Unhedged Commentary

By Sam Diedrich

The extraordinary liquidity provided by global central banks following the recent credit crisis has led some investors to anticipate a future rise in inflation. As investors evaluate strategies to profit from or hedge against inflation, many have considered buying inflation-linked bonds (inflation-linkers). However, in the face of a sudden rise in inflation, an inflation-indexed bond portfolio may not behave as some investors expect. Though buying inflation-linkers in lieu of nominal bonds can protect investors from principal loss due to inflation, using inflation-linkers to profit from or to hedge an overall portfolio against inflation may not be effective.

Three features in particular limit linkers’ effectiveness. First, the mechanics of the instrument limit its sensitivity to changes in realized inflation. The volatility and return of an inflation linked bond is driven by changes in real yields during the holding period, rather than by realized inflation. As a result, investors wishing to profit directly from changes in inflation are better positioned using a break-even trade structure (explored below), rather than simply buying inflation linked bonds.

Second, there may be differences between the actual economic inflation that investors face and the reference inflation represented by the index used by the bond. These differences may result in the failure of inflation linked bonds to provide adequate protection.

Finally, inflation-linkers are subject to taxation that may have a significant effect on total return. Inflation-linkers protect against inflation by adjusting principle and coupon payments for inflation. Both adjustments are taxed each year, but principle payout only happens at maturity.

Rising Inflation, Price Appreciation, and the Break-Even Position

The total return of inflation-linked bonds is driven by changes in the real yield, which, in the long run, is primarily driven by changes in real economic growth. Changes in inflation alone will not affect the price of inflation-linked bonds since increased cash flows in principle and coupon payments compensate for realized inflation (not price appreciation). For an investor who buys TIPS and holds them to maturity, the real yield the investor earns over the holding period will be the same in high inflation as in low inflation. A tactical long-only allocation to linkers in order to profit from a rise in inflation will only be effective if the rise in inflation coincides with a reduction in real yields.

Investors hoping to capture price appreciation from a change in inflation are better off constructing a “break-even” trade structure. A break-even trade structure is created by going long TIPS while shorting a duration-equivalent amount of nominal bonds against it. Crucially, this hedges out the real yield component of the nominal yield, and retains only its inflation premium component. Increases in inflation will lead to increases in nominal interest rates (price decreases in the nominal bond), and will mean profits for the short nominal bond position. The long inflation-linked position offsets any change in real yields – meaning the overall position effectively “carves out” the inflation component (premium) of the nominal yield, allowing profit purely from inflation.

An Impending Rise in Inflation May Already Be Priced In

The potential profit from a break-even or long-only linker position depends on the valuation of linkers at the time of purchase and sale. Linkers have two primary measures relevant to their valuation. The first is the break-even (BE) rate, which is essentially the difference between the yield of a nominal bond and the yield of the duration equivalent inflation-linked bond. The BE rate can be thought of as the amount of inflation needed over the holding period for an investor to be indifferent between TIPS and nominal bonds.

The second important valuation measure for TIPS is the yield to maturity, which is equivalent to the real rate of return, and is the most relevant valuation metric for long-only linker investors. These two valuation metrics indicate different market expectations depending on macroeconomic conditions. Below are scenarios where these measures change.

Typically, rising inflation rates occur during periods of economic expansion, when demand for production inputs is at its highest. This can lead to higher real rates, and thus cause TIPS to sell off. Meanwhile, the increased inflation expectations typically lead to a larger sell-off in nominal bonds that TIPS, and thus provide a profitable environment for break-even trade positions.

Conversely, an economic slowdown can lead to rising unemployment, and put downward pressure on wage inflation (demonstrated by the Phillips Curve). Capacity utilization drops, causing demand for cyclical commodities to fall. This often leads to lower levels of realized inflation and, typically, lower inflation expectations. In these scenarios, real rates are often bid quite low because investors have fewer opportunities to obtain positive real returns. This results in price appreciation for long-only allocations to TIPS. Break-even rates also decrease, as investors price in low, or even negative, rates of inflation, which means negative performance for break-even positions.

