Oct 14/15 – Central Bank e-mini flow

2015-10-14 11am EDT  |  #Carlyle #Central Banks #Fortress

Earlier this week, another high profile macro hedge fund announced it was closing the doors. From the WSJ:

A troubled year on Wall Street has brought down one of its biggest stars.

Michael Novogratz will leave Fortress Investment Group LLC, and the private-equity and hedge-fund firm will close the flagship macro hedge fund he runs after it suffered heavy losses and redemptions, according to people familiar with the matter.

Fortress’s macro fund, launched in 2002 to bet on global macroeconomic shifts by trading equity, debt, commodity and currency markets, is down 17.5% so far this year through September, according to a regulatory filing. The fund has been hurt by investments in Brazil, a market that has come under pressure in recent months, among other areas, an investor said. Macro funds on average have lost 0.6% this year through September, according to research firm HFR.

The Fortress fund manages about $1.6 billion today, down from more than $8 billion in 2007.

The closure of the Fortress fund, expected to take place before the end of the year, highlights a lackluster run for the hedge-fund industry. Hedge funds are down an average 1.4% in 2015, through September. That beats the 5.3% total loss by the S&P 500 in that time frame, but is worse than the 1.1% total return of the Barclays U.S. Aggregate Bond Index. Hedge funds tout their ability to produce steady returns in almost any environment, and their lagging behind the bull market over the past several years has caused some clients to take a harder look at their value.

It has been tough slugging for the “supposedly” smart money. Guys like Novogratz were often regarded as the smartest of the smart, but recently he has been shovelling money out the window at a fierce rate. And it’s not only Fortress that is struggling.

High profile hedge fund group Carlyle Group made similar admissions this summer (again from the WSJ):

Investors are preparing to pull roughly half their money from Claren Road Asset Management LLC, the latest blow for Carlyle Group LP’s hedge-fund firm.

Clients of Claren Road have requested nearly $2 billion of their money back from the New York firm, Carlyle said in a regulatory filing Monday. The money is scheduled to be paid back after Sept. 30, said a person familiar with the matter. The firm managed about $4.1 billion at the end of July.

The turmoil adds to a growing list of troubles for Carlyle’s hedge-fund investments. Carlyle has already split with the founders of another hedge-fund firm it owns, Vermillion Asset Management LLC, after Vermillion’s flagship fund shrank from $2 billion to less than $50 million in assets amid heavy losses and investor redemptions, according to people familiar with the matter. Vermillion, a commodities-trading outfit, was battered by a collapsing market for raw materials.

So what’s going on? Why are the hedge fund carcasses littering the road like that time in the summer when too many toads insist on trying to make it across the highway?

Of course they have excuses:

Some macro funds blame their challenges on an investment environment they say isn’t ripe for their strategy. Central banks in the U.S. and Japan have kept interest rates steady, creating fewer opportunities to profit from moves, they say. Meanwhile, many funds have failed to profit from large selloffs in markets including China and Brazil.

But is that a valid reason for their abysmal performance?

Let’s start with the obvious. At a dinner the other night with a buddy, we were discussing the amazing performance of a fairly new Canadian fixed income hedge fund. They have blown the barn doors right off and money is flooding in. I asked if he thought there was more risk than their numbers seem to indicate. I wondered if they were simply long credit and it wasn’t as magical as it appeared. At which point my pal looked at me in the eye and said, “Of course there is more risk than appears. At the end of the day, hedge funds are paid to take risks. We are all long risk, all the time.”

I have long thought that too many hedge funds are simply leveraged beta masquerading as alpha. The recent downturn in the markets has exposed this all too fatal tendency. So to a certain extent, the recent hedge fund rout is the result of a correction in risk assets.

But there is more to it than that. Markets correct all the time, and hedge funds aren’t forced to go out of business. And macro hedge funds especially have a broad array of different assets to trade. A risk off environment should not cause the pain they have experienced over the last year.

There can be no denying that there are too many hedge funds. I recently heard in the 1980s there was something like 100 hedge funds, and that number has ballooned to more than 5,000 today. To a certain extent, the increased amount of failures could simply be the survival of the fittest. For every Fortress or Carlyle there could be another fund experiencing massive asset growth.

Yet I think there is more to this story. There are always old guys who do not adapt to the new realities of the market, but this cycle is filled with way more than previous eras.

And who are the new turks? Who is making money in this environment?

The biggest winners are the quant guys. Whether it is Jim Simmon’s Renaissance Capital or Ken Griffin’s Citadel, the majority of funds knocking the cover off the ball have a tendency to be more quantitative in nature. We can argue about HFT, and whether these guys are simply front running client orders (they are), but I think there is more too it than that.

My theory is the reason these quant guys are doing so well is that they don’t have any preconceived notions about what the markets should do. Of course some of their success is due to the fact that technology has changed the way we trade, but that is not the full story.

Michael Novogratz from Fortress had a long and extremely successful career. Do yo really think he got stupid and forgot how to make money? Not a chance.

I contend the reason guys like Novogratz and the rest of the “smart” guys are getting blown out of the water is the game has changed. And I don’t mean changed in some small way like technology has introduced more competition. Nope, I mean there has been a fundamental change in the markets.

Never before have the Central Banks been as active in the markets as today. The level of direct intervention is mind boggling.

Take a guess at how many shares of Apple the Swiss National Bank holds? At the time of their last filing they owned 9,424,416 shares, up 490,041 during the reporting period.

Or how about the CME’s Central Bank incentive program?

Why would Central Banks ever need to bang around S&P 500 futures?

The monetization of Central Banks’ balance sheets in risk assets is bat shit crazy. As stupid as negative rates seem, they pale in comparison to a Central Bank owning equities.

The world’s Central Banks are increasingly distorting all asset classes. This is why even cagey veteran traders like Novagratz are having trouble. These Central Banks are not price sensitive. Their actions make little logical sense.

I know I sound a little like one of those tin foil hat wearing conspiracy theorists. But I am not making excuses. For those traders who understood how big a role Central Banks would play, the markets have been fertile ground. I take nothing away from those who have profited from these moves. All I am trying to do is understand how it might unfold from here.

One of the stories from Michael Lewis’ Liar’s Poker that always stuck with me was his observation about the 1987 crash. Leading up to the crash, Soloman Brothers was making most of its money in equities and longer term fixed income. The money market department was a drag on earnings, so they closed it. When the stock market crash hit, most other Wall Street firms offset some of their losses with increased business in money market as capital flowed to the safe part of the curve. Soloman had no money market as they had just closed the whole departmnet at the absolute bottom…

The closure of all these macro funds is actually good news for us that ply in this trade. My suspicion is Central Bankers cannot continue their game indefinitely. Eventually market forces will triumph over the Central Bank activism. At that point, risk markets might just start to once again behave based on fundamentals instead of Central Bank e-mini flow.

Thanks for reading,

Kevin Muir

the MacroTourist