August 2006 Review and Shifting Norms
THE FOLLOWING ARTICLE DOES NOT CONSTITUTE A SOLICITATION TO INVEST IN ANY PROGRAM OF CERVINO CAPITAL MANAGEMENT LLC. AN INVESTMENT MAY ONLY BE MADE AT THE TIME A QUALIFIED INVESTOR RECEIVES CERVINO CAPITAL'S DISCLOSURE DOCUMENT FOR ITS COMMODITY TRADING ADVISOR PROGRAM OR DISCLOSURE BROCHURE FOR ITS REGISTERED INVESTMENT ADVISER PROGRAMS. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.
As we conclude August 2006 our Diversified Option Strategy program returned a positive 1.51% resulting in a year-to-date return of 7.10%. The S&P 500 Index (GSPC) returned 2.13% finally overcoming the negative sentiment leftover from May and is up 4.45% year-to-date. For comparison, the Barclay CTA Index is positive 0.32% as of this writing and up 1.20% for the year. Please refer to our website at www.cervinocapital.com for the most recent performance statistics on our investment programs.
It seemed appropriate at this time to take a step back and analyze the state of the “hedge fund” industry, the changes that have taken place over the past fifty years and opportunities that are still available to us, participants in the alternative investment arena.
We were recently invited to be guest speakers at an international business class at UCLA. The topic of our presentation was “Cultural Crosscurrents within the Financial Services Industry.” Our thesis, applied across various economic case studies, was that norms within society have been progressively influenced by the rapid pace of globalization, resulting in macro-level transformation of the financial industry’s values and its institutions. Which ever way resulting cultural values and norms shift, astute players seek to arbitrage anomalies between local business practices versus innovations in global products/services, regulatory jurisdictions and price parity.
Such arbitrage is fast taking place in the alternative investments segment of the financial services industry as an increasingly competitive environment has subjected practitioners and their respective strategies to the unrelenting march of market efficiency. Over the past fifteen years hedge funds have become widely accepted by investors and institutionalized. By doing so, many sophisticated and previously successful investment strategies have effectively become victims to the hedge funds industry’s success.
The raison d′etre of our industry should be to provide superior money management to clients. Unfortunately this altruistic objective has in varying degrees been complicated by well-meaning regulators, sales practices distorted by conflicts of interest, but most importantly human nature itself where the intrinsic need for social acceptance and validation undermines essential qualities that are prevalent with successful investors – that of nonconformity and unorthodox thinking. Yet as soon as the mainstream assimilates maverick strategies into their portfolios, the seeds of demise are laid for such investment approaches due to a concept George Soros calls reflexivity.
The term “hedge fund” as it is now commonly used is a misnomer. It is loosely defined to be either synonymous with any type of non-regulated fund regardless of investment strategy, or jargon meant to represent all alternative investments strategies in general. Even the Department of Treasury, Board of Governors of the Federal Reserve System, Securities Exchange Commission and Commodity Futures Trading Commission in their 1999 report on “Hedge Funds, Leverage and the Lessons of Long-Term Capital Management” admit that the term is “not statutorily defined.”
Hedge funds first came into existence in 1949 when Alfred Winslow Jones opened an equity fund that was organized as a private partnership to provide maximum latitude and flexibility in constructing a portfolio. He took both long and short positions in securities (thus the name) to increase returns while reducing net market exposure and used leverage to further enhance the performance. To those investors who regarded short selling with suspicion, Jones would simply say that he was using ‘speculative techniques for conservative ends.’ Not only did Jones’ fund outperform the best mutual funds, he kept all of his own money in the fund and employed a performance-based fee structure.
It is interesting to note that Jones operated in near obscurity for seventeen years. Nevertheless, by 1968 approximately 200 hedge funds were recognized to exist, most notably those managed by George Soros and Michael Steinhardt.
During the 1960s bull market, many new hedge fund managers found that selling short impaired absolute performance while leveraging created exceptional returns. Such leveraged exposure turned out to be dangerous as many of these new funds perished after the market downturn of 1969. In 1984 only 68 hedge funds were identified, but this trough marked the beginning of an upsurge with $39 billion under management and 550 funds documented in 1990 growing into $1.2 trillion in assets and over 8,800 hedge funds in existence today.
