Aubrey McClendon has by most accounts assembled a team of very able engineers and geologists as Chesapeake (CHK) has acquired the natural gas assets they own. We’d never invest with CHK because McClendon ‘s risk appetite is too big, but it’s stll interesting to watch what they do because thematically we are in agreement. The element of his compensation package that allowed McClendon to take a personal stake in each well drilled, financed with personal debt, was obviously wrong. Even though some came out and defended the approach as aligning his interests with stakeholders, the obvious flaw in this argument is that his ownership of stock is supposed to do just that. Maybe we’d all like to just own a piece of CHK’s wells without any of the other parts of their enterprise, but such a choice is not publicly available. So naturally the Board had to put a stop to it as it became clear even they were unaware of the manner in which McClendon was financing his side deals.

So now Reuters reports that McClendon was also running a hedge fund, cementing his reputation as a visionary with a complete absence of judgment. It’ll be interesting to see how his supporters defend this revelation as being in the interests of CHK stockholders. At some point this may become an attractive investment. We’re probably heading into territory where the CEO’s departure would push the stock up, however unlikely that is.

ISS caught my attention today in their criticism of the compensation structure set up for JC Penney (JCP) senor management. ISS describes the peer group JCP used as “aspirational” in that it includes far larger companies such as Nike (NKE) and Target (TGT). ISS would prefer a set of similarly sized companies and their own peer group for JCP apparently includes four auto-parts companies. JCP defends their method as reflecting the market in which they must compete for talent, noting that recent senior hires had come from TGT and other companies in their peer group. ISS recommends shareholders vote against the compensation structure. It’s unlikely to fail because Pershing Square who owns 26% and were instrumental in bringing Ron Johnson on board will obviously vote yes, as will Voronado another large holder. For our part, we’ll vote Yes as well. JCP is a turn around story, and that requires a different compensation model. We are invested in JCP precisely because of the senior team.

To pick a different example, Citigroup’s owners recently rejected the proposed executive compensation structure. Since Vikram Pandit took over as CEO in December 2007 the stock has lost 90% of its value. No doubt he inherited a tough hand, but don’t forget that among the billions in losses was the complete write off of the hedge fund of funds business Old Lane that Pandit had only months earlier sold to Citigroup for $800 million. You’d think he’d have had the good grace to resign right then.

Disclosure: Author is Long JCP

Click here to see a spot I did today discussing the hedge fund lobbying group, AIMA, and their recent report promoting hedge funds. They are a soft target.

Hedge funds have received quite a battering in the financial press of late. Persistently disappointing results have rightly drawn attention to the high fees, opaque strategies and limited liquidity that characterize much of the industry. My recent book, The Hedge Fund Mirage, has helped promote a long overdue debate about how investors should access some of the most talented money managers around. Although in aggregate all the money ever invested in hedge funds would have been better off in treasury bills, there are and probably always will be fantastic managers and happy clients. However, in recent years these have increasingly become the exception.

Although this description of hedge funds is provocative, much of the industry has sensibly kept its head down. In fact, few managers promote the industry and most are focused simply on their hedge fund. Many insiders readily acknowledge the disappointing results of the past with little surprise. However, the Alternative Investment Managers Association (AIMA), a UK-based lobbying group, has come to the defense of hedge funds. They recently commissioned a report titled “The value of the hedge fund industry to investors, markets, and the broader economy” in partnership with KPMG and the Centre for Hedge Fund Research at Imperial College, London. Although the paper concludes by noting the substantial social benefits of hedge funds such as employing 300,000 people globally, generating £3.2 billion in UK tax revenues and their stewardship of assets for “socially valuable investors”, I’m just going to focus on whether hedge funds have been a good deal for their clients.

Asset weighted returns, or the return on the average dollar, are poor. My analysis shows in aggregate treasury bills were a better bet. I found this to be the case only through 2010, and while some may torture the data to produce modestly different results, 2011 was the second worst year in history for hedge funds and should pretty much end the performance discussion.

