Thursday, November 13, 2008

Will Hedge Hogs Bail Out Global Pensions?

The Dow Jones industrial average up more than 550 points after driving it down near its lows for the year on a stream of negative economic and corporate news.

As foreclosure rates shot up 25% year-over-year and jobless claims unexpectedly jumped to a 7-year high, the Dow sunk like a stone, reaching a low of 7965.42 at around 1:00 p.m. and then, just like magic, the bulls came back to buy and the Dow closed at 8876.59 - almost 1000 points off its lows.

Are you confused? Have you ever seen this much volatility on an index of 30 of the largest companies in the U.S.?

Let demystify it all for you. Remember that conversation with the Financial Ninja a couple of days ago where I told him that I doubt we will retest the October 10 lows on the Dow of

We came close today but those lows were made on huge volume that day and there was real fear in the markets. Over 11,456,230,400 shares traded on October 10th, signaling blowoff volume.

Since then, the credit markets have calmed down as the extraordinary measures by global policymakers seem to be working. Volume came back to normal levels in the stock markets.

So what happened today? Basically, it was a classic technical rally where we almost retested the lows but then shot up higher. It seems that hedge funds have rediscovered the art of technical analysis:

Hedge funds using technical indicators are likely to fare better in the next two years than those purely basing their strategy on economic fundamentals, a survey of around 200 investors showed on Wednesday.

The survey of asset managers, institutions, and high net worth investors at the Global Alternative Investment Management (GAIM) Fund of Funds conference in Geneva showed 36 percent saw such trading-based strategies set to outperform in 2009-2010.

These strategies generally use technical indicators or a combination of technical and fundamental indicators to make short or medium-term bets on market movements.

But it isn't just hedge funds playing these technical rallies. As I stated many times, hedge funds, mutual funds, and pension funds are all hemorrhaging and they have a vested interest to buy this sucker up going into year-end. They will all try to make back the huge losses they suffered last quarter.

So forget those smart individuals telling you that the stock market is still expensive and analysts are out to lunch. We know they are but you'd better play these technical rallies because there will not be many opportunities to make money buying and holding over the next five or ten years.

Actually, let me qualify that last statement. I saw an article in the Globe and Mail today that basically argued that clean tech is finished and the green bubble will burst following the crisis.

Interestingly, that same paper carried an article today stating that the Maldives, a tiny nation off the south of India's coastline, is seeking dry land because it is submerging as sea levels rise due to global warming.

Here is a hint: whenever you read an article proclaiming the end of clean tech or the green bubble has burst, remember the Maldives and ignore it!

I have seen many solar stocks get slaughtered - nay, annihilated - in the stock market rout. Most of them have fallen off a cliff, not because their fundamentals are poor, but because of forced liquidation by hedge funds who are selling to pay out redemptions.

Moreover, some solar companies like JASO Solar Holdings (JASO) rightly blamed Lehman Brothers for their Q3 loss. Other solar like LDK Solar (LDK), came out with a statement today telling investors to relax because they are fine.

This hysteria has created an amazing long-term buying opportunity in the solar sector. I will admit that I am like a kid in a candy store when I see solars get killed like this. As I stated in my last discussion on the solar sector, I am a long-term bull on clean tech, betting alongside VC giants like John Doerr of Kleiner Perkins Caufield & Byers.

Anyways, I am digressing from my main topic. As the stock market took off like a rocket this afternoon, five of the most powerful hedge fund managers made an unprecedented appearance before Congress, defending their practices and profits while splitting over whether the U.S. should impose stricter regulations:

``This is not a case where management takes huge bonuses or stock options while the company is failing,'' said Falcone, one of five billionaire investors who testified today before the House Committee on Oversight and Government Reform in Washington.

Falcone, senior managing director of New York-based Harbinger Capital Partners, urged Congress to require more disclosure by hedge funds, which oversee $1.7 trillion of investments. Soros, founder of Soros Fund Management LLC, cautioned against ``ill-considered'' rules because this industry is reeling from market losses and client defections.

``We do not need greater regulation of hedge funds,'' said Kenneth Griffin, founder of Citadel Investment Group LLC in Chicago. ``We've not seen hedge funds as a focal point of the carnage.''


Waxman and Representative Thomas Davis of Virginia, the panel's top Republican, suggested the need for more oversight of the industry.

``This isn't just about sophisticated, high-stakes investors anymore,'' Davis said. ``Institutional funds and public pensions now have a huge stake in hedge funds' promises of steady, above-market returns. That means public employees and middle-income senior citizens, not just Tom Wolfe's Masters of the Universe, lose money when hedge funds decline or collapse.''

Falcone, 46, said he supported more public disclosure and transparency. Investors ``have a right to know what assets companies have an interest in -- whether on or off their balance sheets -- and what those assets are really worth,'' he said.