Increases in inflation also may occur due to supply-side commodity shocks. Here, break-even rates may become quite elevated due to a sudden rise in inflation expectations. Meanwhile, input price increases negatively affect economic growth, causing real rates of return priced into linkers to be bid lower. In these scenarios, break-even positions and long-only allocations to linkers can prove profitable.

During a flight to quality, investors seek the most liquid, riskless securities. Inflation expectations fall as these periods are typically coincident with dramatic reductions in economic growth expectations. Therefore, break-even rates also decrease dramatically. However, a significant portion of this fall is due to the increase in liquidity premium embedded in TIPS. Since TIPS are less liquid than Treasuries, relative demand for TIPS falls and real yields increase dramatically. In these scenarios, TIPS often sell off as real yields move higher. Meanwhile, break-even positions also post negative returns as inflation expectations collapse.

Finally, volatility in real yields can be caused by monetary action. Accommodative policy typically occurs in the context of low growth, during which the market will most likely price in very low inflation expectations. Prior to signaling policy action, break-even rates, nominal yields, and real yields are bid very low because of the low inflation expectations. However, following an announcement of accommodative policy action, nominal yields actually fall in anticipation of nominal bond purchases. With lower nominal yields and higher inflation expectations, real yields plummet. Then, as policy is implemented, inflation expectations continue rising, and nominal yields rise sharply along with break-even rates. That leads to rising real yields, and thus a sell-off in TIPS.

These scenarios illustrate how the profitability of break-even and long-only linker investments are driven by current market valuations and subsequent market movements. Depending on the break-even rate and real rate of return priced into the market at purchase, long-only and break-even positions in linkers may lose value if inflation and real rates do not move in line with market expectations.

In the US, interest payments from Treasury Inflation-Protected Securities (TIPS) and inflation-related adjustments to the principal are both subject to federal tax, but exempt from state and local income taxes. The tax implications of the interest payments are straightforward: the taxable investor will owe taxes on coupon payments as paid just as with nominal bonds. As inflation rises, the taxable investor in TIPS will also accrue a tax liability on the increase in the principal value of the bonds due to the rise in inflation. However this increase in principal value is not paid to the investor until maturity of the bond. Thus the investor may have to pay taxes in the current year on cash flows they will not receive until bond maturity. Complicating the issue is the fact that the coupons on linkers are typically low, so cash inflows may be small or even less than the necessary cash outflows required to pay taxes.

The cash flows of an inflation-linked bond are protected from inflation insofar as the changes in actual ‘economic’ inflation are reflected in the reference index in an appropriate fashion. Though the inflation reference index is carefully chosen by issuers to best capture the general inflation rate in a timely manner, there are issues that can lead to differences in the inflation ratio used to compensate investors, and the ‘economic’ inflation rate seen in the economy. For example, though the CPI Index showed only a 4.5% growth over two years through 2011, commodity prices (measured by the S&P GSCI) rose much more – fully 23% over the same period.

For long-only investors who hold securities to maturity, inflation-linked bonds can serve a valuable role in a portfolio due to their embedded inflation protection. When inflation rises, inflation-linked bonds offer protection of principal and cash flows, and can outperform nominal bonds. However, for tactical investors hoping to profit from inflation, buying inflation-linked bonds may not be an effective strategy.

Inflation linkers may be limited because of their payout structure, the expected inflation already reflected in current market valuations, the determination of taxable interest, and issues with the reference inflation index. Other trade structures, including break-even structures, provide more direct means to profit from rising inflation.

Sam Diedrich is a portfolio management associate at Pacific Alternative Asset Management Company (PAAMCO), an $8.4 billion institutional fund of hedge funds.

	Maroon 5

LAS VEGAS -- Maroon 5 is used to playing sold-out arenas before thousands of screaming fans, mostly young women in love with ultra-cool lead singer Adam Levine. On Wednesday night in Sin City, they got a surprise after walking on stage in an opulent Bellagio ballroom shortly after 10 pm: greying middle aged men wearing SALT Conference lanyards and loafers.

"In case you don't know who we are, we're Maroon 5," joked Levine, who performed wearing skinny jeans, a tight black T-shirt revealing extensive tattoos, and his signature three-day stubble. Most people in the several hundred person crowd indeed weren't sure what they were watching. "What's their name again?" asked one elderly asset trustee; another 40-something hedge fund manager said he looked up the odd-sounding name shortly before the show. "I had to Google it," he admitted.

