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| Comment: From the Editor |
Bitter Fruit
Dwight Cass
12/01/2006
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Rarely do you see a finance
minister berating foreign investors for flooding his country with money. So it
came as a surprise to see New Zealand’s Michael Cullen telling the
Financial Times in mid-September that the hedge funds that were plowing capital
into kiwi dollars were being "irrational," in light of the country’s fiscal
mess. "Just how badly do we have to do on the current account before [investors]
take notice?" he asked. Those private investors exposed to the funds that were crushed
by the precipitous decline of the kiwi and the Icelandic koruna in the first
quarter of 2006 may echo Cullen’s question. His country’s current account
deficit (the world’s second largest) has not materially improved. So why have
the hedge fund carry traders—who borrow in cheap currencies like the yen and
invest in high-yielding ones like the kiwi and koruna—flocked back to New
Zealand and Iceland, revisiting two of the recent trades they are presumably
most eager to forget?
The principle reason seems to be the lack of underexploited
opportunities elsewhere. The capacity effect (the idea that the surfeit of
capital flowing into hedge funds has swamped the market aberrations that they
exploit) is—its growing legions of believers say—now clearly observable in the
industry’s uninspired returns. As Worth
went to press, the Credit Suisse/Tremont Hedge Fund Index, a fund performance
benchmark, was up only 7.5 percent for the year to date. The S&P 500 was up
7.7 percent and the Dow Jones Industrial Index had just surpassed its all-time
high. The gross indifference to risk inherent in the kiwi and koruna
carry trades reflects a growing sense of panic in the industry. Rational
investors should be loath to take on these plays, especially in light of the
tenuousness of the world’s high-yielding currencies. The Thai coup, Hungarian
riots and Brazilian scandals are preying on most traders’ nerves. Yet firms continue to pursue irrationally risky strategies
because they need to justify their 2-and-20 fee structure, which is hard to do
in an environment where low-risk (and fee-free) six-month Treasuries are
yielding about 5 percent. Their attempts to swing for the fences have had tragic
consequences for their investors. Amaranth Advisors lost $6 billion in a few
months; Vega Asset Management lost even more over the course of the past three
years; Pirate Capital has had to scramble to avoid capsizing as its staff
decamped for calmer seas. Hundreds of other funds have sunk. Smart Money
Despite this, there are still both cyclical and secular
economic and market developments that smart funds can exploit. The slowing of
the U.S. economy, the growing concerns about the health of the credit markets,
global macroeconomic imbalances . . . these and other trends offer openings for
prepared and observant fund managers. For example: • Those who expect the ongoing slowdown in
U.S. GDP growth to end in recession are considering whether this will dampen
inflationary expectations enough to lead to a long-bond rally. Since the price
sensitivity of long-tenor bonds to changes in interest rates is very high, a
decline in interest rates would lead to a relatively large increase in their
value. • Those who expect the credit markets to
tank are buying protection in the credit derivatives market and shorting the
monoline insurance companies that guarantee the upper tranches of a lot of dicey
collateralized debt obligations. • In what George Feiger, head of Contango
Capital Advisors, calls "the anti-LTCM trade," those who believe that Italy will
be forced out of the euro, either because its fiscal profligacy causes its debt
to fall below investment grade, or because it simply decides the inflexible
exchange regime is gutting its competitiveness, are looking for ways to short
the debt via the cash or credit derivatives markets. Unfortunately, both
strategies are costly, and will become more so as the crisis
approaches. Clearly, the capacity effect has not extinguished every bright
idea. But investing with one of the handful of intellectual leaders able to
identify and trade on an ever-dwindling number of untrammeled market
opportunities is becoming more difficult, and more essential.
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