In the Great Global Macro Experiment, the Next Bubble to Burst Is...

I am going to introduce a paradigm shift in the content that I introduce to the blog. As reporters and institutional investors who have contacted me can attest, I have been very secretive and stand-offish in terms of what I do for a living. The reason is that I was in the process of launching a hedge fund, and my lawyers were quite explicit in telling me that I am in no way to promote the fund through the blog. You see, I think I'm pretty good at this investment stuff, and I needed access to more capital to fully exploit the next step in my investment thesis. So, what better route than to open a fund up to investors who can appreciate my investment style, and take advantage of that 20:1 leverage offered so freely?

Well, one of the reasons I have had such a strong investment record is that I am able to smell bubbles. Unfortunately, I smelled this fund bubble coming but I thought I could sidestep it. I seem to have been wrong, but didn't realize it until after I spent an upper middle income family's salary on fund formation. With a raft of adverse legislation, tightening operating environment and increased regulation, this bubblicious industry just ain't what it used to be.

So, I have decided to simply go it alone through my single family office. What does this mean? Well, for one, I can now be much more explicit with what I do in my postings to the blog since I cannot be seen as selling investment management products - which I both do not do and do not want to do. I want to make that clear from the outset, again! I will start being more communicative right now by releasing my own proprietary account investment results and comparing them with the blog's research model, hedge funds, and the US broad market.

Here's a sneak preview to bait you into reading this rather lengthy article behind my decision. Keep in mind that I used no leverage, and averaged about 50% in cash. I make my money the old fashioned way, by rolling up my sleeves and performing hard core fundamental and forensic research - the exact stuff that you see in this blog:

Click all images to enlarge

I will reveal a lot more in the future, as well as how to compare newsletters, investment advisors, funds, pundits and blowhards on a true risk adjusted reward basis (watch out Cramer!) in my next post or two. But first, a public service announcement...

Hedge funds haven't been performing that well anyway

Hedge funds have experienced historically record losses, record client redemptions, record volatility, and record closures. Sounds like the bubble is burst. There are a few fundamental reasons for these occurrences (other than there being just too many of them (7,000+ as of last year):

• Leveraged loans and high yield securities posted their worst monthly performance on record as prices tumbled to new lows and volatility spikes after Lehman filed for bankruptcy: The Standard & Poor's/LSTA Leveraged Loan Index returned a negative 6.15 percent in September, almost double the previous record loss of 3.35 percent set in July 2007. Leveraged loan prices tumbled 8.57 cents in September to a record low of 79.8 cents on the dollar as financial companies failed and hedge fund managers sold assets anticipating client withdrawals. The selling of assets into falling market always exacerbates the collapse in price precipitating more selling, which leads to a further collapse in price which precipitates more selling. Rinse, lather, repeat. The leveraged loan debacle is covered in explicit detail in The Asset Securitization Crisis Part 27: The Butterfly Effect.

• Perfect Storm for Hedge Funds: Short-selling was banned literally overnight, the actual collapse or near collapse of ALL of Wall Street's major broker dealers, a literal freeze in the credit markets and unprecedented volatility not only reduces the possibility for funds to borrow money and hedge through exchanges, they're stuck with forced delivering and increased regulation at the same time they are experiencing their own "run on the bank" as September came to a close, marking the end of the fiscal year for many funds. Forced redemptions in volatile and/or illiquid markets lead to fire sales which lead to lower prices that precipitate forced redemptions which leads to... Rinse, lather, repeat! What also bites is that hedge funds are net sellers of credit protection via CDS in the $62 trillion credit derivatives environment (see The Next Shoe to Drop: Credit Default Swaps (CDS) and Counterparty Risk - Beware what lies beneath! and Reggie Middleton says the CDS market represents a "Clear and Present Danger"!) and were called to perform on their obligations with regard to Lehman, WaMu, Kaupthing, etc. The Lehman credit sellers got a dismal recovery rate of 8.75 cents on the dollar, meaning that they have to cough up roughly $320 billion in cash to make whole their credit protection contracts. I hope they have the spare change lying around.

