By Daryl Jones, Hedgeye
FORTUNE -- For those of you who missed it in high-school history class, Sir Ernest Shackleton is the best-known figure in the "Heroic Age of Antarctic Exploration," which began in 1911 after Roald Amundsen successfully reached the South Pole. Shackleton was a maverick. He wanted to one-up Amundsen. So he set forth raising funds for his journey and eventually launched the ill-fated "Imperial Trans-Antarctic Expedition" to cross the frozen continent's tundra. Mother Nature of course had other plans. Misfortune beset Shackleton and his crew early on when an ice flow froze his ship, The Endurance. The ship was abandoned.
For the next 500 days, Shackleton and his men were stranded. They had no contact with the outside world and routinely faced temperatures below -50 degrees Celsius. Fortunately, after an almost impossible trip to a nearby whaling station, the entire crew was rescued. Even though the expedition fell short of its goal, Shackleton and his crew walked away with their lives and some harsh polar perspective.
While obviously nowhere near the difficultly endured by Shackleton, for many hedge fund managers, this has been a year to gain perspective (if not outperformance). Take a look at the Hennessee Hedge Fund Index which was up 9.9%, as of the end of October 2013 -- a return that paled in comparison to the S&P 500's (SPX) return north of 23%. While returning close to 10% on "2 and 20" hedge fund fees isn't the worst thing in the world, for most hedge fund managers, underperforming a passive strategy by over 1,000 basis points can lead to investor ire and redemptions.
One key reason for the underperformance of hedge funds is the outperformance of heavily shorted stocks. Heavily shorted stocks are outperforming the S&P 500 by a staggering 570 basis points this year. That said, long and short equity managers aren't the only investment managers playing catch-up with the market this year. PIMCO's Total Return Fund (BOND) has returned a capital eroding -0.87% in the year-to-date. Clearly, PIMCO's Bill Gross and the big bond boys are experiencing some performance issues.
The broader issue with bond managers like PIMCO is how far afield they have journeyed in search of yield. And therein lies the key question: At what cost does this hunt for yield come?
As it relates to the PIMCO Total Return Fund, prospective underperformance may even be more concerning given the fund's holdings and where the managers have gone to find yield. According to analysis by our Financials Team here at Hedgeye, almost 34% of PIMCO Total Returns holdings are in agency Mortgage Backed Securities (MBS). Check out the chart below highlighting the spread of agency MBS to the 10-year Treasury Yield.
Prior to the financial crisis, this spread was around 126 basis points. It has now narrowed to approximately 68 basis points. In other words, the almighty chase for yield has effectively priced mortgage backed securities to one of the lowest levels of risk that we've seen in the asset class. Even if the spread for Agency MBS normalized by just 50 basis points, to pre-crisis levels, it would have a meaningful impact on the market. By our estimation, allowing for modified duration, a 50 basis increase (reversal of tapering for instance) in yield would lead to 5% downside in the Agency MBS market.
The issue for firms like PIMCO is that a 5% correction in one of its more significant asset class exposures is likely to lead to continued underperformance and accelerated outflows. Outflows and decreased liquidity, of course, are only likely to exacerbate any move in price in the MBS market.
The Financial Times emphasized this point further in a recent article looking at managers of collateralized loan obligations (CLOs). According to the FT, managers of CLOs have increased the proportion of risky loans that their investment vehicles are allowed to buy to the highest level on record. Currently, 55% of new leveraged loans come in the covenant-lite form, which eclipses the 29% reached shortly before the financial crisis.
In theory, when the economy is stable, covenant-lite loans are fine. But, if there is volatility in economic activity, these loans get much more difficult to repay for many corporates. A good analogy is probably Shackleton and his crew in -50 degrees Celsius weather in Antarctica. You know weather that cold is dangerous but it is survivable, until the wind starts to blow and wind chill sets in.
Given the challenges faced by large asset allocation funds that rely heavily on yield for performance, going forward it might be prudent that managers of these funds search for analysts for their investment teams with a similar advertisement to what Shackleton used to find his crew:
"Men wanted for hazardous journey. Small wages. Bitter cold. Long months of complete darkness. Constant danger. Safe return doubtful. Honour and recognition in case of success."
