Why The Hedge Fund “All-Stars” Are Struggling

Even as the S&P 500 rose a respectable 7.8 percent through the first four months of 2010, before giving it back in the first week of May amid concerns about Greece’s debt woes, the all-stars of the hedge fund world were having a rough start to 2010.

Moore Capital Management, whose founder, Louis Bacon, has his London digs (okay… more like a palace) right around the corner from me, had only posted gains of 1.58 percent this year—despite climbing to the top of the United Kingdom’s “hedge fund rich list” with a personal fortune of 1.1 billion British pounds.

Last year’s shooting star of the London hedge fund scene, emerging market manager Greg Coffey, who famously left a $250 million bonus on the table at European hedge fund group GLG Partners back in 2008, was down 5.88 percent into mid-March. And having recently sat next to the senior macro trader at Tudor Investments during a dinner at the swanky Carlton Club, I know that the mood at this iconic hedge fund is scarcely better than GLG. It turns out that the Tudor BVI Global fund was down 0.55 percent through mid-March.

No wonder this subpar performance has left investors scratching their heads. These hedge funds aren’t the industry’s one-hit wonders, either. They are, in fact, the “Babe Ruths” of the hedge fund world. After all, with the S&P 500 hitting 18-month highs in April 2010, you probably would think that a monkey throwing darts at a copy of The Wall Street Journal could be making money.

Hedge Fund All-Stars: The State Of Play In Global Markets
Well, if that monkey is an American one throwing darts at American stocks, the approach may succeed. But it’s been tougher for the monkey’s more cosmopolitan cousin.

The reality is that outside of the United States stock market, global stock markets haven’t done much in the last six months.

EAFE Versus S&P 500

Chart for iShares MSCI EAFE Index (EFA)

 

While the U.S. stock market rose a solid 15 percent during the last six months through April 2010, the MSCI EAFE Index—a stock market index that reflects market performance of developed markets in Europe, Australasia and the Far East—was clearly in the red for 2010. The formerly high-octane BRICs (Brazil, Russia, India and China) are struggling this year. And the weak performance of global markets masks a now seemingly distant but stomach-churning 15 percent sell-off in global stocks within the span of two weeks in January and February.

Hedge Funds Struggling: Here’s Why
Unlike U.S. retail investors, global macro hedge funds—or “multi-strategy funds”—aren’t necessarily focused solely on the U.S. stock market. And opportunities to make money outside of the U.S. stock market have been limited.

Yes, the dollar is up, and the euro and the British pound are down. Sugar soared for a while, but then collapsed. But gains on those trades have hardly made up for the cost of being whipsawed in and out of the market by sharp sell-offs in January and again in early May this year.

For retail investors, “buy and hold” remains the dominant investment mantra. And it’s also the strategy that has worked best over the past 14 months. But after a paradigm-shifting 2008, hedge funds are understandably skittish. They are (rightly) focused on the downside risks—whether financial contagion from Greece or another “Black Swan” event which they cannot predict.

Top hedge funds are also struggling because they look at risk in a fundamentally different way than investors schooled in the ways of "buy and hold." They are focused on the downside to a degree that is hard for most investors to imagine. At SAC Capital, if a portfolio manager is down 5 percent, he loses half of his money under management. If he loses 10 percent, he is shown the door. Apply that same standard to your favorite broker and see how long he’d last.

The experience of 2008 is also why many top hedge funds went on the defensive after the sharp sell-off in January. And they have been scrambling to recover ever since. Recent volatility in global financial markets notwithstanding, after an eight-week rally in the U.S. markets through the end of April, the sharpness and suddenness of the January sell-off seemed to fade into distant memory. As John Kenneth Galbraith observed, “the financial memory is very short.” For U.S. investors glued to the non-stop video game that is CNBC, “fear” rapidly transformed into “greed.” Of course, the big sell-off in the first week of May should serve as a reminder that risk management is as relevant to individual investors as it is to big institutions.

The bottom line? Yes, staying "dumb and long" in the U.S. stock market while ignoring the dips has been the single-best investment strategy over the past year. And any monkey, throwing darts at The Wall Street Journal would have outperformed the world’s top Market Wizards over the course of the last 14 months.

But as any old trader on Wall Street will tell you, “never confuse brains with a bull market.” And as any hedge fund manager will add: “If you pay peanuts, you get monkeys.”

Sincerely,
Nicholas A. Vardy signature
Nicholas A. Vardy
Editor, The Global Guru

P.S. If you want to keep up with my latest insights on developments in fast-paced global markets, you can now follow me on Twitter on @NickVardy or on my new blog, NickVardy.com.

