Renaissance

Like everyone else today, I’m reading Katherine Burton’s amazing inside look at Renaissance Technologies, the greatest hedge fund in history.

Among their secrets – hiring non-finance people with science and math backgrounds, avoiding contact with Wall Street at all costs, constantly developing new edges as old ones grow stale – their ability to stick to what they know works is probably a key one. How did they learn this lesson? By “losing” a billion dollars in a few days, how else?

When rivals and former investors are asked how Renaissance can continue to make such mind-blowing returns, the response is unanimous: They run faster than anyone else. Yet all that running hasn’t always kept them on their feet when everyone else stumbled.

In August 2007, rising mortgage defaults sent several of the largest quant hedge funds, including a $30 billion giant run by Goldman Sachs, into a tailspin. Managers at these firms were forced to cut positions, worsening the carnage. Insiders say the rout cost Medallion almost $1 billion—around one-fifth of the fund—in a matter of days. Renaissance executives, wary that continued chaos would wipe out their own fund, braced to turn down their own risk dial and begin selling positions. They were on the verge of capitulating when the market rebounded; over the remainder of the year, Medallion made up the losses and more, ending 2007 with an 85.9 percent gain. The Renaissance executives had learned an important lesson: Don’t mess with the models.

Sudden, sharp drawdowns will frequently have us second-guessing our portfolios. This is only natural – in the heat of the moment, it always looks like something is wrong or that action must be taken. One of the worst things an investor (or advisor) can do is throw away the playbook in response to temporary volatility or unexpected events.

Renaissance is using leverage in their Medallion fund, so they’ve got considerations beyond performance to consider – like the survival of the company. For most investors, this is not the case, so capitulation is always a wrong move.

Don’t mess with the models.

But, although Renaissance has been around for quite some time and weathered a number of storms, you still have to remember Long Term Capital Management, who were brought down by leverage.

 

Capital Structure

Rhodytrader has a post up that links to a couple other posts regarding Capital Structure Essentially he joins the discussion with the viewpoint of:

As much as the old methods of financial analysis have come under sharp criticism, there is definitely the question of cost of capital which needs addressing, and that’s something Felix and Joe have ignored. They’ve just harped on the “debt is bad” theme. I understand it given what we’ve gone through, but it risks swinging things in the whole opposite direction, which isn’t any better.

The bottom line is that each company should be making decision about their capital structure that make sense for their particular situation, maximizing the return of their shareholder’s investment, but with a reasonable risk profile.

The cost of capital is an interesting point, and really where I wish to take up the discussion. If we first approach the cost of capital from the point of view of Arbitrage Theory, which undelies the Modigliani – Miller Capital Structure Theory

Along with Merton Miller, he formulated the important Modigliani-Miller theorem in corporate finance. This demonstrated that under certain assumptions, the value of a firm is not affected by whether it is financed by equity (selling shares) or debt (borrowing money).

M&M’s often cited Proposition 1 states essentially that a firm cannot change the total value of it’s securities just by splitting cash-flow claims into different streams.

Two analogies: first, if you have a pizza, if you slice the pizza into six slices or eight slices, do you have any more pizza? The second analogy offers an observation that chicken pieces in a supermarket, often cost more than buying the whole chicken.

Leverage [adding debt] to the capital structure increases returns, and losses to the equity holders, this is so well accepted that I won’t even bother with an example. This is largely due to the reason that in the real world, debt is tax free. All corporate profits allow interest payments to be deducted prior to the paying of any tax, thus debt has a very significant incentive attached to it.

The central point however, as regarding the theoretical valuation, debt will cost exactly the same as equity, if it didn’t, there would appear an arbitrage opportunity.

The kicker in the equation revolves around interest rates. If the interest rate is not being manipulated by a Central Bank, viz. Federal Reserve, then, the cost of capital is equal. However, should the interest rates become manipulated, as they are currently, some very real distortions enter the picture.

Currently, equity prices are still [well] off their highs, making the selling of equity very expensive to the [selling] corporation, while the cost of debt, assuming one can sell debt, is far cheaper, particularly if you have a strong rating, MSFT comes to mind.

Microsoft Corp. Announces Debt Offering
May 11, 2009
Microsoft Corp. announced the pricing of its offering of $3.75 billion of senior unsecured notes. The notes consist of the following tranches; $2 billion of 2.95% notes due June 1, 2014, $1 billion of 4.20% notes due June 1, 2019 and $750 million of 5.20% notes due June 1, 2039. The Company intends to use the net proceeds from the offering for general corporate purposes, which may include funding for working capital, capital expenditures, repurchases of stock and acquisitions. The offering is expected to close on May 18, 2009.

