Tuesday, May 22, 2012

Einhorn's Macro Trades

We know that Einhorn has taken a view on some sovereign credit, Japanese yen and gold etc.  So I thought I'd take a quick look at his macro positions.

First of all, for reference, at the end of the first quarter total investments were $1.18 billion and shareholders' equity was $869 million.

This is not all of the macro positions, but just some of the larger ones:

Long Position:
   Commodities:  $104 million

Einhorn has said that he wants to keep 10% of funds invested in gold as a tail hedge, so I guess this $104 million is all gold.  He also owns gold stocks which would be in the equity portfolio and may own some GLD which may be booked in the equity portfolio.

Short Position: 
   Non-U.S. sovereign:  $150 million

Interest rate options:  $3 billion notional amount

Credit default swaps:
   Sovereign debt:  $281 million notional
   Corporate debt:  $287 million notional

Put Options:  $260 million notional amount (Japanese yen?)

Futures:         $335 million  (doesn't say if it's long or short or what the underlying is; probably interest rate instrument given interest rate exposure table below)

For the above positions, I would guess that the sovereign shorts and interest rate options relate to the Japan trade and may include others.

Foreign Currency Risk
GLRE has exposure to foreign exchange, but the big exposure is the Japanese yen (JPY).  In the table in the 10Q that shows FX risk, it shows that a 10% increase in the U.S. dollar against the JPY would lead to a $40 million gain, and a 10% decrease would lead to a $15 million loss.  The asymmetry is due to the position being held as a put option.

So this is a pretty large position.  There is a smaller position in the Euro, but it seems the JPY is the big FX trade.

Interest Rate Risk
The interest rate risk table shows what the exposure is on a 100 basis point move in interest rates due to holdings in corporate bonds, sovereign bonds, interest rate options and futures, credit default swaps etc.

Below is the gain on a 100 basis point increase in interest rates (this isn't the whole table; I just picked large items, and it's pretty symmetrical so I didn't put in what happens on a 100 basis point decrease in rates).

Debt:                            $11 million
Interest rate options:     $1.5 million
Futures:                        $15 million
Net:                              $27 million

So that's a snapshot of exposures that GLRE has on the non-equity portfolio;  a sizable position in gold, Japanese yen puts, short sovereigns and interest rate futures and long some credit default swaps on corporates and sovereigns.

How Have These Trades Done in the Past?
GLRE breaks out gains and losses recognized in their derivatives portfolio so I looked at the past five years (they didn't disclose details further back) to see if they have been making money on these trades or not.

Here are some figures I pulled out of past 10K's:

             gain (loss) on derivs:                Total gains recognized in income
             Equity:                                      Shareholders' equity of GLRE
             Total Inv:                                  Total investments of GLRE
             Gain/loss on equity swaps:       Derivs gain/loss on equity total return swaps
             % equity:                                   derivatives gain/loss as a percent of shareholders' equity
             % invest:                                   derivatives gain/loss as a percent of total investments
             derivs gain excl equity swaps:  Total derivs gain/loss without equity swaps
             % equity:                                    the above as a percentage of shareholders' equity
             % invest:                                    the avove as a percentage of total investments
             Investment return:                     Return on investment portfolio at GLRE

So it looks like these derivatives positions have cost GLRE some money over the years.  Equity total return swaps are included in here, but these may be part of the equity portfolio so it may not be a good idea to include.  They may be structured to offset positions in the equity book etc.   It doesn't reflect, I don't think, Einhorn's macro views.  That's why I created a column where I net out the equity swap gains and losses to get a more 'pure' derivatives gain or loss.

According to that, GLRE has usually spent around 1.6% per year of the investment portfolio on these macro trades.  Of course, the temptation is to think that if Einhorn didn't do these trades, then GLRE would have done 1.6%/year better in their investment portfolio.

But I would not look at it like that.  If these macro, tail hedges were not on, then Einhorn very well may have had less long equities or otherwise reduce risk (and return) elsewhere in the portfolio.  So you can't really look at it that way.   (You would be slightly better off without homeowner's insurance too, but would you really live in a house you own if it wasn't insured?)

Also, this derivatives gain/loss doesn't include their large gold position which is held as a commodity long position, not a derivatives position  (Also, gold stocks and gold ETF's would be in the equity portfolio). 

So just looking at the derivatives gain and loss like this doesn't tell the whole picture.
Judging from the above table,  I am sort of surprised that there wasn't some sort of gain during the financial crisis in 2008-2009.  But overall, it seems like a manageable expense to keep these trades on as they may eventually work out.  Even if not, the overall investment performance with these derivatives losses has been pretty good in an awful environment.

Anyway, it looks like they have some sizeable positions that can really benefit from some chaos in the market.  A $3 billion notional amount interest rate position is large; almost 3x the total investment portfolio.  But since this is in the form of interest rate options, the downside risk is limited so this won't lead to any unpleasant surprises.