This growth was not in a vacuum. In response to Congress’ actions with respect to the Small Business Investment Incentive Act of 1980, the SEC proposed Regulation D to replace existing private and limited offering exemptions contained in Rules 146, 240 and 242. Regulation D recognized that there are situations in which there may be no need for the registration provision of the Securities Act, and it also further clarified the definition of “accredited investor.” Shortly after adoption of Regulation D, in a series of no-action letters, the SEC confirmed that hedge funds that made offerings of securities under Rule 506 could rely on Section 3(c)(1) under the Investment Company Act, assuming they had no more than 100 investors. Ultimately, hedge funds came to rely heavily on Section 203(b)(3) of the 1940 Investment Advisers Act which exempts from registration an adviser with fewer than 15 clients during the prior 12 months and who does not hold himself out to the public as an investment adviser, and does not act as an adviser to a registered investment company.
The “retailization” of hedge funds is based on Section 203(b)(3), and the fact that historically the SEC has interpreted a "client" to be someone who is given financial advice by the investment adviser. Since investors in a hedge fund do not receive advice—they are simply investing their money—the recipient of the advice is the fund itself as administered by the investment adviser. What evolved in practice is a non-regulated structure in which a hedge fund manager could advise15 funds (ie, 15 clients), each with 100 investors or 1,500 ultimate investors. This is an example of regulatory arbitrage.
In 2004 the SEC concluded that the “retailization” of hedge funds merited regulatory action and proposed a rule requiring registration. In its push to expand its regulatory oversight to hedge funds, the SEC contended that the meaning of “client” should include the ultimate investors and under this new definition regulators would ‘look through’ the fund to the actual number of investors in the fund.
This rule was put into effect in February 2006. Hedge funds with at least $30 million in assets and investment lockups of less than two years were required to register with the Commission. But to the surprise of many, the U.S. Court of Appeals for the District of Columbia Circuit recently ruled in favor of a lawsuit brought by a hedge fund manager named Phillip Goldstein. In their unanimous ruling the Court stated that the SEC’s argument for imposing hedge fund registration was unconvincing and its rule “arbitrary.”
But this is only one half of the story…
As suggested previously, hedge funds have evolved to represent the vehicle of choice for most alternative investment strategies. These investment strategies as tracked by The Barclay Group include: convertible arbitrage, distressed securities, emerging markets, equity long bias, equity long/short, equity market neutral, equity short bias, event driven, fixed income arbitrage, global macro, merger arbitrage and multi strategy.
Such strategies use to be niche plays disregarded by the mainstream financial services industry as recently as the late 1980s. But in the aftermath of the great bull market of the 1990s they are now being marketed vis-à-vis name-brand wirehouses as institutionalized financial products. Give such acceptance, what does the future hold for this segment of the industry when “fund-of-hedge funds” have successfully exploited the Section 203(b)(3) loophole to become multi-billion dollar “retail” products?
What we do know is that at this size hedge funds need to operate differently than they have in the past.
Already we have seen one hedge fund purchase a controlling interest in K-Mart for the land underneath, while others have been engaged in private investments in public equity (PIPEs) or involved with leverage buy-outs reminiscent of the Michael Milken days. At the same time certain investment companies have redirected their efforts into offering alternative investments within the mutual fund product structure. There is no explicit rule against derivatives in mutual funds, but rather usage of such instruments is constrained by various rules such as “cover requirements,” “illiquid assets" 15 percent rule, and Subchapter M “diversification test,” and “90 percent” and “30 percent gross income” tests.
Many respected opinion makers including James Altucher in his Financial Times article “A thriving juggernaut that is getting too greedy” and Bradley Rotter in his MARHedge guest commentary “Why I’m Getting Out of Hedge Funds” have pointed out that returns have diminished significantly and many opportunities have dissipated as the “anomalies and arbitrage situations these funds earned their keep on don’t really exist any more.” Further, they argue that given recent performance, most of these hedge funds do not deserve the management and incentive fees they’re charging, much less all the other administration fees “fund-of-hedge funds” tack on.
Yet there is still very much a need for superior risk adjusted performance notwithstanding the effort by the industry to commoditize performance with absurd ideas such as hedge fund indices. So what are savvy investors to do?
The answer is to identify emerging niche money managers who operate transparently with agility in markets where anomalies still exist, but also where larger hedge funds cannot trade profitably without incurring undue risk for miniscule returns relative to their size. This is known as the “investor’s edge,” an explainable source for returns and an advantage with respect to trading skills and performance. Institutions call this “alpha.”
