Hedge Fund Results and Cryonic Debt

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
Read More.
a | A

How are hedge funds doing?

Barclays put out a big sad report about the hedge fund industry this week, and this may be the saddest chart:

Hedge funds, as a group, produced all the value that they've ever produced by late 2011. Since then they've just been slowly destroying value:

In the last almost 4.5 years, HFs actually generated negative cumulative alpha. More specifically, the average monthly alpha has declined to -0.07% (annualised ~0.8%) from 2011 to May 2016 compared to an average of +0.48% (~5.9% annualised) for the entire period analysed (1993 to May 2016).

Obviously one should not, like, perform technical analysis on a chart like that. But, just looking at it, would you bet on a big break to the upside? Here's the necessary companion chart:

Since the end of 2011, hedge funds as a whole have (1) produced negative alpha and (2) added almost $900 billion of assets. Why? This seems to be the best explanation:

There are various reasons why investors are still by and large faithful to Hedge Funds, even if they are disappointed by their recent performance. One of the most important reasons is that it is difficult to find an alternative with similar risk / return characteristics. And when the risk-adjusted returns are combined with the low correlation they tend to have, the impact on investors’ portfolios tend to be positive. Indeed, according to our analysis in Figure 13, a majority (55%) of HFs, even in a year like 2015 where HFs did not perform particularly well, would have been additive and improved the efficient frontier of the 60 / 40 portfolio. Thus while performance may have seemed poor on a stand-alone basis, there appears to be a role for HFs in investors’ portfolios.

Improving the efficient frontier of the 60/40 portfolio is a rather lower bar than providing alpha, but there you go. A lot of sophisticated investors pay hedge funds' fees because they think -- often correctly! -- that those hedge funds, as part of a balanced diet, improve the overall performance, and reduce the overall risk, of their investments. It is not a magic-masters-of-the-universe-doubling-your-money-every-year sort of explanation, but it seems to get the job done.

Elsewhere, Bloomberg News discusses Barclays's view that hedge fund performance has been poor because hedge funds get too big and run into capacity constraints, and Business Insider discusses Barclays's view that it's been poor because we are in a high-correlation, low-dispersion stock market: "They generated 9.9% of alpha, or outperformance, when dispersion was high and correlation was low — and very little when the reverse was true." To some extent you want to get you an investment strategy that can do both, but yes, sure, when everything trades the same way, it's hard to make money doing something different.

Debt deep-freeze!

Remember Argentina? It defaulted on its bonds in 2001, and in 2005 and 2010 most of its old bondholders agreed to take new bonds in exchange, at around 30 cents on the dollar. But the holdouts who didn't accept the new bonds sued, claiming that the "pari passu" clause in the old bonds prohibited Argentina from paying the new bonds until it paid off the old bonds in full. The U.S. courts agreed, there was a long horrible stalemate involving a default on the new bonds, and eventually Argentina settled with the holdouts for amounts that were, in some cases, 10 times the original principal amount of the underlying bonds.

There has been quite a lot of interest in preventing that from happening again. Here is a fun paper from Lee Buchheit and Mitu Gulati on "Restructuring Sovereign Debt after NML v. Argentina," proposing a list of tricks for sovereigns to use to prevent holdouts from derailing a debt restructuring the way Argentina's holdouts did. Some of these tricks are straightforward and reasonable but will take forever: Issuing bonds with better-written pari passu and collective action clauses will help, but old bonds with the old clauses will remain outstanding for many years. Some of the tricks are embarrassingly tricky, like keeping payment streams outside of the U.S., or issuing exchange bonds that don't count as "external debt" under the pari passu clauses.

But one trick is great! Robin Wigglesworth explains:

But what if countries hold onto the old defaulted bonds, deep-freezing them with a helpful trustee instead of wiping them out? Then, if some hard-nosed hedge fund manages to get an Argentine-style pari passu ruling, the country can simply reheat the old bonds – which should in size be far larger than any hedge fund’s claim – and rank itself equally with the hedge fund.

