An article in Pensions & Investments reports data from Hedge Fund Research showing that hedge fund industry assets fell by $156 billion in October, with $115 billion from performance-related losses, and another $41 billion from net redemptions. Investors withdrew $22 billion in October alone. Aren't redemptions, at least those above normal withdraws, due to performance-related issues? Then again, redemptions are adding to the poor performance in what is becoming a "chicken or the egg" downward spiral. I guess it does not really matter which came first at this point. We are still left with a market that has laid an egg, and investors too chicken to buy (sorry, I could not resist). The quote of the day from the article: "HFR analysts attributed the outflows to investor dissatisfaction with under performance." Yes, it is true. Markets that are cut in half have a way of generating dissatisfaction.

The UNC Chapel Hill Board of Trustees announced that their endowment lost about $320 million (see Charlotte Observer article). A big loss indeed, but when you consider that the endowment is currently worth about $2.5 billion, the approximately 13 percent loss is not too bad when compared to the broader market - albeit some funds are more conservative and are geared towards protecting the capital at all cost (something worth considering once again for everyone). On the other hand, the fund appears to have underperformed other endowments - the top 30 university endowments (each over $1 billion in AUM) have lost on average about 9.8 percent. Then again, "just down 10-13 percent" is usually followed by "we need to cut spending and raise tuition," which is not what anyone wants to hear or say right now. Just ask students, faculty, and of course, parents.

Option trading in the United States has decreased 23 percent compared to October (see Bloomberg article). During market moves, it would normally seem to make sense that market moves might cause increased option activity as investors look to protect their equity investments, but rapid sell-offs (and subsequent rallies) have resulted in higher volatility, driving option premiums higher. While higher option premiums may be prohibiting some traders from being able to efficiently use options for hedging, the root cause may be with the equity trading itself. Regardless of its impact on option premiums, the increased trading has reduced the number of equity trades for those who typically hedge such positions, thereby reducing the need for hedging with options. As hedge funds get smaller, their impact on trading (currently about one-third of all trading) will also decrease, reducing volume, and putting further pressure on liquidity. As traders search for a market bottom, they may be misleading themselves. We could simply be looking at a type of mean reversion to a pre-hedge-fund-explosion market with regard to asset prices and trading volumes. Current levels may be less about bottom building, and more about new market norms. Of course, this means reversion from the mean could take us into seemingly scary territory in the near future as the market recalibrates to a new post-irrational-exuberance world.

There is an interesting Business Week article regarding the increased use of FHA-backed loans that are being used to continue lending to borrowers who once again may be unable and unlikely to pay back their loans. Inside Mortgage Finance (a research / newsletter firm) estimates that bad FHA-backed loans could end up costing taxpayers more than $100 billion over the next five years. As subprime loans have dried up, the FHA loans have become the only source of lending for many at-risk borrowers. Congress and the current administration have been encouraging lenders to apply for FHA guaranteed loans in order to access the current FHA loan reservoir, but the banks and loan quality are not being monitored, allowing the funds to be loaned to the very same borrowers that had trouble paying before, and which of course began the chain reaction of defaults we are now witnessing. To make matters worse, the government guarantees are creating incentives for banks to buy the FHA loans and securitize them, in what may become another bad dream realized. Hopefully the markets will wake up and be spared in a year or so when the new "FHA-insurance Armageddon" is suppose to hit - but past history is not encouraging.

Changing rules, even when the change may ultimately be good, can be disruptive. As a result of the change in the TARP from buying troubled assets to injecting capital directly into companies, the credit markets have once again reversed course (see Financial Times article). The fact that now there are no buyers for some toxic assets has the value of some mortgage-related securities falling to new lows. Jay Mueller, portfolio manager from Wells Capital Management, said it best:

“Now those markets will go back to being completely illiquid as there will be no price discovery process started by the Tarp. It is tremendously difficult to trade when the rules of the game change.”

Now that the government has realized that it cannot justify and support non-market prices, the banks and other holders of toxic debt will have no choice but to further discount and account for reduced asset values. For the rest of us, this just means more volatility, lower asset values, and a market that continues to suffer under its own weight. At this point, "building a bottom" may be the best we can hope for in the near term.