"Awwww yeah!" screamed Levine early on, looking for an echo from the crowd. No response. An attempt to set a clapping beat with the audience also fell flat.

Of course, some in the audience watched excitedly, particularly those in the elevated VIP section sponsored by Northern Trust. The hippest attendees had changed out of their daytime suits for a decidedly casual-but-one-percent look: un-tucked, french cuff dress shirts with two buttons down. But the styling might equally have been preparation for playing the Black Jack table or heading to a nightclub later on.

For the most part, hedge funders watched politely if unenthusiastically while sipping on Bud Light bottles and 2008 Washington state merlot; others networked in the half-full ballroom, checking their Blackberries in between business card exchanges. 

The concert was for a good cause: SALT's new Aspire Giving charity initiative benefiting three nonprofits: Network for Teaching Entrepreneurship, charity:water and Warrior Gateway. Some attendees evidently shelled out: charity packages included a $15,000 option for backstage passes and a signed guitar or $1,000 for a VIP ticket.

It was one of the last songs shortly after 11 pm, Moves like Jagger, that got the crowd going. The annoyingly catchy song has spent 45 weeks on Billboard's top 100 chart, including a stint as the most popular song in the country. Networking stopped and the iPhone cameras came out—mostly to take pictures for adoring children back home.

Sensing a shift, Levine engaged with the SALT audeince. "Where are the ladies tonight?" he asked as the drummer kept a faint beat. One could hear a few screams. "That means there are a lot of dudes here," he shot back. "It's not the best ratio." The men nodded and laughed knowingly. A few adoring women in front screamed a little louder, and Levine indulged them. "Ladies, this song is dedicated to you," he said before launching into another hit, She will be loved. "We love you so damn much."

By the end, everyone beamed. Being cool with photos for the kids to prove it — if only for an hour at a hedge fund conference — seemed well worth the price of admission.

By Andrew S. Kofman

When two of the largest players in an industry come together to do a deal, people tend to sit up and take notice. And when the $101 billion Austin-based Teacher Retirement System of Texas in February acquired a $250 million equity interest in the $120 billion hedge fund firm Bridgewater Associates, the deal attracted plenty of attention. Still, it bears an even closer look. While management company equity transactions are not uncommon, the Bridgewater deal should be a wake-up call for both hedge fund managers and institutional investors who are seeking to maximize their returns.

Bridgewater CEO Ray Dalio, who founded the Westport, Connecticut–based firm in 1975, is methodically implementing a succession plan that includes distributing the ownership of Bridgewater to people other than himself. By putting a clear strategy in place, Dalio is reducing uncertainty about the future of his firm, thereby increasing its value. The transaction also enables him to take some of his own net worth off the table. At a time when many hedge funds, including several of the industry’s leaders, are evolving to the point where the succession question is a priority for their employees and their investors, the success that Dalio is achieving is noteworthy.

Dalio, who is 62, is reportedly planning further reductions in his ownership in the coming years. He is incentivizing his employees to purchase additional equity, a process that may significantly reduce the CEO’s ownership, given his multiyear time horizon (particularly as third-party financing may be available to cover a portion of employees’ purchases).

There are still other options. During the February 16, 2012, board meeting of the Teacher Retirement System of Texas, at which the trustees and staff discussed the Bridgewater deal, Texas Teachers’ senior director of private markets Richard Hall stated that “a good portion of the [Texas Teachers] return — at least half” would come from annual distributions that come as part of owning a hedge fund business. Hall’s remark reminds us that returns could come both from yearly profit distributions and from some additional source. This other source could be a liquidity event, such as an initial public offering. It is unlikely that Texas Teachers is expecting an IPO or some other exit event anytime soon. But opportunities will present themselves.

The evolution of the ownership of the $74.8 billion Los Angeles–based alternative investment firm Oaktree Capital Management highlights the various corporate balance sheet options that are available to owners of well-run firms. Before going public in April of this year, Oaktree’s co-founders, including chairman Howard Marks, sold equity in stages — first to the firm’s employees, then to the firm’s clients, then to institutional investors in a private placement.

