BREAKSIT

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That’s what I call the Brexit vote – “Breaksit.” It breaks stereotypes, it cuts across demographics, it astounds the pundits, and it breaks the unity of a pseudo-government called the European Union. It breaks preconceptions. Brexit was a rebellion by the people of England against an overbearing, uncontrollable, unaccountable socialist bureaucracy without adequate checks and balances. England will be free of this octopus with its insidious tentacles that destroy national sovereignty and upend traditional social order. I was convinced, before the vote, that England would vote to Brexit. So few of the political pundits agreed with me, but I was sure it would happen. I was also sure that the stock markets would (temporarily) tank.

For the investor, this is an extremely good buying opportunity. For the 401K and IRA owner, it is a time of confusion and stress. “How could I lose so much money in one day?” you ask. Just hold on. The market will be back. If your investments were sound, they still are sound. The companies in which you invested will survive, and will continue to prosper. If your investments were risky, they remain risky, and the companies may fail – or may succeed beyond your wildest expectations. That’s the nature of risk. I’m going to ride the roller coaster, and look for opportunities at the bottom.

England will do well. There will be a “period of adjustment” because it was linked so intimately to the European economic system, but Europe will still need English products, and England will still need European products, and so a new trade agreement will be reached. Similarly for the US: Our economy is intimately meshed with the English economy and also with the European economy. Our trade agreements with Europe will remain, and we will quickly reach new trade agreements with England. Trade and economics will return to normal.

Scotland may or may not decide to separate from the United Kingdom and re-join the European Union. Even if they do, H.M. Elizabeth II will still be Queen of Scotland. If Scotland splits, Scotland will no longer be united with England in a common government (almost federal), but Scotland will still have H.M. Elizabeth II, as Head of State for Scotland, just as Canada still has H.M. Elizabeth II as Head of State. Northern Ireland will be in a similar quandary: whether or not to leave the United Kingdom and unite with Ireland so as to be a part of the European Union. Both Scotland and Northern Ireland need to determine whether their economic systems are more tied to England’s or to Europe’s.

We all shall all wait and see what will happen. Only the Shadow knows.

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The Symbiosis of Institutional Investors and Activist Hedge Funds

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Second quarter 2016 has waxed brutally for hedge funds in the realm of regulatory compliance. The Securities and Exchange Commission (SEC) has called on investigative authority over hedge funds such as RD Legal Capital LLC and Platinum Partners LP for full disclosure of investment vehicles and practices. Of late, Visium Asset Management has joined the growing list of hedge funds flagged for insider-trading. The Wall Street Journal recently cited SEC’s Director Andrew Ceresney as stating hedge fund “Valuation [to be] one of the core issues.”

As we pointed out in our prior article Hedge Fund Performance and Regulation hedge funds historically had greater leeway in choosing how to value and categorize the portfolio’s underlying investments, drawing on the Securities Act of 1933’s Regulation D safe harbor rules. We also stated that regulatory compliance dictates from the SEC should remain constant, and not increase as hedge funds are above all performance driven. There is deep reasoning behind support for hedge funds, especially activist hedge funds, in the investment world – reasoning that laymen may not understand, but which focuses on the benefits institutional investors derive from seemingly mutually exclusive activist hedge fund activity.

Activist hedge funds exhibit corporate control activism, which according to L. Bebchuk, A.Brav, and W. Jiang, Harvard Law Review authors of The Long-Term Effects of Hedge Fund Activism, can be categorized via three strategies. First, as shareholders of a potential acquirer company, the strategy involves taking high stakes in a target company to ensure full acquisition over competition. Second, as shareholders of a potential target, hedge funds may use blocking strategies to benefit target shareholders. Third, hedge funds have themselves taken aggressive positions in a portfolio of companies solely in order to become activist, rather than diversifying and becoming involved when companies are exhibiting non-performance. Although not widely publicized, traditional institutional investors such as large pension and mutual funds engage in shareholder activism mainly through SEC Rule 14a-8, forcing inclusion of shareholder proposals in the proxy statements of vested public companies.