Just about every day we get a new prediction / forecast of where the hedge fund industry is headed. Now Citigroup is reporting that total hedge fund assets may fall to around $1 trillion by the middle of next year (see Bloomberg article). This figure would represent a decline of nearly 50 percent from peak levels. Of possibly even more interest in the report is how hedge funds are believed to have raised cash equivalent to around 40 percent of assets in anticipation of both known and unknown (but expected) redemption requests. As posted yesterday (see post), this cash could be adding to daily volatility as funds allocate it on a short-term basis while waiting for redemption requests to slow. While this may be contributing to market volatility in the short-term, there is also an expectation that once this money (forecast to approach $1 trillion) does get deployed in to longer-term investments, it could be a strong catalyst for driving the market higher. Unfortunately, many investors are following the belief that it is still "too late to sell, but too soon to buy." Once hedge funds start getting back into the market in earnest, the move could be both quick and significant enough to begin thinking it is "too late to buy." Of course, whether that happens tomorrow or late next year is just a guess at this point. Daily rallies of over 5 percent that have failed to hold have certainly not engender any extra confidence for traders or investors.

There is an interesting Forbes article that discusses the issue of whether hedge fund selling as a result of redemption notices has been contributing to market volatility (see previous posts here, here, here, and here, on the subject). The article notes that while last Saturday was the 45 day period before the end of the year that is often the one and a half month last chance opportunity to request withdraw of funds as required by some hedge funds, recent volatility cannot be blamed entirely on the forced selling of hedge funds before this date. Many funds have shorter notices, while for some the required notification period is longer. Furthermore, any volatility that was experienced may have been due more to the self-fulfilling prophecy that often follows other calendar events, such as those experienced with the January Effect, option expiration dates, and end of month/quarter trading. Instead, analysts expect that it is more likely hedge funds will systematically continue to sell as needed over the next 12 months in order to meet requests.

Of interest is that many funds have been accumulating cash, with managers eager to deploy funds into a market that some managers feel is depressed and laden with attractive values. While funds are nervous about locking up money in longer-term and possibly illiquid investments, many are also unwilling to simply sit on the cash. As a result, some are engaging in more short-term trading, both from the buy and sell sides, that ironically may be contributing to the volatility being blamed solely on redemption requests. Furthermore, there is an expectation that once redemption requests slow down to normal levels, much of this money will quickly find its way back into the market, generating a rally that could be as large as the one recently seen on the downside, albeit over a longer time frame. Of course, predicting the timing of such a move is difficult, but once previously illiquid instruments such as complex debt securities, private equity, and thinly traded companies start to increase on higher level of trading volume, the market may start seeing the beginning of hedge funds once again throwing their weight, and capital, back into the market.

Given the recent "black swan" events in the market, quant funds that have relied on longer-term trading strategies have suffered (see Reuters article). As a result, many quants are now focusing on higher-frequency strategies that are executed quickly, both to get into and out of positions. No doubt that such an increase in programmed algorithmic trading is contributing to already elevated levels of market volatility. Ironically, many traditional quant funds operate more efficiently in stable market environments, causing such funds to suffer under the recent higher levels of volatility.

The change in trading duration is needed in part since many of the longer-term strategies are no longer valid given the changing market landscape, which due to company failures and shifting regulations, seems to be changing nearly everyday. Modelers using intelligent trading systems, especially supervised systems like neural networks that require extensive historical data in order to learn market patterns, are finding it a challenge to train their systems given the changing market dynamics and subsequent lack of relevant data. The tracking errors have also been significant enough to cause many funds to scale back their use of leverage, putting further pressure on quant funds that rely on borrowed money to juice returns.

While some quant funds could potentially go out of business given current losses, there is no doubt that many other quant traders are seeing this as an opportunity to create new algorithms not yet adopted by the larger quantitative trading community. I image the next great algorithms and trading strategies - which we will not hear about for a few years - are begin developed and deployed as we speak. If there is one thing many quants like more than money, it is a good challenge. The market has certainly provided the challenge, along with some unique opportunities.

First State Investments' Media Works fund has acquired the copyrights to more than 26,000 songs, earning a royalty fee every time they are played commercially (see Financial Times article). Using leverage up to 50 percent, the fund expects to generate minimum returns of 15 percent or more, net of fees, including a dividend of 8-10 percent. The fund has already raised $130 million from institutional investors and private wealth managers. One benefit of the fund is that it is uncorrelated to other asset classes and believed to be largely immune to current problems in the economy. Better yet, since royalties are relatively consistent, the generated cash flow is easier to predict, making it easier to value and generate a net present value. At least now you can encourage others to listen to some music as a distraction from the markets, and make money in the process.