Latin America’s Chile: A Top Stock Market Performer

Headlines around the world are full of news about the aftermath of Chile taking a big hit Feb. 27 with a magnitude 8.8 earthquake, the fifth-strongest ever measured in the country. The good news is Chile’s capital, Santiago, is located about 200 miles northeast of the quake’s epicenter and avoided the worst of the disaster. The airport had resumed operations and several shops were open for business on the Monday following the weekend earthquake. In addition, the Chilean stock market was back online March 1 without a hitch.

Indeed, iShares MSCI Chile Investable Mkt Idx (ECH) jumped 4.46 percent during the week following the earthquake, as the powerful temblor barely registered as a blip on Chile’s stock exchange. Chile’s stock exchange proved to be as robust as most of Chile’s rigorously constructed buildings.

Chile: Free Market Reforms + Discipline = Economic Success
Unlike Greece or other countries on Europe’s periphery, Chile has been a model for how a small developing country should conduct its economic affairs. This country of nearly 17 million people, with an economy about the size of Alabama, is arguably the most economically successful and certainly, on a per capita basis, the wealthiest country in Latin America.

Understanding the reasons behind Chile’s economic success can help you identify other countries in the world that are getting the basics right—and, like Chile, are the source of stock market profits that put the United States S&P 500 to shame.

Despite its impressive achievements, Chile’s success has been a quiet one, with few countries seeking to duplicate the “Chilean Miracle.” Chile first introduced free market-oriented reforms with the help of the “Chicago Boys”—a group of University of Chicago-trained economists—during the bad old days of August Pinochet’s military government in the 1970s. The first democratic government of Patricio Aylwin—which took over from the military in 1990—continued with these economic reforms, as have successive governments since then. The impact of these reforms became crystal clear as Chile’s economic growth rates began to outpace that of its Latin American rivals virtually overnight.

Chart for iShares S&P Latin America 40 Index (ILF)

Chile’s growth in real gross domestic product (GDP) averaged 8 percent during the period 1991-1997, rivaling that of the Asian Tigers. Although it fell to half that level after the Asian financial crisis in 1998, Chile’s economy recovered, boasting growth rates of 5 percent to 7 percent for most of the past decade—considerably outstripping growth rates in neighboring Brazil. By 2006, Chile had the highest nominal GDP per capita in Latin America. And recently, it was the first Latin American country to join the Organisation for Economic Co-operation and Development (OECD), an exclusive club of “developed nations.”

What’s most impressive about Chile is that it has stuck to its reforms through thick and thin—a discipline that is sorely lacking in recent U.S. administrations. After being elected in 2006, President Michelle Bachelet took a lot of flack when she failed to succumb to pressure to spend Chile’s windfall earnings from high copper prices. The “Great Recession” of 2008 and 2009 revealed the wisdom of her policies. When the global financial crisis set in, government coffers had the cash to implement one of the world’s largest stimulus plans. The ant prevailed over the grasshopper yet again.

Skeptics point out that for all the importance of free-market reforms, Chile wouldn’t be this far along without its huge reserves of copper. Copper accounts for about one-third of the government’s revenue and, as the world’s third-biggest producer of copper, even a small stumble in Chile’s copper production due to the recent earthquake sent global copper prices soaring.

But ideas do matter. What copper is to Chile, oil is to Venezuela. Yet, Venezuela is an economic basket case. Contrast the economic fates of Latin American countries that invoked the name of Che Guevara (Cuba, Venezuela) with the economic views of Milton Friedman and the “Chicago Boys” (Chile) during the past 40 years and you can see why Chile has become a poster child for free-market reforms. As the late, great Jim Rohn observed, “People aren’t building rafts to escape to Cuba.”

Chile: Consistently Hot
While most global stock markets go in and out of fashion, Chile has been the single most consistent performer among all global markets over the past decade. It has ranked as the third-best performing market in the world for each of the last 10 years, three years and year-to-date.

Sadly, U.S investors did not have a chance to profit directly from the Chilean index’s performance until the launch of the iShares MSCI Chile Investable Mkt Idx (ECH) in November of 2007.

But had you invested $10,000 in the iShares MSCI Chile Investable Mkt Idx (ECH) on the date of its launch on Nov. 20, 2007, you’d be sitting on $12,001—a solid 20 percent gain. Had you invested that same amount into the S&P 500, you’d have only $8,685. That’s a remarkable 38 percent difference over the span of only 27 months.

iShares MSCI Chile Investable Mkt Idx (ECH)

Chile also has been a star this year among emerging markets, up 6.9 percent so far, the top performer in Latin America, even as the overall MSCI Emerging Markets Index has dropped 5.4 percent.

Bottom line? Chile may sell off briefly after the devastating earthquake but I believe that Chilean equities will recover soon and will continue to be among the top stock-market performers for the coming decade.