• NYT: In the month of July, hedge funds experienced nearly $12 billion in outflows. September 30 was the deadline when many funds are scheduled to accept withdrawal requests for the end of the year. To pay back investors, some funds may be forced to dump investments at a time when the markets are already shaky thus fuelling a vicious circle--> some hedge funds are reported to block withdrawals.

• Attari/Ruckes: Redemption feature causes fundamental maturity mismatch with borrowing short term and lending/investing long-term and illiquid e.g. in leveraged loans--> when redemptions increase, hedge funds have no other choice than liquidate assets thus fueling a negative spiral. Evidence from the leveraged loan market shows that this is unraveling is underway. Rating agencies start to downgrade collateralized fund obligations (C.F.O.) which are the hedge fund equivalent of mortgage-backed securities: securities backed by hedge funds. Some have a 7-year lock-up period. While few in number, C.F.O.'s represent a broad swath of the $2 trillion industry.

• In terms of performance, this year looks like the worst on record: the average fund is down nearly 10 percent so far, according to Hedge Fund Research.

• About 350 funds were liquidated in the first half of the year and if the trend continues, the number of closures would be up 24 percent this year from 2007.

• Oct 1: There are dozens of hedge funds whose Lehman prime-brokerage accounts were frozen when the company filed for protection from creditors on Sept. 15. "One executive who used Lehman as a prime broker -- and who asked not to be named because his firm is private -- estimates that hedge funds had between $50 billion and $70 billion in Lehman prime-brokerage accounts." Moreover, hedge funds had pledged equity securities as collateral that Lehman then loaned to other investors under a practice known as rehypothecation - PWC says in that case "clients may cease to have any proprietary interest in them."

• Seides (InvestorsInsight): Hedge funds are sellers of 32% of all CDS, insuring exposure of $14.5 trillion. Recent estimates indicate that the entire hedge fund market is approximately $2.5 trillion in net assets under management. Thus, hedge funds are bearing risk in excess of their ability to pay the piper if anything goes wrong--> risk might well land again with former investment banks and broker dealers (what's left of them, anyway) whose exposure to hedge funds are significant, both through their prime brokerages operations and as counterparties. As you can see, there is a risk of systemic failure here.Roubini: "one cannot rule out that some systemically important hedge fund may get into trouble with systemic consequences."

And exactly what was the hedge funds' performance?

Let's take a look-see.

Source: BarclayHedge

As can be seen above, hedge funds do dampen volatility through lessened standard deviation, and provide superior relative returns. Thus on a basis relative to the broad market, they provide superior risk adjusted returns. But hey, wait a minute! Aren't hedge funds marketed as delivering superior "absolute" returns? Don't they preach diversification from the traditional asset classes via uncorrelated returns? Correlations to the US broad market index are actually very high for an alleged "alternative asset class". This means that if you think you invested in hedge funds to offset the risk of the broad market, you have another thing coming!

Notice how truly uncorrelated (actually negatively correlated) my investment returns have been in this down market. You can see it numerically in the table above, and graphically in the chart above that. This is what investors should strive to achieve when pursuing alternative asset strategies. It's too bad our government is about to regulate the industry to death, or I may have been able to offer a Reggie powered hedge fund!

Also of note, although the Sharpe and Sortino ratios of the fund indices are higher than that of the S&P 500, they are still abysmal as compared to my results. They are even abysmal compared to a buy and hold strategy based on this blog's research model. If you still think that is worth 2&20, then check out the actual alpha (Jensen's) generated. No single category generated more than 100bp of alpha except for... You know, that handsome, cynical, hard edged brother that blogs a lot.

Readers interested in hedge funds may find it worthwhile to participate in the BarclayHedge Blog. If you go by, tell 'em Reggie sent ya'. Be sure to kick up a lot of dirt about how a blogger tore the pants off of EVERY index that they track, and published the research behind the performance free for a year, to boot. That's one way to make friends over there.