From the perspective of institutional investors — like Texas Teachers — that have the benefit of long-term investment horizons, private investments in the general partnership of a hedge fund firm can make more sense than being just a limited partner. That’s particularly true right now. The combination of heightened sensitivity to liquidity concerns, choppy and heavily regulated public markets, and limited credit has created a range of investment challenges but also opportunities for long-term investors. Other sophisticated institutional asset owners have made similar deals in the past. For example, the country’s largest public pension plan — the $233.2 billion California Public Employees’ Retirement System in Sacramento, California — has pursued this path, taking an equity stake in the Carlyle Group and several other alternative asset managers.

These kinds of transactions require creative — and for some investors, uncomfortable — thinking. New valuation and risk management approaches are needed. Investors would do well to build diversified portfolios of ownership stakes, protect their interests through customized transaction structures, and risk-weight the combined capital exposed to a manager and that manager’s funds.

Finally, the Texas Teachers deal with Bridgewater illustrates that the amount of money that investors are pumping into hedge funds continues to grow. Just five years ago the Texas state legislature capped Texas Teachers’ hedge fund allocation at 5 percent of assets; last year the legislature doubled that allocation, and this year the retirement plan purchased the Bridgewater stake. Notwithstanding the public focus on the challenges and flaws of hedge funds, their market-share expansion seems to have a great deal of room to run. AR

Andrew S. Kofman is an independent asset management consultant with nearly 20 years of investment management experience.

	Ward Davis

By Ward Davis

Last Thursday evening my thirteen-year-old daughter coerced me into seeing the midnight premier of the new blockbuster film, The Hunger Games. The big screen adaptation of the immensely popular young adult novel opened to an enormous $153 million gross in its first weekend, third all-time. The story depicts a post-apocalyptic world where the privileged few living in the Capitol (read the 1%) hold all the power over the poor, struggling masses (read the 99%) living in twelve surrounding districts. The Hunger Games are an annual event in which one boy and one girl from each of the districts are selected by lottery to compete in a televised battle in which only one person can survive; a gruesome fight to the death, all for the amusement of the more fortunate Capitol dwellers.

I hadn’t been to a midnight movie since a 1982 showing of The Rocky Horror Picture Show. I’m not sure which experience was freakier. The hoards of hyper teens, college students, young and middle-aged adults decked out as Hunger Game characters were quite a spectacle. What was even more interesting was watching the entire audience become transfixed by the main character, Katniss Everdeen. Katniss, a young girl from a poverty stricken mining district, not only succeeds in combat, but her non-conforming ways during the televised fight sequences rouse the masses and enrage the upper crust audience. By the movie’s end a class struggle rebellion seems inevitable. The audience in the theater cheered, exited then most seemed to hop into their awaiting town cars.

The Hunger Games economy of polarized extremes and elite complacency may be closer to the current real world example than many believe. Over the last few weeks there has been a growing sense that the economy is improving. Macro economic data have been decidedly mixed, but the positive reports have received far more attention in the press. This feel good mood has permeated into investor sentiment, which has climbed from near max bearish last fall to decidedly bullish in the most recent readings. Complacency has taken root again and appears surprisingly high as measured by the VIX (volatility index), which has sunk back to the pre-European debt crisis lows. The stock market has rallied sharply on pure multiple expansion. Earnings estimates for the average company in our universe have actually gone down, as we have reported in prior letters. The extraordinarily warm end to winter/beginning of spring has consumers feeling good too. Luxury goods spending and white table dining trends have been robust. The 1% Capitol dwellers, at least, are feeling pretty good.

The same can’t be said for the rest of the economy. Prices for summer rentals in the Hamptons are up sharply this year fueling a sense on Wall Street that housing is in a recovery mode. Yet, the Case Schiller Home Price Index continues to track lower. New Home Sales fell to annualized SAAR of 313,000, close to the trough recession lows. Mortgage applications are falling because of rising rates. The S&P 500 Index is up 12.5% so far this year, and was up over 3% in March alone. Market participants are feeling pretty good. Personal Consumption for February recently came in better than expectations at a positive 1.9% year-over-year. But, the average Joe without a personal trading account isn’t faring quite as well. Average Hourly Earnings were up a scant 1.9% year-over-year for the month of February, and have remained in a downward trajectory since mid 2011. Disposable Personal Income increased just 0.2% for February. Not surprisingly, the savings rate fell from 4.3% in January to just 3.7% in February, the lowest level since August 2009. Meanwhile gasoline prices have recently surged through the critical $4.00 per gallon barrier just in time for the spring/summer driving season. So, let’s not get too giddy over the market’s strong start to the year. The lower end of the economy is still struggling and not really feeling the improving trends. At least the 99 percenters don’t have to send their sons and daughters into a televised fight to the death. But where are the Katnisses of the world when you really need them?

