Edited Version of Letter written in December 2011
Although, in many ways much has happened since the end of 2011, in reality few of the issues outlined here have actually been resolved. In spite of this, the equity markets have soared and the fixed income ones have yet to need to correct. Pension funds and investors have been able to enjoy strong returns that helps their level of funding, but the degree of fear remains quite high. I have changed none of the original commentary.
THE WORLD
We know it must come as a complete shock to all our readers that there are unresolved issues in the European Union and around the globe. The wild swings of pessimism, followed by powerful relief rallies, based on little more than short-term expedients continue to make this an extraordinarily tricky environment for virtually all investors. What is likely to create a meaningful paradigmatic shift at this point in time? Unfortunately, we see nothing on the horizon; politics and economic influence on politics are likely to drive the status quo among power brokers leading to a period of continued uncertainty. In the past military intervention has been the most common outcome of severe economic shifts or major shifts in balances of power; however, in an era of greatly changed military capability and much more diffuse and broad-based forms of communication, historic patterns are not necessarily great predictors. In order to evaluate the situation, though, it is necessary to understand underlying fundamentals.
The problems. Boiling everything down, the biggest global issue is that developed nations – Europe, U.S.A., Japan, Australia, etc. – as nations, have developed a sense of entitlement and have passed on a series of entitlements to a broad range of their citizens in the forms of benefits (retirement, health care, services, etc.) that might or might not have been reasonable at the time of granting, but today are becoming increasingly less sustainable. The severity of the problem has increased dramatically, the longer it has been swept under the carpet. Whether that is the increasing budget deficits or unrealistic pension (social security or private) structures in the U.S., the demographic nightmares of Japan and larger swathes of Europe and the concomitant social programs widely available in these social democracies. In a nutshell, these are either currently not affordable (as in Greece and similarly stressed economies) or not sustainable in most other developed nations that are becoming more and more dependent on effective ‘subsidies’ from developing nations such as the BRIC nations. Hardly surprising, it is much more difficult to get individuals to accept cutbacks than to take on cheap loans and increase material standard of living. Discontent is in the air around the world, as Wall Street, Boston, San Francisco and even Detroit are ‘occupied’, students (and others) storm through the City and other parts of the U.K. and pre-riots occur around the Continent. Yet, an equilibrium needs to be established. Either privileges need to be revoked, inflation allowed to devalue the accumulating debt (and individuals’ wealth) or taxes increased sufficiently to afford the current high levels of spending. We ignore the obvious increasing the efficiency of programs – something surprisingly resistant to any form of applicable change!
Who is currently the tallest midget? Europe is not a candidate. It remains in the spotlight as the most obviously dysfunctional and conflicted geographic region, with a fundamentally challenged currency structure highlighted by massive cultural, economic, tax and productivity differences across the continent. Yet, Japan’s insistence on an ostrich-like approach to ignoring the issue does not place it much further up the ladder. The U.K., Canada and Australia have their own issues and Switzerland and Norway are simply too small to have major global impact. That leaves the U.S. as the most likely destination of ‘flight to safety’ capital, in spite of a large and growing set of deficits and a political system that is controlled by interest groups that fund the political process, and are rife with self-interest that can prevent the types of solutions that a free market economy would advocate. None of this makes us feel sanguine about the future. Yet, as 2008 has clearly demonstrated, there is a sufficient existing ‘reservoir’ that even crises are unlikely to cause an immediate collapse. We have experienced muddling through, but with a mounting severity, it is uncertain just how long this laissez-faire attitude can continue.
Above and beyond the national and regional struggles there remain the large unsolved issues surrounding the global financial system. This remains in need of a revision that unfortunately seems unlikely to happen in the foreseeable future. The desire to regulate is laudable but unrealistic even in individual countries, let alone across national borders. Without a concerted effort to arrive at a holistic global situation, there is no way to significantly improve the banking, insurance and other overlapping financial sectors. And with apparently insurmountable internecine strife among regulatory bodies within specific regions, it is hard to imagine a solution brokered across borders. With unclear mandates as to their respective functions, banks and other financial institutions blend providing services with risk taking in ways that are unclear, with mandates that are equally lacking in precision.
The solutions. There are no clear multi-faceted solutions to our current financial mess. We have little confidence in top-down solutions, given an apparently intractable and labyrinthine political landscape. As unpopular and improbable as this might sound, it will be financial institutions themselves, pressured by their investors, debt holders and clients that will need to articulate and implement clear solutions. These will entail establishing appropriate balances among risk taking and service providing, setting appropriate balance sheet parameters, particularly vis-à-vis leverage, and forcing the implementation of employee compensation systems that reflect a longer time frame and better align employees with those having balance sheet interests. Although reticence will most likely be the modal ‘first response’, we see progress along these lines as fairly inevitable.
Impact on hedge fund investing. Over any meaningful period of time, uncertainty generally benefits hedge funds operating on mean reversion. A more in-depth understanding of balance sheets, companies and industries can allow for positions to be taken with greater certainty, often against the tide. This can also create disproportionate upside. However, in the shorter run, it remains a difficult environment. Low interest rates continue to put pressure on short selling and random volatility from macro events continues to whipsaw many managers attempting to control risk. The lack of clear governmental leadership and direction makes many global macro and CTA strategies tricky as well. The
current low level of corporate defaults tends to limit new distressed opportunities. Low spreads on plain vanilla deals and reduced activity in M&A generally limit interest in risk arbitrage and many event strategies. We believe investors should be looking at hedge funds in the short run more in terms of risk mitigation than upside capture.
Future of hedge fund industry. In a low interest rate, lower return environment, it is hard to see how the current structure of hedge funds can be sustained. Historically while at Cadogan, I tried to lead the charge in attempting to affect fundamental changes in how fees are charged and how hedge funds are structured and run. I hope going forward there will be those willing to take the time and effort to sustain these efforts. I think it will be a win/win situation. With major financial institutions needing to limit their risk-taking functions, independent investment firms should be in a strong position to gain market share in many investment strategies. Institutions looking to access differentiated return and risk streams are likely to continue deploying capital into alpha-oriented strategies. However, there is increasing knowledge and sophistication in the buyer market and the value proposition will need to be more clearly defined.
This is particularly true in the intermediary market, where FoHF’s and consultants must justify the fees they charge. We anticipate the big will get bigger for some period of time, but remain confident the real future of the intermediary market institutionally (and probably in the HNW market as well) will be in providing niche and differentiated solutions.