Buchheit and Gulati call this the "Cryonic Solution." From their paper:

Assume that the Old Bonds have a principal amount of $100 million and that the debt restructuring seeks a 50% principal haircut on those instruments. Holders of 75% of the Old Bonds participate in the Exchange Offer. Under a Cryonic Solution, the Custodian Trustee would thus be holding $75 million principal amount of Old Bonds after the exchange; the remaining $25 million would be left in the hands of holdouts. For purposes of this illustration, let’s assume that the annual coupon on the New Bonds and the Old Bonds is the same -- 6% p.a.

If holdouts succeeded in obtaining an NML-style pari passu injunction requiring a “ratable” payment on the Old Bonds as a condition to the issuer making any payments on the New Bonds, the issuer could not make an annual coupon payment on the New Bonds of $2.25 million (6% of the $37.5 million principal amount of the New Bonds) without paying the holdouts the full $25 million principal of the Old Bonds owned by the holdouts together with accrued interest on those instruments. A Cryonic Solution, however, would allow the issuer in this situation to make a partial payment under the Old Bonds of only $3 million. Three-quarters of that amount ($2.25 million) would go to the Custodian Trustee who would, in turn, apply it as a payment under the New Bonds. The coupon falling due under the New Bonds would thus be fully covered; the holdouts would receive $750,000 as their share of the partial payment made under the Old Bonds.

It's not perfect -- "Making even partial payments to creditors that did not join the restructuring could be distasteful for the issuer" -- but it's very cute. What I particularly like about it is that it weaponizes the concept of fairness that lies behind the pari passu clause. The pari passu clause is meant to provide for equal treatment of creditors, but of course the Argentina holdouts used it to demand terms that were far more favorable than the exchanging bondholders got. (In some cases, 1,000 cents on the dollar instead of 30.) The Cryonic Solution caps the holdouts at equality with the exchanging bondholders, measured based on their pre-exchange holdings. It's hard to see a court or holdout making much of an argument that that's unfair.

Elsewhere in sovereign debt: "Venezuela Seen Staving Off Default Again Even as Crisis Worsens."


For some reason both major U.S. political parties think that they want to bring back Glass-Steagall and separate commercial banking from investment banking. But if that's what you want, you don't really need Glass-Steagall. What you need to do is think about why commercial banks and investment banks go so well together -- basically, that commercial banks can get cheap deposit funding and use it to provide capital in investment banking businesses -- and then address the cross-subsidies there. Which is happening: With the Volcker rule and new capital requirements and the leveraged-loan limits and so forth, it is getting more and more annoying for commercial banks to do investment banking. And so independent investment banks like Jefferies are having their moment:

In the six years since regulators forced Wall Street banks to rein in risk-taking, Jefferies has emerged with an appetite for risk and a set of relationships to rival bigger Wall Street firms. It never took federal bailout money. Now, as a subsidiary of the conglomerate Leucadia National, Jefferies is not subject to the trading restrictions and capital requirements imposed on other investment banks that did take bailout funds and became part of bank holding companies. That gives it room to make bolder moves than some of its larger peers.

Obviously Jefferies is not yet beating JPMorgan in a lot of business lines. But a good measure of the success of banking reform will be how well Jefferies -- or Moelis, or Citadel, or whoever -- is doing at taking advisory and trading business from the big banks.

Market structure.

Here's a story about how "the Securities and Exchange Board of India (Sebi) has proposed seven new ways to level the playing field between those using high frequency trading (HFT) systems and regular market users," and it is funny to read the seven proposals and imagine them all being implemented at once. "Sebi has suggested matching orders under a batch system." "The regulator wants to introduce random delays of a few milliseconds in order processing." "Sebi proposes to revise the order queue randomly every 1-2 seconds." "Sebi has proposed that the order-to-trade ratio be capped." If you run batch auctions and introduce random delays and reshuffle the queue constantly, you are basically replacing your matching engine with a randomizer. You might as well just hold a lottery for who gets which stocks, instead of a market. Presumably the reason for all the proposals is that maybe Sebi will implement, like, two of them, and those two might work.

Meanwhile in Korea:

South Korea’s exchange is renewing its push to rid the country of a technology used by high-speed trading firms in the world’s biggest stock markets, arguing that it’s unfair.

Korea Exchange asked brokers in July to disclose whether they’re using microwave networks, said Ko Young Tae, a KRX official in charge of derivatives policy. While Ko suspects the practice has stopped in the wake of an official bourse notice to avoid the technology last year, the exchange is surveying the market to know for certain, he said.