Average annual returns are good. The KPMG/AIMA study referenced above finds that an investment in an equally weighted portfolio of hedge funds starting in 1994 (as far back as data can reasonably be sourced) generated an annual return of over 9%, handily beating stocks, bonds and commodities. Returns in the 90s were good for the small number of investors participating. The 9% figure is the average over 18 years. The question is whether the 12.4% return from 1994-98 is just as important as the 2.6% return from 2007-11, when the industry was twenty times as big.

Hedge fund investors know that small hedge funds outperform big ones; they also know that most big hedge funds they look at performed better when they were smaller. What is true for most individual funds is true for the industry as a whole. Using an equally weighted portfolio to represent returns will be upwardly biased for this reason. An equally weighted S&P500 has outperformed the cap-weighted version too. While equal weights might be a good way to invest, it’s clearly not a strategy available to all investors, since hedge funds are not equally sized. The return enjoyed by a hypothetical investor who started in 1994 investing equal dollars in each hedge fund isn’t representative of the average investor and is more marketing pitch than analysis.

Given how poorly actual hedge fund investors have done how could new investors possibly think that they will make money going forward? To do so they must accept the returns of a hypothetical investor who invested equal dollar amounts in hedge funds and maintained those equal investments in each hedge fund every year since 1994!  As I point out in The Hedge Fund Mirage performance was better both for the industry when it was smaller and for individual hedge funds when they were smaller.

Fees are egregious by any measure. The 2% management fee and 20% incentive fee have resulted in an enormous transfer of wealth from clients to the hedge fund industry. My analysis shows that pretty much all the profits earned by hedge funds in excess of the risk free rate have been consumed by fees. Anybody with a spreadsheet can calculate this using publicly available data without great difficulty. KPMG/AIMA concede that hedge funds have garnered 28% of investor profits, although treasury bills averaged 3.2% over this same period so even using their own numbers reveals that in fact fees took 64% of the returns in excess of the risk free rate. This is for the hypothetical, equally weighted portfolio begun in 1994. It also ignores netting – winning hedge funds charge an incentive fee whereas losing managers don’t offer a rebate. By treating the industry as one giant hedge fund it ignores the fact that whenever an investor holds some losing hedge funds his effective incentive fee will be higher than the typical 20% of profits. Without doubt, for the actual universe of investors whose hedge fund investments performed worse than the hypothetical investor, fees have consumed all the profits.

Those who think the first five years of hedge fund history are as important as the last five will hold out hope for that 9% historic return. Even a 7% return on hedge funds, the typical expectation of many investors, represents $140 billion in annual profits (net of fees, naturally) on the approximately $2 trillion in AUM. It’s a figure the industry has never generated other than in 2009 following a $450 billion shellacking in 2008. Generating $140 billion of uncorrelated, absolute return every year (after fees) has proved to be a bridge too far. Hedge funds are over-capitalized.

AIMA would better serve its constituents by promoting transparency, improved governance and fee structures that are commensurate with a world of near zero interest rates. Instead the 2&20 crowd has spent some of their fees on a glossy marketing brochure. By promoting the status quo they’re ignoring the experience of hedge fund clients, who are struggling with the reality of continued poor results delivered at great expense.  Institutions such as Allstate Insurance, whose global head of hedge funds Chris Vogt recently said, “This is a make-or-break year for hedge funds” will increasingly force change on the hedge fund industry, to the undoubted benefit of the clients hedge funds are supposed to serve.

In case anyone’s forgotten, this is how fees were carved up from 1998-2010.

Today’s FOMC interest rate forecasts reveal an updated look at the thinking of the Fed. In January The Federal Reserve began releasing forecasts for the year-end Federal Funds rate from each FOMC member. They don’t identify each forecast with a name, but in aggregate this provides a very clear view of thinking on rate policy at the Fed. Nobody can complain that Bernanke is being anything other than totally open.

In January, their median forecast for short term rates was 0.25% at the end of 2013 and 0.75% for the end of 2014, suggesting they expect to raise rates by 0.5% in 2014. Each FOMC member’s forecast for each year is represented by a blue dots on a chart that the FOMC publishes. The eurodollar futures market reflected expectations of only around 0.3% of tightening, though it did subsequently move out to 0.50% before returning to around 0.35%.

