December 2015 – Monthly Commentary
As we expected, December was a tumultuous month for the capital markets. The FOMC finally raised interest rates and in the days following the move there were three obvious outcomes. First, the Fed was successful in raising the Fed Funds rate. We’ve written in the past about our concern over the committee’s ability to move interest rates higher given the enormous amount of liquidity in the system. They were able to work around the liquidity issue by lifting the cap on overnight reverse repo’s (the effective interest rate floor) from $300 billion to $3.75 trillion. Clearly, such an enormous facility is more than sufficient to sop up excess liquidity. However, they further confused investors by promising a gradual path of rate hikes but put forth a more aggressive forecast that indicated four rate hikes in 2016. That confusion, paired with the diminished liquidity of the season caused stocks, bonds, and currencies to react violently. The volatility has continued into the early days of the New Year, haunted by many of same worries of last year. Namely, global monetary policy, falling energy prices, slowing economic growth in the emerging markets, and soon to be released fourth quarter earnings.
We’ve written on numerous occasions about the illiquidity risk implicit in the Exchange Traded Funds and “liquid alternative” mutual funds. That concern came to pass on December 10th when Third Avenue Management halted redemptions from their liquid alternative mutual fund. With year to date losses exceeding 26%, the Third Avenue Focused Credit Fund, was unable to meet redemption requests. While certainly distressing news for its investors and Third Avenue Management, it’s likely to prove distressing to most of the liquid alternative industry as well. Following the financial crisis, investors became reluctant to invest in the liquidity constrained limited partnership hedge fund structure. Recall that during the crisis, many segments of the high yield credit sectors ceased to trade. As a result, investor redemptions were suspended until liquidity returned to the market. Given the challenge that episode posed, the hedge fund industry responded by obtaining approval from the Securities and Exchange Commission to create a daily liquidity mutual fund structure. The resultant “liquid alternative” funds offered daily liquidity similar to a plain vanilla mutual fund and was marketed as enabling retail and institutional investors to access exotic and levered strategies once available only to the ultra wealthy. The problem, as we see it, is that those funds quite often focus on less liquid investments where valuation is somewhat opaque and subjective. Excluding the managed futures strategies, where exchange traded futures allow their mutual funds to be truly liquid, critics have raised the question, “if a fund experiences significant redemptions, would it be able to continue to offer daily liquidity?” The Third Avenue Focused Credit Fund answered the question. No it can’t! What’s worse is that since the fund is a mutual fund, the holdings are publicly disclosed. With that information, the fund is at risk of having unsavory speculators push the price of its holdings lower in advance of the mutual fund liquidation.
Simultaneously with the Third Avenue fund gating, the High Yield ETF’s came under intense selling pressure as sellers significantly outnumbered buyers. This is the third time this year selling has overwhelmed these ETF’s and each instance has been followed by a new low in the security. There have been unsubstantiated speculation that the ETF sponsors stepped in to provide support during the panic, only to sell the holdings when markets normalize. While that’s debatable, what seems true is that investing in a daily liquidity security that gives you exposure to illiquid markets is not a sensible investment strategy.