Beware Non-GAAP Accounting Standards

By Mark Melin, published on ValueWalk.com

The practice of companies using their own, non-GAAP accounting standards to spin earnings is nothing new.  But did last week a statement from Target Stores go too far?  The Minneapolis-based retailer’s spokesman Eric Hausman was quoted as saying it will exclude from its accounting statements costs from a recent technology breach where 40 million of its customer credit and debit card accounts were hacked, customer’s private information stolen.

The key question is: are these really one time charges?  Is there any residual, lasting impact on the Target brand or customers sense of security going forward?  Multiple sources  reported that after the December data breach occurred, Target’s traffic and credit card sales saw a significant drop.  Can Target claim definitely the event is really only a onetime cost?

As Bloomberg’s Jonathan Weil notes: “It’s not as if Target hasn’t had stuff stolen from it before, or that it doesn’t get sued on a regular basis. The difference is that the latest data heists were really, really bad. The upshot: Small losses count (think shoplifters). But losses stemming from the theft of personal data for tens of millions of customers don’t count, because those would be much bigger. Put another way, the bigger the losses are, the less they matter.”

The costs being excluded from the firm’s forthcoming earnings report includes “liabilities to payment card networks for reimbursements of credit card fraud and card reissuance costs, liabilities related to REDcard fraud and card re-issuance, liabilities from civil litigation, governmental investigations and enforcement proceedings, expenses for legal, investigative and consulting fees, and incremental expenses and capital investments for remediation activities.”

Target’s Mr. Hausman was quoted as saying “It is a unique, nonrecurring event. This has never happened before. So it is not considered a part of our recurring operations.”

Pay attention to the concept that this is a unique, nonrecurring event when considering Target’s annual report which identifies several risk factors, including significant data security breaches that “could adversely affect our reputation and results of operations.”

If a firm identifies a potential risk, and then that risk occurs and costs the company money, can it be defined as a unique and non-recurring event?  This is particularly interesting given the recent uptick in cyber security breaches and online crime.  In the report  2013 Cost of Cyber Crime Study, HP and the Ponemon Institute said the cost, frequency and time it takes to resolve cyber attacks has risen for the fourth consecutive year.  The report clearly shows a trend towards increasing costs of cyber crime, noting that the costs of solving cyber crime increased by 55% in 2013 when compared to 2012.  Not only did the cost increase, but the time involved in solving the problems grew as well from 24 days in 2012 to 32 days in 2013. Perhaps most troubling is the fact the number of cyber crimes continues to rise, from 102 attacks per week in 2012 to an average of 122 in 2013.  When investors consider the cost of cyber crime on earnings they consider that the costs a company actually incurs might be in the eye of the beholder.

 

 

 

Update on Short Ten Year / Taper Trade and New Gold / Currency Trade In Works

This article addresses the yield curve trade that recommended a short position in the Ten Year Note going into the Federal Reserve taper announcement and also tees up a new relative value trade in gold / silver vs a small basket of currencies selected based on their levels of debt.

Yield Curve Trade

In our yield curve trade recommendation, the long debit spread (buy June 2014 120 put, sell 118 Put) has essentially been treading water while the real performer is the short in the money credit spread (sell March 2014 125 call buy 128 call.  Note that the initial quoted prices were inaccurate).

Ultimately my expectation is that the short credit spread, currently in the money, will move out of the money at some point before expiration in March.  When this happens I may recommend a trade to move from an in the money spread to a more out of the money spread, as the first breach of the 120 level could be the point at which buyers find short term support.  The goal with this trade is the value of the options sold goes down in price.  My planning on this trade is that the time premium baked into the options will be rapidly declining in February and March, which is when I anticipate the trade to be most profitable.

With the long debit spread the goal is to see the price of the spread increase in value.  In the out of the money debit spread I anticipate the Ten Year Note market will move in the money (past 120) at some point between now and the option expiration in September. As I said this is a long term trade and my expectation is that this will happen before the 2nd quarter of 2014 ends.  If this doesn’t happen – and my assumptions are incorrect – we may look to exit this trade near the second quarter of 2014.

Long Gold & Silver Recommendation / Short Select Currencies

Another recommendation I’m looking at, and may put within a week, is long gold / long silver and short a basket of currencies where government debt is an issue.  This is a relative value (spread / arbitrage) trade and I might actually overweight the long gold aspect of the trade.

The gold market appears manipulated to me, which is speculation on my part.  More concrete, on a relative value basis the spread between gold and certain currencies has moved past a divergent point and I’m going to look for convergence back to the mean.  Selection of the exact point a relative value trade is overvalued and undervalued is impossible, and thus this trade could experience some downside loss depending on the trade entry point.

Much like the yield curve trade, I’m going to recommend the trade be executed using option spreads.  I find this to be the best risk / reward execution method in my opinion.

Managed Futures Recommendations

In addition to trade recommendations based on my previous hedge fund trading method, this site is going to be making managed futures recommendations.