This exact problem was encountered after the 1921 bear market that the lower quality companies that did sell debt, found in the business [credit expansion] that ran through to 1929 created the massive boom in stock prices due to the leverage employed, but due to the vulnerable cash-flow ratios, directly contributed to the number of bankruptcies that characterised the Depression. These were created by the lack of appropriate companies willing to optimise their capital structures at [1921] this point in time. Strong companies became so conservative in their capital structure decisions, that it created a dearth of investment grade bond issues.

This creates the very real problem that without the AAA companies converting their capital structure in times of low manipulated interest rates, and thereby absorbing the available liquidity, the door is thrown open to weak companies to speculate within their capital structures. In 2003 when Greenspan lowered the interest rates in the face of a bear market in equities, the cost of capital was seriously distorted, driving marginal lending to firms and others who speculated on the mispricing. Thus, today, we have bankruptcies soaring due to inappropriate capital structures that were never constructed on rational interest rates and cash-flows.

Currently, companies are scrambling to convert commercial paper, short-term borrowing, that was rolled over, essentially providing the spread twixt long-term higher rates, and lower short-term rates, into either long-term debt or equity, as the short-term commercial paper market has shrunk dramatically.

The rising rates for corporate borrowers is now bringing [gradually] the cost of capital back into equilibrium, however, it is at the cost of increasing bankruptcies and rising unemployment.

That the Federal Reserve and other Central Banks continue to try and effect a mispricing in the cost of capital, if they are successful, will lead to another boom/bust cycle.

 

Citi arbitrage

The WSJ has divulged the arbitrage that was available in Citi convertible Preferreds and Common stock.

Posted by David Gaffen

Shares of Citigroup Inc. are dropping after the company’s conference call – but that’s a good thing, according to those who have been betting that the bank would execute a planned conversion of preferred shares to common shares, announced in late February.

The Treasury Department had planned to convert up to $25 billion of its preferred stake into common stock, as long as it persuaded foreign government investment funds as well as other private investors to do the same. The benefit to Citigroup would be to reassure the markets by stabilizing Citigroup, and would also lower its costs through reduced need to pay preferred dividends.

When this conversion was first announced on February 27, investors of all stripes started to execute arbitrage trades – buying the preferred shares and shorting the common stock. One common trade involved buying the company’s Preferred F series, which was slated to be converted into 7.3 shares of Citigroup’s common shares. At the end of the next day of trading, March 2, Citigroup’s common shares were at $1.20 – which makes the fair value of one preferred share about $8.77. The preferred shares were at $7.95, so ownership of one of those shares would mean a profit of 82 cents just by hanging around and waiting for the conversion.

Of course, as it became a more well known trade, and uncertainty surrounded the intentions of the US Government, the Options market became active:

Those active in Citigroup’s options have been taking moves Friday to protect themselves, just in case the company does not commence with its offer to convert preferred shares of stock to common stock shortly after the government’s stress test in May.

Since shorting Citigroup shares has become increasingly difficult as a result of the arbitrage trade that has been put on since late February, when the conversion offer was first announced, investors have waded into the options world to put on what are known as “synthetic shorts,” in effect, creating a short position while still buying the preferred shares.

These synthetic shorts commonly involved buying the June put options at a $5 strike (a put option gives an investor the right to sell shares at a later date at a given price), and selling June call options, also at a $5 strike price. The investor then also buys the shares, and sells them, creating this “synthetic” position. How popular is this trade? Open interest at the $5 strike is nearly 1.5 million contracts in the put options, and more than 1.6 million call options.

Here’s where the problems started: As the stock rallied, those holding these options positions started to get nervous, because if shares reached $5, there was a risk that the buyers of call options would exercise that option. Those investors who had sold calls would be required to deliver that stock – which they would have then had to buy to avoid losing money. But that would have created a vicious cycle as other investors sought to cover short positions with further buying.

“The rational for choosing the 5 strike was that C shares, then trading at [around] $1, were unlikely to reach the strike and risking the call option to get exercised,” wrote strategists at Credit Suisse, on Thursday. “However, now with C trading above $4, some have become nervous that shares could advance above $5.”

Investors started to get nervous about the timing of the conversion offer, because they wanted the 30-day window on the tender offer to end by the time June options expire. Now, investors have been rolling out of those positions into September options at the $10 strike. More than 235,000 call options have changed hands at the $5 June strike, and nearly 108,000 September calls have changed hands. The same goes for puts – more than 167,000 call options have changed hands at the June $5, and more than 112,000 put options have changed hands at the $10 September strike.

