The Alpha Masters: Unlocking the Genius of the World's Top Hedge Funds (35 page)

Recovery swaps have been used in recent years with stressed companies such as GMAC, CIT and AIG, and with countries like Greece and Ireland. “With the recovery swap,” says Weinstein; “we could lock in American Axle at 30. Meaning, if it were to default, we would be obligated to deliver our bonds, and in return, we would receive 30. So, having bought the bonds at 33, our risk is reduced to just three points. You no longer have to worry that you’re going to lose 22, or 33.”

The aspect Weinstein most likes about the swap is that it costs nothing. “You don’t have to pay for it, unlike a credit default swap,” he says, “because the other side is getting something, too. They think it’s going to be higher than 30 or for some other reason have a need to hedge that outcome.” After putting the bond and recovery trades together, Weinstein liked the investment much better than the traditional approach of just being long the bonds. . . . “We now have a position where the worst that could happen is that we lose nine percent,” he says. “If the company gave bondholders just one coupon payment, we would still be in the black. And if it survived and went from 33 to say, 66, it would make 100 percent.”

In the end, the Saba analyst was right on the money: Axle received emergency funding. When the price on the bonds got into the 60s, Saba sold the position. In the end, Axle got all the way back to par.

Saba may be focused on the credit market, but that doesn’t mean it is limited to it. “Right now, I think the most interesting thematic trade is a shift out of credit and into equities, because stocks still offer good upside whereas the index of high-yield bonds is trading at $103 and will eventually reach a ceiling since even the best bonds mature at par,” says Weinstein. “So, the way to be positioned is to be long equities and short credit.”

As an example of a credit and equity relationship he finds interesting, Weinstein discussed Wendy’s, the fast food restaurant chain. In 2007, Wendy’s sold for $20 a share, and like many stocks, it dropped during the 2008 crisis. But unlike its peers, it never recovered, dipping from $20 to $4 a share, and currently trading at $5. Trian Fund Management, who own nearly 30 percent of the company, has been working with Wendy’s management on operational improvements as well as the use of cash to buy back a significant amount of stock.

This has led to downgrades of the company’s credit rating. “S&P has rated it CCC,” says Weinstein. “Not too good, and Moody’s is just a little better, at B—. We actually think it’s kind of a solid single B.”

Weinstein then consults the credit spread, which at 230 basis points for CDS is more typical of a better-rated BB company. “We think a leveraged company with activist shareholders and an aggressive stock buyback program should not be trading at 230 basis points,” says Weinstein. And actually it was as low as 150 basis points in 2010 when we put the trade on. But we’re keeping it. And we own the stock.”

Meanwhile, Weinstein keeps other developments in mind. “The restaurant sector has seen more than its share of LBOs, with Burger King as the most important example. We think that the Wendy’s CDS and equity trade is attractive because of similar LBO potential. In that dream scenario, the position would make money on both sides.”

Couldn’t Saba just choose the CDS or the shares, rather than having a pair trade? “In general, most of the fund’s investments are long versus short in order to maintain a balanced position to the overall market while seeking to profit from relative mispricing between companies, or a company’s capital structure or term structure.”

That strategy seems to have served Weinstein quite well. Saba Capital rose to over $5 billion in assets under management, and the flagship Saba Capital Master fund delivered gains of 9.3 percent for 2011, compared to the majority of hedge funds that ended the year flat, or worse.

The consequences of the Volcker rule, both intended and unintended, on fixed income markets are still far from known. But already we have seen a big decline in the competition for certain investments that we like, as the most knowledgeable participants in credit derivatives are largely at banks rather than hedge funds. This has led to a more stable set of opportunities for Saba of late and, according to Weinstein, is unlikely to change in the near future.

Afterword

Myron S. Scholes

1997 Nobel Laureate in Economics, Co-Author of the Black-Scholes Option Pricing Model

I read Maneet Ahuja’s book,
The Alpha Masters
, less interested in understanding the wonderful personalities in the book and more interested in culling out lessons on investing. For those, however, who want to become familiar with larger-than-life personalities, the
Alpha Masters
, Bill Ackman, Ray Dalio, Jim Chanos, Pierre Lagrange and Tim Wong, Marc Lasry and Sonia Gardner, Daniel Loeb, John Paulson, David Tepper, and Boaz Weinstein provide great material for the investor’s
People
magazine.

The stories are fun to read and provide insights into those who perform in such a competitive “dog-eat-dog” atmosphere. Moreover, the stories provide us with the managers’ versions of their trading successes and failures. I was impressed that they all learned from their experiences. One common lesson is that they were persistent in achieving their goals, realizing that both bad and good outcomes provide learning that would make them better future investors. Many willingly impart their learning to the next generation of investors, students at their own firms or in universities, and to Ms. Ahuja in this book.

What did I gleam about these investors? As personalities, they stressed that their own road to success involved a tremendous amount of learning how to invest in their trading strategies; that is, what skills they needed to acquire to embrace and understand uncertainty how to handle risks and the factors that affect their returns. To build an investment business, they all had to become “experts” in their discipline, which involves a combination of evolving theory and experience. Many disciplined themselves to approach investment as a business without emotion.

Learning here included: (1) trust your own intuition and be willing to make and learn from mistakes; (2) take a longer-term perspective, realizing that the best strategies might take many years to come to fruition; (3) handle risk aversion unemotionally (meaning don’t be afraid to lose money), and make sure that all money is not invested in one single strategy so it is easier to remain calm and analytical; (4) take aggressive postures in combination with protecting the downside; (5) invest with those who have their own money on the line and assign backup information gathering (the homework of investing) to the team, and test investment ideas by listening to others across a broad cross-section; and (6) work with the numbers (accounting statements, time series, previous shocks, systematization of previous learning, etc.) to calculate value and test ideas.