For us at Cervino Capital Management, we understand that our clients' returns and by extension our success depends on how we approach the following issues:
Problem #1: Structure—hedge fund structure has certain advantages, but disadvantages include lack of transparency, greater potential for conflicts of interest, lockup periods that restrict redemptions to timeframes inconvenient for investors, and with respect to “fund-of-funds” the layering of fees resulting in much higher costs.
Solution #1: Separate Managed Accounts—clients assets are held by a third party custodian resulting in full transparency and the ability to monitor trading activities on a daily basis; increased flexibility with respect to account additions and withdrawals; ability to revoke trading authorization at any time; competitive fee schedule when compared to the “fund-of-funds” structure due to fee layering.
Problem #2: Regulations—hedge funds are not free from all regulation, but a substantial change in regulations regarding hedge funds poses a major threat to the industry as it is an important factor when assessing the sustainability of certain strategies.
Solution #2: CFTC Oversight—managed futures is unique within the alternative investment universe in that it has operated in a highly regulated environment for the last 30 years under the purview of the Commodity Futures Trading Commission and self-regulatory organization National Futures Association.
Problem #3: Performance—the new paradigm of “portable alpha” proposes that market return (ie, beta) can acquired cheaply and excess returns (ie, alpha) can be “ported” onto beta through exposure to hedge funds; problem is that in recent years hedge funds have reflected performance that is highly correlated to the market as witnessed this May 2006.
Solution #3: Absolute Returns— diversification across a variety of relative value trading strategies with high probability for positive outcomes is the best way to achieve “absolute returns” on a consistent basis; recognition that capacity limitations are a material hindrance to large funds, but the upside is that market anomalies remain in existence with money managers who operate at a smaller size; repeatable strategies utilizing speculative techniques for conservative ends is best way to achieve “alpha.”
Cervino Capital Management has incorporated all the above solutions into its Diversified Options Strategy program. Our vision is to remain a niche money manager utilizing sustainable and lucrative trading techniques in which we can explain where our returns are derived from. We believe that fundamentally the outlook to the global economy present situations that cannot remain in equilibrium. The eventual dislocation of major trends is wonderful for nimble players, where volatility is the friend. For funds whose size prohibit agility, this is a minefield. For the best trading talent, it is a gold mine.
- Davide Accomazzo, Managing Director
- Mack Frankfurter, Managing Director
As we conclude August 2006 our Diversified Option Strategy program returned a positive 1.51% resulting in a year-to-date return of 7.10%. The S&P 500 Index (GSPC) returned 2.13% finally overcoming the negative sentiment leftover from May and is up 4.45% year-to-date. For comparison, the Barclay CTA Index is positive 0.32% as of this writing and up 1.20% for the year. Please refer to our website at www.cervinocapital.com for the most recent performance statistics on our investment programs.
It seemed appropriate at this time to take a step back and analyze the state of the “hedge fund” industry, the changes that have taken place over the past fifty years and opportunities that are still available to us, participants in the alternative investment arena.
We were recently invited to be guest speakers at an international business class at UCLA. The topic of our presentation was “Cultural Crosscurrents within the Financial Services Industry.” Our thesis, applied across various economic case studies, was that norms within society have been progressively influenced by the rapid pace of globalization, resulting in macro-level transformation of the financial industry’s values and its institutions. Which ever way resulting cultural values and norms shift, astute players seek to arbitrage anomalies between local business practices versus innovations in global products/services, regulatory jurisdictions and price parity.
Such arbitrage is fast taking place in the alternative investments segment of the financial services industry as an increasingly competitive environment has subjected practitioners and their respective strategies to the unrelenting march of market efficiency. Over the past fifteen years hedge funds have become widely accepted by investors and institutionalized. By doing so, many sophisticated and previously successful investment strategies have effectively become victims to the hedge funds industry’s success.
The raison d′etre of our industry should be to provide superior money management to clients. Unfortunately this altruistic objective has in varying degrees been complicated by well-meaning regulators, sales practices distorted by conflicts of interest, but most importantly human nature itself where the intrinsic need for social acceptance and validation undermines essential qualities that are prevalent with successful investors – that of nonconformity and unorthodox thinking. Yet as soon as the mainstream assimilates maverick strategies into their portfolios, the seeds of demise are laid for such investment approaches due to a concept George Soros calls reflexivity.
