Hedge Fund Monitor

CALLAN INSTITUTE Hedge Fund Monitor

Second Quarter 2017

Bear Ahead? Beware of the ‘False Charge.’

FIDUCIARY PERSPECTIVES

“Be Prepared” I wondered aloud whether the pot-clanging technique still —Boy Scout motto worked. It did not, he quickly countered; bears today were quite used to that behavior. Now you need to holler and throw rocks When I was a Boy Scout backpacking in the Sierras, I thought at them, he declared.1 I had timeless advice for dealing with black bears rummaging through campsites looking for an easy meal. The bears were Seeing me gob-smacked by his provocative advice, he crisply nimble climbers, and many had already figured out they could added an important disclosure, “But beware of the false snatch food that had been stored high in trees by ropes. charge.” Satisfied that he had dispensed sound advice with all the necessary disclosures, he left us to ponder the worst-case To manage this well-known risk of motivated bears, my troop scenarios implied in his warning. It seems today’s more condi- assigned shifts of scouts at night, rotating every hour, to watch tioned bear has learned how to check the resolve of its “coun- for marauding bears on the perimeter. To scare them off, the terparties.” More on this later. sentry clanged a pot or made some raucous noise. That simple but chaotic-sounding response seemed to work fine—the four- As we look at capital markets today, we must worry about footed opportunist, however hungry, usually got the hint and another kind of evolving bear that tests the courage of our con- strolled off in search of less noisy campsites with a hint of food victions. I am not referring to the traditional bear associated in the air. with steadily declining stock prices driven by a looming reces- sion or other deteriorating fundamentals, but rather one that Fast forward three decades. I recently returned to the Sierras, suddenly explodes on the scene with, er, barely the slightest sharing a similar backpacking experience with my son. We provocation. After a quick purge of market confidence, prices came upon what appeared to be an experienced backpacker. recover speedily and fears subside. Given how fast information Unshaven with layers of trail dust, he seemed qualified to dis- travels, these flash crashes are predictably unnerving, particu- pense advice about risks in the wilderness, including bears. larly for the casual observer or inexperienced investor.

1 For more tips on bear safety, see www.fs.fed.us/visit/know-before-you-go/bears.

Knowledge. Experience. Integrity. 1 FIDUCIARY PERSPECTIVES (Continued)

This Fiduciary Perspectives reviews recent historical examples of these sudden market dislocations that proved to be “false LTCM Crisis – September 1998 charges.” A cursory look at each event’s contributing factors A giant hedge fund’s normally unrelated trades became can help to illustrate what defines a temporary crash versus a related. LTCM’s collapse spooked markets but also bolstered more self-sustaining, systemic move like those that followed the credibility behind the ‘Greenspan Put,’ the view among the Dot-Com Bubble in the late ‘90s and the Global Financial traders that the Federal Reserve and other central bankers Crisis in the mid-2000s. Given this distinction, risk-seeking would act to stem market downturns. behaviors leave some investors more exposed than others to a sudden bear market rout and rebound. Aware of these behaviors, investors can be better prepared to protect their own capi- One often-cited “correction” that did not translate into a full tal and position themselves for a safer investment experience. bear market surrounded the plight of Long-Term Capital Management (LTCM) in 1998. Prior to its demise, this $4 bil- “Forewarned, forearmed.” lion hedge fund boasted a well-diversified portfolio loaded —Ancient Roman Proverb with a wide array of profitable but normally unrelated trades (e.g., yield curve arbitrage, emerging market debt, credit arbi- Respect Wildlife trage). Comforted by its diversification, LTCM applied a signifi- Although capital markets are much more efficient than in years cant degree of leverage (more than 25x its equity capital) to past, they are also potentially less stable in the short run. generate attractive risk-adjusted returns. However, as events Sudden crashes are the manifestation of this instability, and around the world took their toll on investor confidence (e.g., a they can affect broad markets, niche markets, or risk factors series of emerging market currency devaluations in Thailand within a market. Then, almost as soon as these markets crash, and Russia), the S&P 500 fell 15.4% in July and August 1998. prices find their footing and jump back to their former levels, In this nervous setting, the previously accretive leverage com- leaving witnesses to wonder what just happened. bined with unexpected illiquidity to create a toxic mix for LTCM in September. Under the supervision of a Federal Reserve Ill-fated investors can suffer permanent damage for one of two worried that the fund’s collapse would lead to broader losses reasons. First, investors lose their resolve and sell risk assets throughout the financial markets, LTCM’s creditors assumed to be in safe harbors until the risk becomes better understood, control of the portfolio. but the market rebounds too quickly for them to get reinvested. Second, counterparties to investors, such as financing agents The process illustrated how LTCM’s trading partners could or underlying equity investors, yank their capital when margin step away from their bids as they witnessed the equity capital calls are unanswered. Since catalysts of such flash crashes of an overly confident risk taker being consumed by widening may be tied to deep-seated fears, the sudden ferocity can spreads. However, once the losses affecting LTCM—as well prompt any nervous participant to run for cash, Treasury as Russia and other related trades—were realized and dissi- bonds, or other havens. pated, the market regained its footing and marched to higher highs by the end of 1998. That correction of 1998 proved to be History has a variety of market meltdowns that occurred sud- only a brief setback for other long-term investors of risk capital. denly, leading to massive losses for the least prepared, or most Based on that experience of “temporary” systemic risk being over-confident, investors. Then markets quickly recovered reversed, in part by the Fed as a buyer of last resort, the nar- without seemingly any lasting damage to those able to stay rative behind the “Greenspan Put” gained wider acceptance. invested or move more nimbly. Consider these three examples: That is, market speculators were emboldened to buy future

