As we head towards another deadline for Greece, during which they must convince the troika that austerity is on track, there is growing speculation that Greece may be forced out of the Euro. A “Grexit” to use a popular term.

Well, maybe, but here’s why it’s not inevitable. First, from Germany’s point of view, Greece’s presence in the Euro isn’t the real problem; it’s the money Greece owes. In fact, Greece’s recession is if anything creating downward pressure on the Euro which helps Germany’s exporters. The notion that Germany may force Greece to leave the Euro is based on the flawed assumption that this would be in Germany’s interests. No doubt popular opinion in Germany may be moving in that direction, choosing to “punish” the profligate Greeks for their poor budgeting skills. But leaders in Germany must know that such a move would be their “Lehman moment”. The risk of contagion swiftly moving to Spain and Italy would be such that perhaps as much as 1 trillion Euros might need to be available to support those countries’ ongoing borrowing needs. Untold additional dominoes might fall. It’d be a foolhardy German government that contemplated such a move.

Moreover, the instant Greek default on their cross border debts which would immediately follow their ejection would hurt their Euro-zone creditors including Germany. Indeed, the ECB itself might need to be bailed out. So there seems little point in kicking Greece out of the Euro while they still owe any significant sums to other Europeans.

For Greece, while a New Drachma may appear an appealing way to generate inflation and allow a drop in living standards to create a more competitive economy, introducing a new currency over even an extended bank holiday is a daunting task. A well run government bureaucracy like Germany’s would be hard pressed to pull that off. Greece is not Germany. It would be a disaster. In fact, for Greece their interests are best served by continuing to negotiate for an ever decreasing debt burden. Regular brinkmanship around austerity targets and the next release of EU/IMF funds is becoming their strategy. It can continue to work as long as the promise of some ultimate repayment is sufficient to outweigh the risks to Germany of kicking them out.

But Greece has an additional option, which is a stealth devaluation. The government could start paying its bills in IOUs, as California has done in the past. The IOUs would promise to repay the holder in full in five years in the then prevailing currency. These IOUs would of course trade at a discount to face value, but over time the Greek private sector’s holdings of these would grow as their government issued more of them. Their discount to par would no doubt fluctuate with the odds of Greece staying or leaving, but over time as the discount stabilized and their volumes grew the “New Drachma Notes” as they might be dubbed, would provide visibility around the type of depreciation the New Drachma might suffer if it replaced the Euro. In fact, it could co-exist with the Euro, but by creating a plausible alternative currency that was slowly introduced over 2-3 years through the Greek government paying its bills, it would improve Greece’s negotiating stance with the troika and perhaps allow them to achieve greater debt forgiveness than would otherwise be possible.

The Greeks have played a weak hand pretty well so far. Their forced exit from the Euro needn’t be as inevitable as it might appear.

Modern financial theory holds that a diversified portfolio of securities is the most efficient way for an investor to access an asset class. Idiosyncratic risk, the risk associated with an individual stock say, can be diversified away and therefore theory holds that investors don’t achieve any additional return for holding concentrated portfolios of their favorite stocks. It’s an idea that makes a lot of intuitive sense. Consequently, you can invest in equities and possess no particular stock-picking skill by using an index fund. Hundreds of billions of dollars are invested passively in this way. Based on many decades of performance from public equities (although admittedly the last decade was no walk in the park) this is a sound strategy.

Using the same construct with hedge funds produces a different result. A key underlying assumption in the “diversification is good” approach is that the underlying asset class has a positive return. However, as I show in my book The Hedge Fund Mirage, if all the money ever invested in hedge funds had been in treasury bills instead, the investors would have been better off. The average hedge fund $ generated a negative return with respect to the risk-free rate. There are great hedge funds and happy clients, but these are not the norm. Since I wrote my book hedge funds have continued to provide empirical support for my findings. YTD performance for the HFRX Global Hedge Fund Index is 1.2% through June – actually outpacing treasury bills (which yield approximately 0%) but for the tenth straight year lagging a simple 60/40 stocks/bonds portfolio.

Since hedge funds in aggregate have been a bad investment, the only way to win as an investor is to be better than average at picking managers. Some people are. But since diversification is intended to draw you towards the average return, and the average return is in this case not something you want, the rational use of hedge funds in an investment portfolio is to select only two or three where you have insight and high conviction. Adding more funds creates more diversification, which for a hedge fund investor is a bad thing.

Some of the smartest people in the hedge fund industry are the hedge fund managers themselves. You’ll rarely hear them advocating a diverse portfolio of hedge funds. They already understand the mediocrity and lack of return persistence so prevalent amongst their peers. And often the happiest clients are those who don’t have many hedge funds, but made a few good choices with a small part of their portfolio. For if a diversified hedge fund portfolio is bad, so is a large allocation to hedge funds. A 1-2% allocation to two or three funds takes the best of what hedge funds have to offer. Hedge fund returns have steadily deteriorated as assets have grown, just as is the case with individual funds.

But the consultants and advisors who promote a diversified portfolio of hedge funds as an important component of an institution’s overall portfolio are misusing the Capital Asset Pricing Model. A diversified hedge fund portfolio is The Dumbest Idea in Finance.

The Energy Information Agency (EIA) is a rich source of data on everything related to energy production, consumption and storage in the U.S. This chart caught my attention, showing that coal use for electricity generation continues to fall sharply, with the result that in April for the first time natural gas was used to produce as much power as coal. The price advantage and environmental issues are both helping drive natural gas consumption higher, and the EIA even project that the U.S. will eventually become a natural gas exporter (though that time is 5-10 years away).

Meanwhile, Patriot Coal (PCX) filed for bankruptcy yesterday as the deteriorating economics of the coal industry proved insurmountable.

We continue to hold positions in three E&P names: Range Resources (RRC), which stands to benefit over the long term from greater natural gas consumption since they have such large potential reserves (50-60 Trillion Cubic Feet Equivalent). Their current market cap of $9.7BN is far less than the cash they can generate if even half of this potential is realized. We also like Comstock Resources (CRK) which we think will ultimately be acquired, although its daily volatility is multiples of the broader equity market so it’s not for the faint of heart.

Back in April some were forecasting that natural gas prices might go negative, such was the excess supply and shortage of available storage. That was around the time prices hit their low.

I am once again indebted to The Economist for writing about my book and noting some of the points I made about hedge funds’ poor performance. On January 7 they covered it in the Buttonwood column, and this weekend they once again discussed the issues I raised. They are performing a public service by highlighting some important concerns for investors.

Last week Coeur d’Alene (CDE) announced plans to issue debt, even though they have no obvious need of any extra cash. It looked very much as if the company was planning to make an acquisition rather than focus on returning value to shareholders, and we commented as such on this blog. It seems the bond market reached a similar conclusion since today CDE announced that unfavorable market conditions had prompted them to withdraw the bond offering.

Of course it’s not hard for any creditworthy borrower to raise funds at today’s rock-bottom interest rates, but evidently the long history of value destruction by prior management combined with CEO Mitch Krebs’ very small personal investment in CDE equity persuaded bond buyers that CDE debt was not an investment the market needed. The irony is that pulling the issue has boosted their stock price by 5% today. What a pity CEO Krebs doesn’t believe more fervently in his company’s ability to create shareholder value, otherwise he’d have a bigger stake and would be benefitting from the bond market’s rejection of their acquisition plans.