In addition to traditional blog entries, in the future I will also be linking to various articles of interest, usually related to a specific topic, but for which I will usually offer a short summary, commentary, or opinion. These are articles that I felt were worth reading, and offered something new, even if it is just a new perspective, or a better/different explanation of an existing issue. This first set of links will include various hedge fund articles, a topic for which I am very interested in. My hope it to release this and other lists (commodities, energy, derivatives, quantitative finance, computational finance, financial engineering, and trading among others) each weekend, based on articles from the previous week. This will start slow, but hopefully will get more consistent, especially as the summer approaches when I have more time.

Hedge Funds

"How The 10 Richest Hedge Fund Managers Got That Way"
Heidi N. Moore - Deal Journal Blog at the WSJ
* Turns out, it was not just those funds that shorted sub-prime that did well, although that certainly helped and made large contributions.

"A Reprieve for Hedge Funds - But Challenges Remain"
Cam Hui - Seeking Alpha
* Nice discussion of hedge fund correlation with market indexes, and whether we should continue to pay up when we can replicate for less.

"Hedge Fund Assets Grew by 27%"
Kathy Shwiff - WSJ
* Hedge fund assets up to $2.65 trillion in AUM. 144 of the 391 hedge funds with assets of at least $1 billion are in New York.

"Top Holdings of the Top Hedge Fund Earners Last Year"
Bespoke Investment Group - Seeking Alpha
* A listing of the top 10 long holding from the top 3 hedge fund earners. Even more interesting then the long holdings is how poorly they did on average. The real money was made on the short side, but unfortunately, that data is not released.

"Where is the Hedge Fund Industry Going, 2 Years Later?"
Roger Ehrenberg - Information Arbitrage
* I discussed this article more in a recent blog, but in a nutshell, it is forecasted that industry consolidation will continue, and that the shape of the industry will continue to approach a "barbell," with large players on one end, and smaller boutiques on the other. Multi-strategy funds will increase, and funds-of-funds will continue to gain popularity before leveling off.

"Why Do Investors Pay Fund-of-Funds Managers?"
Felix Salmon - Seeking Alpha
* Another case against paying hedge fund managers the usual 2/20 fees, in particular, fund-of-funds managers. Of interest is data showing the negative returns of traditional hedge strategies, such as convertible arbitrage, event driven, and long/short, while the dedicated short sellers (aka Jim Chanos) are not surprisingly doing well. But aren't they all hedged anyway? .... just kidding.

Nice article over at the A Dash of Insight blog regarding LIBOR and its recent issues (some of which we have discussed). Of interest is how much of the discussion / problems relate to currencies other than the dollar, and how the relevant discussion with regard to the U.S. dollars involves Eurodollars, which are dollar denominated deposits in banks outside the U.S. As is turns out, many banks cannot move between the two markets, reducing arbitrage, although U.S. investors can trade Eurodollar futures on the Chicago Mercantile Exchange. Finally, of interest is how the 6-month Eurodollar rate, which is often not referred to (the 3-month Eurodollars have the liquidity and are often used for hedging), are linked to adjustable rate mortgages (ARM), and are therefore the rate that U.S. investors should be paying more attention to as it relates to the housing market and its current and potential reset problems.

The New Zealand Rugby Union "dodged a financial bullet in 2007" by hedging against movements between the New Zealand dollar and the U.S. dollar. The hedge was put in place as the New Zealand dollar briefly dropped to 68 cents against the U.S. greenback. The Union hedged more than $24 million U.S, and ended up saving $6 million as the New Zealand dollar rose to 77 cents against the U.S. dollar. No word exactly what they were hedging against (possibly salaries for U.S. players?). Maybe speculating, and not hedging, might be a better description of their position, but who really know.

The globeandmail.com is reporting how EnCana's hedging strategy "backfired" as the company recently hedged 40% of its expected 2008 natural gas production at around $8, while prices for natural gas are currently over $10. The impact of the hedging showed up in Encana's first quarter results as profit plunged to $93 million from $497 million a year earlier, with the decrease in the first quarter resulting from unrealized hedging losses. While Encana's 2008 hedges have not expired, mark-to-market accounting generated the balance sheet losses as natural gas prices moved above the original $8 contract price. Also mention is how the Encana executives are "looking on the bright side" as the higher prices have helped the 60% of their production that is not hedged.