2 FIDUCIARY PERSPECTIVES (Continued) market dips during brief spasms when systemic risk bared its or even positive, depending on whether they were able to add to teeth, confident that central bankers would step in at moments their positions that had become even more attractively priced. of peril.

Flash Crash – May 6, 2010 Quant Crash – August 2007 A meltdown in the Dow Jones Industrial Average over a matter Some quantitative strategies imploded under pressure from of minutes showed how fragile markets are, even with steps external events. Highly leveraged firms were exposed to by regulators to control market behavior. painful losses; those more defensively positioned were able to ride out the storm and emerge in good shape.

During the recovery from the Global Financial Crisis (GFC), some key developments affecting the market’s underlying Another notable “false charge” scared investors in early August liquidity became increasingly apparent. To address the unsafe 2007 with the Quant Crash, when a confluence of events led to levels of leverage in the U.S. banking system that helped to losses of 30% or more, primarily in quantitatively driven strat- precipitate the GFC, the Dodd-Frank legislation effectively egies with highly levered equity capital. These strategies bet barred financial institutions backed by federal deposit guar- on the mean-reverting relationships between overvalued and antees from providing market liquidity. Consequently, when undervalued securities. Since such strategies are not neces- markets fall to attractive levels, these potential buyers with big sarily betting on the direction of equity markets, broader market balance sheets are less able to buy when others are frantically participants were only marginally affected. Because managers selling regardless of price. of quantitative strategies often have similar, if not identical, trades with varying degrees of leverage, their equity at stake is Meanwhile, as a result of SEC regulations to promote efficient subject to counterparty risk. markets, high-frequency trading firms assumed a growing presence in the most liquid markets. These firms, with their However liquid the underlying factor exposures were, the lever- highly automated order-generation processes, aggressively age needed to make those strategies profitable enough to pursue tested the market’s bids and offers to identify pending trades with scale was a key issue. When significant losses occurred, from larger market-moving investors like mutual funds. Being even if not realized, the counterparties could take full control of able to discern when to trade in front of those orders became those positions to protect themselves while demanding more a profitable business. equity capital from the affected manager. The highly leveraged quant managers unable to provide that capital realized losses On May 6, 2010, the combined effect of the sidelining of when the prime brokers liquidated their positions. Others with massive balance sheets and rise of high-frequency traders less leverage, or more equity capital to contribute, were able to contributed to a self-sustaining market sell-off. With the retain positions, even while the liquidation process caused the Greek debt crisis agitating investors, the Dow Jones Industrial relative value spreads to widen to more painful levels. Average fell almost 9% within minutes, only to recover most of those losses a half hour later by the market’s close. In this Before the end of August 2007, after the liquidation process market freefall, some individual ETF and stock prices fell to unwound the weaker hands in these trades, the unusually wide pennies, far below their underlying fundamental values. In spreads reversed quickly. When the dust settled for that month, the aftermath of this Flash Crash, regulators added more most of the surviving quant players were only marginally down “circuit breakers” to stop trading after certain thresholds of

Knowledge. Experience. Integrity. 3 FIDUCIARY PERSPECTIVES (Continued)

