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FRED
08-04-06, 09:43 AM
MotherRock Hedge Fund to Close After `Terrible Performance' (http://www.bloomberg.com/apps/news?pid=20601109&sid=a2RV_7_smzJ4&refer=home)
August 4, 2006 (Bloomberg)

MotherRock LP, the hedge fund firm run by former Nymex President Robert ``Bo'' Collins, is preparing to shut down because of ``terrible performance'' as natural gas plunged this year.

``We are in the process of developing a detailed plan for winding down the fund,'' Collins said in a letter sent today to investors in his MotherRock Energy Master Fund. MotherRock, begun in December 2004, invests in gas futures, seeking to exploit price differences based on the delivery month for the contracts.

Benchmark New York gas prices dropped 66 percent from an all-time high in December as a mild winter created a supply glut and then rallied in the second half of July. While prices for summer fell, contracts for next winter stayed unusually high, widening the price differential or spread.

AntiSpin: The demise of MotherRock on the heals of Dynasty the day before (Dynasty, once-hot China hedge fund, calls it quits (http://www.post-gazette.com/pg/06214/710498-28.stm)) are likely the canaries in the coal mine of USIPs, hedge funds that aren't really "hedge funds" at all but are, as we call them here, Unregulated Speculative Investment Pools or USIPS. Hedge funds are hedged whereas USIPs are merely long. When their long bets fail, the go under, usually after a period of redemptions.

We expect to see a string of such announcements as rumors of hedge fund redemptions that have been floating for months start to see the light of day, as the following from Jon 'Doctor J' Najarian at ChangeWave predicts:

Gambling With Other People's Money (http://www.changewave.com) -- By Jon 'Doctor J' Najarian

"Of course, there's a huge difference between Las Vegas and Washington. See, in Las Vegas, people gamble with their own money." -- Jay Leno

It's my great pleasure to sit in for Toby Smith while the Kahuna is off in the Emerald Isle doing some recon on the links (that's golf by the sea, for the uninitiated).

Toby and his band of merry men know what they're in for, being seasoned players, but I have to wonder how they can pack enough balls to meet the demands of those postage-stamp-sized greens at Old Head of Kinsale, 10 stories above the Irish Sea.

By the way, Toby, on the fourth hole of Old Head, don't back up to line up your putt unless you've got a parachute on your back, 'cause we'd miss you!

HEDGE FUNDS AND VOLATILITY

Toby has continually cited the $1.4 trillion of global equity in hedge funds, and we know these hedge funds routinely leverage that capital to trade as if it were 10, 20 and as much as 100 times larger than it actually is. How do they do that? One popular way is through Joint Back Office arrangements with large investment banks.

Basically, the bank sells a percentage of itself for, say, $10,000. It might only be 1/10,000th of a single percent, but it allows the fund to trade on what's known in our business as "firm capital." This means that, unlike regular Joes and Janes, hedge funds do not have to meet Reg-T requirements, which is what the Federal Reserve Board requires investors to put up as a minimum deposit for their securities purchases.

Reg-T decrees that investors must have available a minimum of 50% of the funds for the purchase of marginable securities, also known as initial margin. Imagine how big you could trade if you didn't have to post 50% of the purchase price. The mind reels!

The reason why I bring up the leverage that hedge funds enjoy is that, like fire, it can be helpful or harmful. Put another way, you can use fire for good, to cook your food -- or you can get cooked instead. And in the investing world, given the massive positions you can put on with minimum dollars, the cooking happens at light-speed!

Back in the day, I would use $5 million to $10 million in capital to take down more than $300 million in positions, so you can imagine what damage a 27-year-old can do with a billion dollars under management!

'EMERGING' CAPITAL, LESSONS

Chicago-based Hedge Fund Research estimated that investors had poured nearly $340 billion into hedge funds globally during the past half-decade. Most recently, managers chasing double-digit returns have massively increased their exposure to emerging markets.

With all due respect to my brethren in the hedge fund industry, when you're playing with someone else's money, factors like liquidity quickly give way to the potential for personal enrichment that a 2% load and 20% profit participation can offer. James Simons of Renaissance Technologies, who brought his investors a net return of 29.5% and took home a record $1.5 billion in fees for himself, set the high-water mark among managers.