Today, the updated forecasts reflect an expectation of a 0.75% increase based on median rate forecasts. The FOMC expects to raise rates by this amount in 2014, a more hawkish forecast than they made in January. The futures market is looking for only half of this move.

The market may be right; the FOMC’s forecast is just that, and they may turn out to be overly optimistic on how the economy, inflation and unemployment will perform. But it does provide a fascinating insight into their thinking as it evolves.

Disclosure: Author is Long the Sep ’13/Sep ’14 eurodollar calendar spread.

Today I was invited back on Business News Network, Canada’s answer to CNBC. The presenters are charming and somehow always like to get me on when natural gas prices are plummeting – as if we haven’t noticed! But it did give me the opportunity to talk about Range Resources (RRC), one of our larger holdings in the sector. Last week RRC held an investor dinner to which I was invited. It was great to discuss their business in an informal setting, and while naturally nothing of a non-public nature was disclosed, it did reinforce my feeling that CEO Jeff Ventura leads a capable management team that’s hard-working and straight. Whether or not RRC really will ultimately access 60 Trillion Cubic Feet of natural gas, I assess that Jeff Ventura sincerely believes they have that much. It’s the upside case to be sure, but at $9BN in market cap with a solid, simple balance sheet they represent an attractive investment in the developing natural gas story.  We are long RRC.

Last night’s event organized by Catalyst Financial Partners was a great success. I was paired in a debate with an old friend Peter Fell, with whom I traded interest rate swaps back in the 80s when we were both at Manufacturers Hanover Trust (Manny Hanny). The question posed was “The Eroding Profitabilty of Hedge Funds”. Peter (now with Kenmar) gamely took what I felt to be the much harder side (i.e. defending the hedge fund industry) and it was capably moderated by Brenda Mauro of Trident Fund Services. Peter was not distracted by the autographed copy of my book that I shamelessly thrust into his hands moments before we began, and while there may be varying opinions on the future of hedge funds most would agree that investors will need better terms and results if the industry is to prosper.

Today KPMG released a report on hedge funds in partnership with AIMA, the UK-based hedge fund lobbying group. They evidently felt moved to set the record straight after the relentless battering hedge funds have received in the financial media of late. I am grateful that they have made such an effort – it’s given me something to write about.

On Monday I shall be taking part in a debate on this topic on Monday evening in NY with my friend Peter Fell, from Kenmar, at The Harvard Club. I am looking forward to the opportunity to discuss with other investors how hedge fund clients might improve upon the frankly abysmal results that the industry has delivered. Fees, lack of transparency, gates and other elements all combine to ensure that whatever profits hedge funds generate are taken up in fees.

Investors deserve far better than they have received, and I’m looking forward to an entertaining and lively discussion.

Chesapeake (CHK)  has long been the flag bearer for the natural gas industry. Aubrey McClendon has been front and center in making the case for shale drilling and the abundant natural gas reserves it is revealing. To many this is a game changer for U.S. energy consumption.

Aubrey McClendon has also shown a tendency to get over his skis in terms of his own risk profile, most notably in 2008 when personal loans he had taken out to buy CHK stock almost bankrupted him. In 2008 he was the highest paid CEO, earning $112MM which was intended to offset somewhat the $1.9BN he lost on leveraged holdings of CHK stock as it sank from $74 to $16.52 where he sold most of it to meet a margin call. For this reason, while we are bullish on certain natural gas E&P names, we long ago concluded that Mr. McClendon risk appetite wasn’t the same as ours.

There’s little doubt he’s a big believer in natural gas. But Aubrey’s not content with owning 3.25 million shares of stock; he also has an unusual deal that allows him to personally invest in individual wells that the company drills. It now turns out that he has taken out $1BN in personal loans top pay for these stakes. This is described by their general counsel as “aligning his interests with those of other investors” according to an article in the FT. Well, I guess so, but why not use that cash to buy more shares in CHK? By cherry picking amongst the assets CHK owns, he creates at least the potential for a conflict of interest and certainly the appearance of one.

