Risk On, Risk Off?

Svea Herbst-Bayliss and Lawrence Delevingne of Reuters report, Hedge fund Elliott eyes fresh market turbulence:
Paul Singer's $27 billion hedge fund Elliott Associates is worried about Europe's prospects and is bracing for fresh market turbulence.

In a letter to investors dated July 23 and seen by Reuters on Thursday, the New York-based firm told clients that it has returned 2.8 percent in its Elliott Associates, L.P. and 2.2 percent in its Elliott International Limited.

While both funds beat the Standard & Poor's 500 Stock Index's 1.2 percent gain, the fund spent pages explaining its more cautious approach and warning that even after a six-year bull market in stocks, there is "no such thing as a permanent trend in the markets."

It worries about central bankers' easy money policy noting that governments that have "abused the power to create 'money' have always, eventually, paid a huge price for their profligacy."

"We are not bragging about our record, nor do we feel defensive about not keeping up with the S&P 500 in the last few years," adding that it invests carefully especially at a time it sees more chance for severe market turmoil.

It also expressed concern about Europe even after the region found a solution to Greece's debt problem and worries that long-term problems have not been adequately addressed, possibly causing "the breakup of the euro."

"The bottom line in our view is that Europe is in a very difficult situation," the fund wrote.

Still Elliott sees what it calls "attractive opportunities in the activist equity area and a few interesting situations in event arbitrage." The firm recently lost a campaign to block the merger of two Samsung affiliates in Korea.

It also said it is cooling on real estate investments, noting "the balance in our real estate securities trading has turned to the sell side."

The firm recently raised $2.5 billion in new capital, calling it "dry powder."

But it also warned investors in the normally secretive hedge fund world to stop sending its closely followed letters to journalists and others.

"We have learned the identities of certain individuals who breached their confidentiality obligations by disclosing the contents of Elliott's quarterly reports," the firm wrote adding "We are taking action and seeking monetary damages from violators."

The Wall Street Journal first reported on Elliott's tough stance to keep its letters private.
I would ask Paul Singer and all other "elite hedge fund gurus" to make their quarterly or monthly letters to investors public as most of the money they manage comes from public pension funds.

Singer is an outspoken critic of central banks engaging in quantitative easing and has recently stated that bonds are the bigger short. I disagree with him on that call as I see the return of deflation -- or more precisely, the continuation of deflation -- wreaking havoc on the global economy for a prolonged period, which basically means we haven't seen the secular low in Treasury bond yields.

But I agree with Singer that the latest deal to save Greece and Europe is effectively a sham and that European leaders have failed to address deep structural issues that threaten the eurozone's future. In fact, despite massive QE from the ECB, I'm convinced the euro deflation crisis will rage on, wreaking havoc on unsustainable debts of periphery economies but also on core eurozone economies.

I also agree with Singer's call to shed real estate assets and raise cash to have "dry powder" at hand for opportunities. And in these volatile markets, there will be plenty of opportunities at hand but you need to pick your spots carefully or risk getting slaughtered.

Singer's Elliott Associates is doing relatively well, beating the S&P 500. Most hedge funds are struggling to remain open. The rout in commodities has annihilated many commodity hedge funds. The Wall Street Journal reports that Cargill's Black River Asset Management plans to shut down four of its hedge funds and return more than $1 billion to investors over the next several months.

Fortress Investment Group (FIG) on Thursday said its liquid hedge funds posted a $6million pre-tax loss for the second quarter as a result of turmoil at its flagship hedge fund portfolio that bets on global economic trends, sending its shares down.

Earlier this week, Laurence Fletcher of the Wall Street Journal reported, Hedge Fund’s Assets Fall by 95%:
One of the big hedge fund winners of the credit crisis has become a major loser in the era of easy money.

London-based bond-trader Mako Investment Managers LLP was a star performer in 2008 and investors poured money into its flagship Pelagus Capital Fund. But assets under management have fallen 95% since the end of 2012 due to weak returns and because investors have yanked their money.

Pelagus’s assets stood at $1.14 billion at the end of 2012, according to a person familiar with the matter, and have fallen to just $59 million at the end of June, according to an investor letter reviewed by The Wall Street Journal.

The decline highlights the difficulties faced by bond funds that have struggled to generate performance as huge quantitative easing programs by major central banks have suppressed volatility in the market.

On average, hedge funds that trade sovereign bonds are up 2.1% in the first half of this year, according to Hedge Fund Research, having gained just 1.2% in both 2013 and 2014—those results significantly lag the average return from hedge funds as a whole.

“QE has almost killed these strategies,” said one major European investor in hedge funds.

