The Wile E Coyote Theory Disproven Preemptively

by Mr Juggles

Upon watching Wile E Coyote and his efforts to catch, kill, skin and eat the Road Runner you may have noticed a recurring theme — Wile was always very very close but never quite caught the Road Runner. While we admire his sticktuitiveness (not a word), we scorn his lack of ever trying the same thing twice. We notice the same flaw in Cobra Commander (CEO of Cobra Inc) and also in Megatron (Chairman of the Board for the Decepticon Group). They all shared the flaw of spending a lot on R&D only to give up upon the first failure of their generally well thought out plans and technology. We always wonder what would have happened if only Wile E Coyote had tried one of these traps/plans more than once — surely the Road Runner couldn’t make the same improbable miraculous elusion TWICE. It’s just not statistically likely that a once in a millennium type of event would happen again. So you should always try a failed genius plan at least one more time per the Wile E Coyote Theory of Management. Well, now we know (and knowing is half the battle).

Now, Mr. Meriwether’s biggest fund, a bond portfolio, has plunged 28% this year….

Mr. Meriwether’s recent troubles partly stem from borrowing. His bond fund had $14.90 in borrowed money for every $1 in equity at the end of February, according to the March 18 letter.

Mr. Meriwether marketed his bond fund as a lower-risk version of LTCM’s core strategy, of identifying the next financial crisis and profiting from it by buying securities its managers consider underpriced. Investors were told that the firm would aim to keep borrowings below 15-to-1 even during less-volatile times.

JWM’s Relative Value bond fund, launched in December 1999, has lost 28% this year through last week after notching a 5.6% return in 2007, according to people familiar with the fund. The recent losses further weigh on the fund’s average annualized return since inception of about 7% through February 2008. The Lehman Brothers U.S. Aggregate Index, a measure of investment-grade bond performance, has returned an annualized 6.5% during that period.

Recommendation: Leverage kills. Short funds that are dependent largely on leverage to generate even sub-adequate returns, especially ones that were amazingly collecting 2 and 20 for it and ones run by people associated with the worst hedge fund blow-up ever, having had their hubris chronicled in a popular book. We recommend that Meriwether be permanently elevated to the role of Chief Investment Coyote and only be allowed to manage the Acme Family of Funds.

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  1. March 28th, 2008 | 11:03 am

    I thought all the regular and investment banks have leverage ratios of liabilities to equity of 10, 20, or 30 to 1, as well as most hedge funds. I get that leverage kills, but none of these operating models generate sufficient ROE without leverage, right?

  2. March 28th, 2008 | 11:51 am

    You might be onto something. Let me noodle on it.

  3. March 28th, 2008 | 11:57 am

    I just noodled on it. The answer is yes, sort of. Hedge funds typically do NOT have that kind of leverage. Some do obviously. I-banks and banks have a different type of model so are not an apples to apples comparison; this is why the recommendation specifies to short FUNDS.

  4. To The Hilt
    March 28th, 2008 | 12:11 pm

    If Jimmy Cayne starts another bank, you should probaby short that too.

  5. March 28th, 2008 | 12:28 pm

    What if he started it in…the Cayneman Islands.


  6. March 28th, 2008 | 1:08 pm

    the relationship between wile E coyote and VaR. Ok it is a VaR article with a snazzy cartoon image.

  7. Size
    March 28th, 2008 | 2:03 pm

    Well, when credit spreads are almost zero, it’s pretty hard to generate sufficient ROE without piling on more risk by piling on as much leverage as you can beg your prime broker to extend to you. How many hedge funds were levering bank loans and CDO’s?

  8. March 28th, 2008 | 2:18 pm

    Not most of them (I just don’t imagine there is enough bank loan paper but correct me if I’m wrong) and not at greater than 10x. Otherwise the 10% downward move in the bank loan market means they would no longer exist (maybe they don’t?).

  9. Size
    March 28th, 2008 | 3:05 pm

    I don’t know how many of them were doing it. I have absolutely no idea how much bank loan paper was available relative to the number of hedge funds that wanted to buy it. The funds I know of that were buying bank loans were levering their positions 8x and that wasn’t their only strategy. They’re still around – barely. Levering CDOs 10x was more common – wasn’t Global Beta…I mean Global Alpha doing that too? Isn’t that what blew up the Bear funds, Sowood and a few others? It never struck me as a good idea to lever an asset for which there is no good hedge. But that was the only way they could earn an acceptable ROE. Everyone just ignored the fact that the leverage amounted to a massive short volatility position and that their risk adjusted return (of which they made a big deal) was based on a muted volatility calc due to the lack of trading in these loans and that it expired with the next volatility spike. Where’s the alpha in that? Why are these guys getting paid 2 and 20 for just loading up on risk?

  10. Size
    March 28th, 2008 | 3:07 pm

    Oh, wait….I’ll answer my own last question: because they can.

  11. March 28th, 2008 | 3:33 pm

    Now you get it. If you have to lever something up 10x+, you’re doing it wrong. Actually, to be more clear, you’re doing it wrong for your investors, but you are doing right for yourself.

    Year 1: Collect 2 & 20
    Year 2: Collect 2 & 20
    Year 3: Collect 2 & 20
    Year 4: Collect 2 & 20
    Year 5: Collect 2 & 20
    Year 6: Collect 2 & 20
    Year 7: Anomalous Event Y happens, fund blows up, lose all my investors money, pray I don’t have too much in the fund
    Year 8: Raise money for new fund that will be modeled after old fund, which would have worked well if not for those pesky kids

  12. Size
    March 28th, 2008 | 4:18 pm

    Ah! By Victor, I think you’ve got it! Shall we call it the Niederhoffer Theorem?

  13. March 30th, 2008 | 2:10 pm

    Well done, both with the post and the discussion.

    You are all of course aware that Coyote finally abandoned his schemes and sought to make his fortune the American way, via a personal injury lawsuit.

  14. Jeremy
    April 12th, 2008 | 6:06 pm

    I help run a fund that buys high yield bank loans in Collateralized Loan Obligation (CLO) structures. We are 12.5 to 1 leveraged, just like most commercial banks. The bank loan market is enormous by the way.

    Even though the average bank loan traded down to roughly 90, we still exist because the mechanics of the fund do not call for immediately marking to market (just like a commercial bank), and all our liabilities are non-call so an investor can’t say I want out. As long as there is a reasonable expectation that the vast majority of the loans will be paid back at par, then there is no problem. Again similar to a commercial bank.

    Now the reason most bank loans traded down isn’t because of defaults but rather other investments started yielding much more and required rates of return have gone up. There have been some defaults and I am sure they will accelerate over the coming year and that could very well be the next shoe to drop.

    We don’t get anywhere near 2 and 20. More like 40 basis points and 20% of returns above a hurdle rate of 12 to 15%. So if the IRR of the fund is 10%, we get no incentive fee. If the IRR is 17% and the hurdle is 12%, we would get 1% or 20% of the 5% outperformance. However, we wouldn’t get that fee for at least 5 years.

    Hedge funds that run bank loans under different structures would probably get 1 and 15 or 20 although I am sure there is a wide range. Those funds have almost all been blown out of the water because they are marked to market daily.