Marcel Kahan and Edward B. Rock of University of Pennsylvania Law Review do a superb job of explaining the constraints of institutional investor activism and the ensuing need for hedge fund activism via Hedge Funds in Corporate Governance and Corporate Control. We examine the most poignant points:

Pension Funds

  • Governance changes through shareholder proposals have largely been a practice of public pension funds due to the sheer asset size and scope. We have seen a surge of shareholder engagement from pension funds from 2015 to present, with the plunge in global economic and business climates. However, while proxy contests from pension funds aid in activism, the activism is more post-event reactive to company performance than pre-event business structuring. As the authors put it, pension funds traditionally handle only the “motherhood and apple pie issues” of shareholder engagement.
  • Pension funds have political constraints that inhibit an aggressively proactive approach to shareholder activism. Many pension fund trustees tend to overlap between private and public sector duties such as “gubernatorial appointees or elected politicians.” Such positions may lead to a bias towards political establishment dictates as opposed to actively working with company Boards to ensure optimal investment returns. The authors cite CalPERS as a prime example of such constraints, as historically the pension fund has held a strong pro-union position and has widely held union representatives on the Board.

Mutual Funds

  • Mutual Funds are generally retail investors.  The authors state that only TIAA-CREF has held what can be considered as an activist position in the industry. Mutual funds tend to take even a more passive position than pension funds in shareholder engagement.  Specifically, the necessary semiannual filing of all amounts and values of securities renders it difficult for mutual funds to take aggressive “pre-emptive strike” positions in a portfolio of companies.
  • SEC guidelines clearly stipulate the percentage of assets that all mutual funds can have in illiquid investments. In addition, mutual funds have requirements to redeem shares on short notice. These requirements put mutual funds in a passive shareholder engagement position.
  • Diversified mutual funds have major regulatory barriers and expenses that inhibit assertive activism. Unlike hedge funds, mutual funds for the most part do not charge performance based fees, and so depend on feed based on a fixed percentage of the of the mutual fund’s assets under management. Since activist investor proxy contests are costly, we find that most index mutual fund management would prefer to take a reactive position.
  • Most mutual funds have conflict of relationships due to affiliations with other non-activist financial institutions such as insurance companies and conservative pension funds. Many mutual funds have corporate pension plans as core business, and may not want to practice aggressive shareholder activism so as to not jeopardize client preferences.

Shareholder proposals from both pension and mutual funds are more a corporate governance wish list from shareholders, and fall more under the category of broad shareholder engagement than the activism partaken by activist hedge funds. Mutual and pension funds do not use the leverage that activist hedge funds employ to take the necessary positions for pre-emptive strikes to change company financial and operating structures.  As the authors rightly state, “hedge fund activism is strategic and ex ante: hedge fund managers first determine whether a company would benefit from activism, then take a position and become active.”  Hedge funds have become almost synonymous with activism. However, Kahan and Rock point out that only US$50 billion of the US$3 trillion global hedge fund assets under management are structured for shareholder activism. The point being that hedge funds are not solely formed to be activist investors. Yet, the small number of hedge funds that are activists truly pack a punch in active corporate governance.

The Columbia Law School’s Blue Sky blog’s article, Hedge Fund Activism: A Guide for the Perplexed has a bit of a mixed review when it comes to the activist hedge fund outlook. While there is an acknowledgement of activist hedge fund influence on company performance, the article takes an almost tongue in cheek approach to the effectiveness of activism, stating that  “institutional investors and knee-jerk academics…both believe that activists are doing the Lord’s work” as the champion of shareholder engagement, but in actuality hedge funds are by and large self-interested. From the points offered by Kathan and Rock on the limits of institutional investors to actively engage in pre-emptive structuring of companies to bolster shareholder interests, the industry must avow to the need for activist hedge fund activity, whether the motives are self-interested or otherwise. Regulatory dictates of the hedge fund industry may bring about transparency in valuations and curb insider-trading in the short term, which can be beneficial. However, a plethora of punitive regulatory barriers can seriously hinder effective shareholder engagement and corporate governance that may only be achieved through hedge fund activism.

REFERENCES

  • Bebchuk et al. 2015. “The Long Term Effects of Hedge Fund Activism.” Harvard Business Law Discussion Paper. Columbia Law Review. Pages 1064 – 1154.
  • Coffee, John C. Jr. 2016. “Hedge Fund Activism: A Guide for the Perplexed.”  The Columbia Law School Blue Sky Blog.
  • Copeland, Rob et al. 2016. “Scrutiny of Funds Grows.” The Wall Street Journal. Print Edition.
  • Kahan, Marcel, et al. 2007. “Hedge Funds in Corporate Governance and Corporate Control.”  University of Pennsylvania Law Review. Pages 1029 – 1069.

