The Advantages and Disadvantages To A 130/30 Hedge Fund

Not long ago I attended a presentation at Columbia University that included a discussion on Equity Hedge funds and the percentage allocations that are popular. One of the popular allocations seems to be the 130% Long 30% Short fund. So what does this type of fund attempt to accomplish? A close examination brings to light some interesting observations.

First, what does this 130/30 break down mean? It may be easier to first look at a 100% Long only fund. A 100% Long fund means that every dollar of the assets is invested in equities. For example, if the fund had $10 million in assets, then the fund would own $10 million worth of equities (as close as reasonably possible, less commissions). Let's move from the 100% Long fund to the 130/30 fund. This fund would use leverage and would increase its Long exposure by 30% and initiate a Short position of 30%. If the fund had $10 million in assets, the fund would own $13 million in equities and simultaneously be short $3 million in equities. The leverage in this case would be 60%.

Another way to look at the 130/30 fund is to back out the leverage for a moment. In this case the fund would be 81.75% Long and 18.75% short. This is the same ratio as the 130/30 fund. The 130/30 fund is just an 81.75/18.75 fund on steroids. The important question is why do such an elaborate percentage as 130/30? If the fund is really an 81.75/18.75 fund in disguise why not just make the fund 81.75/18.75? The first reason is the potential for increased return. Instead of using only 100% of the assets, by using 160% of the funds assets the fund manager is levering the portfolio and therefor increasing potential returns. There is tremendous upside potential with this type of leverage. For example in a down market, the upside exists if the fund manager is able to pick longs that decrease less than the market and or pick shorts that go down more. If the fund managers wits exactly match the market then the fund will match the market exactly. The market and the fund will move identically.

However there is potential risk as well. The largest risk is that the extra 60% leverage goes against the manager. For instance in a worst case scenario lets say that the manager made poor picks. In this case the 130% Long positions decrease in value and simultaneously the 30% Short positions decrease in value (as the stocks the manager is short go up). Let's say that the longs go against the manager by 20% and the shorts go against the manager by 20%. The $10 million fund would drop to $6.8 million for a drop of 32%. If the fund had not used any leverage the fund would have only lost 20% and the assets would have been $8 million. In this case the manager would have been better without the leverage.

Tread carefully when using leverage. I have seen my fair share of problems arising from too much leverage and returns can definitely increase when used properly. Again it all comes down to risk management. Make the positions too big and your problems could cascade. Even if you think you are 100% Long via a 130/30 fund if there is a problem such that the extra 60% margin is really neutralized reality may be completely different if both the longs and the shorts go against you. In that case, action should be taken to lower the leverage and quickly.

The Dollar Strikes Back

Good to see the US dollar flex its muscles. In the short run the direction of the dollar will depend on the Fed. The strength of the economy and the rate of inflation will also factor in. Over the longer term the dollars position in the world will depend on the deficits it runs.

I am still a believer that the US is will be in the throes of a deflationary spiral and that the early stages of a deflationary spiral exist and can be seen through the housing market. However the deflationary run although deep in the housing market has not yet begun for either of two reasons. One: I am plain wrong and deflation will not spread from the housing market to the rest of the economy or two: My synopsis was just early and deflation has not made its way through yet. I am not sure of the answer but still believe deflation is coming and I was just very early. I think another sign to look out for will be the local and state governments and their budgets. If the state and local tax revenues fall off precipitously these local governments will be forced to do one of two things. They will either have to find a way to raise more revenues which likely means higher taxes or two they will have to make cuts to their budgets. Neither of these scenarios are of the pleasant variety. If deflation does take hold expect to see the dollar g on a tear and the model Giselle may then wish to rethink her wishes to getting paid in Euros.

TED Spread Again Moving Higher

The TED Spread is again moving higher. It is still below that important '2' level but it is showing tremendous nervousness again. Maybe there is nothing behind this but fear, but if there is something behind this move higher in the TED then caution is the word.

US Equity Indexes Year To Date

The stats here are from the close of trading on Friday April 18th 2008 and are taken from Yahoo Finance ( http://finance.yahoo.com/ ). The calculations are from me.