The term “hedge fund” as it is now commonly used is a misnomer. It is loosely defined to be either synonymous with any type of non-regulated fund regardless of investment strategy, or jargon meant to represent all alternative investments strategies in general. Even the Department of Treasury, Board of Governors of the Federal Reserve System, Securities Exchange Commission and Commodity Futures Trading Commission in their 1999 report on “Hedge Funds, Leverage and the Lessons of Long-Term Capital Management” admit that the term is “not statutorily defined.”
Hedge funds first came into existence in 1949 when Alfred Winslow Jones opened an equity fund that was organized as a private partnership to provide maximum latitude and flexibility in constructing a portfolio. He took both long and short positions in securities (thus the name) to increase returns while reducing net market exposure and used leverage to further enhance the performance. To those investors who regarded short selling with suspicion, Jones would simply say that he was using ‘speculative techniques for conservative ends.’ Not only did Jones’ fund outperform the best mutual funds, he kept all of his own money in the fund and employed a performance-based fee structure.
It is interesting to note that Jones operated in near obscurity for seventeen years. Nevertheless, by 1968 approximately 200 hedge funds were recognized to exist, most notably those managed by George Soros and Michael Steinhardt.
During the 1960s bull market, many new hedge fund managers found that selling short impaired absolute performance while leveraging created exceptional returns. Such leveraged exposure turned out to be dangerous as many of these new funds perished after the market downturn of 1969. In 1984 only 68 hedge funds were identified, but this trough marked the beginning of an upsurge with $39 billion under management and 550 funds documented in 1990 growing into $1.2 trillion in assets and over 8,800 hedge funds in existence today.
This growth was not in a vacuum. In response to Congress’ actions with respect to the Small Business Investment Incentive Act of 1980, the SEC proposed Regulation D to replace existing private and limited offering exemptions contained in Rules 146, 240 and 242. Regulation D recognized that there are situations in which there may be no need for the registration provision of the Securities Act, and it also further clarified the definition of “accredited investor.” Shortly after adoption of Regulation D, in a series of no-action letters, the SEC confirmed that hedge funds that made offerings of securities under Rule 506 could rely on Section 3(c)(1) under the Investment Company Act, assuming they had no more than 100 investors. Ultimately, hedge funds came to rely heavily on Section 203(b)(3) of the 1940 Investment Advisers Act which exempts from registration an adviser with fewer than 15 clients during the prior 12 months and who does not hold himself out to the public as an investment adviser, and does not act as an adviser to a registered investment company.
The “retailization” of hedge funds is based on Section 203(b)(3), and the fact that historically the SEC has interpreted a "client" to be someone who is given financial advice by the investment adviser. Since investors in a hedge fund do not receive advice—they are simply investing their money—the recipient of the advice is the fund itself as administered by the investment adviser. What evolved in practice is a non-regulated structure in which a hedge fund manager could advise15 funds (ie, 15 clients), each with 100 investors or 1,500 ultimate investors. This is an example of regulatory arbitrage.
In 2004 the SEC concluded that the “retailization” of hedge funds merited regulatory action and proposed a rule requiring registration. In its push to expand its regulatory oversight to hedge funds, the SEC contended that the meaning of “client” should include the ultimate investors and under this new definition regulators would ‘look through’ the fund to the actual number of investors in the fund.
This rule was put into effect in February 2006. Hedge funds with at least $30 million in assets and investment lockups of less than two years were required to register with the Commission. But to the surprise of many, the U.S. Court of Appeals for the District of Columbia Circuit recently ruled in favor of a lawsuit brought by a hedge fund manager named Phillip Goldstein. In their unanimous ruling the Court stated that the SEC’s argument for imposing hedge fund registration was unconvincing and its rule “arbitrary.”
But this is only one half of the story…
As suggested previously, hedge funds have evolved to represent the vehicle of choice for most alternative investment strategies. These investment strategies as tracked by The Barclay Group include: convertible arbitrage, distressed securities, emerging markets, equity long bias, equity long/short, equity market neutral, equity short bias, event driven, fixed income arbitrage, global macro, merger arbitrage and multi strategy.