As an academic, I wouldn’t be doing my part if I didn’t take issue with the title, however.

Although these
Masters
make excess returns for their investors (including themselves), in my reading of their strategies, I would not call these excess returns “alpha.” In a global sense, alpha might be returns that are not explained by systematic factors (e.g., the stock market), so-called “beta” returns. But, in my view, the classic definition of generating alphas are returns that are earned by those who can forecast future cash flows or the beta factor returns (macro factors) more accurately than other market participants, which, as alluded to in the book, is a zero-sum game. Not all can outperform—those that do are paid by those who don’t—and it is extremely difficult for those that do to replicate their successes over many periods. This is not at all the story I read in this book. There is a systematic bias that favors them. They don’t believe that they are investing in a zero-sum game; they are paid for their expertise.

I have defined the true earning power of these hedge fund managers as not alpha but “omega” after Ohm’s law, where omega is the varying amounts of resistance in the market. As resistance increases (decreases), they are willing to step in (step out by short-selling or exiting positions) and reduce (increase) the resistance and earn a profit by so doing as other market participants change their holdings of securities over time. I have called these reasons constraints (e.g., although investors know that they are selling at too low a price they are forced to sell to reduce their balance sheet risk); money is made by understanding constraints and reacting to them. Omega is not zero sums because investors are willing to pay others to take risks from them. Risk transfer is a crucial component of the investment process wherein speculators, those willing to carry inventory forward until others realize the value (or provide inventory to the market when investors willing overpay for it, for example, dividend paying stocks because of low bond yields), are compensated by hedgers, those wanting to transfer inventory risk to others. Speculators are paid by hedgers who don’t have the skills to understand the risks (or are in different businesses) and willingly pay the more skilled speculators to carry the risks forward until others can understand the value.

Graham and Dodd’s value investing starts with the question of whether an investment is cheap and then why is it cheap. These questions involve forecasting the future and not knowing which among thousands of investments to analyze or even to start looking at to ask their questions. For example, out of thousands of stocks I could pick Microsoft and project its cash flows, future investment prospects, financing policies, and so on and determine whether it is undervalued according to my model and then ask, if it is undervalued, why so. (I remember that they do have rules that truncate the analysis process and with computing power and databases, filters can generate a much smaller list into which to make the deep dive.)

All of the
Masters
start with the question that great speculators ask: Why does someone want to pay me to carry the risks forward in my domain of expertise? Or why should I not sell inventory because investors no longer want to pay me to carry risks forward? This is a business; it is the risk transfer business and, like any business, the proprietor is required to understand the uncertainty of running that business. As the business makes money, markets function more efficiently.
¹
They make money because they understand the activities they are involved in and that there is a demand for their services of transferring risk in their chosen areas of expertise.

William Ackman, for example, developed an expertise in the restructuring of companies to make them more efficient, not as a consultant, but as an active participant. Understanding the business, in particular consumer companies and related businesses, gives his fund the opportunity to take a significant position in a company without paying a control premium, while also capturing its share of the gains on improving the operations of the company. And, if companies are in difficulty, his business’s understanding of the underlying potential of the company’s assets and whether their claims have downside protection allows the business to carry the risks forward while others who have little understanding or the skills to analyze the situation give up returns. Time is needed to carry the risks forward, and, as a result, he seeks ways to raise permanent capital that protects his activities if the horizon of the funds’ investors is shorter than the risk transfer needs of the deals.

James Chanos is a short-seller. His filter is accounting mismanagement at corporations because corporate officers use accounting for their own ends, maybe to smooth earnings (borrowing from the future to inflate the current with the hope that the future will provide enough bounty to cover both the past shortfall and the current earnings needs). This sets in motion a vicious cycle of needing to borrow more and more if future bounty is not realized. This cycle tightens the constraints on managerial activity, providing opportunities for Chanos’s group to focus their expertise on spotting “red flags” and unraveling these accounting tricks. Although this might seem more like alpha than omega, the friction caused by managerial actions that cause the imbalances between market value and economic value provide an opportunity for risk transfer services. Market participants use a model to value companies; corporate officers attempt to reverse-engineer that model, and some game the modelers by providing them with “bad” inputs to the models. Market participants do not have the skills or it is not their business to dig deeply into accounting statements and corporate structures to reconfigure the inputs to their models. And, perhaps more important, they are willing to give up returns to the short sellers who have discovered the “bad” inputs.
²
It was interesting to discover how Chanos finds these “red flags,” a key to his business, and those that he currently sees everywhere in China and with Chinese stocks (such as real estate and bank stocks).

Marc Lasry and Sonia Gardner (Avenue Capital) are classic omega providers. For example, their expertise is in assuming trade credit risk at a discount and carrying the risks forward until they are able to settle the claims knowing that trade creditors don’t want to take bonds or stock and wait out the bankruptcy process. Avenue Capital concentrates on the capital structure of distressed or bankrupt capital not only determining which risks to carry forward but also which risks provide downside protection. They argue that Avenue profits because investors want companies without problems and are willing to transfer risks of troubled companies to Avenue. They don’t use leverage because they make money by carrying positions (risks) through crises. (I enjoyed the characterization that others focus on liquidity while they focus on value: others want liquidity and are willing to give up returns to risk-transfer specialists who are willing to provide it.