“We saw a few large trades,” says one options strategist, who declined to be identified. “You buy yourself more time for the deal to go through.”

 

USO ETF…the debacle

From Yahoo Finance

Commodities are bulky. Futures contracts have been the most practical way to approximate physical ownership and still accommodate all investors, with few exceptions. In late 2008 and early 2009, however, disaster struck one of the largest commodities ETFs and demonstrated the limitations of futures contracts. We recommend caution with any large ETF using undiversified futures.

In just three years United States Oil Fund (NYSEArca:USO – News) ballooned from a few million dollars to nearly $4 Billion. But it was not USO’s size which proved its undoing. Many huge ETFs have performed admirably. Rather it was an overly simple and public trading strategy focused on just one security. USO owned only futures maturing in one month or less, exchanging contracts due to expire for new ones at the same time each month.

On Feb. 6 oil was trading calmly until just hours before USO was about to execute its pre-announced monthly roll trade. Professional arbitrage traders reportedly jumped in with huge orders on futures USO needed to buy and sell. Prices spiked. When USO entered the market it found that it had to pay tens of millions of dollars more to execute its roll than it would have just hours earlier. The arbitrageurs largely sold their contracts to USO, ringing up easy profits in hours at the expense of USO investors.

The Commodities Futures Trading Commission is investigating the incident, but it is debatable whether market manipulation took place. The arbitrageurs did not create an artificial perception of demand and scarcity to manipulate misinformed investors. On the contrary, the arbitrageurs exploited real scarcity and demand created by professional managers who broadcasted their intentions.

In response to the debacle, USO managers have expanded their trading window to four days at the end of the month to force arbitrageurs to guess when to place their trades and to force them to hold onto volatile futures for more extended periods.

The mere fact that USO commonly trades 20% of all front-month US crude oil contracts means that it undoubtedly impacts prices against the interests of its investors. USO has trailed spot crude oil returns by double digits in early 2009, although this may not be entirely due to futures trading woes. Relative to spot prices at least, this futures strategy is likely to suffer during contango (the condition where near month contracts sell for less than distant months). Conversely, it can benefit in rising markets.

Unfortunately contango reached absurd levels, attracting unwelcome arbitrageurs of a different kind. The spread between March 2009 and June 2009 contracts grew to as much as 14%, which meant that by accepting March delivery and selling June it was possible to lock in 35% returns over only 90 days, minus the cost of oil storage.

The SEC has sensibly encouraged transparency and formula-driven indexes for ETFs to maintain liquidity and to avoid insider information abuses. Passive index equity ETFs have operated fine with a largely transparent model. While it has been shown that arbitrageurs can exploit stock listings and delistings on popular indexes, these are modest events in enormous markets. Such inefficiencies to index funds have tended to be below 1% of assets per year when identified, and steps have been taken to dampen them.

Unfortunately, futures operate in far smaller capital markets with far fewer securities than equities. Prices can whipsaw with much smaller trades. It seems clear that basic passive index fund management techniques are poorly suited to futures-based ETFs. All commodities funds which deal in futures are caught in a bind not of their making.

What can commodities ETF managers do to avoid trouble? These are just some of the possible defensive techniques:

expand the roll window to many days or even weeks
expand the list of securities (such as months of futures contracts)
take occasional physical delivery
adopt disruptive trading tactics

USO has chosen to expand its roll window to four days, but why stop there? The wider the period, the more arbitrageurs have to be in the market and exposed to the underlying commodity’s risk. USO selects only one-month maturities so as to track spot oil, but what difference would adding a few months make in this regard? It could severely disrupt arbitrageurs if they bid up one month’s futures contracts only to find that USO has moved on to another. Taking delivery of actual oil in actual storage tanks on occasion could be an effective “brush-back pitch”, and USO has the right to do so, according to its prospectus. Burning the arbitrageurs occasionally with these gambits will drive many away.

It should be noted that USO’s sister ETF, United States 12 Month Oil Fund (NYSEArca:USL – News), diversifies into all monthly contracts going out one year. It is ironic but no surprise to us that USL tracks spot oil prices better than USO, and it seems to have been less of a target to arbitrageurs.

USO and USL managers are mum on the entire subject of trading strategy, which is understandable but which makes judging their efforts hard to gauge. They do not appear to have used all resources at their disposal well.