 

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Emerging Economies – Black Holes or Treasure Troves?

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Diamonds South Africa

It is often said that there is no gain without risk. The greater the risk, the greater the potential gain; and the greater the potential gain, the greater the potential risk. Investors look to emerging economies because the potential for gain is great; but at the same time, the potential risk is great. Until just recently, the investment world looked to the BRICS group of emerging markets to produce much of the growth for the world economy, and these five emerging markets played every-increasing political roles in the world due to their growing economic clout.

A look at Brazil, the “B” of the BRICS group, gives rise to concern. President Dilma Roussef just lost an impeachment vote against her, and this shows just how far Brazil’s current government has fallen in recent years. Since she took office, President Roussef has faced a host of problems, many of which are the direct result of her and her party’s leadership. The largest of these problems is corruption, which has been the undoing of many regimes in Brazil. Now, the massive Petrobras scandal has destroyed the credibility of the government and, in particular, of President Roussef. The scandal has created a loss of confidence in the Brazilian economy, plunging the nation into a recession, one of the worst in Brazil’s recent history. Shortly before, Brazil believed it was positioned for a long period of China-like rates of economic growth, allowing the country to play a dominant role in Latin America and giving it a major voice on the world stage. Instead, thanks in large part to President Rousseff’s government’s lackluster performance and corruption, Brazil has fallen further behind most of the world’s other leading powers in political power and economic development. Rousseff appears to be on the way out. Last weekend, the lower house of Brazil’s parliament voted in favor of launching impeachment proceedings against her, easily exceeding the two-thirds’ majority required to do so. This motion will now go to the Brazilian Senate, which is expected to suspend President Rousseff for the duration of the trial, and then to sit in trial over her next month. President Rousseff has countered by accusing her political opposition of staging a coup.

India and China continue to meet expectations, despite China’s recent slowdown and India’s struggle with internal divisions; and Russia continues to play a greater role in many of the leading political and security issues facing the world today, despite its recent economic woes. However, the woes of Brazil and South Africa show that they have undoubtedly failed live up to expectations on the political and economic fronts in recent years. For both countries, much of the blame lies with their political leadership, which has led both countries astray. Unfortunately, this poor political leadership has caused great harm to both countries and could result in long-term loss of power and influence.

South Africa, the smallest of the BRICS – and the least qualified for membership in such a group – has been backsliding in recent years. This is due largely to the disastrous leadership of President Jacob Zuma and the deep divisions that have emerged in that country’s dominant political party, the African National Congress (ANC). Of course, low natural resource prices have severely hurt the South African economy. However, the current government there has failed to take the steps needed to diversify the country’s economy away from its dependence upon natural resource exports, and instead has rolled back many of the programs that had been enacted by its predecessors. Meanwhile, President Zuma also has faced a number of corruption scandals in recent years that have weakened his ability to govern South Africa. As a result of these economic struggles and corruption scandals, South Africa has found it more difficult to play the leading role in Sub-Saharan Africa that it has sought to do since the end of apartheid.

The problems facing Brazil and South Africa are clear examples of how poor governance (corrupt governance that does not understand the market economy) can squander massive economic and resource advantages. Brazil and South Africa are both incredibly rich in natural resources. In Brazil, President Rousseff’s disastrous leadership has caused Brazil’s failure to take advantage of its huge resource and demographic advantages that are in many ways similar to that of other large “New World” economies. Meanwhile, although South Africa has great resource and infrastructure advantages over many of its emerging market rivals, President Zuma’s numerous missteps are squandering these advantages. As a result, South Africa is losing political clout in its region, while its economic lead over its neighbors is shrinking. While both presidents are nearing the end of their reigns, both countries have the opportunity to elect more capable leaders. Nevertheless, the opportunities wasted by both countries could have long-term consequences, both within their borders and across their respective regions.

So, what is the interested investor to do? An investor may park his or her funds in more predictable economies, minimizing the investment risk. Alternatively, the investor can perform thorough research and invest carefully in the BRICS, being careful to hedge the bets. Some investors, instead of investing in companies in these countries, invest directly, creating industry in those countries. That can have a high degree of risk, but also a very high level of reward. The BRICS are like diamonds in the rough – indistinguishable to the untrained eye from clear quartz.

