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A Day of Reflection

(May 25, 2009)

Dear Subscribers and Readers,

Memorial Day in America is both a day of remembrance and reflection.  It is a day when we remember those who have fallen, who have come before us, and a when we reflect on what will shape the US and global society in the future.  In a departure from the format of our regular weekend commentary, I want to use this opportunity to discuss the many important trends that will shape our society – and to a lesser extent, our investment and career implications.  As I promised, this will be a fun ride.

But before I do that, I want to reiterate one thing.  Financiers who abuse their authority for private gain simply cannot function in this highly specialized market.  During the late 19th century, having a respected banker on their finance committees was very important for the railroads.  Bankers like Junius and his son, J.P. Morgan were responsible for overseeing billions of dollars for both their domestic and foreign clientele, and were instrumental for providing financial advice, bailing out railroads, firing and hiring managers, and even restructuring entire railroad markets (in 1885, J.P. Morgan famously brokered the non-compete agreement –known as the ‘Corsair Compact” – between the New York Central and the Penn Railroad, two of the largest railroads in the country).  Appearing before the Pujo Committee in December 1912 (as part of an investigation into the so-called “Money Trust”), J.P. Morgan famously declared that “character,” and not property, was the most important trait the Morgan bank relies on for extending credit.  This famous exchange between Samuel Untermyer, a corporate lawyer, and Morgan went as follows:

Untermyer: "Is not commercial credit based primarily upon money or property?"
Morgan: "No sir. The first thing is character."
Untermyer: "Before money or property?"
Morgan: "Before money or property or anything else. Money cannot buy it...because a man I do not trust could not get money from me on all the bonds in Christendom."

Morgan's words may be from a different era, but as events over the last 18 months demonstrate, they still ring true.  Sure, financial transparency, SEC regulation, FDIC, and SIPC protection have generally rendered our confidence in the financial system as an afterthought – but with an increasingly proportion of our financial system invested in private assets, securitized assets, hedge funds, and emerging markets, Morgan's 100-year old words came back to haunt us with a vengeance.  For the first time since the 1930s, bank runs became an all-too common event in both the US and the UK.  And much to their dismay, overleveraged firms such as Bear Stearns and Lehman Brothers realized the dangers of depending on overnight funding when market liquidity and confidence completely disappeared.  Aldus Equity, a $5 billion fund of funds – whose managing partner was sued by the New York State Attorney General and the SEC of providing kickbacks to secure investments by the state's pension funds last month – saw an exodus of virtually all of its clients in a matter of days.

Not only did the “greed culture” take over Wall Street, but Main Street as well.  Neighbors and friends try to “one up” each other by buying the biggest house and the baddest SUV – all on borrowed credit.  This drive for returns and “aspirational spending” resulted in a culture mainly driven by short-term thinking.  Within the stock market, this culture manifested itself in earnings manipulations, the proliferation of day trading, naked short selling, and outright accounting frauds over the last 10 to 15 years.  Not only has trust in our financial system been destroyed, but so has trust in our ability to do good and to be considerate of others, especially with respect to our moral standing around the world.  While the global financial crisis was perpetuated by only a small minority of the population (including selected politicians, financial leaders, mortgage brokers, overextended subprime borrowers, etc.), this could not have occurred without the broad support of our “me” culture and shall we say, entrenched narcissism.  As we reflect on our historic actions on Memorial Day, it is also time to think about what we need to teach and what legacy we want to leave behind for our children. 

Of course, this commentary is more than a mere rant.  I predict (although it is not exactly a bold prediction) that building one's character, integrity, and overall leadership/teamwork abilities would be instrumental for both personal and career success in the 21st century.  In the industrialized world of the 1950s to 1980s – when roles were clearly defined and when titles carried much more weight (e.g. the Christian clergy) – possessing such leadership/teamwork skills were not as important, as long as one possessed the necessary technical skills and the political connections. With the advent of the information age (where roles are less clearly defined and teamwork is essential to success) and the “new era” of skepticism now upon us, J.P. Morgan's advice of building character is more important than ever – especially since reputations can now be destroyed in a matter of minutes with no advanced warning.  At the corporate level, I expect CEOs and COOs to promote corporate social responsibility via customized strategies that further their own competitive advantages (once they recognize that corporate success and social welfare do not necessarily conflict with each other).  Patagonia and Whole Foods, in particular, are two companies who have embraced socially responsible policies as part of their core strategies and competitive advantages.