Disruptive trading tactics are essential, but they needn’t require great skill or impede posting of real-time net asset values. Choosing roll over times by random or by undisclosed formula could easily be implemented. Meanwhile NAV can be calculated and published at all times to retain ETF liquidity.

Commodities ETFs need not telegraph their every move to achieve useful transparency. Fundamental ETFs, for instance, use proprietary black box stock picking techniques even though they disclose in real-time the Net Asset Value of their holdings. Small cap ETFs, meanwhile, sample from an index population so as not to be forced into buying illiquid or arbitraged stocks at unreasonable prices. And index providers have spaced out over many months the transition time for listing and de-listing a holding in order to force arbitrageurs to hold stocks for long periods and take on ownership risk. Different players have adopted different defensive techniques without impacting aspects of transparency most critical to investors.

A little ingenuity and determination is needed for an ETF to avoid getting picked apart by professional traders in the commodities arena. Clearly not all ETF managers have what it takes. Investors should avoid any ETF which is large, deploys a simple and public trading strategy, and focuses on a small number of securities in a small capital market.

 

Arbitrage opportunities

From “The Economist”

WHEN will the arbitrageurs return? A look across the financial markets at the moment reveals all sorts of potential anomalies that are not being exploited.

One example is in the corporate bond markets, where cash bonds offer a very high yield—higher, indeed, than the cost of insuring (via a credit default swap or CDS) against the failure of the corporate issuers concerned. This gap has narrowed a little but is still around a full percentage point for European issuers, according to Citigroup.

In other words, an investor could buy the bond and then protect himself against default risk at a profit. He would end up with a risk-free asset yielding around a percentage point more than the equivalent government bond.

So why don’t investors do this and eliminate the discrepancy? One reason may be that some risk would linger in such a trade: the risk that the swap counterparty might default at exactly the same time as the issuer of the corporate bond. Although swap participants have to put up collateral against their positions, it takes time to sort out the mess when one party defaults (as those who dealt with Lehman discovered, to their cost).

But the most important reason seems to be that arbitrage trades usually require borrowed money—leverage, in other words. Earning a percentage point over Treasury bonds is not enough for a hedge fund, especially considering the fees it charges (2% on an annual basis, even before the performance fee). At the moment, it is so difficult and so expensive for hedge funds to borrow money that the bond/CDS trade is not worth doing.

Another arbitrage possibility that has been ignored for a while is the money markets. Central banks have been willing to lend an almost limitless amount of money to commercial banks at the official rate-level, but interbank rates have stayed stubbornly above that level. In theory, a bank could borrow money from the authorities and immediately lend it out to other banks at a profit.

It is not too difficult to see why banks did not do this trade in the immediate aftermath of the collapse of Lehman Brothers. But now there appears to be little credit risk; there are government guarantees for other banks in a variety of explicit and implicit forms. First, as already mentioned, liquidity-constrained banks can borrow from the authorities. Secondly, there are explicit guarantees available for some bank debts. Third, governments now own minority or majority stakes in big lenders. And fourth, it seems doubtful that governments would risk a repeat of the Lehman debacle.

So why aren’t banks doing the trade? One reason is that central banks require collateral against lending, and the type of assets that are suitable for pledging are in short supply. Another problem is that banks are still unsure about the calls on their capital that could come from the corporate sector; a lot of back-up facilities were agreed during the credit years. The approach of the year-end may also be making bank treasurers cautious.

Slowly, however, the gap is being closed (see graph). Three-month dollar LIBOR is now around 100 basis points above the Fed funds rate. That is a huge margin by traditional standards but well below the heights seen in the autumn. Bridging this gap down to a fifth of a percentage point or so would be a sign that financial markets had returned to health. And so would the return of arbitrage in other areas.

Convertible bonds (fixed-income instruments that can be swapped for a company’s shares) have been battered in 2008. Traditionally, these were bought heavily by hedge funds (a specialist sector called convertible arbitrage) that hedged themselves by selling short (betting on a price fall) the shares of the company concerned. The trade has been almost impossible in recent weeks, thanks to the difficulty in getting leverage and restrictions on short-selling. Convertible bonds may look cheap but no one can take advantage of them.

In short, to arbitrage, you need both access to credit and confidence that market conditions will return to normal. Both are in short supply. If we want the financial system to recover, we need the arbitrageurs to come back.

 

Time to go “short” Treasuries

Now is the time to go short Treasuries, in essence you have an arbitrage.

At some point during the afternoon, the yield on the three-month Treasury bill dipped below 0%, according to traders, as investor desire to hold short-term liquid debt trumps all else.

