RESEARCH
The most important thing we do at Tidepool is to actively select the best funds and ETFs for profitable investment lineups. ERISA mandates that investment lineups be designed to minimize the risk of large losses. The potential for large losses lie in various corners of the financial system. A common theme involves asset correlation — a death-knell to diversification. We work hard to see the longer-term liquidity flows, rather than the daily whiplash of the markets; and to identify investing strategies that take advantage of liquidity flows. Our research focuses on the following general categories:
1. Correlation. A standard investing strategy recommended by most pension managers is to allocate among large cap, mid-cap and small cap funds. We don’t agree with this, because of the clear correlation among equities and equity indexes. We believe the better view is to de-correlate lineup options, so that if equities are under stress, the entire lineup will not suffer by correlation. Accordingly, it is very important for us to identify correlation risk and to offer lineup options that help avoid this risk.
Of general importance is the concept of the “risk parity” trades that allocate a percentage of assets among equities, bonds and commodities. These asset categories typically act independent of one another, resulting in greater safety in most environments.
2. Macro Flows. We also track current macroeconomic trend data for flows of funds. These are the long term currents that define investing opportunities. In recent years, investing trends have moved eastward, particularly to the opportunities presented in China, India and, once again, Japan. By following cross-border investment flows, we are tracking the proverbial smart money, to consider if they have greater insights that could be effectively emulated.
Additionally, US corporations provide a proxy view into cross-border flows, as these corporations aggressively scan the globe for new market opportunities, further boosting the US dollar and S&P 500 index.
Importantly, in today’s debt-laden global economy, cross-border flows of funds typicially require cross-border repo lending, largely from the Eurodollar markets. Importantly, the repo lending structure is at the center of virtually all global finance.
3. Wholesale Money Markets. In our view, a primary key to understanding the risks of large losses lies in the global wholesale money markets and hedge fund strategies that draw on money markets for their liquidity lifeblood. Global wholesale money markets trade upwards of $4 trillion per day across the tri-party (cleared) setment of the repo market and the bilateral OTC (non-cleared) segment of repo. Often described as the “plumbing” of the financial system, money markets provide short-term lending to banks and nonbank financial institutions. Originally designed for lending amoung commerial banks, repo has broadly expanded to include “shadow banks” of the financial system–the unregulated hedge funds, private equity and debt funds.
When money markets experience distress, that distress reverberates throughout the entire financial system, creating large losses in equity and debt markets. To minimize the risk of large losses related to money markets, a tremendously important factor is is whether unregulated money market lenders retain faith, or are losing faith, in prevailing hedge fund or private equity (shadow bank) strategies.
Hedge funds and private equity/debt funds are the largest consumers of money market funds. Therefore, leveraged hedge fund strategies have an enormous impact on market liquidity and stability. Virtually every hedge fund uses money markets (nowadays, the repo markets) to borrow short and invest long. If hedge funds and private equity/debt funds are unable to access the money markets, longer term investments that depend on money markets for initial financing and roll-over refinancing can evaporate, causing significant market distress. Large losses in correlated investments naturally follow.
Even though repo lender sentiment can change rapidly, there are always warning signs. In Sept. 2019, the warning signs were CRE turmoil brought on by insolvency of WeWork. In 2007, the warning signs were massive mortgage defaults after unaffordable interest rates reset on variable-rate loans. There are always warning signs for those who look carefully.
4. Hedge Fund Strategy Trades. Hedge funds are designed to take advantage of market inefficiencies — these are often policy changes and market events that change market structures. The most important hedge fund strategies are variations on the “relative value” arbitrage strategy that takes advantage of pricing inefficiencies in market indexes and their options or other derivative products. This includes the ubiquitous “VIX carry trade” a variation on the relative value options trade.
Also, if the Federal Reserve changes its benchmark federal funds interest rate, you can bet that hedge funds are trying to figure out an angle to profit. Likewise with inflationary pressures. Hedge funds have tremendous resources to identify and take advantage of market changes. And when enough funds pile into a specific strategy, it is time to pay attention, since a great deal of money is betting on that strategy.
It is important to note that hedge fund strategies can be, and usually are, divorced from consumer trends. Hedge fund investments are essentially bets on the outcome of various Fed policies (such as interest rate increases) or other trading wagers. Unregulated hedge funds focus on their own profitability; ” consumers be damned.” This means that hedge fund strategies pose significant market risks, but lack virtually any corresponding economic benefit. But whatever one’s views on the politics surrounding unregulated hedge funds and other shadow banks, these players are an important risk factor to assess in avoiding the risk of large losses.
An important current strategy is the massive $600 billion short position of hedge funds against US Treasury Bonds, 5-year and 10-year. These short bets are highly leveraged: up to 75/1 for 5-year bonds and 50/1 for 10-year bonds. The borrowed money comes from the opaque repo market. So, this massive short position seems like a disaster waiting to happen: if the hedge fund bets are stopped out by margin calls, the hedge fund losses will drain massive amounts of liquidity from the economy as they attempt to cover the short positions. On the other hand, if the hedge fund bets are winners, that means that the US bond market will likely lose credibility, and Treasury bonds may no longer be seen as the clear “safe asset” benchmark. Either way, the outcome could become a huge problem, causing large losses across the investing universe.
Love or hate them, hedge funds are the proverbial “smart money” in the room. It is important to pay attention to their trends and bets. Further, general economic information is all rolled up in hedge fund strategies, since the funds are closely tracking and analyzing this data. Since we are more interested in identifying large flows of funds, hedge fund strategies serve as a useful proxy for fine-grain economic analysis, in the context of broader trends.
For all of the above reasons, we believe that following hedge fund strategies is more important that trying to read Federal Reserve “tea leaves.” Fed announcements are designed to maniuplate investing markets, and are difficult to interpret — to say the least. Hedge fund strategies do their own job of Fed policy statement interpretations and, importantly, put bets down on certain policies. Because hedge funds actually put real money on hedging positions, we view their “actions” as more credible than the “words” of Fed policy statements or economic data.
5. S&P 500 Index. The S&P 500 index remains enormously important to any analysis of the global economy. Even as flows of investment funds move eastward, the S&P 500 index remains important to China. As much as China would like to distance its economy from the US dollar, it relies heavily on the dollar for its own economy, both internally and externally, and is further integrated to the S&P 500 through multiple hedging strategies.
The S&P 500 index follows a well-known path of gradual increases, then sudden drops; then (as investors “buy the dip”) another pickup of gradual increases — followed by another drop.
This has been the pattern since 1987. But there is no guarantee — and little comfort — that the next index dive will the followed by upswings of dip-buying. The economy is too fragile and too unpredictable to count on never-ending recoveries. Further, there is simply no reason funds should be subjected to these sudden value drops, and the uncertainty they engender, when uncorrelated funds exist that maintain value, through good times and bad, avoiding the risk of large losses.
Passive investors are content to follow the S&P 500 roller coaster through its ups and downs. Effective active investors must do better. By identifying correlation factors between funds and the major market indexes, and by understanding the underlying investing currents discussed above, our job is to avoid large losses in our investment lineup, while also maintaining strong profitability.
Research is our competitive advantage against nearly all other pension fund managers — to avoid the risk of large losses arising in global money markets, while positioning to gain from profitable strategies in areas of high liquidity.