It reflects on Mr. McClendon’s tendency to push risk to its limits. The fact that the company didn’t reveal the loans necessary to finance his purchases until reported by Reuters doesn’t help, and is contributing to today’s 5% drop in the stick price. But there are plenty of other companies to choose from that are run by less accident-prone managements. If CHK stock doubles because of positive developments in natural gas, other names in the sector will do well too. But CHK investors bear additional risks specific to the company for which they’re not obviously rewarded. Why provide capital to CHK by investing in their stock when their CEO shows such questionable judgment?

Managing tail risk is a constant worry for any investor using leverage, and many others who shouldn’t worry since they’re not levered also fret over the possibility of a market swoon. It’s a real dilemma; low risk assets such as government bonds offer no return at all unless a flight to quality drives prices temporarily higher. Risky assets such as equities are attractively priced as long as (take your pick) (1) housing doesn’t turn down, (2) Spain doesn’t need a bailout, (3) Israel doesn’t bomb Iran. As someone once said, you can have cheap markets and safe markets but not both at the same time.

Buying equity put options can afford some protection but of course the option premiums will eat into the return. Long stock with a put is equivalent to a long call, and buying call options isn’t generally a reliable way to build wealth. We started looking at using a short Euro position last year in combination with risky assets. The logic at the time was that most of the bad things that could derail the market were likely to begin in Europe. While that’s not as obviously the case today, it can still represent an attractive way to combine risky, yield generating assets (such as bank debt) with a market hedge.

The 90 day rolling correlation between the S&P500 and the Euro has moderated from its high levels in the Fall when the Euro crisis dominated the news. However, while day-to-day moves are fairly independent of one another, the Euro reliably drops when stocks are notably weak. Over the past year, the Euro fell 69% of the time when the S&P was down 0.25% or more. Falls of 0.5% or greater saw a weaker Euro 90% of the time.

The U.S. is likely to experience GDP growth of 2.5-3% greater than the Euro-zone this year. The focus on austerity as the solution to Europe’s excessive debt makes a weaker currency in their interests as a way to stimulate some demand for southern European exports. So a short Euro position is probably the path of least resistance barring another crisis, but in addition it provides some tail risk protection for holders of higher yielding assets.

Investors are living in a time of unprecedented openness by the Federal Reserve. Many readers are old enough to recall the days when “Fed-watchers” would seek to divine the central bank’s intentions on monetary policy through its open market operations. If managing reserves, and therefore indirectly the cost of short term financing through the Federal Funds rate, required that the NY Fed conduct a “System RP” and they instead provided somewhat less overnight funding through a “Customer RP”, bond traders would immediately interpret an intention by the Fed to raise interest rates and react accordingly. It was subject to all kinds of communication problems – sometimes the Fed wasn’t trying to say anything, but Wall Street analysts had got their reserve requirement Math wrong and thought they heard a warning of higher rates. Then the Fed might oversupply short term credit the next day, in order to correct the mis-communication. Somehow this obscure back and forth of action by the Fed followed by reaction from the markets was state of the art central bank communication back in the 80s and 90s. It all now seems so quaint and pointless at the same time. The Fed under Alan Greenspan, following custom, deemed plain English unsuited to its purpose. And Greenspan himself took evident pride at his ability to provide long Congressional testimony using tortured erudition that shrouded monetary policy in a fog and left senators befuddled.

Ben Bernanke has continued a new tradition begun in the latter Greenspan years of communicating quite plainly. Opinions are easily formed on this Fed, because their intentions are so clear. There’s no more hiding behind obfuscation. The conduct of monetary policy takes place right out in the open. FOMC minutes are released in a timely fashion; Bernanke holds “town halls” to discuss monetary policy, goes on “60 Minutes” and the Fed now actually tells you, with a fair degree of precision, where they think interest rates will be.