 

Trade Recommendation: Predicting the Taper Wasn’t The Key Component of This Trade

The goal of this article is to explain the volatility yield curve trade to a certain degree.  I know this might sound odd, but the trade was not entirely predicated on accurately predicting the taper even thought that is what occured.  I will explain why in an article on Monday, but understand that yields were likely rising regardless.

Allow me to begin by addressing predicting the taper.  I don’t want to take credit for this.  I had an on the record conversation with Jay Feuerstein, CIO and founder of 2100 Xenon, who flatly called for a December taper from the Fed.  Jay is an accomplished yield curve trader and is credited with helping develop the first bond futures contract and I highly respect him.  After he outlined the economic rational, I heard from other hedge fund traders along the yield curve, all of whom shared the view of the December taper.  Then I spoke to a DC contact who has been on the money regarding what’s really going on behind the scenes, and speculation was a Dec taper was highly likely.

I had my own reasons for thinking a Dec taper was likely, including Bernanke’s legacy and how the taper timing would be optimal during the holiday period.  But also the sense I was getting was that credibility on the yield curve was eroding – and if the Fed kept up its bond buying program the market’s reputation as a mechanism to true price discovery would be badly damaged.  These were reasons I thought the taper would come.  If you would like to hear me engage in a casual conversation about the taper and other topics, go to this Internet video interview I conducted: https://www.youtube.com/watch?v=kzeFV5lwO9c

In regards to the trade itself, it is playing out as anticipated.  Hold your position.  The debit spread in the puts will have a time horizon of several months (2 or 4 depending on price action) while the credit spread in the calls could have a shorter duration (less than one month to 2 months depending on price action).  Take note of the different time horizon’s selected relative to volatility expectations, I designed the trade in this regard for a specific reason.  I will explain the details of the trade strategy in an article I will post on Monday.

Don’t Be Surprised By Clear Taper Talk From Bernanke For Reasons Other Than Jobs Numbers

On the eve of the Federal Reserve Chairman Ben Bernanke presiding his last Federal Open Market Committee meeting, which wraps up this Wednesday with a press conference, a growing number of hedge fund traders who operate along the yield curve are anticipating Bernanke to announce the beginning of the end of quantitative easing.

What is behind the tapering talk? It could be about more than just a positive jobs number.

While a robust jobs market was a prerequisite for a taper, two other behind the scenes factors could come into play. Bernanke has been praised but also widely criticized for the unconventional bond purchasing program. Many economists and professional investors have said the Fed does not have an a workable exit program for quantitative easing and the program is suppressing the free markets role in price discovery. To this end, Bernanke announcing the end of the program as he leaves office is expected to place in the history books the fact Bernanke started and began the exit process, something he is said to want tied to his name.

The second reason to taper in December is more practical. With equity markets dropping at the mere whiff of tapering talk, announcing the end of the program during the holiday season – a traditionally bullish period of time for stocks with many professional traders not as active – could be the ultimate period of time to taper as it could lesson potential negative market impact.

If the Fed does not begin the actual taper in December, hedge fund traders expect some definitive indication that the program will begin to be announced at the press conference this Wednesday.

What will the exit of the Fed from the interest rate market do to interest rates? While many hedge fund traders say the yield of the ten year note could quickly rise to 4.75%, Feuerstein expects the yield to top out at 3.60%.

Yield Curve Trade Recommendation: Short Ten Year Note, Expect Rising Rates (Long Put Volatility / Short Call Volatility)

Expect interest rates to rise

 

Buy Five Debit Spreads:

Buy: 120 June 2014 Put Option (0’59)

Sell: 118 June 2014 Put Option (0’30)

Purchase spread differential near 0’31 (assume 1 tick transaction cost / slippage on each side of the trade as the closing prices were a spread differential of 0’29)

 

Sell Five Credit Spreads:

Sell 125 March 2014 Call Option (0’54)

Buy 128.5 March 2014 Call Option (0’03)

Purchase spread differential near 0’49 (assume 1 tick transaction cost / slippage on each side of the trade as the closing prices were a spread differential of 0’29)

This trade puts the investor long volatility in correlation with a rising rate environment. The expectation is that interest rates at the long end of the yield curve will rise faster than the short end of the curve.  There will be another leg of this trade placed in the two year note over the next week. The general thesis of the trade is to expect Bernanke to lay the groundwork for the taper – if not announce the taper itself on Wednesday.  This trade puts the investor long a debit spread in a 6 month time horizon and short a credit spread in the three month time horizon.

This trading system is a new feature of the web site and will coincide with recommendations for various managed futures investments as well.  I operated a hedge fund along the yield curve and the trade and risk management methodology used will be from that system.