As usual, it is interesting how hedging is considered to have backfired when it turns out that you would have been better off being without a hedged position. Of course, if it had turned out that $8 was the top, and Encana was selling the majority of its 2008 production for $6, then the same authors, and many shareholders, would be wondering why the company did not lock into prices when they were so high. Rather than seeing a "backfired" strategy, Encana's approach to managing their business appears sound and stable, and less risky and foolish than one might expect.

Tickers: ECA

Nice article and supporting graphs/charts at Mark Perry's Carpe Diem site showing how high unemployment is not only rare, but usually occurs for a short amount of time. Given that unemployment is at 5.1%, below the 50-year long-run average of 5.9%, it is still not time to panic. Next Friday's job numbers may tell a different story, but for now unemployment appears relatively contained. Furthermore, the median duration of unemployment is currently at 8.1 weeks, or about 2 months, with over 2/3rd of unemployed workers out less than 14 weeks. Of course, if you are unemployed, this may be encouraging, but of little consolation, especially when we continue to hear daily about how bad the situation is.

The Dow Jones Transportation Average has been rising since the end of January, moving nearly 25%, even as increased fuel costs take their toll on the transportation sector. During the same time, the Dow Jones Industrial Average has been relatively flat.



While not a perfect indicator, the transports have at times been a leading indicator for the industrials. The logic behind the indicator is as follows. If product is being shipped from supplier to retailer, than retailers are experiencing lower inventory and increased demand, eventually resulting in both the supplier and retailer booking revenues and earnings. The leading transportation indicator occurs since the transports are the first to signal demand, with the transportation companies also being the first to actually get paid for their services, resulting in higher valuations and stock prices. Both the suppliers and retailers have to wait a few months before seeing increased revenues at the retail level, or increases in accounts payable at the supplier level. As a result, increases in the transports can at times signal future revenues and stock prices for the industrial companies.

Of course, one important caveat is in order. Given the recent agricultural and energy demands, both the trucking and rail industries have seen increased business moving coal and crude, along with wheat, corn, soybeans, and fertilizers across that states. Given that they have pricing power to ship these high priced, and high demand cargo, they are also able to recoup most of their increased fuel costs. This business in particular is certainly contributing to some, if not most of the recent moves in the transports. Only time will tell if this trend transfers over to the entire economy, but at least for now the signal looks positive.

The airlines, some of which have been hedging, some of which have not, are finding themselves in a difficult position - do they hedge the cost of their fuel with crude oil around $120 a barrel, and jet fuel near $3.50 a gallon? These companies must decide whether it is time to lock into prices, or whether they should simply be at the mercy of the future spot price, hoping that when they need fuel 3 to 6 months out, the market will be a little more "rational".

With high prices for fuel, it helps to drive home the point that hedging is not always the most profitable, or short-term earnings friendly move, but may be a smart long-term play. When prices are rising, then yes, you get the benefit of buying fuel on the cheap, and possibly the added benefit of raising product prices along with your competitors to compensate for the higher overall fuel cost (which may not impact you as much since you were hedged). But the story is different on the down side. As spot prices fall, you are locked into higher priced futures contracts for your raw material and energy needs, while your "risky" competitors who decided not to hedge, or simply could not hedge since they were not credit worthy and did not have the proper margin, are taking advantage of lower spot prices. To add insult to injury, you no longer have pricing power, and may even see price cuts as your competitors put the squeeze on you. If options are employed instead of futures, such that you have the right but not the obligation to pay the higher strike prices as spot prices drop (compared to how you would be obligated with a futures contract), you still do not get away unscathed. The options you buy will not come cheap, and are likely to be quite expensive during times when prices are volatile - just when you are probably most interested in hedging.

