December 20, 2011
So, What’s a Hedge Fund, Anyway?
The Investment View from Prescott, Arizona
By Will Hepburn
I was asked the other day what the difference was between the hedging strategies we use and a Hedge Fund. It is a question that I ought to address because there is substantial difference, creating room for confusion.
What we use occasionally at Hepburn Capital is a technique called hedging that merely offsets the risk of owning one investment (a “long” position, in industry terms) by making another investment that generally moves opposite to the original investment (called a “short” position). A dollar lost on one is often offset with a dollar made on the other. 
In its simplest form, hedging allows us to reduce the risk of holding investments we’d prefer not to sell in declining markets. With some thought behind it, hedging can be used to make money in down markets.
On the other hand, a Hedge Fund is a single pool of big money from institutions and very wealthy investors. Although they can have widely varying investment strategies, hedge funds are noted for making very large, very concentrated and often highly leveraged investments. And occasionally hedge fund managers will try to manipulate the markets in which they’re invested. That is why they have the reputation they do.
Michael Lewis, in his recent book “Boomerang” quoted a hedge fund manager who said, “This is a herd of cattle that can be stampeded!”
Incidentally, Hedge Funds were not even regulated until earlier this year.
In 1998, a Hedge Fund called Long Term Capital Management (LCTM), a $2 billion fund run by two Nobel Prize winners and more than a dozen PhD’s, was able to borrow $100 billion with which they bought US Treasury Bonds – leveraging their net worth so it controlled 50 times their principal.
However, when the Treasury market moved against them, it wiped out not only the LTCM principal, but a lot of bank money loaned to them as well. The aftermath threatened the entire banking system and knocked the stock market down by almost 20%.
Other spectacular hedge fund failures have involved commodities traders and energy funds. Then in 2008, hedge funds mistakenly believed that AAA rated mortgages had no risk at all, they leveraged themselves up and then crashed . . . just like LTCM.
So, as you can see, the technique of hedging is very different from the world of hedge funds.
A Slice of Life
It’s odd how Christmas party season winds down a whole week ahead of Christmas. It is also good because it gives me time to quietly reflect on all that is good in my life and that’s what really gets me in the mood for Christmas. Naturally, you are part of that, and I am grateful. Merry Christmas and Happy Hanukkah from everyone here at Hepburn Capital Management.
‘Til Debt Do We Part
By Bryan Jarman, CFA
Growing up, we had a set of Encyclopedia Britannica books where I enjoyed the section that described and defined numbers. I learned early on what a “million” represented. I was fascinated that after millions came billions, then trillions, then quadrillions, then quintillions…. My favorites were duodecillion and centillion just because of the way they sounded, not because I had any concept of the numbers they represented.
Zimbabwe, in 2009, printed single banknotes denominated as 100,000,000,000,000 or one hundred trillion Zimbabwean dollars. In 1946, Hungary printed single banknotes denominated as 100,000,000,000,000,000,000 or one hundred quintillion Hungarian pengos.
I recently heard a number referenced by David Buckner, of Columbia University, representing the total value of all loans collateralized with other loans, which are then used as collateral for even more loans, etc., as being “1½ Q” or $1.5 quadrillion ($1,500,000,000,000,000 if you are counting zeros). What surprised me is that this value isn’t denominated in some hyper-inflated currency but in US dollars.
Wondering what will ever become of this huge pile of loans reminded me of the story of the guest who walked into the hotel in a very cash-strapped town, plunked down a $100 bill and went off to inspect the room. The hotel’s proprietor, desperate for cash, grabbed the bill and ran to the butcher to pay off his $100 tab there. The butcher quickly took the $100 to pay the rancher he owed for beef. The greatly relieved rancher, promptly paid the gas station the $100 it was owed, and the gas station owner finally had enough to pay his tab at the hotel, which he promptly did. Just as the gas station owner laid the $100 bill on the hotel counter, the hotel’s guest showed up saying he changed his mind about staying there and took his $100 back. In the few minutes he had been in town he had provided the cash to retire many $100’s of old loans.
There is an oddly accurate logic to how that scenario unfolded in the small town, and that is exactly what central banks all over the world, including our own Federal Reserve Bank are trying to engineer with the stacks of money they are printing and loaning out all over the world. It is called de-leveraging.
We badly need to de-lever our finances. The habit of borrowing needs to be replaced with saving money and using it to pay down the mountain of loans we face. The alternative is to wait helplessly for, and be at the mercy of, a stranger with a bunch of $100 bills.
Sometimes I worry that my children may be growing up in an unfortunate environment where, contrary to popular idioms, the only sure things in life are debt and taxes.