Comparing CTA Indexes

In their recent white paper, “A Comparison of CTA Indexes,” Red Rock Capital principals Thomas N. Rollinger and Scott T. Hoffman compare the major CTA indexes.  Below is an excerpt of the paper’s primary thesis.  To view the entire paper, click here: A Comparison of CTA Indexes (Nov 2013)

 

By Thomas N. Rollinger and Scott T. Hoffman

ALTEGRIS 40 INDEX

The Altegris 40 Index is designed to represent the performance of the 40 largest CTA programs based on program assets. All programs in the Altegris CTA database are eligible for inclusion in the index. Each month all CTA programs in the Altegris database are ranked by program assets. The 40 largest programs are selected as index constituents for the following month. The index return for the month is the asset weighted average return of the constituent programs for that month. As of September 2013, the 40 programs in the index represented assets of approximately $94 billion.

The proprietor of the Altegris 40 Index is Altegris Clearing Solutions, LLC, and they, in conjunction with Altegris Advisors, LLC, calculate the index. The index is available without cost online at www.managedfutures. com and Altegris Clearing Solutions.

BARCLAY BTOP50 INDEX

The Barclay BTOP50 Index is designed to represent the performance of CTA programs in the Barclay Hedge database representing at least 50% of total assets in all CTA programs that are open to new investment. To qualify for inclusion in the index the program must be open to new investment, the manager must be willing to report daily returns, the program must have two years of performance history, and the pro­gram CTA must have at least three years of operating history.

The index calculation methodology is such that the index performance represents the return of a hypo­thetical portfolio comprising an equal dollar allocation to each index constituent at the beginning of each calendar year. During the fourth quarter of each year, all CTA programs in the BarclayHedge database that meet the inclusion requirements (candidate universe) are ranked by third quarter ending program assets. Beginning with the largest program, the constituent list for the following year is compiled by successively adding the next largest program to the constituent list until a minimum of 20 programs have been included and the cumulative program assets of the constituent list equals at least 50% of the total program assets of the candidate universe. The result of this process is the constituent list for the index for the following calen­dar year. At the beginning of the year a hypothetical portfolio is formed with each constituent program given an equal dollar allocation. The index daily return is simply the daily return of this hypothetical portfolio. There is no rebalancing of allocations during the year.

As of October 2013 there were 20 constituent pro­grams in the index.

The proprietor of the Barclay BTOP50 Index is Bar­clayHedge, Ltd., and they also calculate the index. The index is available without cost online at www.bar­clayhedge.com

BARCLAY CTA INDEX

The Barclay CTA Index is designed to broadly rep­resent the performance of all CTA programs in the BarclayHedge database that meet the inclusion re­quirements. To qualify for inclusion in the index, a program must have at least four years of performance history. Additional programs introduced by qualified advisors (advisors who have at least one program that meets the four year history requirement) must have at least two years of performance history.

The index constituent list each year is comprised of all CTA programs that meet the inclusion require­ments at the end of the prior year. At the beginning of the year a hypothetical portfolio is formed with each constituent program given an equal allocation. The index monthly return is simply the monthly return of this hypothetical portfolio. There is no rebalancing of allocations during the year.

As of October 2013 there were 582 constituent pro­grams in the index.

The proprietor of the Barclay CTA Index is Barclay­Hedge, Ltd., and they also calculate the index. The index is available via a $150 yearly subscription which provides a complete monthly historical data set for all of the Barclay CTA Indexes and monthly updates for the next 12 months. BarclayHedge’s website is www. barclayhedge.com

BARCLAY SYSTEMATIC TRADERS INDEX

The Barclay Systematic Traders Index is designed to represent the performance of CTA programs in the BarclayHedge database whose approach is at least 95% systematic. To qualify for inclusion in the index, a program’s approach must be at least 95% systematic and have at least two years of performance history. The index constituent list each year is comprised of all CTA programs that meet the inclusion requirements at the end of the prior year. At the beginning of the year a hypothetical portfolio is formed with each con­stituent program given an equal allocation. The index monthly rates of return are simply the monthly rates of return of this hypothetical portfolio. There is no rebalancing of allocations during the year.

As of October 2013, there were 466 constituent pro­grams in the index.

The proprietor of the Barclay Systematic Traders Index is BarclayHedge, Ltd., and they also calculate the index. The index is available via a $150 yearly subscription which provides a complete monthly historical data set for all of the Barclay CTA Indexes and monthly updates for the next 12 months. Bar­clayHedge’s website is www.barclayhedge.com

CISDM CTA EQUAL WEIGHTED INDEX

The CISDM CTA Equal Weighted Index is designed to broadly represent the performance of all CTA programs in the Morningstar database that meet the inclusion requirements.

The index calculation methodology is designed to exclude, each month, constituent performance deemed to be an outlier observation. Each month, statistics are generated for CTA programs in the Morningstar database that meet the inclusion requirements and that have reported returns for that month. Programs whose returns are +/- 3 standard deviations from the average return are excluded. The index return for the month is the simple average return of the non-exclud­ed programs.

As of October 2013 there were 435 constituent pro­grams in the index.

