year, though others will be planning how to spend their performance fee bounty already. On balance a trading environment with a positive bias.

relevant link: 'December Effect' Bodes Well for Hedge Funds, Equities'

Information Flows to Hedge Funds 2 - Twitter

The best article on information searching for hedge funds that I know about was by Colin Maclean of Scottish Value Management. You can find it on "The Hedge Fund Journal" website at this link.

The search for an information edge goes on. Any source will do. The newswires carried this story recently:

"Traders are using software developed by US-based technology StreamBase to monitor "tweets" for price sensitive information.

The software plugs into Algorithm-based automated trading platforms that have been used by traders for years. But rather than searching Reuters or Bloomberg the software now scans

Streambase - whose client base includes Royal Bank of Canada and London-based hedge fund BlueCrest Capital Management - was commissioned to develop the software by several "unnamed" clients."

Wednesday, 2 December 2009

Podcast 2- A Discussion with UK Equity Portfolio Manager Nick Shenton at Polar Capital

Click on the links to download or play the sound files (embedded player available).

Part 1 (7 minutes 51 seconds)

0.30 Joining Phil Hardy at Polar Capital

1.50 Idea generation

4.40 What Phil Hardy brings to the process of stock selection

5.15 Harder to find shorts now

6.30 Shorts can work faster than longs

Part 2 (10 minutes 50 seconds)

0.25 Websites look at daily

1.35 Websites useful for company insight

2.58 Segro as an example

4.50 Recent investment book reading- Niall Ferguson, "The Greatest Trade Ever"

8.37 Risk/Reward for UK equity trades

9.05 Two other influential books - "Soros on Soros" and "Inside the House of Money"

With thanks to Nick Shenton CFA who works on UK equity hedge fund and absolute return products with Polar Capital Director Philip Hardy

The Greatest Trade Ever

By Gregory Zuckerman
Reviewed by Alexandra Scaggs from

Ever wonder how a single trade can create a legend? Gregory Zuckerman outlines how just such a thing happened with John Paulson and the rest of the characters who profited wildly from the collapse of the real estate bubble."

In The Greatest Trade Ever," Zuckerman, who writes The Wall Street Journal’s "Heard on the Street" column, focuses as much on the personalities and characters of the investors as on the bubble and collapse that increased their wealth exponentially.

Players here include Paulson, whom Zuckerman characterizes as a reformed playboy and true skeptic; Paolo Pellegrini, a Wall Street outsider who went to Paulson for his last shot at a career; Jeffrey Greene, the Hollywood version of a big-shot investor; and Andrew Lahde, the young West-Coast investor who cashed out and left finance for good.

The book addresses how deals are made and how personality counts just as much as the financial mechanics behind the trade, which may be why Paulson has come out with a statement saying he is “disappointed” with the book. But Zuckerman shows that in finance, office politics can matter as much as smarts.

Tuesday, 1 December 2009

Ari Kiev and the Trader Trainers

I'm sad to record that Ari Kiev died this week - you can find an obituary in The New York Times. Ari Kiev was a psychiatrist with interests in several areas including depression and suicide. He applied his knowledge and techniques to new fields including working with top tier athletes and traders in markets. And in working with traders he expanded the armoury of techniques of trader trainers.

I first came across trader trainers about ten years ago. To be clear, I'm not writing about Richard Dennis' turtles experiment, though that itself is an interesting topic. Trader trainers such as Van Tharp and Scott Kaminski (and Ari Kiev) work with investors, typically short-term leveraged players in markets, looking to improve their outcomes. These trainers teach time-tested methods and approaches that have worked for the very best traders in markets. I have a book case full of investment and trading books – biographies, historical accounts, academic papers and classic writing on investments. I rate the "market wizard" type books particularly highly for giving helpful insight. Those who truly invest, that is operate with a long holding period and rely on fundamentals rather than technicals, have a wide variety of approaches and methods. Those who trade for a living (short term, and price and technically focussed) and are successful at it do not vary to anything like the same degree. Kiev's practice with traders concentrated on the classic elements, adding his own technique.

There are a number of core activities, skills, disciplines and attitudes for successful traders. These are what Ari Kiev spent much of his time putting across to his trader clients. He was first brought into working with traders by Steve Cohen of SAC, who recognised parallels in trading with top-performing athletes, and had heard of Kiev's work with the sporting elite. Kiev was retained by SAC and worked part of his week in Connecticut in one-on-one sessions with SAC's traders. In the course of time Kiev codified his thoughts and put them into print. So you can read what and how he trained traders in his classic "Trading to Win" (1998), and other titles. I would also recommend Ari Kiev's podcasts.

Of all the trader trainers I know about, it was Ari Kiev's approach and methods I have referred to most over the last year in the course of my consulting work with hedge fund managers. Consultants on the investment and risk management processes such as myself have to tailor their work to the specific portfolio manager or team that is the client at the time. When it comes to the trading part of managing a hedge fund, Ari Kiev's techniques and tools will be part of that body of work on which we draw for years to come. A good legacy in work terms.


The photograph above is from The New York Times website (see first hyperlink above).