Daryl Jones is the Director of Research at Hedgeye Risk Management.
Twitter kicked off its roadshow with potential investors in its upcoming IPO. Here's what they should ask.
By Daryl Jones, Hedgeye
FORTUNE -- Our top questions for Twitter management on their IPO roadshow.
The TWTR Top 11:
1. How are you going to use the IPO proceeds? Can you outline how we should expect the proceeds to accelerate your growth?
2. More than 77% of Twitter users are from outside the United States, but only 26% MOREOct 30, 2013 12:13 PM ET
This seismic shift in interest rates will certainly be one of the most critical factors over the coming quarters and years.
By Daryl G. Jones, Hedgeye
FORTUNE -- Every quarter, our team here at Hedgeye gets together and boils down the turmoil in global macro markets to three neat and tidy themes for our clients. But, in the spirit of Gary Keller's new, thought-provoking book, The ONE Thing, I'm going to employ MOREAug 15, 2013 9:04 AM ET
Without China to fuel the engine, Asia's economic racecar looks to be in for a long pit stop.
By Moshe Silver, Hedgeye
FORTUNE -- Right now, Japan's equity markets are being buoyed by the same "Print-And-Spend" policy that the Federal Reserve used to pay off Wall Street, emanating from the same ivory tower that paid untold trillions in bonuses to America's failed bankers. Meanwhile, a motley crew of high-level economists including Ben MOREAug 7, 2013 11:43 AM ET
In times of turmoil, gold is considered a safe haven. So why is it still crashing now?
By Moshe Silver, Hedgeye
FORTUNE -- Gold is down more than 25% from its recent highs, leading some observers to declare it on track for its biggest one-quarter decline since the Bretton Woods system collapsed in 1971.
This is a bit misleading: the average price of gold in 1971 was around $40 an ounce. The following year MOREJul 8, 2013 2:38 PM ET
The Fed does not need an economist to run it. Perhaps it needs someone able to meet operating budgets.
By Moshe Silver, Hedgeye
FORTUNE -- Scientists observing bird flight patterns tell us the lead goose in the migratory V-pattern switches back and forth between looking ahead and looking back. It constantly checks the formation behind and adjusts its position to make sure it remains at the point of the flock. Periodically, the lead MOREJun 25, 2013 10:56 AM ET
All of the market dislocations -- Treasuries, commodities, etc. -- were percolating underneath the surface well before this frenzy.
By Keith McCullough, Hedgeye
FORTUNE -- What an epic 48 hours it has been. Just. Total. Chaos.
We are officially going over the waterfall now. Boats are in midair. People are hanging on trees. Everybody is scrambling, trying to explain what they missed. Trying to make sense out of it all. Hat tip to MOREJun 21, 2013 10:00 AM ET
Unemployment should remain staggeringly high in many parts of Europe, and unreasonable debt levels will persist. But that doesn't mean there aren't investment opportunities in the troubled region, both long and short.
By Matt Hedrick and Moshe Silver, Hedgeye
FORTUNE -- Henry Kissinger famously said -- or maybe didn't say, according to people who claim to know -- "Who do I call if I want to call Europe?"
The comment referred to MOREJun 13, 2013 11:47 AM ET
More good news for the housing market.
By Joshua Steiner, Hedgeye
FORTUNE -- The chart above shows the ratio of new home sales to total sales historically back to 1999. Currently, new home sales are running at 7.8% of total sales. From 1999 to 2005, new home sales averaged a fairly consistent 16% of total sales. The low watermark was 5.5% in May 2010.
The trend in new home sales as a MOREApr 25, 2013 12:47 PM ET
European leaders have strong incentives to try and smooth over this 'crisis' by signaling that Cyprus is a unique and extreme case.
By Matthew Hedrick, Hedgeye
FORTUNE -- The market's reaction to Cyprus's bailout is overdone, and these 'crisis' conditions will be short-lived.
A quick update on the latest development is that parliament has delayed until Tuesday a scheduled vote on the proposed bailout, namely on the levying of a one-time tax MOREMar 18, 2013 1:43 PM ET
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