Richard Wilson's Hedge Fund Blogger is a much less corporate (the Barclays spot is really a corporate press kit masquerading as a blog - big financial companies just don't get new media), more interactive blog that contains a lot of info - although none of them have activated the ability to openly comment on the articles. I urge my readers to go over there and kick up some dirt as well. Might as well start some trouble.

For the record, more than 30% of the BoomBustBlog readers are multi-millionaires, over 47% make more than $350k per year, and many of them influence decision making in their respesctive companies and firms. The largest demographic of the site, by far, is the financial services industry. The largest occupational tranche is entrepenuer. If BoomBustBloggers are not prime fodder for hedge funds, I don't know what is. Take the BoomBustBlog survey to find out more.

Here are some definitions for those of you who are not nerdy enough to memorize all of these financial and statistical terms:

Jensen's Alpha (From Investopedia, this is the most important measure): A risk-adjusted performance measure that represents the average return on a portfolio over and above that predicted by the capital asset pricing model (CAPM), given the portfolio's beta and the average market return. This is the portfolio's alpha. If this definition makes your head spin, don't worry: you aren't alone! This is a very technical term that has its roots in financial theory.

The basic idea is that to analyze the performance of an investment manager you must look not only at the overall return of a portfolio, but also at the risk of that portfolio. For example, if there are two mutual funds that both have a 12% return, a rational investor will want the fund that is less risky. Jensen's measure is one of the ways to help determine if a portfolio is earning the proper return for its level of risk. If the value is positive, then the portfolio is earning excess returns. In other words, a positive value for Jensen's alpha means a fund manager has "beat the market" with his or her investing skills. Now, armed with this newfound knowledge, revisit the chart above.

Sharpe Ratio: A ratio developed by Nobel laureate William F. Sharpe to measure risk-adjusted performance. The Sharpe ratio is calculated by subtracting the risk-free rate - such as that of the 10-year U.S. Treasury bond - from the rate of return for a portfolio and dividing the result by the standard deviation of the portfolio returns. The Sharpe ratio tells us whether a portfolio's returns are due to smart investment decisions or a result of excess risk. This measurement is very useful because although one portfolio or fund can reap higher returns than its peers, it is only a good investment if those higher returns do not come with too much additional risk. The greater a portfolio's Sharpe ratio, the better its risk-adjusted performance has been. A variation of the Sharpe ratio is the Sortino ratio, which removes the effects of upward price movements on standard deviation to measure only return against downward price volatility.

The Sortino ratio measures the risk-adjusted return of an investment asset, portfolio or strategy. It is a modification of the Sharpe ratio but penalizes only those returns falling below a user-specified target, or required rate of return, while the Sharpe ratio penalizes both upside and downside volatility equally. It is thus a measure of risk-adjusted returns that some people find to be more relevant than the Sharpe. Thus, the ratio is the actual rate of return in excess of the investor's target rate of return, per unit of downside risk.

I know that many will probably try to excuse the hedge fund industry's performance, just as they excused the collapse of the investment banks ran by all of those smart people. I can hear the cackling now, "but no one could have foreseen devastation of this magnitude", "Who could have known?". Well, for one, I don't appreciate being called "no one." 

Debunking the "Nobody could have saw this coming" mythos!

Well, if nobody could have seen this coming, where did my returns come from? I actually believe nearly everybody ensconced in the industry saw it coming and were tunnel vision-ed to act accordingly. I am not even all that smart and I figured it out. Let's walk through this visually. Here is an opportunity to relate my proprietary results to the research that I released to the blog on a month by month basis. See the post "More on the accuracy of this blog's research" to follow the verbose postings and analysis that I used to power through each and every peak and trough on the graph below. You may peruse "Actionable Research and Ideas" for research and opinion that is literally time stamped along the lines of the peaks and troughs in the chart below. If there is anything that I am not lacking in, it is documentation. Click the graph to enlarge to full size print quality.

So, no one could have seen this coming, or guess the magnitude of the damage?!