The proprietor of the CISDM CTA Equal Weighted Index is the Center of International Securities and De­rivatives Markets (CISDM) and their research analysts calculate the index. CISDM provides Morningstar with the index on a monthly basis and it is available without cost on both Morningstar’s and CISDM’s websites. See CISDM’s website at www.isenberg. umass.edu/CISDM

CREDIT SUISSE MANAGED FUTURES HEDGE FUND INDEX

The Credit Suisse Managed Futures Hedge Fund In­dex is designed to broadly represent the performance of Managed Futures hedge funds (in contrast to CTA programs) in the Credit Suisse database representing at least 85% of total Managed Futures hedge fund assets under management. To qualify for inclusion in the index, a fund must provide audited financials, have a minimum $50 million in assets, have a minimum one year of performance history, and consistently report to the database.

At the end of each quarter, funds that meet the in­clusion requirements are added to the constituent list for the following quarter. Constituent funds remain in the index until they cease operations even though they may not continue to meet the initial inclusion requirements. The index return each month is the asset weighted average return of all constituents for that month.

As of September 2013, there were 34 constituent funds in the index.

Credit Suisse is both the proprietor and responsible for calculating the Credit Suisse Managed Futures Index. The index is available without cost online at www.hedgeindex.com

“A rolling 36 month standard deviation of each constituent’s returns is used as the measure of volatility.”

ISTOXX® EFFICIENT CAPITAL® MANAGED FUTURES 20 INDEX

The iSTOXX® Efficient Capital® Managed Futures 20 Index is designed to represent the aggregate return of 20 of the largest CTA programs and be easily replicat­ed as an investment product. To qualify for inclusion in the index, a program must have a minimum of $100 million in assets, be open to new investment, be available through a managed account, be offered with fees lower than or equal to the corresponding publically traded fund, and have at least three years of performance history. At the end of each year all CTA programs that meet the inclusion requirements are ranked by program assets. The 20 largest programs that meet the inclusion requirements are selected as index constituents for the following year. The index return each month is the simple average of the individual volatility adjusted (normalized) return of each constituent. A rolling 36 month standard deviation of each constituent’s returns is used as the measure of volatility.

As of September 2013, the 20 constituents in the index represented over $70 billion in assets.

The proprietor of the iSTOXX Efficient Capital Managed Futures 20 Index is STOXX Ltd, and they independently calculate and publish the index value on a daily basis. Efficient Capital Management serves as the research partner. The index is available online at http://www.stoxx.com/indices/index_information.

NEWEDGE CTA INDEX

The Newedge CTA Index is designed to represent the performance of the 20 largest CTA programs. To qualify for inclusion in the index, a program must be open to new investment and report returns on a daily basis.

At the end of each year all CTA programs in the Newedge CTA database that meet the inclusion requirements are ranked by program assets. The 20 largest programs are selected as index constituents for the following year. At the beginning of the year a hypothetical portfolio is formed with each constituent program given an equal allocation. The index daily return is simply the daily return of this hypotheti­cal portfolio. There is no rebalancing of allocations during the year.

As of October 2013, the 20 programs in the index rep­resented assets of approximately $76 billion.

The proprietor of the Newedge CTA Index is Newedge Group, and they, in conjunction with Bar­clayHedge, calculate the index. The index is available without cost online at www.newedge.com

STARK 300 TRADER INDEX

The Stark 300 Trader Index is designed to represent the performance of the 300 largest CTA programs in the Stark database that meet the inclusion require­ments. To qualify for inclusion in the index, a pro­gram’s CTA must be registered with the NFA and be willing to report performance to the Stark database on the monthly basis.

Each month all CTA programs in the database are ranked by program assets. The 300 largest programs comprise the constituent list for the following month. The index return for the month is the asset weighted average return of the constituent programs for that month.

As of October 2013, the 300 programs in the index represented assets of approximately $75 billion.

Daniel B. Stark & Co., Inc. is both the proprietor and is responsible for calculating the Stark 300 Trader Index. The index is available without cost online at www.starkresearch.com

STARK SYSTEMATIC TRADER INDEX

The Stark Systematic Trader Index is designed to broadly represent the performance of the all CTA programs in the Stark database whose approach is systematic and that meet the inclusion requirements. To qualify for inclusion in the index, a program’s ap­proach must be systematic, the program’s CTA must be registered with the NFA and be willing to report performance to the Stark database on a monthly basis.

The index return for the month is the asset weighted average return of all programs that meet the inclusion requirements for that month.

As of October 2013, there were 357 constituent pro­grams in the index representing approximately $69 billion in assets.

