Friday, October 17, 2008

Voice of a Hedge Fund

With the great hedge fund unwind underway, I thought it might be a good idea to publish a very recent investor letter of a hedge fund (the letter was written yesterday). I am skipping the boring (and private) parts on the returns of the fund and publishing the commentary on the current markets, with the manager's permission of course...

"...But we should ask ourselves, why is gold not making a stronger comeback? Gold, to many investors, is a safe haven. People demand gold as a hard asset which can protect investor’s diminishing wealth. The euro/dollar parity is showing a -9.92% drop while gold’s decline of -5.12% is less severe. The strengthening dollar contradicts skyrocketing money supplies and people are buying dollars instead of gold to shelter cash during this financial crisis.

We are going through a historic time which I believe and reiterate is the end of the credit era. The U.S. announced its bail-out plan to save the banks with a $700bn budget. European leaders pressed for an overhaul of global financial structures after Asia joined western countries in bailing out banks to avert a financial meltdown and tackle a looming global recession. Developing countries are investing directly into the banking system to insure bank deposits, guarantee certain bank debt and in some cases nationalize banks. I believe companies, mainly small and micro-cap ones, which need short term financing to continue their operations, are going to have a difficult time staying in business. Banks are not willing to lend and the customers they do lend to are being charged higher rates.

The catalyst to this lack of short term lending is Lehman Brothers. When Lehman went bankrupt, most investors, myself included, thought the bank’s failure—like Bear Stearns—was necessary to clean up the financial system. However, the most alarming development to emerge in the aftermath of the Lehman collapse centered on other bank’s money market accounts which held Lehman bonds in their portfolios. When Lehman became insolvent, investors saw an instant decline in the value of their money market accounts. Thus, people got scared and pulled their capital out. Furthermore, on the other side of the scale, banks used the funds from the money market accounts to lend short-term loans or lines of credit to small businesses and other banks. The bankruptcy of Lehman therefore, stopped lending between banks, capitulating the fall of the financial system.

The liquidity the government is pouring into the financial markets will take time to jumpstart the economy. The credit problems are beyond sub prime and will soon reveal the effects of the deterioration in the consumer credit markets. Two thirds of this economy depends on consumer spending which has tapered off considerably in the past six months. This is a very special time for the financial markets. The most important thing for investors to achieve is to preserve capital and steer clear of any unnecessary risk, as the additional systemic risk premium is still hovering in the markets.

The Meadowbrook Beta Neutral Fund is benefiting from its asset allocation model in these unstable and extremely volatile markets. Although we have experienced rough markets in the past and navigated our way through them, we are aware of the current market situation and additional risks like systemic risk, economic risk and political risk. We are confident in our processes and our investment discipline and we see great opportunity amidst this market turmoil. People make irrational decisions in chaotic markets and we are ready to take advantage of that. Once we see the markets stabilize, there will be an opportunity of a lifetime for funds like us with preserved capital and sensible risk management. Thank you for your continued support during this exceptional period.

Afsin Alp
Portfolio Manager"

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