Such strategies use to be niche plays disregarded by the mainstream financial services industry as recently as the late 1980s. But in the aftermath of the great bull market of the 1990s they are now being marketed vis-à-vis name-brand wirehouses as institutionalized financial products. Give such acceptance, what does the future hold for this segment of the industry when “fund-of-hedge funds” have successfully exploited the Section 203(b)(3) loophole to become multi-billion dollar “retail” products?
What we do know is that at this size hedge funds need to operate differently than they have in the past.
Already we have seen one hedge fund purchase a controlling interest in K-Mart for the land underneath, while others have been engaged in private investments in public equity (PIPEs) or involved with leverage buy-outs reminiscent of the Michael Milken days. At the same time certain investment companies have redirected their efforts into offering alternative investments within the mutual fund product structure. There is no explicit rule against derivatives in mutual funds, but rather usage of such instruments is constrained by various rules such as “cover requirements,” “illiquid assets" 15 percent rule, and Subchapter M “diversification test,” and “90 percent” and “30 percent gross income” tests.
Many respected opinion makers including James Altucher in his Financial Times article “A thriving juggernaut that is getting too greedy” and Bradley Rotter in his MARHedge guest commentary “Why I’m Getting Out of Hedge Funds” have pointed out that returns have diminished significantly and many opportunities have dissipated as the “anomalies and arbitrage situations these funds earned their keep on don’t really exist any more.” Further, they argue that given recent performance, most of these hedge funds do not deserve the management and incentive fees they’re charging, much less all the other administration fees “fund-of-hedge funds” tack on.
Yet there is still very much a need for superior risk adjusted performance notwithstanding the effort by the industry to commoditize performance with absurd ideas such as hedge fund indices. So what are savvy investors to do?
The answer is to identify emerging niche money managers who operate transparently with agility in markets where anomalies still exist, but also where larger hedge funds cannot trade profitably without incurring undue risk for miniscule returns relative to their size. This is known as the “investor’s edge,” an explainable source for returns and an advantage with respect to trading skills and performance. Institutions call this “alpha.”
For us at Cervino Capital Management, we understand that our clients' returns and by extension our success depends on how we approach the following issues:
Problem #1: Structure—hedge fund structure has certain advantages, but disadvantages include lack of transparency, greater potential for conflicts of interest, lockup periods that restrict redemptions to timeframes inconvenient for investors, and with respect to “fund-of-funds” the layering of fees resulting in much higher costs.
Solution #1: Separate Managed Accounts—clients assets are held by a third party custodian resulting in full transparency and the ability to monitor trading activities on a daily basis; increased flexibility with respect to account additions and withdrawals; ability to revoke trading authorization at any time; competitive fee schedule when compared to the “fund-of-funds” structure due to fee layering.
Problem #2: Regulations—hedge funds are not free from all regulation, but a substantial change in regulations regarding hedge funds poses a major threat to the industry as it is an important factor when assessing the sustainability of certain strategies.
Solution #2: CFTC Oversight—managed futures is unique within the alternative investment universe in that it has operated in a highly regulated environment for the last 30 years under the purview of the Commodity Futures Trading Commission and self-regulatory organization National Futures Association.
Problem #3: Performance—the new paradigm of “portable alpha” proposes that market return (ie, beta) can acquired cheaply and excess returns (ie, alpha) can be “ported” onto beta through exposure to hedge funds; problem is that in recent years hedge funds have reflected performance that is highly correlated to the market as witnessed this May 2006.
Solution #3: Absolute Returns— diversification across a variety of relative value trading strategies with high probability for positive outcomes is the best way to achieve “absolute returns” on a consistent basis; recognition that capacity limitations are a material hindrance to large funds, but the upside is that market anomalies remain in existence with money managers who operate at a smaller size; repeatable strategies utilizing speculative techniques for conservative ends is best way to achieve “alpha.”
Cervino Capital Management has incorporated all the above solutions into its Diversified Options Strategy program. Our vision is to remain a niche money manager utilizing sustainable and lucrative trading techniques in which we can explain where our returns are derived from. We believe that fundamentally the outlook to the global economy present situations that cannot remain in equilibrium. The eventual dislocation of major trends is wonderful for nimble players, where volatility is the friend. For funds whose size prohibit agility, this is a minefield. For the best trading talent, it is a gold mine.
- Davide Accomazzo, Managing Director
- Mack Frankfurter, Managing Director
posted by Cervino Capital Management LLC at 9/06/2006
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