Those mind-blowing figures are why so many managers want to get into the industry. Hedge Fund Research said that the number of new funds rose 44% in '05 to 2,073, bringing the total above 8,500. However, more than 850 hedge funds were liquidated, which was nearly triple the closures in '04!

The May meltdown in the markets certainly tested the mettle of hedge fund managers, as the leverage I spoke of made a difficult situation nearly impossible for U.S. equity managers. Trust me when I tell you the pain experienced here was nothing compared to that in overseas markets and, God help 'em, by emerging-market managers!

The only thing worse than losing money is losing it without the possibility of an exit. Just ask the geniuses over at Long-Term Capital Management (LTCM) about what happened in 1998 (when they almost crashed the global financial system), or this year's Long-Term Capital-like debacle on the Bombay Stock Exchange!

The smartest guys in the room prior to Enron were the crew over at Long-Term Capital. They had two Nobel Prize winners among the group of advisers and founders, and yet they let themselves be lulled into a false sense of security over their ability to continually, dynamically hedge their portfolio. Their world came crashing down when the global markets encountered a disconnect, and their investors suffered from a breakdown in historical correlations that their models had been predicated on.

Similarly, many of the managers in emerging markets wrongly believed they could hit the exits when the stuff hit the fan, only to find that was not the case. Consider this: ExxonMobil (XOM) trades 20 million shares every day -- that's $1.2 billion in market capitalization.

Now, for a moment, try to put yourself in the shoes of a money manager trying to get out of some trades on the Bombay. The entire capitalization of EVERY STOCK listed is less than $800 billion, and 30 stocks account for 50% of that.

During the meltdown that shut down their exchange overseas, investors dumped $555 million worth of shares (or, half of the value of what XOM trades every day) and it took them four sessions to do that!

REDEMPTION RUMORS EVERYWHERE

Throughout the months of May and June, I've been hearing a ton about hedge fund redemptions. Anyone in the trading biz has heard rumors about this $10 billion fund closing its doors, or that $20 billion fund being forced out of its positions. Such talk has instigated every triple-digit decline suffered by the Dow since the mid-May market top.

Although the talk has been just that, talk, we're about to see how the rubber meets the road as we wrap up the second quarter of 2006. The end of Q2 means we will soon know which of the rumored meltdowns will indeed be real and which ones were just convenient excuses for the whuppin' that the market took. My personal take is that $50 trillion to $100 trillion in leveraged trades were at the heart of the surge in volatility, and the end of the quarter will bring a reduction in overall market volatility.

What you should keep in mind about hedge fund redemptions is that they are really the stock market equivalent of throwing gasoline on a fire. When the markets are falling you need to find buyers, not sellers. As the fund manager tries to sell to generate cash to pay to his or her investors, he or she may also hit the futures markets -- selling the S&P 500, Nasdaq or whatever will help slow the bleeding -- and that action also accelerates the slide.

I've often thought that in times of turmoil (like May 11 through June 2006), the ultimate insider trade might be to know the holdings of a particular fund that is experiencing big redemptions, and shorting their longs and buying their shorts. Anyone out there think maybe someone at a big clearinghouse has figured this out as well? Hmmm...

Jon "Doctor J" Najarian
Editor
ChangeWave Options Trader

WDCRob
08-06-06, 12:59 PM
Anyone with knowledge care to reply? Editorial in today's Washington Post

Hands Off Hedge Funds
Sometimes libertarians deserve to win an argument.

EIGHT YEARS AGO the collapse of a hedge fund named Long-Term Capital Management triggered fears of international financial instability. Since then, hedge funds have quadrupled the volume of money they manage and account for perhaps 30 percent of trading on U.S. stock markets. Meanwhile, the regulatory response has been confused. Two years ago the Securities and Exchange Commission decided, in a controversial 3-to-2 vote, to require hedge fund managers to register and submit to inspections. This policy was opposed by Alan Greenspan, Fed chairman at the time, and got a cool response from regulators at the Treasury Department. In June a federal court vacated it.