Image credit: http://static.rappler.com/images/Diamonds%20South%20Africa%20hands%20AFP.jpg

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Financial Impacts of Foreign Events

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Events around the world have an impact on financial policy, investment strategy, trade and commerce, and each of these has an impact on the others. It is time to do another review of global events and their financial impact. This article contains both analysis and my own editorial opinion. It does not necessarily reflect the opinions of whoever publishes it.

One issue that has attracted a great deal of interest in news reports is the issue of internal and external security threats to Europe. Much of this has to do with the mass immigration of refugees from the tumult in the Middle East, and Islamist Jihadist extremists in their midst. However, in my opinion, the greatest threat at present is the deepening fragmentation within Europe of public opinion camps – and policymaking camps – over policies and policy-making of the European Union. Three factors are influencing this: the rising power of Germany within the EU; the apparent inability of the regions minorities – and particularly the recently-arrived Islamic minorities – to integrate into European society; and the threat of terrorism, largely from Islamist Jihadist cells within the immigrant population. These threaten to stall the region’s efforts at greater integration and enhanced common security. External factors that are affecting this are: the collapse of previously stable states in North Africa and the Middle East into failed states; the retreat of the United States from the world stage, both militarily and from its historic leadership role; and the resurgence of Russian State military ambitions and its apparent efforts to resume the empire-building of Peter the Great. Middle Eastern events have produced the flood of refugees that provides internal instability; the retreat of the United States leads to increased instability world-wide, and a fragmented Europe has difficulty in dealing with this without US leadership; and Russia provides threats to the eastern frontiers of Europe. Unfortunately, all of these factors are likely to intensify in the near future rather than to wane.

Europe is beset by some of its most serious threats internally since the collapse of the Soviet Union. The European Union has failed to achieve the unity of purpose and policy needed to handle the complex issues it faces. National policies tend to take precedent over pan-European issues in the stronger European countries. Economic uncertainties and failures have awoken the struggles between left and right that had remained largely submerged when Europe was facing the threat of Soviet invasion. Ethnic and religious minorities that remained relatively quiet during the Cold War are now asserting themselves, in large part either in opposition to, or emboldened by, the influx of Muslims. This threatens to balkanize Europe politically, even as national boundaries and states remain as they were. High levels of joblessness and financial insecurity among many of these minority populations produce demands that the State “do something.” Germany, Sweden, Greece, France, Italy, and Belgium are particularly affected by this. Recent terrorist attacks in France and Belgium have highlighted the problems resulting from uncontrolled immigration and the failure to screen out dangerous immigrants from those simply seeking a better life.

Externally, the situation is worsening as well. The unprecedented period of peace along the eastern periphery that followed the ending of the wars in the former Yugoslavia enabled Europe and the European nations to focus on internal issues, downsize their militaries, and further subsidize and adjust their social subsidies. The resulting decrease in levels of military, security and intelligence activity paved the way not only for internal attacks by terrorists but for Russia’s expansionist imperialism. When Europe needs her most, the United States is “leading from behind,” which means not leading. There are even calls by US politicians to reconsider whether NATO is even useful.

Internal and external political and security risks to Europe and its nations are at their highest levels in decades, and rising. The resulting instability depresses legitimate trade, encourages smuggling, increases illegal arms trade and distribution, and produces demands on central banks to “do something.” From the standpoint of central banks, there is little that can be done financially without cooperation from the political sphere. Trade and commerce need these things in order to prosper: the rule of law; stable currency; lack of barriers to trade; low levels of regulation; societal security and prosperity; and government policy that aids all of these. These things can be summed up as small government, economic freedom, and stable currency. Many politicians (and their followers), however, are headed left, which will only make the situation worse. A central bank can only do so much. All it can do is to stabilize its currency. This causes profligate governments to fail financially, and leftist politicians don’t like that. A resurgence of capitalism is needed, and the world needs the US to lead that resurgence.

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Hedge Fund Performance and Regulation

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The hedge fund industry has taken quite a hit over the past year, leaving institutional investors fairly disappointed with ROI expectations. Preqin, the industry’s leading investment analytics company cited its 2015’s aggregate 2.02% return as the worst since 2011. Preqin further reported that 44% of fund managers reported failure to meet return objectives. The hedge fund industry is no lightweight; globally the industry accounts for over USD3 trillion assets under management. Poor hedge fund performance is a strong indicator of how unstable the overall financial system has become, even though the industry is not considered a market maker. Both large and boutique hedge funds that pursued single strategy objectives bore the brunt of poor performance. Hedge funds that focused on equity, macroeconomic, managed futures and relative value strategies had the most fund closures for last quarter 2015. Funds with multi-strategy, event-driven strategies and credit strategies had the best overall performance, and a larger number of fund launches. On a positive note, the entire industry saw an increased transfer of capital flows from family offices and high-net-worth individuals in 2015. Evidently, private wealth investors have waning confidence in public capital markets.