Of course, is this really what hedging is about - trying to time the market? Ideally, no. Let us look at the airlines again. In an attempt to have some forward looking predictability, they book revenue by selling tickets 3-6 months out. Shouldn't they be hedging their fuel costs now, for payment 3-6 months forward, to insure that given the prices they are currently selling tickets that they can make a profit in 3-6 months based on revenues (ticket sales) and cost (fuel) they will realize at that time? I would think so. Why do many fail to do exactly this? Well, there are probably a number of reasons, but a short-term perspective which is more interested in making earnings next quarter is probably one of the biggest culprits, not to mention those pesky credit issues. It is the classic problem for risk managers. They love you when the hedge "works", but hate you when it does "not work". If done properly, the hedge works in both situations - high and low costs - but this is not what the CFO and investors see. They only see how the company is paying $3.50 a gallon for fuel when the spot price is $3.00 a gallon. Reminding them that the company only paid $3.50 a gallon when prices were $4.00 a gallon a month ago doesn't compute, nor does the fact that you are able to help the company price its tickets properly in order to generate stable returns, since you know in advance what your cost of fuel is going to be. Ah, don't bother me with those details. Again they ask: "Why is our cost of fuel $3.50 now when spot prices are $3.00." Sigh....

Yet all of this discussion may miss the bigger issue. Anytime a company, or industry for that matter, can only show profits when it gets the hedge "right", or in other words, was fortunate or lucky enough this quarter and showed a profit since their hedge allowed them to cut costs or undercut their competitors, then it might be time to look for other sectors to invest in. Next quarter they may not be as fortunate. Companies that have the same problems with $10 per barrel oil, as with $100 per barrel oil, are simply at the mercy of the markets. These companies may make for an interesting trade at times, but in the end, you might as well take your money to the casino and bet on red or black. At least then you could save transaction costs and the bid-ask spread (well, sort of), while at the same time not worrying about strikes, delays, or passengers stranded on the tarmac.

There is a nice article over at the WSJ MarketBeat Blog discussing how the recent run of declining Treasury yields may be nearing an end. For the first time in about three years, the yield on the 2-year Treasury note is above the current federal funds rate of 2.25%. Maybe more important, the Treasury rate is also above the 6-month federal funds futures rate. Of course, a few days with a positive spread is good news, but it does not make a trend. Nonetheless, it is encouraging.

Does this bode well for the stock market? Can we assume that people are selling Treasuries and dipping their toes back into the stock market waters? Does this signal the end of the rate cuts, or at least imply that the best we can hope for is a 25 bp cut next week? Maybe, but maybe not. Investors are selling Treasuries, but it may be for reasons other than sector rotation. Given increases in inflation, yields on Treasuries are now low enough that investors are not being properly compensated for the risk of higher inflation. Furthermore, even with lower rates, Treasuries were attractive in a falling stock market if for no other reason than to preserve capital, even with low returns. When inflation increases and rises above your rate received, suddenly your buying power begins to decrease. As such, the recent move from Treasuries (to munis, money market funds, TIPS, corporates, equities - take your pick), may have more to do with inflation, and less to do with attractive new risk/return yields, at least in the short-term. If the spread continues to grow, we may begin to start feeling more confident that a shift in the market is occurring.

As recently discussed, the Shanghai Composite has swung from 3,000 to 6,000, and back to 3,000 in a little over a year. To help curb the sell-off, the exchange instituted new rules to restrict large share sales by controlling investors, putting them in a 30-day lockup window, further reducing the amount of new shares and dilution hitting the market. China is now going further by reducing the stamp duty, or stamp tax, charged on share sales. The tax is being lowered from 0.3% to 0.1% in an effort to reduce buying cost, and increase interest in share purchases. Just last May China and the index did just the exact opposite, raising the tax from 0.1% to 0.3% in an effort to cool a market that was beginning to look overheated. Not surprisingly, the market liked the recent move and tax reversal as the Shanghai Composite posted a 9.3% increase during the session after the news, and is now trading above 3,500. In addition to the overall increase, over 200 shares hit the daily 10% limit imposed by the index.