Daniel B. Stark & Co., Inc. is both the proprietor and is responsible for calculating the Stark Systematic Trader Index. The index is available without cost online at www.starkresearch.com

Index 1

In the above table, rebalance frequency refers to how often the index is reset back to its original weighting scheme. The annual rebalancing methodology of the equal weighted Barclay and Newedge indexes has the effect that during the calendar year between rebal­ancing, the effective weight or contribution of well performing constituents increase relative to poorer performing constituents. In this way, the hypothetical portfolio of the initial equal weighted constituents become unbalanced over time; hence the need to re­balance. Technically, rebalancing only has significance when the index reporting period is different than the rebalance period. If the index reporting period is the same as the rebalance period, the index never has a chance to become unbalanced.

Is an asset weighted index better than an equal weighted index? The answer will depend on what aspect of the Managed Futures space the reader is interested in. An asset weighted approach is more representative of the total assets under manage­ment (AUM) in the space. Equal weighting is more representative of the diversity of different trading styles. They both have merit. If one wants to gauge the performance of the majority of AUM allocated to Managed Futures, then they should focus on an asset weighted index. If, on the other hand, they are interested in how the average program did, then they should concentrate their focus on an equal weighted index.

Are more constituents better than fewer? The num­ber of constituents in an index is a measure of how broadly the index represents the performance of CTA programs. Since the large majority of assets in the Managed Futures space are concentrated in a relative­ly small number of the largest managers, the number of constituents in an asset weighted index becomes less significant once the number of constituents in the index represents the large majority of assets being managed in the space. For an equal weighted index, the more constituents represented in the index, the more broadly the index represents the entire diversity of CTA programs in the Managed Futures space. Ad­ditionally, rebalancing and reconstitution events have a bigger impact with a smaller number of constituents since each constituent has a larger percentage impact on the index as a whole, i.e. with 500+ constituents, dropping, adding, or rebalancing will not have much impact on the entire index.

“Some indexes have been designed to be easily replicated in an investable product”

Index 2

Some indexes have been designed to be easily rep­licated in an investable product, such as the Barclay BTOP50 Index, both the Newedge CTA Index and the Newedge Trend Index and the relatively new iSTOXX Efficient Capital Managed Futures Index. Such indexes will necessarily have fewer constituents and qualify constituents by size. These qualifications are necessary to facilitate the practical considerations of actually replicating the index methodology, partic­ularly the issues of manager capacity, reallocation, and rebalancing events.

Index 3

Indexes with a larger number of constituents tend to be less volatile than indexes with a smaller number of constituents possibly due to the more diversification represented by the more broadly defined indexes.

During the analysis period the maximum drawdowns for all CTA indexes were substantially lower than for U.S. Stocks and the traditional 60% Stocks / 40% Bonds institutional portfolio. Furthermore, all three traditional asset class variants exhibited significant amounts of negative skewness, which means the distribution of monthly returns was impacted more by negative outliers than positive outliers – i.e. they showed a propensity for downside volatility / negative fat tails.

When comparing the performance of CTA indexes to those of traditional asset classes like stocks and bonds, it is important to recognize that the return report­ed by CTAs does not include the return on interest earned on any notional amount invested in the pro­gram. This is a significant point which will understate, and in periods of higher interest rates significantly understate, the actual return earned by an investor in a CTA program.

This is because of the notional funding possible in a futures account whereby an investor in a CTA pro­gram is only required to deposit a small fraction of the nominal account size used by the CTA to determine the size of trading positions. The amount not on deposit as margin with the futures broker, termed the notional amount, is retained by the investor and can earn interest outside the futures account. This interest is in fact earned by the investor, but is not includable in the CTA’s reported performance. Current regula­tions prohibit CTAs from imputing interest earned on notional funds; they may only report returns actually earned in the futures account.

All indexes in our survey were very highly correlated to each other regardless of index size, composition, weighting method, or calculation methodology. For the period of 2003 through 2013, the average correla­tion was 0.94 with a minimum of 0.90.

Index 4

To view the entire white paper, click here: A Comparison of CTA Indexes (Nov 2013)

 

About the Authors:

Thomas N. Rollinger Managing Partner, Chief Investment Officer

A 16-year industry veteran, Mr. Rollinger previously co-developed and co-managed a syste-matic futures trading strategy with Edward O. Thorp, the MIT professor who devised blackjack “card counting” and went on to become a quantitative hedge fund legend (their venture together was mentioned in two recent, best-selling books). Considered a thought leader in the futures industry, Mr. Rollinger published the highly acclaimed 37-page white paper Revisiting Kat in 2012 and co-authored Sortino: A ‘Sharper’ Ratio in mid-2013. He was a consultant to two top CTAs and inspired the creation of an industry-leading trading system design software package. Earlier in his career, Mr. Rollinger founded and operated a systematic trend following fund and worked for original “Turtle” Tom Shanks of Hawksbill Capital Management. After graduating college in Michigan, Mr. Rollinger served as a Lieutenant in the U.S. Marine Corps. He holds a finance degree with a minor in economics.