Ward Davis is founder and portfolio manger at Caerus Global Investors, a consumer-focused long/short equity hedge fund firm in New York that managed $212 million at yearend 2011.

	Friso Buker

A recent Boston Consulting Group study claimed that, out of the ten countries with the highest concentrations of ultra high net worth households, prominent Gulf nations – namely Qatar, the United Arab Emirates, Saudi Arabia and Kuwait – take up more places than any other global region. Saudi Arabia holds the top position with an impressive 18 per 100,000 of households with more than $100 million in assets under management. Qatar, the UAE and Kuwait also made it to the top ten in terms of the highest proportion of millionaire households with 8.9%, 2.6% and 8.5% respectively. The Middle East – along with Africa – showed a significant level of growth in wealth as assets under management rose 8.6% to $4.5 trillion in 2010 with the BCG projecting it will reach $6.7 trillion by 2015. And before one feels the need to claim that all of this wealth is predominantly under the control of the state, the same BCG study found that well over half of the wealth in these Gulf nations are being held by private households scattered throughout the region.

In essence, the report paints a picture of a region that is potentially lucrative for organizations looking to raise capital and to place Middle Eastern assets under management. But it also states that wealth management trends in the Middle East have displayed a distinct lack of financial adventurousness. While 56% of independent Gulf Cooperation Council investors preferred to keep their investment in cash or very short term liquid investments, 31% preferred to invest in regional or home equity markets with 13% opting to invest in bonds. Whatever spare investment cash left over is sunk into a very small numbers of funds that are managed outside of the region.

With all that wealth lying relatively dormant in the Middle East, why aren’t the investors actively considering a much wider range of investment alternatives beyond cash, real estate and low yield bonds?

Financial Conservatism in the Middle East?

The BCG study postulates that this regional trend is simply a reflection of the overall level of risk aversion that has become the historical norm within the Gulf (especially during the global financial upheaval), but anyone who has done business in the Middle East for any significant period of time can tell you that this is only one part of the story. The other comes from a keener understanding of the dynamics involved within any negotiations involving multi-million dollar transactions in the Middle East. And it is this part that mostly remains a mystery to those almost willfully ignorant non-Arabs looking to do a significant level of business in the region.

The massive levels of economic growth and wealth creation that the Gulf has experienced over the past two decades may lead many people to believe that the region has also undergone a radical change in Arab society as well as the way that business is conducted. This could not be further from the truth. By and large, citizens of the Gulf nations – and of the Arab world as a whole – have not changed the major cultural determinants that underpin their respective societies. The more obvious determinants include Islam, a reliance on and devotion to social networks that are based on familial and “tribal” allegiances, a desire to be perceived as hospitable, the seemingly overwhelming levels of bureaucracy and the high value placed on trust and personal relationships. These determinants are reflected in practically every facet of Middle Eastern society, including (and especially) business.

Despite these cultural traits being obvious to anyone who looks closely enough, wealth managers from around the world have so far failed to adapt their working practices and financial marketing techniques to attract the ever wealthier regional investors. Numerous related articles – most recently with titles such as “No honey, no money: Wealth managers learn the regional ropes” and “Qataris unmoved by wealth managers” – have so far failed to make any significant dent in the way investment opportunities have been presented to the Middle East. Instead of adapting their practices to meet the business traditions of the customer, wealth managers largely continue to market their offerings in a way that best suits their own Western business culture, much to the obvious chagrin of potential investors.

The Well Worn Path to Investment Marketing Mediocrity

But that does not mean that investment firms have not at least tried to overcome these capital raising difficulties by incorporating different marketing strategies in their attempts to access the investor market. But despite their strategies, wealth managers have historically had mixed – and usually lackluster – results.