Does the reduction in stamp tax increase trading? Yes, but somewhat indirectly. By paying lower fees, investors have more funds to purchase additional or new securities. One estimate has investors saving 120 billion Yuan over the next year alone, with an expectation that some of these savings will make their way into the market. Of course, with higher return usually comes with higher risk, especially when the move is driven by intervention. As the Shanghai Composite index has just illustrated, both risk and opportunity can come from the same source, but in unexpected ways, and at unexpected times, irrespective of our view of the fundamentals. As a side note, many of us jump into an international index without really knowing what we are investing in. For instance, consider the S&P 500 Index and Nasdaq Composite. Proxies for their markets? Sure. But it is important to know what these markets represent. For the China market, shares of PetroChina represent about 20% of the Shanghai Composite index value. After reducing the stamp tax, and with a little help from oil prices, shares of PetroChina increased 7.1%, contributing a good deal to the move of the index. Being levered more to oil may not be a bad thing, but it is important to make sure we know what is inside the package we are buying, and whether this makes us more or less exposed to a specific sector or industry. Of course, hoping that any expected or unexpected market intervention will be best for our position is something we have a little less control over, even if we “understand” the market.

Vickers Weekly Insider Report finds that the trailing eight week ratio of corporate selling to buying is now at 1.4 to 1. In other words, insiders on average are buying 1 share for every 1.4 they sell. Sounds bad? Not exactly. Traditionally, insiders do much more selling than buying, so any ratio below 2 (2 sells for every 1 buy) is considered bullish. As reported at MarketWatch, the last time the ratio got this low was in November 2002, near the end of the 2000-2002 bear market. Of course, the market did not really begin increasing until March 2003, and it had some catalyst with the military operations occurring at that time. Therefore, while the insider buying numbers appear good, the market bottom may last longer than expected, and may also need a catalyst to help it finally reverse course.

The Shanghai Composite market fell below 3,000, after rising as high as 6,000 just four months ago. The composite first approached 3,000 in the first quarter of 2007, on its way to over 6,000 in October. The recent sell off has the Chinese stock exchange worried, causing it to include rules that restrict large share sales by controlling investors, thereby reducing the amount of new paper hitting the market. So far, the new rules are having little impact.

Yahoo! posted net income of $542.2 million, compared to $142 million a year ago. Nice increase? Well, not exactly, since $401 million of the gain was related to the IPO of Alibaba.com (better known as the kitchen sink). In other words, they made about what they did a year ago - they were flat. Flat is not good on Wall Street. To add insult to injury, international revenue fell 11%, while U.S. revenue was up 19%. Nice increase on the domestic side, but given that the U.S economy is slowing, 19% more of a shrinking share is not good. It looks like the "!" will need to be officially stripped from Yahoo! since the past excitement continues to be lost. Steve Ballmer and Microsoft now need to figure out whether they should continue to offer $31 a share. On the other hand, he is probably dancing something like he did at a past MSFT shareholder meeting, given that he and Microsoft are now back in the driver's seat, not that they ever left. I am really not sure what other cards Yahoo! has left to play. It is hard to see anyone else offering more the $31 a share, and also hard to see how Yahoo! can sustain even $28 if Microsoft were to walk away. Sure, Yahoo! gave good guidance, and mentioned how they are on track to doubling operating cash by 2010, but what do we really expect them to say? Those that bought the $30 and $32.5 calls this last week, hoping to see a huge quarter, followed by Microsoft capitulation and prostrating, are going to have to keep wishing. Their wishes may still come true, but the strategy payoffs are a little less guaranteed, especially with short-term options. Instead of being forced into submission, Ballmer is doing the dance once again, and Jerry Yang would be smart to join in. The Yahoo! board might also want to join the conga line as well - to keep wearing out the dance theme - since the shareholder activist and their lawyers are probably firing up the briefs as we speak.

Tickers: MSFT, YHOO

Intrepid Potash raised $960 million in an IPO priced Monday, with 30 million shares going out at $32 per share. The final price was $3 above the top of the expected range of $27 to $29, which itself had been raised. The stock traded up over $50 a share for a short time today (as of posting time). Intrepid Potash (IPI) accounts for about 1.5% of global potash production. Potash (POT) is also up over 1% today, although Agrium and Mosaic were relatively unchanged, and slightly down (again, as of post time). Potash, Agrium, and Mosaic are each having a simply parabolic April. It will be interesting to see if IPI will join them, or mark a short or longer-term top. Relative strength for each is pointing for a correction, at least short-term.