Financial Reform

All of the above has led to a call for a fundamental “reboot” of the US and global financial system.  Former Federal Reserve Chairman, Paul Volcker, famously remarked in February that for most people, financial innovation had brought minimal benefits – and that the advent of the ATM was more crucial than any other innovation in the last few decades.  Both the Obama administration and the Congress have taken this to heart.  Specifically, the Obama administration has just signed legislation reforming the credit card industry, despite an estimate suggesting this would slash annual consumer spending by $90 billion (or 0.9% of annual consumer spending).  Meanwhile, the House has just passed H.R. 1728 (the so-called “Mortgage Reform and Anti-Predatory Lending Act) by a large margin.  Assuming this bill passes the Senate in its current form, this will make it much harder for lenders to offer anything other than the traditional 30-year fixed mortgage.  This may even kill the business models of non-depositary lenders such as your local mortgage brokers, as H.R. 1728 requires lenders who offer non-conventional mortgages (i.e. anything other than the 30-year fixed mortgage) to have “skin in the game” by retaining at least 5% of the mortgage portfolio (with no hedging allowed).  In other words, your local mortgage brokers will only be able to offer 30-year fixed mortgages assuming the current version of H.R. 1728 stands.  The passage of H.R. 1728 should reduce long-term liquidity in the U.S. housing sector, thus reducing long-term home ownership and the prospect of renewed housing price appreciation.

John Maynard Keynes – in an open letter to President Franklin D. Roosevelt published in the New York Times on December 31, 1933 – stated the “juggling act” of balancing “recovery” and “reform” very clearly (clear and concise communication was one of Keynes' gifts):

You are engaged on a double task, recovery and reform - recovery from the slump and the passage of those business and social reforms which are long overdue. For the first, speed and quick results are essential. The second may be urgent too; but haste will be injurious, and wisdom of long-range purpose is more necessary than immediate achievement. It will be through raising high the prestige of your administration by success in short-range recovery, that you will have the driving force to accomplish long-range reform. On the other hand, even wise and necessary reform may, in some respects, impede and complicate recovery. For it will upset the confidence of the business world and weaken their existing motives to action, before you have had time to put other motives in their place.

Not only does the Obama administration recognize the short-term economic dangers of radical reforms, but there are still powerful interests within the financial community that are resistant to reforms. One great example was the reform of the New York Stock Exchange itself in the aftermath of the September 1929 to July 1932 bear market.  Indeed, the NYSE President at that time, Richard Whitney (younger brother of senior Morgan partner, George Whitney) was very hostile to reform and even tried to derail the Exchange Act of 1934.  On obtaining the SEC Chairmanship in 1934, Joseph Kennedy's first goal was to oust Richard Whitney as NYSE President.  While Kennedy succeeded, Richard Whitney remained a NYSE governor and would retain a amount of substantial power and support.  Whitney was not ousted as a power on the NYSE until March 1938 – but only so because of a financial scandal.  By that time, the public had become so disinterested in equities and had lost so much confidence in the NYSE that trading volume was at its lowest point since 1921 (with the value of an Exchange membership sinking to a mere $52,000 in 1939, down from the dizzying $625,000 peak in late 1929). 