1. I sold off my investment real estate in 2004 and 2005 (the peak in the NY Metro area was 2006).
2. I went short on real estate developers, builders, REITS, banks, brokers and insurers, in 2007 (see "More on the accuracy of this blog's research").
3. I called for massive bank failure in the first quarter of 2008, quite to the contrary of the Secretary Paulson's assertions (that's right, I've been keeping track of the credibility factor of our world leaders - see 
   1. Reggie Middleton says, "Don't believe Paulson": S&L 2.0 - bank failure redux
   2. The worst is behind us, unless massive bank failure is considered a bad thing
   3. Is Paulson to be trusted, or is this Bush Administration Shock and Awe, 2.0?
   4. Reggie Middleton asks, "Do you guys know who you're messin' with?")
4. I called the crash of the Credit Default Swap market (see The Next Shoe to Drop: Credit Default Swaps (CDS) and Counterparty Risk - Beware what lies beneath! and Reggie Middleton says the CDS market represents a "Clear and Present Danger"! ).
5. I called the demise or near demise of Bear Stearns, Lehman, Morgan Stanley (MS), GGP, Ambac (ABK), MBIA (MBI), Countrywide, Washington Mutual, and the extreme overvaluation of Goldman (GS) (see More on the accuracy of this blog's research).
6. I called the municipal sector bust (see The Municipal bond market and the securitization crisis  and The Municipal Bond Market and the Asset Securitization Crisis, pt 2).
7. I called the manufacturing and industrial sector crunch via leveraged loans and dried up financing markets (see The Asset Securitization Crisis Part 27: The Butterfly Effect ).
8. I even told my blog readers about the blood bath that would occur in global markets last week, and I posted the opinion Saturday evening. See Reggie's thoughts on financial mayhem coming into the week of October 5th, 2008. So, please spare me this "surprise of the century" B.S.

Hopefully, you get the message, but I can go on. I am not stating this to toot my own horn. At least half the people in the world are smarter than I am. The point that I am trying to make is that when your government, your investment advisor, your spiritual counselor or anyone else tells you that this was impossible to see coming - you can say they are full of bovine boo-boo. I will finish this rant with a follow up describing more of what I do. It will be called, "The difference between research and advice!"

Comments

[RSAAKS:]

could not figure out what the next bubble to burst is? If you want us to believe you, say what will happen next clearly, and let the readers judge if you were right. Showing charts of last 4 years does not arner credibility

2008 Oct 13 07:36 AM

[inca jones:]

blah blah blah. Are you expecting someone to read this garbage and beg you to take their $10M deposit since you're starting a new hedge fund?!

Why have Seeking Alpha's standards gotten so low? I may as well be on the Yahoo finance boards...

inca jones

2008 Oct 13 08:16 AM

[Fabien Hug:]

He saw it coming clearly and I regret I didn't follow. I was hoping for a better rally before the colapse. Read his past blogs.

2008 Oct 13 09:04 AM

[Reggie Midd...:]

re: 55065
I don't necessarily care whether you believe me or not. I am stating my opinion and findings, I'm not trying to convince you of their veracity. Your belief, or lack thereof, is a decision that you have to make for yourself - hopefully after ample due diligence. If you went through the text and links in the article, you should clearly see where I have illustrated in explicit detail what I believe the next bubble to burst is. I suggest you re-read the article a bit more carefully. The charts are of the last 16 months, not 4 years.

My performance is not based upon your belief, my friend.

RE: Inca
To each their own. If you feel it is garbage you should have moved on way before you got to the comments section. It is obvious you didn't read the article either (maybe too much time on the Yahoo boards?)

Let me walk you through an excerpt from the article:
"So, I have decided to simply go it alone through my single family office. What does this mean? Well, for one, I can now be much more explicit with what I do in my postings to the blog since I cannot be seen as selling investment management products - which I both do not do and do not want to do. I want to make that clear from the outset, again!"

I think this should mean that I WON'T be starting a hedge fund and I WON'T be selling investment management products!

Next to the Yahoo boards, where people call each other scum buckets as a greeting, you guys on SA are some of the most negative, hostile, and cynical commenters on the financial discussion circuit. What's the problem?

