Why Hedge Funds Have Rarely Been More Bearish: Highlights From The SALT Conference

Following last week's Sohn Conference, where the overarching theme was one of prevailing bearishness topped by Stanley Druckenmiller's near-apocalyptic forecast that only gold will be left standing after all confidence evaporates in the "magic people" known as central bankers,  yesterday some 1,800 hedge fund industry executives gathered in Las Vegas at the SkyBridge Alternatives Conference or SALT, where the prevalent concern about the future of the world continued, driven primarily by worries about China.

 

As Bloomberg puts it, the mood "contrasts with last year’s meeting, where many money managers expressed confidence in China. Last May, Passport Capital’s John Burbank -- now a China bear -- predicted that China would come through its economic slowdown “strong and positive.” Michael Novogratz, who at the time ran Fortress Investment Group LLC’s macro fund business, predicted that the country was on the brink of “one of the greatest bull markets we’ve seen.”

Not so much this year.  The conflict of opinion culminated during a "fiery exchange" between money managers Emanuel Friedman, Milton Berg and Don Brownstein "broke with the polite decorum" on the topic was China.

Friedman, co-founder of hedge fund EJF Capital, said he was reminded of overblown reactions to the late 1990s Asian financial crisis: “People said, ‘Well Korea, it’s finished, it’s collapsed. People are in the streets.”’

“The issue is not that,” shot back fellow panelist Berg of MB Advisors. “The issue is not that!” Friedman then shouted, “People are in the streets!" his volume rising as he repeated it five more times.

Some, such as China Investment Corp.’s Roslyn Zhang and others, tried to paint a bullish picture of China however they found themselves on the defensive on Wednesday’s panel. The CIC executive said hedge fund managers, many of whom have never been to China, were succumbing to a “herd mentality” in betting against the yuan. "They really don’t know much about China but they just spend two seconds and put on the trade,” she said. “Should we pay 2 and 20 for treatment like this?” she said, referring to industry fees, traditionally 2 percent of assets and 20 percent of profits.

Zhang, a managing director at the nation’s largest sovereign wealth fund, said investors fail to grasp that China’s massive size requires large-scale construction, pushing back at concerns that the country is building “bridges to nowhere.” She said the country’s leverage and militarization compare favorably with the same metrics in the U.S.  “When you put that all together, China is actually not that scary,” she said. “If you’re worried about China, you should be twice as worried about here.”

Well, she is right, however that does not mean one should not be worried about China, where our contention that Chinese NPLs are at least 20% of bank books is now widely accepted.

Meanwhile, as was widely expected, the bearish charge on China was spearheaded by Kyle Bass who said at a later discussion that China’s economy was already experiencing a hard landing, creating “one of the biggest macro imbalances the world has ever seen." Bass, who’s highlighted woes in the nation’s banking sector, said economies closely tied to China, such as Hong Kong and Malaysia, are beginning to stumble. Credit in Southeast Asian emerging markets including Malaysia and Thailand has grown “recklessly” and Hong Kong’s property market is in “free fall,” he said.

Other money managers on stage with him mostly agreed. “It may be a little slower than Kyle thinks,” said Kenneth Tropin, founder of the $12 billion macro hedge fund Graham Capital Management. But a spike in commodity prices, driven by Chinese retail investors, is a sign that “things may become unglued,” he said, adding, “it’s a question of timing.” At least five commodities in China gained more than 50 percent from their recent lows in just over two months as daily turnover on the nation’s futures markets jumped by the equivalent of $183 billion.

As Bloomberg adds, Paul Brewer, chief investment officer of Rubicon Fund Management, said China’s woes are worse than the U.S. subprime housing crisis.

Leon Cooperman, who runs equity hedge fund Omega Advisors, was more sanguine about prospects for the world’s second-biggest economy. China has been slowing for years without thwarting a three-year rally in U.S. stocks. "It’s overemphasized as an issue," he said.

Some, such as Structured Portfolio Management’s Brownstein, even went so far as to suggest that communist is a better fit for capital allocation: "China came out of a huge, huge mess and it is a huge country with a very, very diverse population,” he said. “I would rather put my money with a communist government than a capitalist government." To which China bear Berg suggested: “Vote for Bernie Sanders.”

