Wednesday, November 4, 2009

Did We Learn Anything? Carry Trade Edition

In theory, it does look like hedge funds are BACK, though it is a bit concerning that EVERY strategy (except those neutral or short equity beta) has been a winner. Back to this in a moment...

While many hedge funds make claims that they don't have any equity beta and the returns are alpha driven, as a group that is certainly not the case. That said, over the long term these funds have done exceptionally well, providing equity like returns when equity markets were up and dampening the downturn when equities sold off.

The problem for hedge funds comes when the correlation among all risk assets approaches one (i.e. the EVERY strategy performing in line issue - see the reverse of the top chart from last November). When 'all assets' sold off in the Fall of 2008, leverage became an investors worst enemy as it meant forced selling to meet liquidity needs. It was only the MASSIVE injection of liquidity from the Fed that stopped the risk asset sell-off downward spiral that had the potential to take out any and all levered investors (along with hedge funds, we can throw banks, endowments, and even homeowners in the mix).

My concern now is that it appears we haven't learned anything from the turmoil that happened all of 8-12 months ago. As Nouriel Roubini recently pointed out, the correlation of all risk assets has approached one as all assets have all moved in one direction... up.

Why? One reason is the world's investors are turning to the US dollar for their carry trade currency of choice (if you haven't read it yet... READ IT). At a high level it goes like this... the dollar's decline is a one way bet. So why wouldn't a foreign investor:

  • Borrow the dollar at a 0% rate
  • Plan to pay the dollar back at some point in the future when it is worth 10-20% less in their local currency
  • Use that money to invest in ANY risk asset (as long as the asset doesn't lose more than the gain on the dollar short, the investor wins... so why not ratchet up the risk?)
The issue is that at some point the dollar will stabilize (or gain in value), increasing the "real" cost of borrowing the dollar.

BUT... if the correlation of assets purchased is near one on the way up, it is sure as hell going to be that high or higher on the way down. And what happens to all these investors that are attempting to leave the same exit door at the same time? Massive re-purchasing of the dollar and massive selling of any risk asset... joy.

Source: Barclay Hedge


  1. Should be "Barclay's" not "Barclays" ... Barclays is the Bank which is not the same as Barclay Hedge

  2. Jake,

    First, I'm very skeptical of one month charts especially when most hedge funds have much longer lock up periods.

    Second, I think your 12 month return comparison of fixed income, commodity and equity hedge funds to the S&P 500 is misleading. It would be helpful to add fixed income mutual funds and blended mutual funds (60/40 bonds/equtiy etc.).

    Stocks were bound to be a lousy investment over the past decade due to historical (and hysterical) over-valuations. Not so with bonds.

  3. that's not 1 month, its YTD across hedge fund strategies... i should make it clearer.

    point taken for other asset classes though

  4. that's not 1 month, its YTD across hedge fund strategies


    My bad. The "YTD" is really small on my screen but the "October" heading sticks out. You'd think I would have noted the ~ 15% gain in the S&P 500. Ka-dur.

    Anyway, it might make sense to add one similar to this in the comparison:

  5. Jake - quibbles aside excellent points with which you know I'm onboard. Not only haven't we learned anything but the risks of getting re-trimmed rise as we speak. Warren wants us to invest when intrinsic value exceeds market by 25%. Now that we're in a regime where the reverse is true, or worse, on a liquidity driven carry trade what does that tell you? More importantly what does it tell you about people's thought processes?

  6. That said, over the long term these funds have done exceptionally well

    Well I guess if you don't include fees, and all the funds that close!

  7. I should have included the fact that Barclay Hedge shows after-fee performance... not positive about survivorship bias though.