In January, the FOMC released short term interest rate forecasts from all 17 FOMC members. From the published data, it’s possible to construct the Fed’s own yield curve. A long term interest rate is simply the sum of all the short term interest rates from which it’s constructed. Libor rates are visible and can be hedged out to ten years through eurodollar futures. In aggregate they form the ten year swap rate. The ten year swap rate is closely tethered to the ten year treasury yield, which is largely set by the Fed’s Operation Twist and its predecessors, QE 1 and 2.

The chart overlays market forecasts of short term interest rates, derived from recent eurodollar futures prices less the typical 0.3% spread to the Fed Funds rate (the blue bars), and compares it with the FOMC’s own interest rate forecast (the red line). It assumes the FOMC expects to return to its equilibrium 4% interest rate in five years.

The Fed expects to raise short term rates by the end of 2014. They expect them to go up by 0.5% between the end of 2013 and 2014. Quite recently, the market forecast for Libor rates was that they’d increase by 0.3% during this time. Futures markets didn’t expect as sharp an increase as the Fed. Of course, the Fed is only making a forecast, and it’s based on GDP growth, inflation, unemployment and many other variables. Their forecast for these might be too optimistic. But when you ponder for a moment the actions of those bond investors who would accept market interest rates as the basis for their purchases, it’s quite bold to insist that buying bonds at yields below the Fed’s expected break-even is a sound move. They are telling you, if you’ll just listen, that short term rates between now and 2022 will average more than the current yield on a bond maturing at that time. The Fed’s forecast may be wrong, but their forecast is obviously a bit more important than yours or mine.

The long end of the yield curve is similarly fascinating. The FOMC’s long run equilibrium rate is 4%. This is where they believe short term rates will return when the Great Recession of 2008 is a distant memory and the economy is chugging along at whatever rate it can just short of causing inflationary pressures on wages and other inputs. The FOMC doesn’t say exactly when things will be back to “normal”. Of course, we’d all like to know. The chart above assumes five years. But the futures market has a different opinion on when that will be, and the answer is March 2022. This is how far out in to the future it’s necessary to go in order to reach a eurodollar futures contract that yields 4%. Everything prior to that date yields less, because investors in aggregate believe the economy won’t quite be back to normal. Or at least,
that’s what investors are saying by their decisions to invest, or not, at prevailing yields.

If Bernanke testified before Congress that we still have another ten years to go before the “extraordinarily accommodative” monetary policy was no longer needed, there would be outcry. He would probably be fired, or even impeached. Further fiscal stimulus not even imaginable would no doubt be contemplated. Big things would happen.

Except that he wouldn’t say that. Although he hasn’t put a date on normalcy’s return, everything about his actions and those of his colleagues on the FOMC strongly suggests they are not nearly that pessimistic. Futures markets are pricing in ten years because the Fed has put them there through their buying of treasuries. 61% of net U.S. Federal government debt issuance was bought by the Fed last year. The Fed is maintaining bond yields at levels far lower, perhaps 1-2% lower, than the likely break-even on short term rates over the same period.

This should be plain to anybody paying attention to the Fed’s communications. It doesn’t necessarily mean ten year treasuries at 2.2% and related corporate bonds at modestly higher yields are guaranteed to lose money. It may take us more than ten years to reinvigorate the economy, to fully repair all the damage excess debt has wrought over the years. But it is obvious that the Fed thinks today’s bond yields are a poor investment. That is a clearer expression of its opinion from the central bank than many of us are used to, and shows how far we’ve come since the old days of Fed watchers.

We continue to think equities are attractively priced, although obviously not as cheap as they were in the Fall. The Equity Risk Premium, the difference between the earnings yield on the S&P 500 and the yield on ten year treasuries, has narrowed modestly from where it was in September, mostly because the strong rally in stocks has driven multiples higher and earnings yields lower while treasury yields have drifted higher. However, this relationship is still historically wide.

But on interest rates, we believe in siding with the elephant in the room. If last year’s buyer of 61% of treasuries thinks yields are too low, that sounds like a view worth respecting. Investors can own a combination of equities and cash divided according to their risk appetite and outlook. But long term bonds, both government and investment grade corporate, are clearly at yields intended to lose you money. The world’s biggest buyer is telling you so.