Holiday Schedule:
HCM offices will be closed on the following days:
Christmas – Mon.-Dec. 26th
New Year’s – Mon.- Jan. 2nd
How’s The Market Doing?
The stock market is giving off a few positive signs but still does not “feel right”. Stocks have yet to fully recover from last summer’s shocking 20% decline, and with the shadow of Europe’s financial crisis lingering, there seems to be a fragility to the stock market that is greater than normal. Even the traditional December “Santa Claus Rally” has yet to show up, as of this writing on December 16th.
It is said that the stock market’s best gains are made when the market “climbs a wall of worry”. The wall of worry is certainly there, however I think the risks right now are higher than normal, so caution is advised for stock market investors.
Commodities in general have been very weak lately: gold, particularly so. Gold is in its worst decline in over 3 years, which means that someone is selling a lot of gold. The timing suggests it may be hedge funds scrambling to meet year-end client redemptions. Or, it could be central banks trying to raise cash. It is hard to know for sure, but something has changed in the gold markets.
Interest rates continue to drift down, which is hardly good news for savers who feel increasingly squeezed by near-zero savings rates. This has made me start thinking of the times 50-60 years ago when stocks were used primarily for income. Bryan and I have discussed a new “dividend” strategy that could be ready next year, paying regular dividends in the 3% range and using our active management skills to reduce the risk of holding stocks for income. Stay tuned for more on this idea . . .
Mental Floss – Tip O’ The Day
Find tiny lost items like earrings by putting a
stocking over the vacuum hose.
What’s Going On In Your Portfolio?
As you might expect from my market comments in this newsletter, we have been completely out of gold in our managed accounts for more than a week now.
Flexible Income* accounts hold a mix of cash, conservative and US Government backed bond funds, along with a strong dollar fund which has finally turned up in a meaningful way. I am pleased to say that with gold out of the portfolio, all current holdings are showing gains. Whew!
The currency strategy* we use has had a rough patch for the past 6 months as the currency markets changed from everyone being down on the dollar, to everyone realizing that next to the Euro the dollar looks pretty good. The currency strategy* has a great long term back-testing history, I am glad it’s finally getting back to its historical pattern.
Growth* portfolios are 100% in cash at the moment since our Safety Net signal a month ago. Hopefully in the New Year the stock markets will clarify their direction so we can get back in and start making money again.
Our Strategy Spotlight -Size Matters
When I use the term “model portfolio” it describes a hypothetical $100,000 account, our practical minimum account size. We often accept smaller accounts as an accommodation for existing clients, referrals and friends, but larger accounts are most efficient for us to manage.
Despite trading at the same time in investments with similar objectives, smaller accounts occasionally end up with different results than larger accounts.
The reason for this is that some trades involve fixed transaction charges, such as the $15.50 the custodian charges to execute a stock or ETF transaction. Large accounts have larger trade sizes and can absorb these fixed costs without greatly affecting performance. The profitability of a smaller trade can be more greatly impacted by transaction costs, so as a policy matter we try to have fewer of them in smaller accounts.
This may lead to different holdings in different sized accounts, and can create different performance results, too. There were six times in 2011 that we had different holdings in Flexible Income* accounts of various sizes. Usually, the performance difference is minimal, but not always.
One exception occurred in February when we bought gold and silver in the Flexible Income* model. To minimize transaction charges in smaller accounts we only bought gold in them while we bought both gold and silver in larger accounts, incurring two transactions charges.
As it turned out, silver was one of our biggest trades for the year, adding almost 5% onto the return of larger accounts. Unfortunately, there was no way to know that ahead of time, so smaller accounts did not participate in this particular gain.
So when I mention model returns it is possible that your returns will be different, sometimes significantly. I’d be happy to sit down with you in person and show you how this works anytime you have questions.
* The model accounts mentioned in this article are hypothetical examples of how the strategy may work as designed. Activity in client accounts may be different from that in the model in amount of each investment, specific timing of trades, and actual security used, which may vary from account to account. Not all trades are profitable. It should not be assumed that current or future holdings will be profitable. A list of all trades in these accounts for the past 12 months will be provided upon written request.
** The S&P 500 and Nasdaq Indexes are unmanaged lists of stocks considered representative of the broad stock market. Investors cannot invest directly in the S&P 500 Index.
This newsletter may contain forward-looking statements, including, but not limited to, statements as to future events that involve various risks and uncertainties. Forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause actual events or results to differ materially from those that were forecasted. Information in this newsletter may be derived from sources deemed to be reliable, however we cannot guarantee its accuracy. Please discuss any legal or tax matters with your advisors in those areas. Neither the information presented nor any opinions expressed herein constitute a solicitation for the purchase or sale of any security.
