While a number of hedge fund managers this year made astronomical gains shorting subprime mortgages, some believe that the trade may be on its last leg. In fact, they say there are more opportunities to be had in the coming year in higher-grade mortgage securities as well as in the little-known master limited partnership space and the sexier alternative energy market.
But a second look at the hedge fund industry in 2007 reveals “a good-to-great year for hedge funds” in terms of volatility in the subprime market, a severe unwinding of carried trades, especially the Japanese yen, and the US dollar plummeting against the euro, according to Virginia Parker, founder of Parker Global Strategies.
“As Bear Stearns was forgetting to measure their risks, there were a handful of firms that had been studying the subprime issue for a number of years and were positioned and simply waiting for the first shoe to drop, which started in February,” Parker told a gathering of journalists this week.
Housing Hits Bottom… In 2010
While shorting the ABX index has served hedge fund managers well this year, Terrence Connelly, a partner and portfolio manager at MKP Partners, said it’s not the home run swing that it was earlier in the year. “We think there are still opportunities, but it’s not a core trade as it was in the first half of the year,” said Connelly.
“Looking into 2008, high-grade assets backed by Freddie Mac and Fannie Mae securities are going to be interesting and we’re going to be constantly evaluating the housing market to determine whether those assets are going to be much good.”
According to Connelly, investors in the upcoming year will look for answers in terms of when the housing market will hit bottom and how that will impact consumers and the global economy, as well as where mortgage securities are priced relative to the housing market. “There’s going to be some unique opportunities to play both the long and short sides and we think the earliest you’re going to see a bottoming of housing is 2009 or even further out in 2010.”
But if mortgage securities aren’t your investment modus operandi, then maybe master limited partnerships are. The under-researched, publicly-traded partnerships, which were created to process, store and move natural resources, have proven to be non-correlated to the equities markets, according to David Fleischer, principal of Chickasaw Capital Management.
“MLPs are a small group of companies that have been around for 22 years and have been quietly outperforming the markets over those 22 years,” said Fleischer. “The group has yielded over 20% over this time so it’s been a great performing group that nobody has heard of. These returns have come with low risks by most measures of risks.”
However, Fleischer admitted that the group has also under-performed the markets in the past to the tune of some 25% in the late 1990s, and more recently in July, when it fell some 15%. But, he added, there’s still a lot more upside to master limited partnerships.
“They don’t pay corporate taxes because they’re partnerships, and they don’t benefit or get hurt from fluctuating energy prices; they collect fees for moving products through their pipelines,” he said.
According to Fleischer, there are currently a group of about 70 MLP-related securities, compared to a little over 30 companies a few years ago, with about 12 to 15 hedge funds dedicated to the MLP space. “We try to look at growth prospects and earnings two to three years out, and this group should be substantially higher in that time period.”
And if MLPs still sound a bit too out there for your tastes, then how about investing in alternative energy? According to John Maxwell, a managing director at Parker Global, the entire alternative energy complex will undergo a multi-decade restructuring fuelled by a perfect storm of drivers including new legislation, globalisation, innovation by clean technologies and multiple access points for capital markets from indices, structured products and private equity dollars.
As well, Maxwell said the demand for alternative energy in high-consumption regions such as India and China should weather the sector from any slowdown in the US in 2008. “They have to continue to spend on infrastructure whether it is on roads or building alternative energy opportunities,” he says. “All the rivers in China are polluted... and half the population there does not have access to clean water. Both China and India will continue to power through 2008 driving a lot of continued growth in alternative energy.”
Interestingly, Maxwell said that the basic necessities of air and water are taking on a premium of their own. “Air and water are not free, and you’re going to have to pay for them in terms of carbon credits for the price of emissions and the scarcity and depreciation of the water table that’s going to drive water prices up. In fact, you’re going to see water-trading exchanges set up over the near term. Water efficiency, integration and reuse will become big issues in 2008.”