Scott T. Hoffman Partner, Chief Technology Officer

Mr. Hoffman graduated Cum Laude with a Bachelor of Science degree in Electrical Engineering from Brigham Young University in April 1987. In the 1990s, Mr. Hoffman began applying his engineering domain expertise in the areas of statistics, mathematics, and model development to the financial markets. In April 2003, after several years of successful proprietary trading, Mr. Hoffman founded Red Rock Capital Management, Inc., a quantitative CTA / CPO. Early in his trading career, Mr. Hoffman participated in a CTA Star Search Challenge, earning a $1M allocation as a result of his top performance. Since then, Red Rock Capital’s outstanding performance has earned the firm multiple awards from BarclayHedge. Mr. Hoffman is active in the research areas of risk and investment performance measurement as well as trading model development. His publications include Sortino: A ‘Sharper’ Ratio which he co-authored with Mr. Rollinger.

Managed Futures Indices Punch Into the Black as Fed Taper Appears Imminent

Major managed futures indexes punched into the black in November, with the Newedge CTA index up 1.62% following a 1.21% gain in October.

Markets currently trending to the upside include the Dax, S&P 500, Japanese 10 year Government Bond, British Pound and Five year note and Eurodollar.  Markets currently trending to the downside include gold, soybean oil, crude oil, corn and, to a lesser extent, coffee, cotton and sugar.   Potential relative value opportunities in diverging / converging markets include the Dax / CAC 40 index (or Hang Seng as a CAC substitute); LME Zinc / Aluminum and to a lesser extent soybean oil / meal.

With the potential for the US Federal Reserve to begin to cut back its quantitative easing program, managed futures industry participants are looking forward to more natural market behavior.  “2014 could be a strong year for managed futures as quantitative easing could end in the third quarter,” said Jay Feuerstein, Chief Investment Officer at 2100 Xenon, a firm that trades along the US yield curve.  “I think tapering could begin in December of 2013.  The every part of the recent employment number was very powerful.”

With over $300 million under his supervision Feuerstein, who helped develop the original futures contracts along the yield curve, said that as long as the curve remains steep it will facilitate job growth, which he expects.  “In 2014 I expect curve to steepen, the dollar to weaken and trend following to return as the economy can stand on its own two feet.”

Feuerstein projects that incoming Federal Reserve Chairman Janet Yellen will change the structure of quantitative easing from focus on the long end of the curve to the short end.  “Yellen is not the biggest fan of QE.  She might tell you the long end of the curve is not what matters most.”  While some yield curve prognosticators have predicted if QE were to end, the ten year note yield might jump to 4.75%, Feuerstein thinks this is too high.  “With inflation this low, I would expect an upside target of 3.60%.”

Feuerstein trading models are now generally benefited from the recent activity in the interest rate complex.  Their Managed Futures (2x) program earned an estimated +3.38 per cent in November; the Futures Alpha program, which has no trendfollowing, earned an estimated +2.68 per cent.

Overall Feuerstein is positive about the economic prospects in 2014.  “The political football that is the debt limit won’t be as intense.  Congress won’t shut down the government and will act more in concert with the interest of the nation as it sees that the government deficit is coming down.  We are on track to have the lowest government deficit since 2006.  Overall I look for the managed futures players that are remaining to do very well,” he predicted.

Blackstone / Codere CDS Event Highlighted on Daily Show Exposes Larger Economic Issues

A recent credit default swap (CDS) payout event, humorously highlighted by The Daily Show, actually opens a much larger issue, pointing to a core problem with unregulated OTC swaps whose notional value exceeds $600 trillion and dwarfs the world GDP by more than five times.  If any unknown event were to trigger a large percentage of these CDS into default the result would be an economic nightmare of unmanageable proportion, making examination of the weak trigger points and inability to hedge risk in many swaps a valid concern.

A Spanish firm received remuneration from a third party if they made a late loan payment.  Both parties benefited from this missed payment because it triggered the equivalent of an “insurance payout.”

Based on published press descriptions and comments from those involved, the ten second description of what happened is: A Spanish firm received remuneration from a third party if they made a late loan payment.  Both parties benefited because it triggered the equivalent of an “insurance payout.”

The Daily Show compared this to a scene from the movie “Goodfellas” where the mobsters burnt down a restaurant to collect the insurance premium.

The Spanish company in the story was Codere, a small but well connected firm that owned horse tracks and betting parlors throughout Europe.  The firm encountered financial struggles resulting from a recent public smoking ban that had seen its attendance, revenue and bond ratings plummet – a case study in the need for why a lender would want CDS insurance protection from loan default. Through a subsidiary, Blackstone Group, the world’s largest private equity firm, purchased Codere debt and also purchased CDS insurance against Codere defaulting on their loan agreement.  The trade was essentially a relative value basis trade benefiting from the differential in pricing and yield of the bonds and the cost of the CDS insurance. Unknown is the cost of the CDS insurance, but it was said to be considerably less than the bond yield. But a significant benefit also came to Blackstone Group and other firms that purchased the CDS insurance when Codere missed the payment.  According to a story first published in Bloomberg, Blackstone’s GSO Capital Partners subsidiary received approximately a $15.6 million payout from the CDS insurance but the total payout to all CDS holders resulted in $197 million.  This payout occurred when Codere is said to have intentionally made a August 2013 bond payment two days after the 30 day grace period.  After the CDS payments were triggered, Codere was able to more successfully re-negotiate its debt.