The JPY position, too, is a put option so can't cause big damage.  The worst that can happen is the option expires worthless.

Additive to Returns
What's important to remember is that these positions are additive to total returns and don't require a whole lot of capital.  A lot of these positions can simply be supported by the assets held in the investment portfolio. 

Despite these large 'bets', GLRE maitains a fully invested long/short equity portfolio at the same time.  As the above shows, even when the trades don't work out, they don't lead to large losses, but small losses sort of like the cost of insurance.  Einhorn is managing this part of the portfolio, presumably, like an insurance plan (small constant losses are OK to protect the portfolio and for a chance at outsized gains when he is right).

The other thing to remember is that these macro trades cost very little for GLRE and he gives up nothing on the long - short equity side. 

Time and again, I hear of and talk to people who try to trade in and out of leveraged interest rate and FX ETF's to try to make money (and nobody does, of course).  But these folks usually have to sell their Apple stock to buy their 3x leverage interest rate ETF.  Or maybe they sell their MCD stock or whatever.

Institutional Advantage Over Retail Investors
So for most individual investors, these macro plays turn into either-or situations; either they maintain a stock portfolio and stay away from the macro stuff, or they sell some of their stocks to put on some macro plays via various ETFs.

What they don't realize is that guys like Einhorn don't have to do that at all.  They can still stay fully invested in their best stock ideas, and oh, if they see a good macro trade, they can put on sizable interest rate and foreign exchange positions.

This, by the way, is why people like Soros was able to make so much money over the years.  In all those years he made huge amounts of money on macro bets, he typically had an equity portfolio supporting all of that, and in bull markets it funded many of the macro bets (or subsidized them in dry periods).

Individual investors typically don't have that advantage, so if they don't like the market, sell their stock and buy inverse bond ETFs, they are screwed when they are wrong.  They might get a double whammy; they lose money on the ETF trade, and most likely the stock they sold went up!  (this scenario is most likely because it's often at bear market bottoms where individuals decide to sell their stocks and buy an inverse S&P fund; they sell their stock and go short at precisely the wrong moment!)

Not Einhorn.  If he is wrong, he still has his equity porfolio and he can manage his macro exposure without touching it.

That's a big difference and is really the key to why some of these hedge funds can make such great returns over long periods while individual investors that try to become a George Soros often fail; it's almost impossible to pull off without this advantage.


  1. Interesting post. However I disagree with the analogy to Soros - who is justifiably famous for his long track record as a macro trader. In contrast Einhorn has no real track record as a macro trader and there's no evidence to believe that these macro hedges will improve his long term risk adjusted returns.

    The fact that they cost less is not really relevant - they're also exceedingly unlikely to pay off.

    1. I didn't mean to compare Einhorn and Soros, actually. I had a bunch of themes all mixed up here. You are right, Einhorn doesn't have a track record in this macro stuff; I do remember many stumbling in this back in the 90s (I remember Steinhardt bragging how many millions he would make for every basis point move in the German Bund or some such, right before the bond market crash. Tiger had some macro stumbles too...).

      I do get nervous when stock pickers start acting like macro guys, but in Einhorn's case, he seems to keep his downside limited so he won't be down 30% because of a leveraged bond carry trade gone bad.

      The cost issue is just another thing altogether. So many people, it seems, got freaked out of stocks in the last bear market, sold it and turned into Michael Burry / John Paulson wannabes, it seems, and I just wanted to point out that there is a difference between individual investors trying to make macro calls using ETFs, versus hedge fund guys just overlaying trades in their prime brokerage account. It's a major point that a lot of individuals don't realize...

      Anyway, we'll see how this plays out...

  2. "a sizable position in gold, Japanese yen puts, short sovereigns and interest rate futures and long some credit default swaps on corporates and sovereigns."

    In totality, seems like a one way bet on a variety of global blowups...insurance indeed. Gold for inflation or other fiat current issues. Japan puts betting on more deflation? Weird since they're committed to printing their way to prosperity...

    I guess, the interest rate futures gamble on a yield curve blowout (same way as gold?). CDS -> more debt deflation.

    Its interesting to see how hes actively buying blow-up risk insurance for his portfolio while Buffett seems content not to. In fact, with those 2018 or 2020 index calls Buffett wrote it seems that hes actively taking on macro risk.

    I wonder who is right? What kind of risk premiums are out there for taking risk right now and is it worth it? Availability heuristic at play? How long do we remain scared shitless from the 2008 fiasco?

    1. I don't know. But when I heard all of these hedge funds looking for the next fat tail trade, I did get a sense that there is a lot of Burry envy going on.

      As long as the cost is manageable, I think it's fine. When Steinhardt and a bunch of others piled into the super-leveraged carry trade back in the early 90s, that was not OK since the risk was symmetrical; if the market moves against you, you are dead.