Among funds to have struggled trading interest rates in recent years is Brevan Howard’s $21.7 billion flagship macro fund, which last year posted its first-ever down year, according to a letter to investors. The BlueCrest Capital International fund, another major macro fund, made just 0.1% last year, according to regulatory filings. Macro funds bet on stocks, currencies, bonds and other assets.

Mako’s chief investment officer, Bruno Usai, said “near-zero interest rates and low market volatility” mean it is tough for funds such as Pelagus to make the double-digit returns of previous years.

In 2008, Pelagus made a return of 33.1%, according to an investor letter reviewed by The Wall Street Journal, while hedge funds on average lost 19% that year, according to data group Hedge Fund Research.

But recent performance has seen the fund lose money in each of the past 12 months, according to the letter. The fund is down 3.4% so far this year to the end of June and lost 4.1% last year, having made only small gains in each of the previous three calendar years.

According to the letter, the fund underestimated how Greece’s debt crisis would hit European bond markets—European sovereign bond yields rose as the crisis escalated—meaning the fund put on some trades too early. It didn’t specify the trades it put on.

Mr. Usai said the firm plans to launch a new fund before the end of September. He said it was an “irony” that investors are leaving funds such as his “just as fixed income volatility is starting to pick up and the Fed is on course to raise official rates this year.”
I keep warning my institutional readers to ignore your useless investment consultants and stop chasing after the hottest hedge funds. Most of the time, you'll get burned.

And while quantitative easing has made it tougher to make money trading sovereign bonds, I'm sick and tired of these excuses. Either your fund can adapt and deliver alpha, or simply bow out and return the money back to your investors.

We all know about quantitative easing and the pending liquidity time bomb, but institutions are paying big fees to hedge funds to navigate through this difficult environment. If they can't deliver alpha, they should get out and return the money to their investors way before losing 95% of their assets (investors should have pulled the plug on Mako years ago!).

All this talk on hedge funds struggling to deliver alpha led me to go back to reading the wonderful letters from Absolute Return Partners. Niels Jensen and his team offer investors some great food for thought. In June, Niels asked whether bond investors are crying wolf, concluding this is NOT the beginning of something much bigger and that economic growth will stay low for many years to come, and central banks have no intentions of suddenly flooding the bond market with sell orders.

In his July comment, A Return to Fundamentals?, Jensen notes that financial markets have in many ways behaved oddly since the near meltdown in 2008 and looks at whether we are finally beginning to see some sort of normalisation – as in a return to the conditions we had prior to 2008 – and what that would mean in practice.

He concludes:
"Overall, I don’t see any clear signs that the risk on, risk off mentality, which has ruled since 2008, is finally coming to an end. Yes, correlations have begun to recede a little bit here and there; however, if it is indeed a sign of bigger things to come, it is still very early days."
I highly recommend you make a habit of reading the letters from Absolute Return Partners. There is obviously some self-promotion but they will provide you with a lot of great insights on markets and alternative investments.

What do I think? I think Risk On/ Risk Off markets are here to stay. This is all a product of the liquidity tsunami from central banks around the world to counter the threat of global deflation, and illiquidity in fixed income markets.

In terms of equities, I've already told you we could be setting up for some nice countertrend rallies in Chinese (FXI), emerging markets (EEM), energy (XLE), commodities (GSG), metals and mining (XME), and gold (GLD) shares in the next few months, especially if global growth improves, but I would steer clear of these sectors. There will be violent short covering rallies but the trend is inexorably down.

My long-term forecast of global deflation remains intact which is why even though I might be tempted to trade countertrend rallies in energy and commodities, I keep steering clear of these sectors in favor of tech (QQQ) and biotech (IBB and XBI). Here too, it's very volatile, but I continue to buy the dips in biotechs I track as I think the long secular bull market in this sector is still in the early innings.

By the way, here is a small list of small biotechs I track and trade (click on image):

Some have performed better than others but they're all volatile and if you have no experience trading biotechs, stick to the indexes (IBB and XBI) or avoid this sector altogether. You literally have to stomach insane volatility and be very patient at times in order to make big profits.

Hope you enjoyed reading my weekend comment. As always, please remember to click on my ads and more importantly to donate or subscribe to this blog via PayPal at the top right-hand side. I sincerely thank all of you who have supported my efforts to bring you the latest insights on pensions and investments.

Below, that famous "Wax On, Wax Off" scene from the Karate Kid. I suggest hedge funds struggling in these "Risk On, Risk Off" markets take the time to listen to Mr. Miyagi. "Don't forget to breathe!".