Having inherited this mess, SEC Chairman Christopher Cox is pondering how to fix it. His objectives should be to mend fences with his fellow regulators and to tread lightly on this industry. Hedge funds, which exist to come up with futuristic trading strategies that others haven't tried, are the classic example of an innovative industry with which regulators can't keep up. Pretending to conduct meaningful oversight is worse than conducting none at all: It dulls investors' incentives to monitor the risks of putting money into hedge funds.

There are three types of argument in favor of regulating hedge funds, and none is persuasive.

The first invokes systemic risk: If a hedge fund collapses, the banks that lent to it may collapse, too, causing a chain reaction through the financial system. This danger is real, but the banks that lend to hedge funds have a strong incentive to manage it by limiting their exposure to hedge funds and by monitoring the risks that the funds take. Since the Long-Term Capital debacle, this is what banks appear to be doing. Regulatory prodding has encouraged the banks to get smarter, though in some cases the rules perversely permit hedge funds to borrow more if they take on extra risk -- an example of how oversight of this complex industry can backfire.

The second argument for regulating hedge funds is that they are havens of insider trading and other sorts of illegal manipulation. It's true that some prominent cases of fraud involve hedge funds, but this isn't surprising given their size. The law already empowers regulators to go after hedge fund managers who commit financial crimes. It's not clear that extra regulations would add much.

The third argument for regulation concerns investor protection. The SEC suggests that by registering and inspecting hedge funds it can reduce the danger that investors will lose money. Some hedge fund managers are happy to accept this line: To reassure anxious clients, some choose to register with the SEC anyway, and they calculate that submitting to mild regulation now may be smarter than waiting until the political storm that would follow the scandalous blowup of a crooked player in their industry. But this is a case of hedge funds and their customers trying to ensure their reputations by gaining a regulatory seal of approval. The regulators should decline to become a security blanket.

There is one fix that does make sense, and Mr. Cox has proposed it. Hedge fund customers are currently required to have personal wealth of at least $1 million -- a relatively low threshold given that home equity counts toward it. But hedge funds make sense only for families richer than that: They have minimum investment requirements of $500,000 or more and are sufficiently risky that they should represent only a small part of a portfolio. The $1 million hurdle should at least be doubled.

EJ
08-06-06, 08:38 PM
Anyone with knowledge care to reply? Editorial in today's Washington Post

Hands Off Hedge Funds
Sometimes libertarians deserve to win an argument.

EIGHT YEARS AGO the collapse of a hedge fund named Long-Term Capital Management triggered fears of international financial instability. Since then, hedge funds have quadrupled the volume of money they manage and account for perhaps 30 percent of trading on U.S. stock markets. Meanwhile, the regulatory response has been confused. Two years ago the Securities and Exchange Commission decided, in a controversial 3-to-2 vote, to require hedge fund managers to register and submit to inspections. This policy was opposed by Alan Greenspan, Fed chairman at the time, and got a cool response from regulators at the Treasury Department. In June a federal court vacated it.

Having inherited this mess, SEC Chairman Christopher Cox is pondering how to fix it. His objectives should be to mend fences with his fellow regulators and to tread lightly on this industry. Hedge funds, which exist to come up with futuristic trading strategies that others haven't tried, are the classic example of an innovative industry with which regulators can't keep up. Pretending to conduct meaningful oversight is worse than conducting none at all: It dulls investors' incentives to monitor the risks of putting money into hedge funds.

There are three types of argument in favor of regulating hedge funds, and none is persuasive.

The first invokes systemic risk: If a hedge fund collapses, the banks that lent to it may collapse, too, causing a chain reaction through the financial system. This danger is real, but the banks that lend to hedge funds have a strong incentive to manage it by limiting their exposure to hedge funds and by monitoring the risks that the funds take. Since the Long-Term Capital debacle, this is what banks appear to be doing. Regulatory prodding has encouraged the banks to get smarter, though in some cases the rules perversely permit hedge funds to borrow more if they take on extra risk -- an example of how oversight of this complex industry can backfire.

The second argument for regulating hedge funds is that they are havens of insider trading and other sorts of illegal manipulation. It's true that some prominent cases of fraud involve hedge funds, but this isn't surprising given their size. The law already empowers regulators to go after hedge fund managers who commit financial crimes. It's not clear that extra regulations would add much.