Going forward, both the Obama administration and the Congress will continue to implement reforms designed to increase transparency and to curb speculation in the financial markets – including setting compensation guides designed to align the interests of bankers, investment managers, and brokers with those of their clients and the society at large.  Even though public support for financial reforms should wane once the economy hits bottom (which I expect to occur sometime this summer), I expect the administration to go slow (lest they “upset the apple cart”) but steady in its plans to overhaul the financial system over the next several years.  While the road to reforms remains highly uncertain, I expect the consequences to manifest themselves in, among other ways:

  • A decrease in discretionary consumer spending, concurrent with a structural increase in the US savings rate as financial innovation and credit abuses are reigned in;

  • More stringent regulations within the hedge fund industry, including the disclosure of short positions and more SEC investigations of insider trading (many hedge funds in recent years have hired company insiders as “consultants” to inform them of the company's latest products or strategies) and naked short selling.  At some point, I also expect the administration to communicate more stringent limits on position sizes (including OTC positions), so that we would not witness a repeat of the $145 crude oil spike last summer.

  • Following from the first bullet point, I expect the US current account deficit to continue to shrink in the next several years and for it to remain “tame” for the next decade or so, especially if the alternative energy industry achieves a “grid parity” breakthrough sometime in the next few years (solar power in parts of Nevada, California, and Texas should reach “grid parity,” in five years).

The Hedge Fund Industry

The hedge fund bubble started popping in early 2007 and has since stabilized.  In fact, net redemptions during April was the lowest in six months.  With liquidity returning to the financial markets, and with investors willing to take risk again, hedge fund inflows should turn positive this month.  At the peak last year, global hedge fund assets topped at nearly $2 trillion, while current estimates suggest that hedge fund assets have since declined to just $1.2 trillion.

With a diminished asset base – and with many investment opportunities staring at us right in the face – I believe hedge funds as an asset class will do well for the rest of this year.  But with many traditional hedge fund strategies showing signs of overcapacity last year, and with the inevitability of more hedge fund regulation and disclosures, I believe it will be immensely difficult to justify “the hedge fund model” going forward.  While there will always be hedge funds who can justify their fee structures (such as Jim Simons' “Medallion Fund” with its “4 and 50” structure), both institutional investors and high net worth individuals will no longer tolerate paying the “2 and 20” structure as the hedge fund industry has grown into a mainstream industry – a sign that hedge funds will most probably not meet investors' expectations going forward (for a good ideas of what we could expect from hedge fund returns in the future, please read David Swensen's 2nd edition of “Pioneering Portfolio Management”).

The adoption of stricter disclosures and leverage ratios will further rein in the hedge fund industry's competitive edge.  While many hedge fund managers have asserted that they could always find a way to maneuver around the regulators, (a partner at a prominent hedge fund of funds have told me just that) – folks should always be conscious of the disclaimer (which appears in every mutual fund's prospectus) that “past performance does not necessarily represent future performance.”  Regulators were willing to “look the other way” during the 1980s and 1990s simply because, in layman's terms, everyone was having too much fun.  There was no populist support for hedge fund regulation; and regulators simply did not have the expertise or the resources to regulate the industry.  This will change.  The Obama administration has already demonstrated that it is willing to go further than most previous administration in curbing the power of the financial industry.  Moreover, there are now a significant number of out-of-work finance professionals (with the appropriate expertise) who are willing to work for the US government in the name of public service.  Almost overnight, the expertise to regulate the hedge fund industry has exponentially increased.  In late 1919, as Jesse Livermore was on the verge of cornering the cotton market, the Secretary of Agriculture, Robert Barton summoned him to the White House to meet with President Woodrow Wilson.  Out of a sense of patriotic duty to the country, President Wilson asked Livermore to back away, so as not to drive up cotton prices.  Fast forward to September/October 2008, when in the wake of the Lehman collapse, Secretary of the Treasury Hank Paulson virtually forced the biggest commercial and investment banks to participate in the TARP (and subsequently forcing Bank of America to acquire Merrill Lynch).  The point is: As long as the regulators have the political will and the accompanying political backing, they will succeed in reining in the hedge fund industry.

From an investor's and a career standpoint, the “golden days” of the hedge fund industry is definitely over.  Moreover, as traditional hedge fund strategies (such as the betting on a narrowing of the swap spread or selling volatility) become highly commoditized, and as the global equity markets become more efficient, the value proposition of investing in a “traditional” hedge fund, especially under a “2 and 20” fee structure, is no longer worth much.

