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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