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In the last few weeks, I have spoken with several investors about their concerns regarding the subprime market. Specifically, many have wondered how the subprime woes will affect their hedge fund investments. The Bear Stearns subprime-related funds, which you have doubtlessly heard about in the media, seem to have cast a dark cloud over the entire hedge fund industry. The fact that Bear Stearns' funds lost a ton of money, and that they are hedge funds, perpetuates the notion held by many that all hedge funds are losing their shirts in the subprime debacle. This conjecture could not be further from the truth.

Let me give you my perspective, as the President and CEO of an alternative investment firm with a platform of dozens of highly-scrutinized hedge funds. For our customers, who have over $2 billion in trading level allocated to our platform of alternative investment products, the subprime debacle has thus far been almost a non-event. Why? Simply put, the managers of the funds on our current platform are not large players in the highly leveraged world of CDOs. In fact, for some of our managers, this may be an opportunity for gain.

Hedge funds are complex. Because of this, the mainstream press often generalizes and tends to do a marvelous job of simplification, grouping the universe of hedge funds into one big bucket. While it's true that most hedge funds share a few characteristics like basic organizational and fee structures, the differences between hedge funds are profound. In my view, it is lazy and probably misleading to generalize the performance characteristics of the 9,000 + hedge funds out there without qualifying the type of hedge fund on which you are commenting. A simple review of some of the major categories of hedge funds will reveal strategy descriptions such as the following: Convertible Arbitrage, Equity Market Neutral, Event Driven, Relative Value, Global Macro, etc., strategies that have very little to do with the subprime tranches of collateralized debt obligations (CDOs). Here is a link to a page on our website that explains some of these strategies in more detail:

Indeed, if you look at the indices for different hedge fund strategies out there, you will find a large dispersion of results for July, with some strategies gaining money and some losing money. The differences between a long/short US manager, a multi-strategy Asia manager, and a leveraged CDO manager are too numerous to mention in this article, but the press would have you believe that these managers are all bound together.

Let me reinforce my point with a basic but very appropriate analogy. In Japan, there is a distinctive pufferfish called the Fugu. It is served in special sushi restaurants by master chefs. Fugu tingles in your mouth when you eat it. It is supposed to be an exotic aphrodisiac in Japan, where diners spend hundreds of dollars a serving to eat it. The problem is that eating Fugu can kill you. There is an old saying in Japan, "I want to eat Fugu, but I don't want to die." People have been known to literally drop dead in sushi bars from cardiac arrest and pulmonary failure if the Fugu they ate wasn't prepared correctly. You have to be a specially trained and licensed Fugu chef to prepare and serve it. Personally, I would want to see the stats of the chef before eating Fugu…just a simple "number of customers killed" would work for me.

Now imagine a family in your town called the Griswolds. (You may remember them from the National Lampoon "Vacation" films.) Suppose for their next trip, the Griswolds decide to travel to Japan and pursue some gastronomical thrills and eat the infamous Fugu. So they do some cursory research, march into a Tokyo Fugu restaurant, plunk down $1,000 and order a huge plate of Fugu. And die on the spot.

The next morning as you sit at your breakfast table sipping coffee, you read the following headline:

You think to yourself, no problem... you continue sipping coffee... and maybe mutter... "They should have known better."

Your reaction may be very different. You are likely going to cancel your reservation at the local sushi bar until you hear more. What if all fish are tainted? Or is it just that restaurant? Or is it a specific type of fish? You'll have lots of questions, and you might assume, until you know more, that no fish are worth eating.

I think the subprime debacle, as it relates to the hedge fund industry, is surprisingly similar and simple. You read the headlines that talk of a few hedge funds exposed to subprimes, and you may conclude all hedge funds are affected. If you don't know the specific details, you may stay out of all hedge funds just to avoid subprime exposure. But once you do some investigating, you may draw a different conclusion. Those who invested in hedge funds with heavy exposure to subprime markets are likely to be the ones most affected by the meltdown. You may surmise that the subprime debacle has very little to do with you and your hedge funds, and you will continue to invest in managers that you believe, after investigation and research, add real value.

My point is that events like these and potential losses should not come as a surprise to knowledgeable and well-educated investors, whether in Bear Stearns' funds (the current focal point of media attention) or other funds. The name of one of the Bear Stearns' funds was "The High-Grade Structured Credit Strategies Enhanced Leverage Fund". If this name alone didn't suggest possible concentrations in potentially high-risk investments, I don't know what would. According to one Citibank report, the fund at one point was 80:1 leveraged!¹ In March of this year, the subprime story was all over the news. At a time when most news sources were already talking about interest rate increases hurting subprime borrowers, Bear Stearns appears to have been marketing a fund that invested in illiquid/exotic mortgage credit instruments with high levels of leverage. While I don't personally know the full details behind the reasons Bear sponsored this fund, it is clear in my mind that investors seem to have been taken by surprise as to what they had invested in. As I see it, and to return to my analogy, this fund may have been serving up large plates of Fugu to investors clamoring for a bite. The "diners" appear to have either been unaware of the risks, or more likely, had not seriously considered what could, and in fact did, go wrong.