Ticker: IPI, POT, AGU, MOS

Amazing, but true. A group of investors is creating International Equine Acquisitions Holding, a horse hedge fund. The group is raising $100 million as seed money to buy, sell, and breed horses. How is this a hedge fund? Are they hedging risk? Do they have a unique investment strategy (well, maybe..)? Seasoned portfolio managers? No, not exactly. How are they a hedge fund you say? Well, they are collecting management and performance fees. OK. Sounds good to me.

Earlier this year I also read how a minor league pitcher was selling $20 shares in his future (which at 25 years, I believe, does not look as good). He eventually returned the money, a total of $36,000 collected, due to Major League Baseball and Union concerns. Apparently he and his advisers are still trying to make it work. Not sure that he called himself a hedge fund, but he might as well have. At least then he can take 2/20 and tax some income (sorry, gains) at 15%.

Back to reality for a moment - does this mean we have hit a top in the hedge fund industry? Doubtful, but is does make you worry. It will certainly get the attention of Congress.

Recently it has been discussed how the traditional 7-8 multiple of crude oil to natural gas has broken down - or at least how natural gas has not caught up as crude continues its march well beyond $100 a barrel. It was further speculated that this may be a buying signal for natural gas and natural gas stocks - even with the recent run up in prices. As it turns out, commodities and bond yields, which have also more or less moved in tandem over the years, have also been gaping apart - with the gap holding for a significant period (approximately the last 5 years), and with the spread between the two continuing to increase. Why do they typically move together? Simple. When commodity prices rise, inflation begins creeping into the system. Anytime inflation increases, bond investors will demand higher yields, causing commodity and bond yields to move together. A simple sector shift from bonds to commodities puts selling pressure on existing bonds, further driving up yields.

So the trade seems easy - short commodities and bonds (driving yields up). Simple, right? Well, maybe not. Others examining the divergence list potential problems with this logic. First, things have changed. Commodities are now believed to have less influence on inflation (not that demand doesn't cause inflation, but that demand is not necessarily scaled back due to price increase). Regardless of prices, people need energy and raw materials. Second, we are in a commodity bubble. Bubbles burst, but we don't know why or when. To the first point, we often hear the refrain: "it is different this time." No, it is not - or at least, usually, it is not. Things may be a little different, and timing may be off, but long-term trends tend to have a way of popping back up and reminding us of efficiencies, and of our own stupidity and greed. As for the second comment - I agree. Even if we know a bubble exist, we don't really know when it will pop. Furthermore, when it does pop, it usually takes longer than we expect. What shall we do? We probably need to sit back and wait for more clarity, at least before taking both sides of the trade looking for convergence. Once the commodity boom stalls and takes a breather in its historically long cyclic move, investors will have less profits to redeploy (such as in the bond market), at which point the selling and stalled buying pressure on bonds should start driving the yields back up. For those that do take both sides of the trade, let us just hope that the old axiom of Wall Street - that our capital last long enough to allow the market to see how smart we are - gives us a reason to laugh and gloat, instead of a reason to cry.

The Yahoo! earnings on Tuesday should prove to be interesting, regardless of whether they meet, beat, or miss expectations. If Yahoo! misses, the handwriting may be on the wall with regard to Microsoft's current takeover attempt and offer. On the other hand, Google's recent results illustrate that click numbers are not nearly as bad as everyone expected. If Yahoo! can show better than expected earnings and beat expectations, the pressure will be on Microsoft to increase its current offer (which is now valued slightly below the original $44.6 billion). Given what is at stake, you can expect Yahoo! to book and include every possible source of revenue in the first quarter. Ironically, in the end this may actually be what is best for Microsoft, allowing it to offer something north of $31 a share, maybe as high as $35 a share, while at the same time saving face as it justifies a higher offer. Let the drama begin, ..... again.

Tickers: MSFT, YHOO