The retail credit universe is dominated by the FICO score. A consumer with a low FICO score will pay higher interest rates or suffer rejected credit requests. Similarly, a nation’s borrowing power is governed by scores from rating agencies. Moody’s, Standard and Poor’s, and Fitch are major players. High ratings make it possible for governments to borrow at favorable rates, typically through the bond markets. The reverse is true for lower ratings.

Consumer vs. Sovereign Default

When an individual defaults on credit obligations, the consequences are usually severe. Consumers face repossession, foreclosure, legal action, and long-term impairment of their ability to access credit. The ramifications for defaulting sovereign nations are not so clear-cut. Argentina may well be the poster child for sovereign debt default, having reneged on its obligations, no fewer than eight times in its history.

The fact that Argentina has eight defaults under its belt, suggests the repercussions for sovereign default may be inadequate to deter it. While it is true that no sovereign state can prosper absent access to capital markets, Argentina has repeatedly succeeded in post default borrowing efforts.  This fact is apparently not lost on Argentina, in default for the second time in a dozen years and its third default in the past three decades.

Who is to Blame?

Argentina points its finger at “vulture” hedge funds as the principal architect of its current default … but is this accusation accurate? Argentina pledged to accede to U.S. financial laws, but having lost its case in U.S. courts, is reneging on that pledge as well.

The argument could certainly be advanced that Argentinean investment was feckless on the part of hedge funds and others given its prior default record. This does not, however, excuse Argentina from its obligations.

The Pertinent Facts

Argentina’s December, 2001 default was the largest in history involving international bond obligations totaling more than $82 billion. Restructuring agreements were concluded with most creditors, who acquiesced to reductions of up to 70 percent of the actual debt due but, there were ‘holdouts’—notably hedge funds, seeking full repayment of the bonds they hold.

While Argentina has adhered to the repayment terms struck in 2005 and 2010, it has repaid nothing to the holdouts. The suit filed by hedge funds and other holdout creditors was adjudicated in their favor. Simply put, the courts concluded that the terms of the bond sale require that all bondholders be treated equally. Translation: Argentina cannot pay the restructured debt and not repay holdouts.

Lesson Learned … or Not

Sovereign debt repudiations clearly have inadequate deterrents. Brazil and Columbia have seven defaults under their collective belts and Venezuela leads Argentina with nine defaults. Standard and Poor’s documents 84 instances of sovereign default around the globe between 1975 and 2002. Nonetheless, these governments have continued to gain access to credit.

Hedge funds and other private investors would like to be perceived as victims when governments default but are they? A case could be made that these investors arguably facilitate bad behavior, as exhibited by Argentina and other sovereign nations having a track record of default, by making such investments. If these investors are indeed facilitators, then wouldn’t the sovereign nations be victimizers rather than victims?

 

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First: Do No Harm

August 17, 2014

There are equivalencies that can be drawn between the physician’s Hippocratic Oath to patients, and the hedge fund’s primary responsibility to its clientele.

Just as the physician pledges to do no harm, the hedge fund manager has a similar charge with respect to preserving the investor’s capital. Don’t lose any principal! Of course, along with the concept of hedge funds as preservers of wealth, is the notion that hedge funds are multipliers of wealth.

While these two objectives are not mutually exclusive, the client’s focus on capital preservation in volatile markets, and expectations of growth in all market conditions are a significant challenge for any hedge fund manager.

In the Beginning

Alfred Winslow Jones, credited with founding the first hedged fund in 1949, was focused on investing in a manner that avoided wild swings in the market. In short, protecting invested funds against market volatility was the fund’s foremost goal. This was achieved by employing the now classic equity long-short strategy.

Hedge Funds in the Short-term

Recently, hedge funds have been on the receiving end of significant criticism because many are under-performing as compared to an arbitrary benchmark index—the S&P 500. Often overlooked, is the fact that a significant percentage of so-called hedge funds, are not “hedged” at all. The more than 10,000 funds in existence employ a variety of strategies other than long-short and would be unrecognizable as hedged funds by the esteemed Mr. Jones. Even so, the long view of hedge funds reveals a record that beats the performance of the S&P 500.

Looking back over the past twenty-years, S&P 500 annualized returns stand at 7.13%. In contrast, HFRI’s weighted composite of all hedge funds, regardless of strategy, delivered annualized returns of 8.84%. Equity hedge fund performance, viewed in the aggregate over the same period, demonstrates annualized returns of 10.3% … more than 3% ahead of the S&P 500.

Here’s the Point

Hedge fund managers do not rise from their nightly slumbers bent on the mission of beating the S&P 500 index. In fact, most who invest in hedge funds do not have beating the S&P 500 as their principal objective. All too frequently, the S&P 500 is the “go-to” index for those in the media struggling to understand hedge fund performance. While the S&P 500 is an important benchmark, it is not the yardstick by which most hedge fund investors gauge the performance of their chosen fund.

The quality of any hedge fund’s performance is best determined by its investors. Investors have a variety of goals and clearly defined expectations from their hedge fund investment. For example, many investors value the lower volatility that hedge funds provide. Others seek down-side protection and enhanced diversification, while still others view their hedge fund investment as a complement to their existing investment strategies. Obviously, none of these examples have strong ties to the S&P 500.

The bottom-line is that a variety of hedge funds, pursuing a plethora of strategies, cater to the diverse needs of investors. Rarely are those needs defined as outperforming the S&P 500.

 

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Imitation: The Most Sincere Form of Flattery

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