The four most common “approach models“ – incorporating a permanent presence, utilizing placement agents, employing investment guides and sending official representatives - constitute the main methods wealth managers have used to raise regional capital in the past. Despite the differing levels of effectiveness and apparent advantages of each model, the established hurdles are still proving difficult to overcome.

Establishing a permanent presence with all the necessary licenses and meeting all the necessary statutory regulations has proven to be effective for those organizations who are able to afford it, given that the entire process of incorporation can take up to a year and involves ring fencing upwards of $2 million. This has proven to be a viable option for wealth management firms that have a wide variety of investment vehicles to entice the local investment community, but identifying a network of willing investors will still prove to be difficult chore for newcomers to the region.

Whenever cost-effectiveness is an issue, wealth management firms have tended towards building a small network of placement agents or third-party marketers, i.e. independent representatives who promise to trawl their respective regions for high net worth individuals and/or family offices with the intention of piquing their interest in placing assets under management in a particular fund. While this method of raising capital may seem initially appealing, it has also proven to be a highly ineffective way of raising Middle Eastern money and leaves the commissioning firm open to the risk of financial and corporate misrepresentation, which may in turn “poison the well” for any subsequent attempts to market investment products.

Recently, sending official representatives for a few days in an attempt to meet potential investors at exhibitions or conferences has proven popular for business visitors to the region, but given the desire of the investors to build trust & long-term business relationships with those who are looking to manage their wealth, it’s not surprising that many locals have balked at the concept of trusting a company representative who expects to raise capital after a handful of rapid, short meetings before they catch their flight home. In this respect, the term “carpet bagging” has increasingly been used by locals to describe this fairly haphazard method of raising funds.

But not all “approach models” have proven to be as ineffective as those previously mentioned. Historically, the use of investment guides – i.e. established residents who provide access to potentially broad networks of active investors for a fee – has proven to be a relatively fruitful method of identifying sources of capital to be placed under management. But the process of finding the right investor guide with the right network is fraught with problems, as the most effective ones tend to work almost exclusively for a small number of fund management firms and there is little or no information on which to gauge the number and/or quality of previous clients sourced by the guide that may constitute a definable track record. In addition, investor guides employed by established investment firms have been notoriously unwilling or unable to provide any effective levels of customer relationship management once the investment representative have left the country.

The Future of Hedge Fund Investment in the Middle East

At present, the common perception of fund managers who manage between $30 million and $200 million is that the larger funds have gotten the Middle Eastern capital raising game sewn up and that these larger funds exert a capital raising “gravitational pull” that is capable of easily canceling out the marketing efforts of their smaller rivals. Unfortunately, this perception is not completely without merit.

But rather than abandoning all hope of tapping into this burgeoning investor pool, fund managers should formulate different market entry strategies that will allow them to side-step the substantial hurdles that lay before them and that will ease their marketing burdens. One relatively new strategy would be to develop partnerships with regional financial institutions – such as small investment banks – that are tapping into the demand from both managers and investors for greater hedge fund visibility in the region. Not only are these institutions able and willing to tap into their established network of active investors to provide both investment marketing and capital raising services, but they are also able to provide more reputable established investor relation services that are capable of developing, maintaining and expanding investor relationships even further beyond their own influence as the financial institution continues to grow. However, these regional institutions have a strong tendency to select funds to represent that either offer market-leading returns or that are closely aligned with regional investor market dynamics and/or preferences. Funds that have a distinct investment strategy or philosophy – aligned with a historical track record that emphasizes medium-term wealth preservation and/or growth – are far more likely to gain a significant foothold in the investor community than a fund that has only demonstrated a few years of reasonable growth coupled with high levels of volatility.

Until fund managers of all stripes finally come to the conclusion that their current marketing efforts and strategies will fail to generate the levels of capital that they are looking for, the goal of placing Middle Eastern assets under management will remain as difficult as ever.

Friso Buker is strategic marketing manager at Dubai-based Royal Investment Bank, an investment advisory firm specializing credit related transactions; and the strategic director for Bridgehead Administration, which facilitates contracts between hedge fund managers and investors in the Middle East and North Africa.