Primack used the word “convince” to term the decision process on why Codere defaulted.  Did Codere receive clear  payments in a specific if / then transaction?

After The Daily Show essentially lambasted Blackstone for engaging in what it termed “legal fraud” it then took many in the mainstream business media to task for not reporting on Wall Street financial crime.  This drew a response from many in the media, some of whom said the size of the fraud at nearly $16 million was not noteworthy, despite the fact the total loss from the CDS insurance was pegged at $197 million.  Fortune Magazine writer Dan Primack , who gave a voice to Blackstone’s defense, failed to mention this larger and more newsworthy loss number, focusing only on Blackstone’s situation, and also papered over the key point about Codere receiving compensation to make a loan payment two days late.  Primack used the word “convince” to term the decision process on why Codere defaulted.  Did Codere receive clear financial benefit or payments to their clear benefit in a specific if / then transaction, or, as Primack implies, was Codere’s decision to make a payment two days late a result of verbal deliberation without clear quid pro quo?

Depending on how the CDS contract was written, Codere receiving payment and signing a specific contractual agreement to technically default on a loan payment to trigger CDS insurance could be one of the most material aspects of the issue.  Yet the Primack article is vague on this point.  The Daily Show makes the clear assertion that Codere received a payment to default on the loan and a formal agreement was in place regarding same.

Another key issue left unaddressed was the identity of the issuer of the CDS insurance.

Another key issue left unaddressed was the identity of the issuer of the CDS insurance.  Who were the participants that took the $197 million loss?  Sources say and general speculation is the CDS were written by new entrants into the CDS game, not the traditional large banks.  Was the new competition being given rough treatment that has been a hallmark of new competition entering the CDS market?  Keeping swaps private and competition to a minimum has been basically a generally unreported battle that extends back to 1998 when then CFTC chairwoman Brooksley Born was ousted because she called for transparency into the dark market.  As Bloomberg pointed out, “Default swaps were blamed by the Financial Crisis Inquiry Commission for contributing to the worst credit meltdown since the Great Depression…”

 Another issue left unaddressed was the legal work behind the underwriting of the CDS.

Another issue left unaddressed was the legal work behind the underwriting of the CDS.  Sources have indicated what might be considered a questionable legal contract could have cost the CDS issuer(s) $196 million because it did not take into consideration significant default considerations.  Who was the law firm that wrote the CDS contract?  Watch for a potential legal liability suit to ensue, as sources with experience writing CDS contracts have indicated the contract appeared to be a “rookie mistake.”

 With over $600 trillion in swaps underlying the world economic system, swap default will likely become a more important economic issue

With over $600 trillion in swaps underlying the world economic system, swap default will likely become a more important economic issue, particularly if world interest rates rise sharply and the asymmetrical hedges employed by swaps issuers potentially fail.  The large majority of CDS are insured by firms that have traditionally benefited from a government failure guarantee backing.  To protect against catastrophic loss, when an issuer of a CDS swap issues insurance, they typically seek to hedge their risk.  Many times there is not exact or even close hedge for the risk and the CDS issuer, so they engage in asymmetrical hedging in markets that are closely tied to but not exactly the same as the risk the CDS insures against.  To provide a very basic example of asymmetrical hedging, a CDS writer who insured against rising rates in Greece might have sold insurance against rising Greek rates while taking the opposite position in French interest rates which are traded on a regulated exchange.  While many of the CDS hedges are more sophisticated, the core risk in asymmetrical hedging is that a dramatic rise in on leg of the hedge, Greek interest rates for instance, reacts differently than the hedging mechanism, in this example French bonds.  In the case of Codere, one example of an asymmetrical hedge could be the stock price.  A company issuing CDS insurance could also sell short the stock.  If the firm’s fundamentals deteriorated to the point they could not pay on their loans it would likely be reflected in a declining stock value.  Executing hedges with smaller companies in sometimes illiquid situations can be difficult.  The more difficult the CDS hedge the more expensive the CDS insurance.

 Another key component of the Codere example is the fact that the contract lacked standardization.

Another key component of the Codere example is the fact that the contract lacked standardization.  In the regulated derivatives industry a key component is that all contracts are standardized and thus risk management can be more precisely executed.  Most swaps, however, are one off contracts and the lack of standardization is a significant risk.

Credit default swap is a term that typically generates a glazed look of confusion from even sophisticated financial professionals.  However, with the potential to significantly harm the world economy in a rising rate environment, mainstream exposure of the Blackstone / Codere CDS provides a peak into an issue that will likely re-appear in the future with more significant consequence than the loss of $196 million.

