Inflation worry sparks new strategies, share classes

Date: Friday, January 30, 2009
Author: Alistair Barr, Market Watch.com

Some hedge fund managers and investors are so concerned about a possible devaluation of major Western currencies and the threat of inflation that they're taking some unusual steps to hedge those risks.

Some well-known managers, such as David Einhorn and Seth Klarman, have shifted investment strategies to protect against inflation.

Other hedge-fund firms are going one step further by offering new classes of shares denominated in gold and even oil.

Since the financial crisis erupted last year, the Federal Reserve has slashed interest rates to almost zero and expanded its balance sheet by more than $1 trillion, effectively pumping lots more money into the ailing U.S. economy. On Wednesday, the Fed suggested it could start buying long-term Treasury bonds in another attempt to keep borrowing costs low.

"The Fed is making loans collateralized by toxic waste and has now begun a policy called 'quantitative easing' - a fancy term for 'printing money,'" Einhorn, president of Greenlight Capital, wrote in a Jan. 20 letter to investors. "The currency is being debased."

Greenlight has been buying gold, call options on gold and an exchange-traded fund that tracks shares of gold mining companies

he added in the letter, a copy of which was posted on hedge fund blogs Seeking Alpha and Zero Hedge. A spokeswoman for Einhorn declined to comment.

Greenlight has also moved some of its cash out of U.S. dollars and into foreign currencies, particularly the Japanese yen, while betting on higher long-term U.S. interest rates, according to the letter.

Klarman, head of The Baupost Group, told investors in October that the firm had built a "sizable position in low-cost inflation protection for the next three to five years."

"The extraordinary and unpaid-for financial market bailout should add to inflationary pressures over time," he added. "The dollar will likely weaken over time, perhaps in a hurry, and gold may further strengthen."

Gold shares

For other hedge fund firms, strategy changes aren't enough.

Osmium Capital Management Ltd., a Bermuda-based firm run by former ABN Amro trader Chris Kuchanny, is launching a new class of shares in its Special Situations hedge fund that will be denominated in gold.

The Osmium Special Situations Fund already has share classes denominated in U.S. dollars, euros and British pounds and currently oversees $178 million.

"Given the challenging market environment, some investors want exposure to gold, which has historically been a good source of value during times of economic crisis," Bermuda-based Osmium said in a letter to clients, a copy of which was obtained by MarketWatch.

"Many investors are already heavily exposed to the major fiat currencies and wish to diversify into gold, without losing their ability to invest," Osmium added.

The Special Situations fund, which focuses on arbitrage trading and events like spin-offs and mergers and acquisitions, has returned more than 12% a year since it started in March 2005, according to the firm's letter to clients. It gained 2.8% in 2008, an enviable performance in light of the heavy losses suffered by many other hedge funds.

When an investor puts money into the new share class, Osmium said it will buy gold with the cash. The fund will then hedge its exposure to gold by selling the metal for cash and buying gold forward on a monthly basis.

That's similar to the way the firm already hedges its exposure to euros and British pounds when investors put money in those share classes, Osmium noted.

Investors get the same returns generated by the Special Situations hedge fund, but these returns will be denominated in troy ounces of gold, rather than in U.S. dollars, euros or pounds, according to the firm.

Superfund

At least one other firm also is using this approach: Christian Baha's Superfund, which runs funds that use computer models to trade futures, is launching the Superfund Gold LP fund.

This new fund uses the same trading strategies as the firm's other funds, but the net asset value of the new fund will be in ounces of gold, rather than dollars or another currency, Superfund explained in a November filing with the Securities and Exchange Commission.

To make this work, the new fund will buy futures contracts giving it the right to purchase gold equal to the amount of money raised from investors. The gold position will be adjusted at the start of each month to reflect new money coming in and redemptions, along with profit and losses from Superfund's trading strategy during the previous month.

Oil

While crude oil prices have slumped in the past year, the commodity is still considered as a useful hedge against possible future inflation.

Reech Alternative Investment Management, run by Christophe Reech, is launching a new share class of its Volcano Relative Value Fund that will be denominated in units of "barrels of oil," according to a letter the firm's broker Newedge sent to investors this week.

The Volcano fund already focuses on arbitrage trading in energy markets, but the new share class will "allow investors to participate in the long-term performance of physical oil whilst simultaneously investing in Volcano," the letter said.

Alistair Barr is a reporter for MarketWatch in San Francisco.