—Nicholas A. Vardy
Editor, The Global Guru

Two Contrarian Trades for the Coming Decade

United States stock markets have just come off of their worst decade ever, with inflation-adjusted returns in the S&P 500 dropping as much as 30 percent. That’s a far cry from what investors were expecting at the turn of the millennium. Then, the Internet was creating paper billionaires overnight.

Fast forward 10 years and Nasdaq is still 40 percent below its peak. In addition, the Pew Research Center just designated the past decade as the “worst in 50 years.”
 
But, just as there was a technology bubble in 2000, today there is also a strong “pessimism bubble” about the U.S. economy over the coming decade. And like all bubbles, this one will eventually pop—as will the rising China bubble. Understanding this is the key to ensuring you don’t end up like investors who have spent the last decade waiting for Cisco to “get back up to $80.”

Rarely has the global stature of the U.S. been lower than it is today. A recent Washington Post/ABC poll found that 61 percent of the American people think the U.S. is in long-term decline. In another poll, 44 percent of Americans said that China was the top economic dog in the world, compared with only 27 percent favoring the U.S.

Much of the investment world holds the same opinion. In fact, the world’s top hedge fund managers are piling into gold, betting billions that the U.S. dollar is toast. Meanwhile, 17 percent of the U.S. workforce is unemployed, underemployed or has stopped looking for work.

And that’s music to the ears of contrarian investors.

Contrarian Trade #1: Buy American
After the financial meltdown of 2008, the greatest contrarian trade in the world became a bet on the U.S. But that’s exactly what I’m doing by shifting my own money and my clients assets back into the U.S.

First, investment is a game of expectations. Or as Bill Browder, formerly the largest investor in Russia, pointed out, Russia doesn’t have to turn into Switzerland for him make money. It just has to turn out better than people expect. In 1998, an investor I met in Russia said that he’d rather eat nuclear waste than invest in Russia. Yet, had he invested there, he’d have made 60x his money, just as Browder and his investors did.

Second, having lived abroad since 1991 has only strengthened my conviction that the global economy largely runs on U.S.-generated ideas. (This is not, as you can imagine, a popular position). The American Academy of Sciences estimates that 85 percent of economic growth in the U.S. is now produced by new ideas. In 2007, companies that were founded by entrepreneurs backed by venture capitalists provided 10.4 million American jobs and generated $2.3 trillion in revenues. That’s equal to the gross domestic product (GDP) of France.

Nowhere is the power of ideas more evident than in the case of decidedly unsexy U.S. manufacturing. On one hand, the media bewails that the American manufacturing workforce has shrunk by more than 40 percent since its peak in 1979, with 6 million of those job losses taking place over the last decade. But thanks to innovation and advances in technology, U.S. manufacturing output per worker recently hit an eye-popping $234,220 for each of that sector’s 11.6 million workers. Workers today produce twice as much manufacturing output as their counterparts did 20 years ago and three times as much as in the early 1980s. The U.S. steel industry—left for dead in the 1980s—produces more steel today than it did 30 years ago.

Contrarian Trade #2: Sell China
If there is one surefire way to make quick money in financial markets, it’s to bet on bubbles popping. Noted value-investor John Templeton made his first fortune over a 40-year period by betting on the rise of Japan. He made a bigger and quicker fortune by betting on the dotcom bust in 1999. I believe we are smack dab in the middle of a “pessimism bubble” about the U.S., much like the bubble about Japan 20 years ago, the Internet 10 years ago and China today.

Twenty years ago last month, Japan’s Nikkei index reached its historic peak of 38,916. In 1989, Japan was No. 1, as U.S. business school students pored over Japanese language texts and studied Japanese management techniques. A mere decade later Japan had been long forgotten and the world was in the midst of another frenzied bubble called the “New Economy.” Today, Japan and the Internet have been supplanted by the “China Miracle.”
 
Everywhere you look you see serious experts earnestly predicting the decline of the U.S. and the rise of China. And they will give you incredibly cogent, well-argued reasons for why you should listen to them. Many of these arguments I agree with myself. But the next time you read predictions about what the world will look like in 10 years, consider this. The most widely recommended stocks 10 years ago were America Online, Cisco Systems, Qualcomm, MCI WorldCom, Nortel, Lucent Technology and Texas Instruments. MCI WorldCom and Nortel went bankrupt. And if you invested in a portfolio of the others that survived, you’d have lost about two-thirds of your money. If the fates of Japan and Internet stocks are any guide, a similar fate awaits your “China strategy.”
 
Unlike many of those pundits who are so certain about what the world will look like in 2020, I never took that class on how to predict the future, naively opting for a course on Japanese joint ventures instead. But the two themes I’d bet on over the coming decade are to buy the U.S. and to sell China.

For the sake of my financial future, I hope you disagree.