The conundrum of China aside, here are the key theses as presented by some of the most prominent hedge fund managers in the US:

  • Carlyle’s David Rubenstein: He’s Surprised Macro Hedge Funds “Got It Wrong”; He expects oil to get back to $70 next year
  • CIC’s Roslyn Zhang: Hedge Fund Crowd Acts Like Chinese Retail Traders, CIC Says
  • Hayman’s Kyle Bass: Biggest Imbalance Is China Credit System; he added that the Hong Kong property market Is in ‘Free Fall
  • Omega’s Leon Cooperman: Likes Tetragon Financial, First Data as Longs; he added that hedge fund fees will have to go down which is probably not a good thing for a hedge fund manager such as Coopermern.
  • Axonic’s Clayton DeGiacinto: DeGiacinto Says CMBS Is Biggest Short Position
  • Canyon’s Josh Friedman: Says He’s ‘Worried’ About High-Yield Rally
  • Kayne Anderson’s Chuck Yates: Sees Gold at $1,825 by Yr-End
  • Graham’s Kenneth Tropin: Going to see risk-off trade in 3Q or 4Q; concerned about debt levels in relation to
  • Waterfall’s Jack Ross likes housing credit, small business loans

Finally, courtesy of Valuewalk, here is a recap of the key session "From Theory to Application: Identifying Opportunity Sets Amid Market Volatility" which saw the participation of Kyle Bass, Chief Investment Officer, Hayman Capital Management LP; Paul Brewer, Chief Executive Offier, Chief Investment Officer & Founding Partner, Rubicon Fund Management LLP; Leon G. Cooperman, Founder, Chairman & Chief Executive Officer, Omega Advisors, Inc; and Kenneth G. Tropin, Chairman & Founder, Graham Capital Management, L.P.

Q: Thoughts on hedge fund industry?

Tropin: “Monetary policy losing effectiveness…it’s much harder to make money without a beta tailwind”

Cooperman: “Market structure is broken due to Volcker rule, Dodd Frank, demise of the specialist system…this has all limited liquidity. The move to passive management will accentuate this. Active turnover is 30% per year, passive is 3% per year – this has huge implications for both industry employment and liquidity. I tell my people, before we put a lot of money to work in a stock: ‘they should charge $1M for a marriage license and let you get divorced for free.’ Overall, there’s a lot of individual stocks that are attractive but the market on a whole is not.

Brewer:  “We’ve seen plenty of ‘air pockets’ in the treasury market. Price makers are retreating – many OTC products trade only by appointment which causes problems for macro investors like us.”

Kyle Bass: “The challenge in macro is handicapping central bankers… I’ve been poor at it so far. We closed all so-called ‘risk positions’ between July and September…to the points on liquidity, it took us way longer to close positions than we thought it would. All these air pockets are there because there’s no specialist depth anymore.”

Q: Where are we in the cycle?

Bass: I think we’re in March or April of 2007 in both credit and equity markets.

Cooperman: The market will have to go higher before it becomes vulnerable. Out of the four phases – pessimism, skepticism, optimism and euphoria – I can say pessimism ended in 2009-2010 – we are between optimism and skepticism – I don’t see any euphoria. 50% of stocks yield more than bonds. The bubble is in fixed income and not equities. Individuals have taken $800B out of markets this cycle and are very conservatively postured. Bear markets come about for one of four reasons:

1. A recession: not present
2. Euphoric prices – not there.
3. Fed takes punch out of punch bowl – nope, Fed is behind the 8ball – focusing on income disparity or job growth. No hostile fed.
4. Geopolitical event – none yet

Tropin: We’re at equilibrium – I don’t see investors spooked, but I don’t see anyone confident – we’re in a boring cycle of waiting for information. Risk-off trade will come but not anytime soon.

Q: How much pressure is the Hedge fund industry under? Is this cyclical or secular?