Exhibit 1: Low Levels of VIX Indicate Complacency About Market Risks

CBOE S&P 500 VIX™ S&P 500 Price 80 2,400

70 2,100

60 1,800 S&P 50 1,500 500 Price 500 VIX™ 40 1,200

30 900

CBOE S&P 20 600

10 300

0 0 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016

Sources: NYSE, S&P 500

price movements were breached. Yet trading markets are still Although empirical evidence suggests the VIX is not predictive fragile given their highly fragmented but still highly connected of future volatility, it does reveal the degree of anxiety among community of buyers and sellers. investors today. Higher levels of VIX indicate that investors are more defensively positioned or otherwise reducing risk. Lower Looking for Signs of Bears Ahead VIX levels suggest investors may be lulling themselves to These false charges that threaten market collapses will con- sleep while accepting greater exposures to risk, such as lever- tinue to test investor resolve. Despite the efforts of authorities age. When such complacency is rewarded long enough (such to regulate market behavior, sudden bouts with bearish mar- as with strategies that sell volatility embedded in derivatives), kets are a fact of life. Given that information is now being trans- risk experts remind us that markets can become more fragile, mitted in nanoseconds, it is important to build awareness about not less, leading to that potential “Minsky Moment.”3 As noted the risk of flash crashes. To that end, investors need to monitor above, higher-than-average leverage can be a lethal burden in evidence of complacency combined with leverage embedded suddenly tense moments, however sound the economy may in the markets. be at that particular moment.

One measure of expected risks in the market is the VIX,2 which In recent weeks, the VIX measure has shrunk to historic lows tracks the expected volatility of market prices embedded in the (Exhibit 1), which suggests that investors are feeling rather options market. This crude proxy for market uncertainty mea- relaxed about future movements in the equity markets. Even sures the expected standard deviation of the S&P 500 Index Treasury markets are expecting historically little movement over the next month on an annualized basis. Reflecting struc- in interest rates, as evident in a measure comparable to VIX tural nervousness of the broad investor community, this implied called the MOVE Index.4 volatility is usually higher than actual, or observed, volatility in the markets at any given moment.

2 www.cboe.com/products/vix-index-volatility/vix-options-and-futures

3 www.economist.com/news/economics-brief/21702740-second-article-our-series-seminal-economic-ideas-looks-hyman-minskys

4 www.bloomberg.com/news/articles/2017-05-10/bond-market-volatility-plunges-to-lowest-since-august-14-chart

4 FIDUCIARY PERSPECTIVES (Continued)

Despite geopolitical risks flaring around the globe, the aver- Be Mindful of Your Neighboring Campsite age investor is evidently less concerned today about rapidly Only in hindsight can we conclude whether a sudden correc- falling stock prices or rising interest rates. Lately events have tion of, say, 10% in a given market is a temporary setback in supported that consensus. Recent Dutch and French elec- an otherwise rising bull market.5 And a bear market (typically tions have postponed the threat of any pending euro break-up. referring to a drop of 20% or more from a high) can get its legs Furthermore, the commonly held view of China driving global from an initial event that seems isolated and not systemic. The growth remains intact, given the country’s unprecedented bear market of the early 1990s can trace its initial descent to credit growth, however unsustainable it may be. Here in the the failed United Airlines buyout.6 U.S., equity markets remain confident in the prospects of fis- cal stimulus and less regulations despite increasingly distract- For that reason, it is always important to know where you ing missteps by the new Trump administration. Sit back and stand and how well you can hold that position, particularly as relax, as markets seem to be telling us to be a happy camper. it relates to leverage and counterparties that can force you to Within this currently stable setting, a contrarian might infer that move. With less baggage, one is more able to rebalance and investors are, more or less, sleeping in their tents while unex- invest in new opportunities without being overtaken by the bear pected risk could be approaching in the darkness. Given such market, whenever it may suddenly appear. complacency in the market, investors should be vigilant about unexpected risks, as fragile market behavior can quickly shift Meanwhile, being aware of everyone else’s baggage is instruc- from calm to agitated. tive. Evolving degrees of leverage can give you insight on how well your peers are prepared for market moves. For example, “Don’t be the bunny.” NYSE margin debt is at its highest on a real-adjusted basis, —“Urinetown: The Musical” after rebounding from a cyclical decline following China’s brush with economic disaster at the beginning of 2016 (Exhibit 2).

Exhibit 2: Sharp Rises in Margin Debt Often Forecast Market Drops

NYSE Margin Debt Growth S&P 500

1,500%

1,250%

1,000%

750%

500% Cumulative Growth

250%

0% 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016

Sources: NYSE, S&P 500

5 https://infogalactic.com/info/List_of_stock_market_crashes_and_bear_markets

6 https://en.wikipedia.org/wiki/Friday_the_13th_mini-crash; http://www.nytimes.com/1989/10/25/business/united-airline-deal-a-costly-fiasco.html?pagewanted=all