Key-Drivers-Hedge
Table 1: Key Drivers of the Hedge Fund Industry. Source: Preqin Hedge Fund Manager Outlook 2016.

While performance and handling market volatility are key drivers for the overall 2016 hedge fund outlook, Preqin cites the number one concern among hedge fund managers to be transparency and risk management, with the need to adapt to new regulations. Hedge funds face conflicting tasks of handling increased costs of improved business infrastructure, while remaining cost competitive with investor fees, in the face of industry regulation. In October 2015 the Securities and Exchange Commission (SEC) found via spot checks that certain hedge fund managers were breaching fiduciary relationships with investors. Fund managers were found to be personally profiting from trades before executing trading strategies, while shrouding performance numbers in performance reports. The SEC has promised further compliance enforcement for private equity and alternative investment firms in 2016, and now mandates hedge funds to provide strict standard data upon registration with the SEC. All private equity funds and investment advisers must file Form ADV to provide fund size and organization structure with the SEC. Funds with at least USD150 million assets under management (AUM) must file an annual Form PF to update leverage, liquidity and investment criteria, and investment fees. The SEC posts all aggregate private equity data derived from reporting publicly, thus satisfying Section 404 of the Dodd-Frank Act’s financial and risk reporting requirements.

Historically, hedge funds needed to meet only Section 4(2) of the Securities Act of 1933 and specifically, the Regulation D safe harbor rules. Hedge funds need to especially adhere to Rule 502, which prohibited general advertising through media and meetings; Rule 505, which exempts offering registration of USD5 million or less, and requires no more than 35 non-accredited investors to be vested in the fund; Rule 506, which allows the hedge fund to offer an unlimited amount of interests to investors. In addition, hedge funds need to file a state-specific “blue sky” filing with the SEC 15 days from the date of an investment into the fund. Under SEC Rule 12(g-1) hedge funds did not have to submit frequent reporting if the fund had less than 500 accredited and non-accredited investors. Hedge funds have been very vigilant in following exemption requirements to avoid over reporting and registration.

Columbia Law School professors Wulf Kaal and Dale Osterle pinpoint why hedge funds have been subjected to further regulation in their blog article, The History of Hedge Fund Regulation in the United States. Long Term Capital Management’s 1998 failure put hedge funds at the forefront of regulation. Prior to LTCM’s bailout by the New York Federal Reserve Bank, hedge funds were not considered as main influencers of systematic risk. However, the SEC began inquiries to regulate transparency and quantify reporting data in the alternative asset management industry. Kaal and Osterle cite the SEC’s failure to achieve all hedge fund registration in 2006’s Goldstein v. SEC case, by which hedge funds were able to deregister and return to the original registration exemptions under the Securities Act of 1933. However, as Kaal and Osterle explain, Title IV of the Dodd-Frank Act finally allowed the SEC to enforce stricture hedge fund regulation, and mandated that the SEC create and enforce rules requiring investment advisors, private equity and asset management firms to complete registration and annual data reporting. Data must include planned strategy disclosure; all risk analytics, credit limits, fund manager positions, and leverage figures must be included as quantifiable metrics.

Fund managers will have a veritable balancing act for the entire fiscal 2016 with continued regulation, and a call for further transparency within the extremely performance driven alternative asset management industry. While hedge funds may not be systematic drivers of the global financial economy in comparison to big banks, the industry’s USD3.2 trillion size is no laughing matter. In addition, sovereign wealth funds are significant players in funding emerging market debt, as we have seen recently with Argentina’s bond debt settlements. While continued regulation is necessary for transparency, fund managers need to have adequate reign in focusing on fund performance, especially in such a volatile macroeconomic system. Fund managers have taken it upon themselves to focus on risk and transparency. Thus, we expect that current data reporting based on Title IV of the Dodd-Frank Act continue with no additional punitive requirements, so as to give hedge funds room for performance improvement in 2016.

REFERENCES

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