Cooperman: Everything is cyclical…one of the most distinguished reporters – Carol Loomis of Fortune – in 1970 she wrote an article proclaiming the end of the HF industry. She said it was over. Entire industry was under $1B in AUM at the time. Now, $2.7 trillion. From 2000-2007, this was the golden era – a lot of money arrived from people who didn’t know what they were doing. Average hedge fund in 2008 did their job – lost 16% when the market lost 34%. Then they put up gates and shot themselves in the foot. Then in the following bull market, as expected, people hedged and underperformed. At the end of the day though, fees have to come down – especially in a low return environment. I ask myself this all the time – is this the wrong structure? The pools that are doing well are HFT’s and quants – that’s not my game, I’m 73, I’m not changing my game. I’m a good stock picker and have made money doing that. You can also play the long game like Buffett. But if you’re worrying about quarterly redemptions then it’s hard to be Buffett.

Tropin: Investors have become more sophisticated and they demand more of HF’s. We all have become more transparent and better communicators. There will come a point of equilibrium where it becomes unprofitable to run at low fees. At some point you can’t cut fees anymore.   If you make 10% with rates at zero, that’s attractive. In 2000 though, I remember people said macro is dead – then we had a bear market and people wanted macro because it wasn’t correlated to beta.

Bass: What’s happening now is that if you’re going to have riskier vehicles, you need side vehicles – and define the vol terms and structure in advance to accompany the prospect of larger returns. Fees need to be correlated to the risk free rate. Unfortunately for us on stage, that’s low right now. I would bet over the next 10 years… I’d bet the under on a 5% global real return expectation. Fees have got to come down.

Q: Current opportunity set?

Bass: One of the biggest macro imbalances is the Chinese credit system…things are going to happen sooner rather than later. I’d add a fifth indicator to Cooperman’s recession list: excessive credit bubbles. If you follow these systems historically and what has broke them, from the US to Europe to Japan and so forth, there are patterns. When you start thinking about how levered China actually is, their asset liability mismatches are 10% of the system vs the US at 2-3% prior to our crisis. SOE’s are going bankrupt. The currency is an afterthought – just a product of the credit system.

Tropin: I agree – its a question of timing. It’ll all come unglued but the current regime wants to kick the can. Speculation in things like iron ore futures are accelerating at amazing levels. It’s a warning sign that it could come unglued sooner rather than later. We’re seeing signs, but the government wants to make it happen on somebody else’s watch down the road.

Bass: We’ve seen credit declines in their partners – Hong Kong and Singapore. HK real estate is collapsing. As if the Chinese government is omnipotent enough to decide when this will happen! Look at credit growth at Malaysian banks. All these emerging markets have grown credit relentlessly. China may be able to fudge numbers for a while but their trading partners are telling the truth – they can’t lie. China just had the lowest GDP print in the last 41 years. Reverse migration for the first time in years. I suppose I need someone to define hard landing for me. Banking cycles take 12 quarters to reach peak and we’re two quarters in. So you need duration in your vehicle. It’s easy to maintain conviction. It’s harder to maintain investors. Maintain your research levels and communication with investors. Our business needs more risk takers and not just people managing small positions. When you see these opportunities you need to take on more vol.

Cooperman: China growth has been slowing for 6-7 years. In 2014 we were hung up on Ebola, and then 2015 on Greece, I think China is overblown but I defer to these gentlemen who know more than I do. In 1992 Barton Biggs took me out for dinner. He said to short JGB’s. That was 25 years ago. These things take a while to unfold. I think the bubble is in fixed income. Equities aren’t even a standard deviation away from historical averages. Buying government bonds, on the other hand, is like walking into a room, seeing a rattlesnake and kicking it to see if it’s alive. Don’t do it. Bad idea. My “can’t-miss stock idea” is Tetragon financial – $1B market cap – it’s a CLO/money manager – 14% in equity – stock yields 7% with the dividend covered 4x – last year 45% of equity in cash. One principal now owns 20%+ of the company. Then they announced a self-tender for $100m. You’re buying a $9.50 stock trading at half of book.

Tropin: My ideas: the psychology of investors is going to become more negative. I like being long gold. As paper assets become less impressive, gold is one people want to own. You want to be prepared to be short risk assets. 10-year yield should go to 1.50%. Still cheap on a relative basis vs rest of world.

Cooperman: I agree. Inflation is picking up. Wages are picking up. Energy prices are reversing. Productivity is terrible so labor costs will be rising. At the end of the day – what do you want to do with your money these days? There are just so many stocks that yield more than bonds.