The Next Asset Class?

Subscribers may now ask: If hedge funds can no longer reliably provide “alpha,” in which asset class should I be researching, from both an investor's and a career standpoint?

As we discussed in our March 22, 2009 commentary (“Levered Beta Plays Are No More”), it is imperative for investors to continue to shift to “less mainstream” asset classes or strategies for alpha purposes.  In the case of US large/mid cap equities or fixed income strategies, investors (retail and institutional alike) should for the most part adopt a passive strategy.

In the case of both mutual fund and hedge fund investments, investors should focus on US microcap strategies, Japanese equities, and emerging markets.  In other words, investors should focus on the “less efficient” asset classes, which is imperative for those who want to achieve alpha in their portfolios.  Emerging markets should also provide ample growth opportunities for subscribers who want to develop an investment career there – especially those who possess an emerging markets background (e.g. the last I heard, Fidelity is still hiring investment professionals in Hong Kong and Tokyo).  Other niche strategies, such as investing in healthcare and technology funds may also reap good rewards, although it is imperative to make sure that: 1) The manager has the necessary edge/advantage when it comes to evaluating the next break-through technology or medical device/trend, and 2) One has a reasonable confidence that the next bull market is driven by technology or healthcare, or both.

But what if you're David Swensen?  Since you are managing a $30 billion endowment with a goal to providing perpetual benefits to Yale university, investing in micro caps (not enough capacity) and sector-specific funds (too much risk) is surely out of the question.  Even if one can identify capable managers in these areas, it may not be worth the time to spend the resources if the capacity constraint is too small.  For example, a $300 million allocation to micro caps represents a mere 1% allocation of the Yale endowment.  At the end of the day, a 1% allocation – even if it outperforms all expectations – will not be a significant driver of one's returns.

For years, the “Yale Endowment Model” has continued to shift into the less efficient “alternative assets” in order to achieve higher-than-equity returns without the associated risk.  Now that capacity constraints, talent constraints, and more stringent regulations have hit the hedge fund industry, I expect institutional investors such as the Yale Endowment and large pension funds to shift more of their assets to private equity funds, especially within the “middle market” space, and from a pension fund standpoint, the infrastructure space.  With many talented business professionals having been laid off over the last two years, I also expect venture capital to make a “come back” as new and innovative businesses are now being started.


As the US consumer continues to rebuild his balance sheet, and as the US current account deficit continues to shrink, I expect the emerging Asian consumer to start picking up some of the “slack” over the next several years.  The financial crisis over the last two years has revealed the “follies” of Asia's mercantilist policies since the 1997 Asian crisis.  Going forward, I expect Asian countries to adopt a more “balanced” growth policy.  These will include: 1) providing more social safety nets for their citizens, 2) relaxing their capital accounts and thus allowing steady currency appreciation, and 3) encouraging domestic consumption growth.  From a stock selection and sector allocation standpoint, I expect Asian “consumer plays” to outperform most other sectors in the next bull market, especially given the vast amount of savings (i.e. hugely underleveraged balance sheets) and ongoing growth in the region. Global brand names in this area (disclaimer: we have not done any recent research in these stocks) may include Coach, Tiffany's, Guess, Fossil, etc.


These are just some of the many trends that I see over the next several years, if not the next decade.  For example – as the Obama administration continues to propose financial reforms and expand government spending – I expect the existing backlash from the “fiscal conservatives” to continue.  While China has responded by purchasing more strategic assets around the world (in lieu of US Treasuries), there are many more alternatives (and innovations) that investors could consider.  The “obvious” investments are gold, commodities, TIPS, and to a lesser extent, art or stocks of companies that could maintain their pricing power in an inflationary environment (in the case of purchasing art, investors should realize that tastes in high-end art are as fickle as changes in fashion).  I will discuss more of these trends in our commentary next weekend.  Until then, I hope each one of you had a great weekend, and please don't hesitate to email me with questions if you want to discuss any of these issues further.

Signing off,

Henry To, CFA

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