Year-end needs for liquidity probably play a part in this, according to one fund manager, but it’s still insane. “It’s the modern version of stuffing it into your mattress,” says Thomas di Galoma, head of trading at Jefferies & Co. “You just can’t make it up.”

A negative bill yield means investors are willing to pay to get the securities and forego the interest they’d normally receive. It comes one day after a three-month bill auction that yielded 0.005%, the lowest auctioned yield since 1941, and at a time when investors, in part because of year-end worries, are “trying to hide their money for year-end in the safest instrument known to mankind, and that’s Treasury bills,” Mr. di Galoma says.

Most of the Treasury bill curve is sporting a yield of zero, or just about. The one-month bill was lately yielding 0.025%; the six-month bill was at 0.25%, and the one-year bill sported a yield of 0.4%

 

An interesting pairs trade

Profit From Panic With This Arb Pair Trade
By Sham Gad

In today’s markets, valuations simply do not matter. If you are a value investor, you see this firsthand as high-quality, cheap businesses seem to get cheaper by the day. With no end in sight, the notion of a business being “too cheap not to own” seems to take a backseat to “too risky to own anything.” Yet during periods of extreme volatility and uncertainty, one channel of market activity that is usually nonexistent opens up: stock arbitrage.

Arbitrage is basically an investment opportunity that is not dependent on the general performance of the market to yield a positive return. Value investors salivate around such opportunities because they can offer complete safety with virtually risk-free upside. Arbitrage exists in many forms. The most common is merger arbitrage, but in today’s market I wouldn’t count on many deals going through unless the government or Berkshire Hathaway is buying.

Another type of arbitrage involves businesses with two classes of stock that both trade simultaneously and should have stock prices that reflect the economic value of the shares. One such company today offers one of the best and safest arbitrage pair trades out there.

That company is Mueller Water Products and , a pure-play water infrastructure company that was spun off from Walter Industries a couple of years ago. Since this arbitrage opportunity has nothing to do with the business and everything to do with the price of the shares, I won’t get into the business details here.

The Trade
As an ultimate result of the spinoff, Mueller has two classes of stock, A and B, both of which trade on the NYSE. The A shares were issued by the company. The B shares were issued to the shareholders of Walter Industries as part of the spinoff.

The two classes of shares have identical economic rights, but the B shares have superior voting rights. In fact, B shareholders are entitled to 8 votes per share vs. 1 vote per share for Class A holders. As such, one would think that the B shares would theoretically be worth more than the A shares, but at a very minimum they should be equal to the A shares. There are no differences between the two classes besides voting rights.

As of the close yesterday, the A shares traded at a premium of more than 30% to the B shares! The B shares were trading around $6, while the A shares were trading at a penny under $8. This is an awfully wide spread and should not exist in the long run. I can only blame the panic-stricken market for allowing this to happen.

So the arbitrage trade is simply to short the A shares and buy an equal number of the B shares. Using prices from the close yesterday, the trade would be:

Short 1,000 shares MWA at $8.00 a share: -$8,000
Long 1,000 shares MWA.B at $6.00: $6,000
This spread will converge either through an appreciation in the B shares, a decline in the A shares, or a combination of both. As of late last week, the spread was more than 65%, so the spread has closed rapidly, but it’s still wide enough to warrant action.

Why the pair trade? Why not simply go long the B shares? You don’t know how the convergence will take place. It could be that the A shares decline while the B shares sit still, or both classes could slowly converge toward each other. By employing the pair trade, you hedge your losses and capture a gain, which is the essence of a pure arbitrage play.

A Note of Caution
Historically, the A shares have typically traded at a 5% premium to the B shares. There’s no logical explanation to this except to say that of the 116 million outstanding shares, 86 million are B shares and 29 million are A shares, so it could simply be a supply/demand issue. Yet there have been periods when the shares were trading equally.

Still, I would be looking for at least a 20% to 25% spread before thinking about making the trade. At last week’s prices, this trade was like stealing candy from a baby. At today’s prices of $6 for the B shares and $8 for the A, there is still room for a tidy profit.

Understand, however, that the spread could actually widen in the short-term, but over the years there has been a tendency for it to hover around 5% or so. And because there are no conversion rights from the B shares to A, there is no guarantee for a complete convergence.

Nonetheless, panicky markets distort prices beyond rationality. And this trade has nothing to do with the Dow rising or plunging 500 points. That’s the beauty of stock arbitrage and why value investors love it so much.