9/15/2011
In the world of finance and history of investing, people are immortalized by their A) Extreme Failure or B) Extreme Success. A) Extreme Failure may be the topic of my next post... perhaps focusing on the recent UBS rogue trader incident.
B) Extreme Success... on the other hand, can be achieved via consistency - batting singles over a number of decades until the consistency pays off and people have no choice but to recognize the eye-popping cumulative results achieved over time. Warren Buffett, Peter Lynch, and a number of other legendary fund managers come to mind. These are gurus who are recognized toward the end of their careers, when their long term track record have taken them to a level that clearly separates them from the rest of the pack.
Extreme Success can also be achieved by hitting homeruns (these two are not exclusive btw). It goes without saying that simply having one killer year / trade does not make one a legend. Investors strike gold on single positions all the time in their portfolios, but most do not do so on a scale that capture the attention of the financial markets. To garner the attention of the markets and earn the fame that comes with owning a "legendary trade", one has to swing with sufficient size and/or be the first to highlight something completely unforeseen by the masses.. I'm going to focus only on those who were actually able to profit from their contrarian positions (let's exclude Meredith Whitney types for now). Examples of legendary trades include George Soros "breaking the Bank of England", John Paulson's Subprime trade, Chanos's short on Enron, Tudor calling the crash '87, David Einhorn's short on Lehman Brothers, Tepper's binge on distressed financials...
The current chaotic macro environment is a result of the world arriving at many key junctures and the increasing size of the financial markets is likely to be fertile ground from which previously unknown investors will emerge or one which will enhance the reputation of those who are already well known. Although Bill Ackman is relatively well known within the financial world for his trades on MBIA and Target, my opinion is that he has yet to reach the same level of fame attained by the legends above. This is because the legendary trades above all coincide with key events that reshape the investment landscape on a global scale; most single name bets do have enough significance to make the list - note that exceptions can be made for Enron and Lehman because Enron became a symbol for corporate fraud and the fall of Lehman Brothers is recognized as the domino that started the onset of the global financial crisis.
In my opinion, Bill Ackman's recent bullish bet on the HKD has the potential to elevate him to the same level as these other financial markets hall of famers because:
1) Global Significance - a repegging, depegging, or floating of the HKD may be a hugely significant historical milestone that marks the continued displacement of the USD as the dominant global currency of exchange.
2) Size - he has taken a sufficiently large enough position for his fund to very meaningfully benefit from this trade should this play out as he anticipates.
3) Being First - he will likely be given the lion's share of the credit for calling this trade (smaller unknown investors who are managing relatively insignificant amounts of money may have seen this coming before Bill but will be overshadowed).
Bill Ackman - Long HKD <--- It is a long presentation but I thought it was very well-presented and convincing trade. I really enjoyed it. To summarize:
- fundamentally, it makes sense - Hong Kong's economic well being is increasingly more tied to the Asian economy and its economic / political integration with China makes for a strong case that it will only be a matter of time before they eventually switch to a RMB peg, peg to a basket of global currencies, or free floating of the currency. Continued peg to the dollar at this current level makes little sense when the fundamentals of Hong Kong (overheating) is so different than that of the US (I happen to believe in stagnation or stagflation for this country).
- limited downside - purely directional bets without a clear floor can be dangerous when they move against ones direction. I like the fact that a) continued medium-longer downtrend of the relative USD will force the HK authorities to act, regardless of what they are saying in the nearterm. b) if instead, deflationists win out and the world blows up from a china hard landing or if we return to a real strong dollar policy backed by more than rhetoric, could Hong Kong be forced to revalue in order to remain trade competitive as some other contrarian investors believe? Possibly... but my opinion is that the current momentum and direction of the HKD/USD exchange rate gives some room for one to get out of the trade by converting back to USD or to take a small loss even if a sudden devaluation happened instead (if done via options).
- asymmetric payout: IMO, this has the hallmark of a great trade because one does not have to risk much to potentially make HUGE returns, especially because this is implementable via derivatives. This is key because without a superb payout ratio, one would not be able to leverage as much without risking a blowup (small-timers can do so, but when you're running a multi-billion dollar hedge fund, such a gamble could put you in the infamous league of Extreme Failures). If one makes a number of these black/white swan trades and if even a small number of them play out, it would more than make up for all the duds. I liken this type of trade to be very much like sitting at the poker table as last to act, with an apparently losing hand that has very few outs, but your opponents with made hands have raised far too little to force you out of the pot with extremely attractive implied odds. You know that if you don't catch the card you need, the amount of additional money you just lost is controlled and small. However if you do happen to catch the one or two cards, you have the opportunity to take down a MONSTER sized pot and send more than one player packing.
- cheap cost: similar to the long CDS trades from the subprime blowup, this has a relatively cheap cost of carry. Out of curiosity, I called a few market making FX desks yesterday and asked for quotes on HKD/USD call options. It is unfortunate that no liquid traded vehicles on this pegged currency (correct me if I'm wrong), so only qualified institutional or very wealth individual investors can put this in the OTC (over the counter) market with select banks. I was quoted offer prices of ~3.5-4% for a 3 year ATM call option, which corresponds to low-mid single digit implied vol.
Why so cheap? Answer: a huge part of an options price is derived from the implied/realized volatility of the underlying asset. For a currency that has been pegged to the USD since 1983 and has traded within a relatively tight band through the last few market crashes, you can see why the sell side market makers don't use a higher vol in their models.
How is the street hedging out their risk? One sell side guy sales person told me, "HK retail investors invested in structured note type products have sold these options, any losses from an actual change in the peg rate will be financed by loss of investors' principle. These investors are picking up nickels in front of steam rollers"
Of course, I been told that the street has seen more interest in this idea since Ackman went public with it two days ago and the price of the options have gone up. However, this is definitely something to still consider / keep an eye on as I believe Ackman's bullish call on the HKD has the potential to be considered a legendary trade down the road...
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