Peace and love, brother. It is perfectly understandable if you disagree with me, but that is not a valid reason to attempt to disparage me in public - particularly when you haven't even read the material.

Do we need a hug? I have lots of love to spread around.

2008 Oct 13 09:09 AM

[wsigler:]

Have decided you're smart, articulate, entertaining, verbose, brash, egotistical.....

Haven't yet added slick, manipulative, shyster, .....

Hope you'll keep writing so I can keep working on your profile :-)

2008 Oct 13 11:44 AM

[Lalo Palo Malo:]

Reggie.Please Comment on the REAL Next Bubble to Burst

prudentinvestor.blogsp...

2008 Oct 13 12:29 PM

[Lalo Palo Malo:]

That should have read "NEXT BUBBLE: $600 TRILLION Derivatives

prudentinvestor.blogsp...

Comments anyone?

2008 Oct 13 12:34 PM

[Reggie Midd...:]

re: wsigler:

I like your style :-)

2008 Oct 13 12:48 PM

[8 Alpha-Zulu:]

Reggie, I like how you think. Being a bubblesniffer is a lot more fun when you share brah... Let us hear more about what we have in store for us in terms of "the next bubble", willya?
Peace be with you.

2008 Oct 13 01:23 PM

[Takayama:]

Good to hear you again on SA. Credit also to SA for making this decision.
But one advice to you, young man -- improve on your style and work on garnering more support from readers.
Also, if your article is not short, you should have a strong and concise introduction and summary (conclusion).
Thanks for sharing your knowledge and opinions here.

2008 Oct 14 09:04 AM

[Reggie Midd...:]

Your welcome, Takayama.

2008 Oct 14 01:03 PM

[InvestBaboo:]

Dear Reggie:

Ignore the naysayers and the bashers. They are everywhere. As the saying goes "Dogs bark but the heaven doesn't care!'

I do have a question fo you. What I am interested right now is charting a course of investment action in this very difficult marketplace. When Warren Buffett picked up sizeable investments in GE and GS I figured here is a reknowned investor trying to tell us it is OK to invest in this market for high future returns. And then I watch Jim Rogers who wants to hang all our Fed officials and politicians for destroyong our economy and one who predicts end of the U.S. economy and U.S. dominance of world market and predicts runaway hyper inflation. Buffett is saying "Go ahead, invest in equities.." and Jim Rogers saying "Buy tons of gold and secure foreign currencies and short everything U.S..."

Where in the blog have you given direction to investors with regards to this conficiting scenario? Appreciate your help.

2008 Oct 14 07:04 PM

[Reggie Midd...:]

Thanks. I have tried to shy away from actually giving investment advice, with the specter of the hedge fund being part of the cause. Since that is no longer an issue, I may be freer of tongue, but I am still no giver of advice. I try to encourage everyone to do their own homework, using my blog as a giant cheat sheet, so to say.

Doing your own homework is quite important, for although quoting name brands makes for profitable media fodder, it doesn't do well for investors - contrary to popular opinion. See boombustblog.com/index... (be sure to read the comments as well), boombustblog.com/index... and particularly boombustblog.com/index...

Name brands are just that, name brands. Some are good investors who make a lot of money investing, others are good marketers who make a lot of money marketing. Buffet's last investment banking foray cost him a fortune in headaches, money and resources. His track record in that arena is not good. Now if he took the big stake in an industrial...

There are many unknown investors who have trounced the name brands of a decade or more (like the handsome brother on the keyboard right now), you just wouldn't know who they are because they are unknown.

Taking investment advice from Rogers or Buffet, or the media darlings without empirically quantifying their risk adjusted success is the same as paying $215 for name brand sneakers - you are being hoodwinked by the marketing machine. I am not saying who is a good investor or who is not, but following blindly due to name branding will put you in the poor house, whether it is buying sneakers, stocks or commodities.

2008 Oct 15 05:09 AM

[Richard Wilson:]

Thanks for the mention, always appreciated.

- Richard
Richard Wilson
Hedge Fund Blogger.com

2008 Dec 11 11:58 AM