Dow = 12,849.36, -3.13% YTD

Dow 50 DMA = 12,366.02

Dow 200 DMA = 13,093.80

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S & P 500 = 1,390.33, -5.31% YTD

S & P 500 50 DMA = 1,340.87

S & P 500 200 DMA = 1439.78

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Nasdaq = 2,402.97, -9.40% YTD

Nasdaq 50 DMA = 2,300.42

Nasdaq 200 DMA = 2,536.14

The Ted Spread

Interesting Ted Spread Chart I picked up from Bloomberg. The TED Spread refers to the difference between the London rate or LIBOR and the 'risk free' 3 month TBill. The spread usually stays around 0.50 or less. When it is in this 0.50 vicinity it means that there is less risk in the system. Currently at around 1.58 it is elevated. It has come down from the 2.4 in August 2007 and the 2.3 in December 2007 and the 2.05 in January 2008 but it still is relatively high. This means that there is still fear in the system and that the credit markets are still under considerable strain. The Fed watches this closely. The topic has popped up a lot since last August due to all of the market turmoil. There was an article in today's Wall Street Journal on this topic.

http://www.bloomberg.com/apps/cbuilder?ticker1=.TEDSP:IND

Could China's GDP Decline?

This is a pretty far out title. Many times in the markets I take a contrarian position. At times it looks like the dumbest call on the planet. Often I am wrong. It goes with the territory of being a contrarian. However when my contrarian view is correct often the position goes in my favor by a large amount.

Back to this title about China's economic output actually dropping. This is such a contrarian view point that I have not heard it - any where. Nobody thinks this could happen. But if the facts are examined closely even though it is an unlikely scenario it may not be as unlikely as people think. First let's look at the stock market. The Shanghai index has been clocked losing at least 35% from the top. The stock market is considered by some to be a leading indicator. Is it saying that China's growth will slow down sharply? Not necessarily but at least it is something to think about. What about the theory that a country that is growing so fast can't fall into recession. Well that doesn't hold much water since the US in the late 1800s and early 1900s had a very fast growing economy whose output was derailed a number of times as recessions ensued. If the US in its hyper - growth spurt a hundred years ago could fall into a recession, couldn't China? The Chinese currency (the Yuan or Remnimbi, not sure why there are two names but there are) has been appreciating as the Chinese authorities try to curb inflation. This is starting to hit the Chinese exporters. Lastly the US economy is rapidly falling deeper into recession. As a consequence the US consumer is pulling back sharply. The US consumer (according to Fred Hickey in Barron's in the Round Table) is about 19% of world GDP. A large portion of China's GDP is exports to the US consumer. Doesn't that mean that China is feeling the pull back too?

China falling into a recession is unlikely. I went through this thought process though to show that although unlikely it is not as unlikely as most believe. China go into recession? What would Jimmy Rogers do? He just packed his bags left New York and moved to China. He could always come back.

Gross Domestic Income - Mr. Nalewaik of the Fed

Looking for a date for the Q1 GDP release date I stumbled on this amazing paper titled, "Estimating Probabilities Of Recession In Real Time Using GDP and GDI." It was written by Jeremy Nalewaik in December 2006. Mr Nalewaik works at the Fed and this paper was part of the staff working papers in the Finance and Economics Discussion series. One always hears about these brilliant people in the background at the Fed. Well this looks like one of these really bright economists that that no one really hears about. Let me check that. After reading Mr. Nalewaik's bio, which says PHD University of Chicago. Well that pretty much says it all. Also here is a link to the paper:

http://www.federalreserve.gov/pubs/feds/2007/200707/200707pap.pdf

I just skimmed it a little. I found it interesting because from the anecdotal data I have been getting in the NYC tri-state area I have come to the guess / conclusion that the depth of the current recession may be much steeper than most think. My data may well be skewed because the tri-state area around New York City is heavily influenced by what happens in finance. And it is pretty easy to say that currently the world of finance has experienced some massive pain. Regardless it is still my gut opinion that Q1 GDP may be really ugly.

Now back to the paper by Mr Nalewaik. The main idea of the paper is that GDI may be a leading indicator for the strength or weakness of the economy. Now again I have not gone through the entire paper but it does seem intriguing. The next question someone may ask is well when does the GDI stat come out and where is it at the moment? It looks like it is released with the GDP number so we will have to wait. Since we already have Q4 2007 a GDI number must have been released from that. I will try to dig some more on this.