Knowledge. Experience. Integrity. 5 Such evidence suggests investors are reaching for more return “To be prepared is half the victory.” with more debt than ever before. The reappearance of any —Miguel de Cervantes threat to the global economy could trigger self-sustaining panic among such peers as they deal with their respective counter- Best Hedge for Bear Attacks party demands for cash. Remember our bear in the woods testing our resolve to stand our ground? What happens if the bear realizes the false Many other measures of excessive leverage or insufficient charge is not enough anymore? Because a bear can out- collateral protection exist for investors to monitor these poten- run any human being, uphill or downhill, wildlife experts say tial threats. Improving risk transparency from managers helps to never run from a bear.8 So be mentally prepared to stand their investors “own” the underlying risks and their investment your ground. And calmly find that bear spray canister that your rationale. While proprietary reports of risk exposures are use- worry-free companions laughed at earlier … just in case a false ful, standardized risk report templates, such as Open Protocol,7 charge becomes more than that. provide common reference points on those exposures. As such exposures ebb and flow over time, investors can decide whether For investors, the same rules apply to the bears they need to their respective risk tolerance is consistent with the investment be concerned about. Most investors familiar with traditional profile of an expected return and its associated risks. market cycles have steeled themselves with broad diversification and rebalancing plans, among other long-term risk-miti- The need to regularly underwrite one’s conviction in the most gating techniques. When investors have set aside sufficient objective manner is true at the manager level or total portfo- reserves to endure a potential bear market, time is generally lio level. Without that added insight and supporting conviction, everyone’s friend as economies and markets eventually heal. unprepared investors are more prone to run when confronted With the added risk of false charges, investors need to be both with uncertainty, the unmeasured form of risk. As highlighted defensively prepared at all times and keenly aware of their in Exhibit 1, reaching for more return when underlying values surroundings. If their reserves have become increasingly thin, get stretched is a challenging proposition among crowds doing time may no longer be their friend (either during false charges the same. Investors who cannot afford the risk should not take or traditional bear markets); the smell of too much leverage it on; lowering one’s return expectation can be the more profit- and illiquidity can eventually invite the next hungry bear into able decision. their campsite.

Do you know about Callan’s hedge fund advisory services? ●● Education—Determining if hedge funds are appropriate for a client’s overall strategy ●● Investment policy—Documenting hedge fund goals and guidelines ●● Asset allocation—Defining the appropriate strategic mix ●● Manager structure—Assessing a manager’s fit within a portfolio ●● Manager search—Following a defined process for identifying qualified managers of diversified hedge fund solutions ●● Performance evaluation—Measuring how well a hedge fund portfolio is adding value relative to its peers

For more information, please contact your Callan consultant or Jim McKee at 415.974.5060 or [email protected].

7 http://www.hfsb.org/toolbox/open-protocol-op-risk-reporting/

8 http://westernwildlife.org/grizzly-bear-outreach-project/bear-safety/

6 Hedge Fund Monitor is a quarterly newsletter that gives our clients a current view of industry trends affecting this popular alternative investment.

Authors

Jim McKee is the director of Callan’s Hedge Fund Research group. He specializes in hedge fund research addressing related issues of asset allocation, manager structure, manager search, and performance evaluation for Callan’s institutional clients.

Sean Lee, CFA, is an assistant vice president in Callan’s Hedge Fund Research Group addressing Callan’s institutional client needs in asset allocation, manager structure, manager searches, and performance evaluation.

Editor – Stephen R. Trousdale; Designer – Jacki Hoagland

About Callan Callan was founded as an employee-owned investment consulting firm in 1973. Ever since, we have empowered institutional clients with creative, customized investment solutions that are backed by proprietary research, exclusive data, and ongoing education. Today, Callan advises on more than $2 trillion in total fund sponsor assets, which makes it among the largest independently owned investment consulting firms in the U.S. Callan uses a client-focused consulting model to serve pension and defined contribu- tion plan sponsors, endowments, foundations, independent investment advisers, investment managers, and other asset owners. Callan has five offices throughout the U.S. For more information, please visit www.callan.com.

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Certain information herein has been compiled by Callan and is based on information provided by a variety of sources believed to be reliable for which Callan has not necessarily verified the accuracy or completeness of or updated. This report is for informational purposes only and should not be construed as legal or tax advice on any matter. Any investment decision you make on the basis of this report is your sole responsibility. You should consult with legal and tax advisers before applying any of this information to your particular situation. Reference in this report to any product, service or entity should not be construed as a recommendation, approval, affiliation or endorsement of such product, service or entity by Callan. Past performance is no guarantee of future results. This report may consist of statements of opinion, which are made as of the date they are expressed and are not statements of fact. The Callan Institute (the “Institute”) is, and will be, the sole owner and copyright holder of all material prepared or developed by the Institute. No party has the right to reproduce, revise, resell, disseminate externally, disseminate to subsidiaries or parents, or post on internal web sites any part of any material prepared or developed by the Institute, without the Institute’s permission. Institute clients only have the right to utilize such material internally in their business.

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