Photo: Heidi Gutman/CNBC
Hedge fund manager Dan Loeb, who runs the $8.7 billion Third Point fund, just put out his second quarter letter to investors.The fund is not doing great – it was down 2.3 per cent in the second quarter as the S&P 500 was down 2.8 per cent, and it’s underperforming the S&P 500 by 5.6 per cent year-to-date.
However, Loeb points out one huge bright spot for the fund: Europe.
We are often asked what “event-driven” investing means in today’s environment, and whether that landscape is still fertile. We have found it to be especially so in Europe in 2012, where we have managed to make money despite the continental chaos by looking for negative events, capitalising on dislocations they generate, and trading well around these individual situations. While Europe overall is a place where we currently have little interest in long-term investing given the circumstances, surprisingly, many of our top winners so far in 2012 are European situations.
In times of turmoil, we look for “fat pitches” that come from factors like forced or panicked selling, market dislocations, or a move in the cycle away from greed towards fear. With all of the mayhem in Europe in the past 12 months, we have been able to find quite a few of these types of investments while remaining disciplined about avoiding anything in the region that falls outside of our very narrowly defined investment parameters…With the turmoil in Europe showing no signs of abating, we expect to continue seeing these types of attractive opportunities. We recently added a new position that fits these parameters through the European IG bond index known as iTraxx.
Loeb explains in the letter that in mid-June, the index, which is comprised of investment-grade European corporate debt, was trading at pretty wide spreads – in other words, it was pricing in a probability of default of 12 per cent, which is 12 times as high as the five-year average of around 1 per cent.
The credit default swaps on the index were trading at a spread of 40 basis points when Loeb started shorting them in June, which according to the letter means that “assuming conservative recovery levels, our June 2013 contract would not incur principal losses until at least 4 defaults [of companies in the index] occurred.”
Interestingly, Loeb says that the four riskiest credits that make up the index are way riskier than the other 121 names that comprise it. So, Loeb says they hedged against a default in these names by buying credit default swaps on those four companies to protect the trade.
The trade has worked out pretty well for Loeb since they put it on in June. From the letter:
Anticipated positive events in the “risky” names and overall spread compression have helped our position appreciate significantly since our purchase, and our contract now trades at ~20 points up front. We anticipate Europe’s dysfunctional capital markets to continue generating a steady stream of similar event-driven, attractive ideas for us to incorporate into our portfolio.