      With Einhorn's trades, that seems not to be the case. The $3 billion notional interest rate options is probably really out of the money so is a catastrophe trade of sorts... But the cost is just the option premium; known up front and can't get worse.

  3. Can you explain why Einhorn doesn't have to pare his equity portfolio to put these trades on? Futures need margin, options need to be paid for, is his equity leveraged or is it something to do with prime brokerage?

    1. Hi,

      Yes, it's a prime brokerage issue. Individual investors would have to set up a margin account for stocks to long short and then a separate one for futures etc... A prime brokerage account acts like one big margin account where hedge fund can trade all sorts of things and use one position against another. The portfolio can be used as collateral to put on swaps and other non-exchange traded OTC derivatives too, which retail investors can't do. For prime brokerage, clients are "exempt", I think from all sorts of things. Having prime brokerage accounts set up offshore also allows flexibility....

    2. I believe that anyone could get a portfolio margin account and make these trades in the same way. holding stocks which are used as collateral against leveraged futures bets. There are retail brokerages which support portfolio margin in this way.

  4. I don't think your statement that the macro trades are "free" is entirely correct. While it is true Greenlight can make use of the long/short portfolio to pledge it for cash from the prime broker in order to pay derivative margins ect, there is definitely an opportunity cost there. Instead of the hedges, Greenlight could use that same long/short portfolio to obtain leverage to buy additional stock positions. and THAT lost opportunity is the cost of the hedges, definitely not free. Where Einhorn has an advantage over retail investors is that his cost of leverage is much much cheaper. (I work for prime brokerage of a major firm).

    1. Good point. Great to hear from someone in the trenches and knows what's going on. Yes, free is not a great word to use.

      On the other hand, the reality, usually, is that people like Greenlight typically wouldn't want to lever up as much as he would be allowed to in a prime brokerage account.

      For example, if he needed only to put up 20% on a long/short, I don't think he'd ever lever up 5x. Most long/short hedge funds go 140% long, 80% short or some such thing.

      And my point is that even if you do 140/80 or something, you probably have plenty of room to put on OTC derivatives and fixed income positions against that portfolio.

      You would know exactly how much of what can be done...

      Anyway, good point. Not free, but compared to the retail guy, it's almost free...

    2. Interactive Brokers offers a portfolio margin account, which allows borrowing costs of about only 1%, so I am not sure why you are saying retail investors could not do the same thing. I think prime brokers would not be offering much better rates than Interactive Brokers.


    3. I'm not sure of the exact details, but there is a big difference. Maybe the prime broker here can answer this better.

      The first difference would be that at Interactive Brokers, retail investors would need to put up 50% margin for stocks. Prime brokerage accounts are much lower. For futures, I don't know if cross margining in retail accounts are allowed; maybe there is a system to do that now. But before, you had to have margin posted separately for each exchange.

      Prime brokerage clients are not limited to futures exchanges. They can put on spot FX, bonds, treasuries positions at low rates and low margin; retail investors can't.

      I don't know if this is still true, but I think most retail investors do not get paid on the cash balance on short sales; prime brokerage customers do.

      As for rates, for a highly liquid securities long/short, the rates offered used to be typically +20 bps / -20 bps, so that's pretty cheap. Much cheaper than 1% now, which is almost Fed Funds + 75/100 bps.

      Anyway, there are a lot of differences here.

    4. Oops, and forgot to mention the other big one; prime broker customers can do swaps and other OTC derivatives transactions (non-exchange traded derivatives). Individuals typically can't. That's a big difference. Hedge funds use all sorts of derivatives like total return swaps and even asset swaps to lever convertible arbitrage trades etc... Retail can't do that.

    5. kk, you are absolutely right. Prime brokers fund themselves at libor (now 0.25) and let at about 30 bps spread. In absolute terms that is not much more than 1% but when rates rise the difference is huge. Also, as kk said, with primes, the cash proceeds from shorts is not restricted, for retails investors it is. So even IF interactive brokers gave you margin at libor +30, your shorts are still twice as expensive because of the restricted cash. Finally, interactive brokers will margin longs at about 50% for most stocks (looked at individually). A prime will apply a portfolio approach and if you have a diverse portfolio with offsetting positions you can easy obtain 80-90% funding from the prime. None of those things are available to retail and the difference is huge, although not in absolute terms with these very low interest rates.

    6. Thanks for the clarification. It hasn't changed much over the years... with rates at zero, it's hard to realize what a difference these things can make (funding long/shorts etc...).

  5. For retail investors under Reg T, you can open a position with 50% equity.

    However, as ShortBus points out, Interactive Brokers (and many others) offer portfolio margin as an alternative to Reg T (assuming you meet the requirements). Typical equity longs are 15% then.


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