Not all CDOs have danger written all over them, but those backed by subprimes would, with the benefit of hindsight, seem to have been quite clearly headed for trouble. It is a very narrow and specialized breed of hedge fund that trades in such a space. Like a sushi "Fugu" bar, such investing is not typical of all hedge funds. That doesn't mean there aren't billions of dollars exposed to it... it just means it isn't your everyday long/short hedge fund.

I speak at hedge fund conferences routinely. At an industry conference in December of 2006, I was invited to speak on a panel to discuss both the state of the hedge fund industry and where I saw the potential for problems in light of the current credit environment.

During this panel, I specifically pointed out my concerns over "leveraged credit" strategies and "yields widening". Spreads between high yield credit and US Government Bonds were at historic lows, and global yield chasing had driven investors to deeper and darker corners to squeeze out greater returns. This is specifically why Altegris has not historically been a fan of highly leveraged credit strategies.

I also pointed out at this conference that one of the real risks was the untested leverage in CDO markets. I outlined a market shock scenario, in which CDOs backed by risky assets could get "hammered", and the spillover could affect the equity markets.

Well, here we are seven months later. I don't claim to always be so right, and I am certainly no clairvoyant. But I am smart enough to know that if you eat Fugu, you can die... and if you invest in highly leveraged, risky CDOs, your portfolio can get hammered. There is nothing complex about that.

In this environment, the types of hedge funds that you should stay away from, in my opinion, are highly leveraged fixed income plays. The repricing risk in credit is too great. There are many hedge funds in this space, and I believe they are going to get hurt badly. More "Fugu" headlines may flash across the screen over the next several months.

For several years, with few exceptions, Altegris has recommended staying away from highly leveraged fixed income strategies.

Contagion Concerns

The real problem, as I see it, is the fallout of the massive repricing of subprime loans, and how that might affect investors in more traditional investments. The exotic credit markets aren't going to affect the average investor. It is asset price repricing that will affect the average investor. After five years of a bull market in equities and home prices, it may be time to "revert to the mean". Have a look at the following recent Wall Street Journal chart for some highlights of recent market volatility:

The massive global liquidity glut may be due for a serious correction. The concern is contagion risk, where the subprime flu becomes a systemic problem. We have seen such contagion before with Long Term Capital Management (Russian debt crisis), etc. People are heading for the door, and they all want out. Knowing that Bear Stearns had to liquidate their funds, will other funds also have to liquidate their assets, creating overall selling pressure in the market? Or, out of fear that there are other Bear Stearns out there, will funds and investment firms start reducing risk across the board in preparation, thereby perpetuating the panic?

There clearly has been a sea change in the credit markets the last several weeks. Subprime mortgage bond ratings have been cut by Moody's, Standard & Poors and Fitch to the tune of approximately $7 billion.³ Leveraged buyouts are losing steam as well... An estimated $60 billion of LBO activity has halted since late June.⁴ Easy borrowing has clearly come to an end, and the massive leverage built into the financial system globally appears to be unwinding. The question nobody can answer is... How bad will it get? How far down into the credit ladder will this repricing go?

What to Do

In my view, events like these demonstrate exactly why you need sound investment counsel and why you need to understand what you are getting into when you invest in any financial product. It might be a prudent time to be asking if your manager can short stocks if he needs to. Can he buy credit default swaps? How much exposure do I have to Asia, and if the dollar gets hammered, should I increase it? If a contagion were to happen, I believe that, if you are the right investor, your hard-earned money should sit with a manager who can effectively hedge, rather than lie dormant in a fund that is limited to long only strategies and highly correlated with the broad market. If subprime woes spill over to prime, if lenders of corporate credit get jittery, if the LBO market finally deflates, I believe you want to be invested with an active manager, not a passive one. This kind of volatile environment is fertile ground for the right type of manager. On our platform, we have several managers that we believe may be well-suited for this environment.

¹ Citibank: US Rate Strategy Focus, US Fixed Income Strategy, Thoughts About Subprime, June 29, 2007.
² Lehman Brothers Fixed Income Research: Will Subprime Woes Spill Over to the Broad Markets? Mar 8, 2007.
³ Poole Says Subprime Investors Deserved to Lose Money, Craig Torres and Anthony Massucci, Bloomberg, July 20, 2007.
⁴ Credit Chill Freezes Leveraged Deals, Victoria Howley, Kate Haywood and Marietta Cauchi, Wall Street Journal, August 3, 2007.