I hope some Korean high-frequency trading firms are hiding secret microwave networks. The regulators show up and look suspiciously at the giant pile of microwave equipment in the corner. "No no no, that's just for reheating our lunch," the traders say. 

Meanwhile in the U.S., "FINRA Offers Tips for Retail Investors on Order Types," and somehow their tips don't include "just don't use market orders." ("On the downside, you may not get the price you were originally quoted, especially in fast-moving markets," says Finra, blandly.) If I ran Finra, my investor alert for retail investors would start with "hey everyone, let's have a nice chat about marketable limit orders, and about not accidentally selling all your stock for a penny," but I don't run Finra. Is there a big lobbying constituency for market orders? Would telling retail investors to cool it with them, like, run afoul of Big Market Order?


Here's a dumb little story. Aleris is an aluminum company. It is privately held, though it has public bonds. So it did a public earnings call last week, but it was a bit of a formality: Only one person, a credit analyst at Bank of America, asked any questions. The company was apparently flattered that he showed up; the chief executive officer began his reply to his first question like this:

Yes. We've talked about the -- the overall mix, and Matt just thanks again for the write-up, that -- that we've seen that you produced, we appreciate it, I think it was well thought out. And just to comment on your question, ...

And then he went on to talk about aluminum production in Zhenjiang. Seems harmless enough? Not to Aleris's lawyers! Yesterday the company put out an 8-K saying:

On Aleris Corporation’s earnings call held on August 4, 2016, the Company made reference to a research report published by Bank of America Merrill Lynch.  We reiterate our policy of not endorsing, adopting or affirming any research reports published regarding the Company.  Accordingly, we do not endorse, adopt or affirm that report or any other third-party research report regarding the Company.

Awkward! Two things that are true about sell-side research are:

  1. Part of an analyst's job is to cultivate good relationships with the companies he covers, so he can get his investor clients access to those companies' managers; and
  2. Many companies help analysts with their reports and try to guide them to the right answer, because the analysts' reports are part of how the company keeps the market informed.

But you're not supposed to say those things.

In other aluminum news, the U.S. Court of Appeals for the 2nd Circuit affirmed the dismissal of the aluminum antitrust lawsuit against Goldman Sachs, which we talked about two years ago. Here's the appeals court's opinion.

Poet and quant.

Here's an interview with Daniel Nadler, the founder and chief executive officer of Kensho, a "data analytics and machine intelligence company" that is making inroads on Wall Street, replacing analysts at Goldman Sachs with robots and so forth. Nadler is also a poet who avoids mirrors:

I heard that you also avoid looking in mirrors.

I never look in a mirror until I am finished writing for the day.

My own reflection in a mirror reminds me that I am an organism situated in time, one that once was not here, one that will at some point not be here.

Later in the interview he talks about the connection between poetry and running a financial artificial-intelligence company, and honestly it sounds a little forced. ("Poetry teaches you how to build a better search engine because it teaches you how to reflect on the needed balance between expectation, utility and serendipity.") The "organism situated in time" stuff seems like the real answer. If you can't walk by a mirror without contemplating your own eventual death and the permanent disappearance of your consciousness, you'd better get to work offloading that consciousness into a program that can run forever. That is just common sense.

Forged will fraud!

Here's a fraud case against a Long Island man whose elderly tenant (referred to as Jane Doe) died, and who then allegedly "placed a series of telephone calls and sent emails to Morgan Stanley in an effort to drain Jane Doe’s financial accounts of over $200,000." Then he allegedly "created a forged will naming himself as the executor and sole beneficiary, aside from a comparatively small charitable donation, of Jane Doe’s estate," had her body cremated, and started selling her estate. "To devise a scheme to steal from the deceased is despicably morbid," says the postal inspector-in-charge (oh yes, he was caught by the postal inspectors!), and while it is morbid, I mean, the deceased need the money less than the living, no?

People are worried about unicorns.

