Saturday, October 4, 2008

Hedge Funds and Opportunities

Hedge funds have been taking it on the chin. A whose whose of hedge funds (guys I track closely) are down from 10 to 40% on the year. It has just been brutal with many closing up shop. The article below talks specifically about Mark Sellers of Sellers Capital who I have always had alot of respect for. He is closing shop after being down 20% ytd. In his case, considering the returns he has had over the last few years, I don't think he had to shut his doors but he talks about the stress of what is going on (I could talk about that at length in another post). The article goes on to talk about smaller funds struggling compared to larger funds. I don't really buy that argument. There are many many more smaller hedge funds, so on an absolute basis you will see more smaller hedge funds closing up shop. Thanks go to Jody and Pete.

Mark Sellers III's hedge-fund career peaked this summer about the time he turned 40. Then it cratered.

Mr. Sellers, who once managed close to $300 million, is shutting his Chicago-based firm and retiring, at least until his distaste for the pressures of managing other people's money subsides.

"What I've learned about the hedge-fund business is that I hate it," says Mr. Sellers, a former stock analyst with Morningstar. "I have enough money that I don't have to work, and why should I put myself under that much stress?"

The past year has been brutal for hedge funds, and September looks to be the worst month in a decade in the industry, according to Hennessee Group, which advises hedge-fund investors. Funds of all sizes have been battered, but the bigger players can often endure rough times.

The day of reckoning can arrive remarkably fast for managers with assets under the half-billion-dollar mark, like Mr. Sellers, who started July with performance up 50% on the year but by the end of last month was down 20%.

"There are real questions about who can stay in business," says Andrew Fishman, president of Schonfeld Group, a New York brokerage and trading firm whose hedge-fund clients range from about $200 million to $3 billion in assets. The most vulnerable are under $1 billion, he says. "There are guys who should not have been in business, and this will force them out, but guys don't want to give up easily."

There is no doubt the hedge fund blow up has started. The question is how far it has to go and what that means for stock prices. Below is a graph from a recent Bridgewater presentation showing how hedge funds have been deleverging (click for bigger picture). I don't really like the graph because you lose sense of scale. For example, back in 1997 you have maybe a 100 billion in assets managed by hedge funds. What was the leverage? 150 billion would be 50% leverage. Now you have 1,500 billion. That same leverage would be 2,250 of levered assets. Are we in line after the latest deleverging or is there still more to go? We may actually have less leverage than back in 1997. You can't tell from the graph because the scale is all out of whack. What you can tell is that starting in 2003 the amount of assets going into hedge funds broke from the trend line and started a much steeper trend line up. This has flattened and here is where I think the real danger is versus the deleverging. This is similar to what you saw in housing prices. Housing prices left their long term trend line around 2002 starting a much higher trajectory up before rolling over. You may for the first time ever see decreases (possibility dramatically) in hedge funds assets under management. Throw on the leverage issue and you are talking about billions if not a trillion leaving the market. Sure some of this will get recycled but most of it in the short term will seek out the same "safe havens" the rest of the cash has been seeking out. This process was greatly accelerated with the total idiotic actions of the SEC on short selling. This has greatly amplified the problem and quickened the unwind causing massive dislocations in the market and I fear maybe even worse dislocations in the coming weeks. The quickening of this process I believe will also have negative impacts on the actual fundamentals of the economy. The unintended consequences I fear could be more brutal than anything else the government has done so far. You cannot have such a big market player shrinking so quickly.
These dislocations do create opportunities though (assuming it doesn't take out the whole system). Below is a graph tracking Mueller Water Products A and B shares. This is a company I have followed for years. The A and B shares essentially have the same intrinsic worth. The absolute only fundamental difference is that the B shares actually have more voting power than the A shares and so would technically have slightly higher intrinsic worth. However, for technical reasons the A shares often times trade at a slight premium. The A shares are part of an index so ETF's and other index tracking funds buy the A shares. Also the B shares have historically had slightly less liquidity. Well starting a couple of weeks ago and peaking last Monday when the market crashed over 7%, the B shares just collapsed compared to the A shares creating a huge gap between the A shares and the B shares. On a percentage basis it was the biggest gap ever. The biggest gap on an absolute basis occurred when the A shares joined the index (I think the Russell 3000). It was obvious that a hedge fund who owned the B shares was liquidating their position and fast. So the trade becomes to short the A and long the B. I never talk about trades on this blog but I figured this would be an exception. I moved 15% of my portfolio into this trade with a spread between $2.40 and $2.00 (the spread is down to $1.54). Their are two risks that essentially are not risks. One is that the gap widens and two is that the gap remains wide for a long period of time driving down your IRR. Considering the other investing opportunities out there, I was more than willing to take both risks especially considering in the long term there was essentially no risk in taking an impairment to your capital investment. Even if the company goes bankrupt you make money. These are the opportunities that are starting to pop up. I have been saying for over a year that the contrarian bet was that things were going to get worse than what everyone expected. We are quickly closing that gap and the contrarian bet is becoming that things are not going to get as bad as what everyone expects. We are not there yet (especially with the freight train of hedge fund liquidations on top of us) but opportunities like this arbitrage trade are starting to come to light.


Anonymous said...

I came across your (thoroughly interesting) blog while searching for "Mark Sellers" after reading that he will close his hedge fund. I too initially valued his opinion (and FT articles) until I read his inane, kooky speech at Harvard, where he claimed that one can only be a successful investor if hard-wired that way from an early age. In case your reading this...Hey Mark - How's that pseudo-science working out for you (or Bill Miller)? And stop ripping off Jonathan Niednagel!

Market Seer said...

Thanks for the kind words on the blog.

My guess is what Mark Sellers was referring to was speculation Warren Buffett made that you may have to be born with something to be a great value investor because it is so counter to how the human brain ticks. There are 100k millionaris everywhere who are heavily in debt who drive the porsches, stay at the 5 star hotels etc. It is natural for the human brain to like things that are flashy and doing well versus finding those companies who are hated and struggling. It sounds from you comment that Mark Sellers may have taken it a step further from Buffett's speculation but my guess is that is what he was referring to.