The third argument for regulation concerns investor protection. The SEC suggests that by registering and inspecting hedge funds it can reduce the danger that investors will lose money. Some hedge fund managers are happy to accept this line: To reassure anxious clients, some choose to register with the SEC anyway, and they calculate that submitting to mild regulation now may be smarter than waiting until the political storm that would follow the scandalous blowup of a crooked player in their industry. But this is a case of hedge funds and their customers trying to ensure their reputations by gaining a regulatory seal of approval. The regulators should decline to become a security blanket.

There is one fix that does make sense, and Mr. Cox has proposed it. Hedge fund customers are currently required to have personal wealth of at least $1 million -- a relatively low threshold given that home equity counts toward it. But hedge funds make sense only for families richer than that: They have minimum investment requirements of $500,000 or more and are sufficiently risky that they should represent only a small part of a portfolio. The $1 million hurdle should at least be doubled.

Raising the bar so that individuals with less than $1M to lose can't go broke by investing in poorly run hedge funds should not be addressed via regulation. For this all that's needed are really strongly and clearly worded warning labels on the products. If you read the comments below by Jon "Doctor J" Najarian, as well as other research, systemic risk is both a real problem and the only one regulators ought to concern themselves with.

"Toby has continually cited the $1.4 trillion of global equity in hedge funds, and we know these hedge funds routinely leverage that capital to trade as if it were 10, 20 and as much as 100 times larger than it actually is. How do they do that? One popular way is through Joint Back Office arrangements with large investment banks.

"Basically, the bank sells a percentage of itself for, say, $10,000. It might only be 1/10,000th of a single percent, but it allows the fund to trade on what's known in our business as "firm capital." This means that, unlike regular Joes and Janes, hedge funds do not have to meet Reg-T requirements, which is what the Federal Reserve Board requires investors to put up as a minimum deposit for their securities purchases."

The SEC and the Fed are well aware of the problem but simply lack the political will to address it. The idea that hedge funds are involved in trades that are too complex for regulators to understand is silly.

jk
08-06-06, 10:30 PM
The idea that hedge funds are involved in trades that are too complex for regulators to understand is silly.

it seems that 2 nobel prize winners didn't understand that everything that's normally uncorrelated gets correlated under systemic stress. and they didn't remember keynes' remark that the markets can stay irrational longer than you can stay solvent. the issue there wasn't the complexity of the trades, though. it was their size.

EJ
08-06-06, 11:47 PM
it seems that 2 nobel prize winners didn't understand that everything that's normally uncorrelated gets correlated under systemic stress. and they didn't remember keynes' remark that the markets can stay irrational longer than you can stay solvent. the issue there wasn't the complexity of the trades, though. it was their size.

A mid-level employee of the SEC could probably see the risks in a highly leveraged one-way bet that the rocket scientists over at LTCM were making. He may not understand all the details of the bet itself, but a few simple questions probably would have determined the likely result if the bet didn't go as planned.

The regulator isn't there to assess the risk of the bet, or the probability of failure. He's there to ask, "What's the worst case?" and "What can you do if that happens?" If the guy running the fund says, "Well, um, there may be a cascade of defaults that might cause a bunch of banks to swamp the Fed's discount window. But, shucks, that'll never never happen. Just look at our model. It's foolproof! We're rocket scientists!" Then the regulator's duty is to make sure that the hedge fund has put aside enough cash in reserve to keep the cascade from happening. Of course, then they couldn't afford to make the bet. To be able to afford the bet, they need you and me to cover it, and I don't recall getting anything on the upside, so why should I pay for the downside?

WDCRob
03-03-08, 05:35 PM
Loved the bolded piece of the Buffet quote below...

QUICK: I want to start off with a question from Brad in Atlanta, Georgia, and he asks, `In your annual letters you make it very clear that you are not a fan of the hedge funds and you think they destroy wealth. Do you think hedge funds have an edge which justifies their huge fees?'

BUFFETT: Well, the answer is an aggregate no. When there were very few of them and a lot of talent, but not a lot of competition with each other, it's very likely that they did. But in Wall Street you have this progression from the innovators to the imitators to the swarming incompetents.