Outgoing CFTC Commissioner Bart Chilton Makes Strong Statements Regardings

The Commodity Futures Trading Commission has been at the center of a fight to regulate the derivatives that were at the center of the 2008 crash.  This fight took center stage when CFTC Commissioner Bart Chilton recently gave what is arguably the most aggressive interview ever by a regulator.  Not since former CFTC Chairperson Brooksley Born confronted big bank forces in 1998 regarding unregulated derivatives and was essentially ousted from office by these same big bank forces has a CFTC commissioner been so outspoken regarding the stealth control of the largest banks.

Seldom do regulators confront other regulators in public for protecting the banks.  In this interview, Chilton discloses how the US Federal Reserve has refused to provide big bank position limits to the CFTC, which is charged with monitoring such activity.  “I’m a CFTC Commissioner and I’ve been trying to find out what the banks own in the way of commodities and I can’t tell you what their positions are,” Chilton said in the interview. “I’ve been trying to find out from the Federal Reserve, which has this information, since the end of July 2013.  I’ve asked the Federal Reserve to send me a list, give me a link to the information they have. I receive links but they go to nowhere where I can see the information.”

Chilton then took aim at a more troubling issue: the overwhelming influence large banks have in controlling a democratic society.  “We have these large banks owning all sorts of things that we are not unaware of. There is a theoretical conflict of interest and some problems with the law,” Chilton noted.  “Do we really want banks influencing our media? Owning our cable companies, phone companies, our grocery stores and movie studios?”

Other issues addressed in the interview included a discussion of “malfeasance” in the MF Global case, the fact that had the Obama administration come to Chilton earlier in 2013 he would have stayed to finish rule writing on Dodd Frank, and Chilton clearly points the finger at unregulated derivatives for the 2008 market crash.

Video Link:

https://www.youtube.com/watch?v=7xcgsKaAXO4#t=177

To read the full interview, click on this link:

http://www.uncorrelatedinvestments.com/blog/wp-content/uploads/2013/11/NovOFIFinal.pdf

 

The shortfalls of Venture Capital: Why VC has to become a scientific investment discipline

By John Bhakdi

When we think about Venture Capital (VC), we think about great entrepreneurs, secret deals, and the adrenaline rush of hitting the “next big thing”. Silicon Valley is in many respects the financial cousin of Hollywood: full of great successes, grand failures, of divas, heroes and villains. Financially not very pleasing, but a fun sport.

But there is a new way of doing business in VC: an approach that uses advanced analytical science and algorithmic investment principles to assist in making funding decisions to remove risk, and give investors much more structured exposure to the world’s most promising asset class.

But before I jump into the details, I have to make one important point: The reason we developed a scientific investment approach to VC is not that we have a general bias towards scientific investment in the first place.

We developed the i2X quantitative VC framework and the corresponding Innovation Index because we realized that the financing of innovation is a very special challenge.

The factors that determine the success of any individual early stage technology startups often lie far outside the company and even the founders themselves. They can found not by looking at just the company, but only by factoring in a much larger set of factors that we call “ecosystem”.

And even after factoring these ecosystems in, it remains impossible to predict an individual startup’s success for logical reasons. Therefore, we have to look at a larger set of startups – a “cluster” – and start looking this cluster an investment object. Only then do we get into a territory that offers statistical significance.

This new quantitative approach to VC is personally important to me. It applies the tools of scientific investing to solve probably the biggest problem in global asset management, which I describe as a lack of alpha.

As Ray Dalio once famously said: “In the long run, income can never grow faster than productivity.” And productivityis a simple function of technology innovation whose largest growth comes from technology startups.

Since VC is in charge of financing innovation, it is not just a fun sport. It is the financial infrastructure that is responsible to generate growth across all asset classes.

And right now, it’s a grandiose failure. At a $26b US volume, dismal returns of 6.9% p.a. – a negative alpha of 2.8% below the Russell 2000 – no liquidity and 30%+ risk, the numbers look not good.

The reason lies in an outdated approach to VC in that Venture firms simply apply the Private Equity playbook to technology startups: they look into their financials, their growth rate, their past. But this is not how innovation works. Truly disruptive startups have no past: they are new. Startups are future potential that unravels far too fast to wait for it to unravel before you invest.

By failing to provide a financial infrastructure that is built around the fundamental traits of innovation, VC fails to build the startup breeding ground our entrepreneurs, financial markets and economy rely on.

This failure and its negative effects have driven us to take action, and develop a financial technology that accounts for the unique nature of startup innovation.

Following this logic, I want to start the description of the i2X Innovation Index and quantitative VC framework by taking a closer look at the system of innovation it empowers. It is a system of four macro-factors which together form a wonderful mechanic of progress that we call the “Innovation Machine”.

 

To read the complete PDF white paper, click here: Innovation_Gap_3part (2)