Soros warned the committee against ``going overboard with regulation'' now that ``the bubble has now burst and hedge funds will be decimated. I would guess that the amount of money they manage will shrink by between 50 and 75 percent. It would be a grave mistake to add to the forced liquidation currently dislocating markets by ill-considered or punitive regulations.''

Simons suggested that hedge funds' positions be disclosed to regulators and made available to the Federal Reserve Bank of New York, though not made public.

The hedge-fund managers also defended their multimillion- dollar compensation, saying they earned money only when their investors did.

``In our business, one of the most fundamental principles is alignment of our interests with those of our clients,'' said Paulson, who takes 20 percent of any gains. ``All of our funds have a 'high-water mark,' which means that if we lose money for our investors, we have to earn it back before we share in future profits.''

Soros, best known for making $1 billion betting against the British pound, is the chairman of the $19 billion Soros Fund Management in New York. He has called credit-default swaps the next crisis area because the market is unregulated, and he has recommended the creation of an exchange where these contracts could be traded, a move seconded by Griffin.

I will not get into whether or not hedge funds are to blame for this financial mess. It is easy to point fingers at them but the truth is that they were not the ones behind the securitization bubble that led to this mess. The big banks were.

Some hedge funds have gotten away with murder over the last few years, using their privilege client status to sway prime brokers and analysts to write positive or negative reports on companies before they sold its stock short or went long on it.

But for the most part, hedge fund managers are not the supermen that the financial media portray them to be. I have gone toe to toe with some of the best in the world and I can tell you from experience that they make lots of investment mistakes just like most investors.

The difference is that hedge funds are more nimble and they know how to manage risk. The best hedge funds will never let a trader take a position that will threaten their fund. Sure, blowups happen and there have been rogue traders at hedge funds, but the best hedge funds are incredibly disciplined money making machines.

[emphasis on the best hedge funds because 90% are no better than mutual funds who are closet indexers]

Unfortunately, I can't say the same thing about global pension funds. According to an estimate from the Organization for Economic Co-operation and Development (OECD), the recent financial crisis drained retirement funds worldwide by $4 trillion:

The estimate was made Wednesday at an OECD seminar in Paris in a presentation by Pablo Antolin, principal economist, financial affairs division at OECD.

“The main message is that losses are substantial and dependent on the asset allocation of pension funds in a specific country,” Mr. Antolin said today in a telephone interview.

The estimate — that defined benefit and defined contribution plans lost the money from Jan. 1 to early November — was calculated by using OECD’s own asset allocation data by country as of Dec. 31 and applying global equities, bonds and cash index returns to those allocations.

Losses were highest in Ireland, the U.S. and the Netherlands, where exposures to equities were the highest at the end of 2007; pension funds in those countries lost 20% or more of assets on average, according to OECD’s website. Pension funds in Korea and Luxembourg, where equity exposures are very low, have experienced minor losses.

Funding levels have declined five to 15 percentage points on average, depending on the discount rate used, and the OECD expects that when year-end data is reported the figures will be worse.

We are on track for the greatest global pension debacle in post-war history. As world leaders get ready to meet at the G-20 summit this weekend, they better refer to some of the discussions that took place at the OECD seminar in Paris this week:

In reaction to the crisis the OECD revealed pension funds in countries with "fair value and quantitative risk-based solvency rules" are selling parts of their equity portfolios, which puts further downward pressure on prices,

Meanwhile concerns over counter-party risk, means pension funds are "shunning derivatives and swaps for risk management purposes", although moves into alternative investments appear to be continuing.

Attendees discussed possible policy reactions to the financial crisis including reviewing funding requirements for DB plans for both the short and long term and implementing an "upgrade in risk management methods" of instruments such as derivatives and swaps.

It was suggested governments could play more of a role in managing risks associated with the payout phase of pensions and annuities, with the idea they could encourage the market for longevity hedging products by producing an official longevity index.

Other proposals included suggestions that governments should issue longevity bonds that "would set a benchmark for private issuers", while they "should also consider" issuing more long-term and inflation-indexed bonds, a move already taken by the Danish government with the release of a 30-year bond that was primarily bought by domestic pension funds and insurance companies. (See earlier IPE article: Schemes snap up Danish 30-year bond)

Professor David Blake, director of the Pensions Institute at Cass Business School, said in his presentation that the effects of the crisis would encourage investors to look for assets that are "uncorrelated with traditional financial asset classes", for example through longevity-linked instruments such as life settlements, while "the state will begin to recognise its role in hedging aggregate longevity risk".

In addition the OECD highlighted the need to look at the adequacy of retirement income from DC plans, and suggested the provision of "default investment strategies that involve switching to less risky assets as people age" – such as life-styling or target date funds.

But all these measures are not going to solve the serious pension shortfalls overnight. Right now, global pensions are hoping that the hedge hogs will help relieve some of the pain from the last quarter bringing the stock markets back up.

Today the hedge hogs responded in kind by slapping the bull. Let's hope global pensions do not get the horns up their backside.

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