This is not exactly a unicorn story -- actually it's not a unicorn story at all, it's a public(-ish) company, valued at way less than $1 billion, not venture-backed, not in technology -- but I take a broad view of this section's mandate, and any form of corporate cryptozoology is good enough for me. So here's an S-1 filing from Bigfoot Project Investments Inc., which is trying to raise $15 million to find Bigfoot: 

Bigfoot Project Investments Inc., plans to establish itself as the most reliable and dependable source for materials including documentaries, physical evidence, and eye witness accounts for the purpose of documenting the evidence of the existence of Bigfoot. Our major source of revenue will be the sale of documentaries and specials that follow our progress.

Someone should start Unicorn Project Investments and trek off into the Enchanted Forest looking for unicorns. "I can smell the Soylent in the air, and hear the faint click of an air hockey table," the narrator whispers. "We must be getting close." 

Elsewhere in corporate cryptozoology, we talked yesterday about genies and corporate governance, and now, from Rob Terrin, here's a unicorn with a governance genie:

I guess if I was drawing a governance genie I'd try to make him look more like Larry Fink. Elsewhere: "Uberisation and the dangers of neo-serfdom." 

People are worried about stock buybacks.

Back in simpler times, I dumbly suggested that the 2016 presidential election might be fought over the issue of the Rule 10b-18 safe harbor for corporate stock buybacks. That ... has not ... exactly ... happened. But Hillary Clinton's economic plan includes a plank that will "shed light on excessive buybacks" by requiring more disclosure, and now Donald Trump's economic ... buddy? ... Carl Icahn thinks Trump will also somehow cure buybacks. From a post titled "Trump is right on about our economy":

I never thought I would say this but we cannot blame even mediocre CEOs for not investing when they have to face regulators that are scaring the hell out of them. Instead they borrow at near zero interest rates and buy back stock.

I assume the Libertarians are cool with buybacks, though I have not bothered to find out. You might remember Icahn from his repeated demands that Apple borrow more money at near zero interest rates to buy back stock. "If he sticks with that economic theme, he should definitely win hands down because I don’t know why you wouldn’t vote for him," says Icahn, with ironic timing

People are worried about bond market liquidity.


The Bank of England’s expanded quantitative-easing program ran into a stumbling block on just its second day as investors proved unwilling to part with their holdings of longer-dated bonds.

The central bank failed to buy enough gilts to reach its stated goal at an operation on Tuesday -- the first such failure since it initially started quantitative easing in 2009. The yield on 10- and 30-year bonds fell to records after the operation.

We seem to have moved into a new phase of liquidity worrying, in which the concern is not that it might be hard to sell bonds but that it is hard to buy them. The BOE is relatively unflustered, and "said Wednesday it will deal with a 52 million-pound shortfall ($60.8 million) in an operation on Tuesday at a later date as it made no changes to the 60 billion-pound measure."

Things happen.

Norway is threatening to derail Brexit. Productivity Slump Threatens Economy’s Long-Term Growth. How biotech executives profit from legal insider trades. Appeals Court Upholds SEC’s In-House Court as Constitutional. U.S. Said to Prepare Case Against Former Goldman MBS Trader. Whistleblowers Are Poised to Collect $100 Million. Randstad to Buy U.S. Jobs Site Monster for $429 Million. Valeant Plans to Ask Lenders for Looser Terms on Debt Pact. ‘Save the CLO’ Crusaders Make Last Stand as Rules Deadline Looms. Mexico’s Richest Man Confronts a New Foe: The State That Helped Make Him Rich. Lululemon Board Member Rhoda Pitcher Resigns. Lending Club’s latest results tell us a lot about the online credit business model. How Conservative Accounting Helped Boost Investment during the Financial Crisis. "Maybe the way to make the estate tax more acceptable, then, would be to start making wealth taxes more common." Markets are quiet. Privacy Scandal Haunts Pokémon Go's CEO. This sex toy tells the manufacturer every time you use it. Soylent Coffee. Maple Syrup Cartel Battles a Black Market Rebellion. How to Find a Beeping Smoke Detector If You Don’t Know Where It Is. 

If you'd like to get Money Stuff in handy e-mail form, right in your inbox, please subscribe at this link. Thanks! 

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Matt Levine at mlevine51@bloomberg.net

To contact the editor responsible for this story:
Brooke Sample at bsample1@bloomberg.net