By Svea Herbst-Bayliss and Katya Wachtel
BOSTON/NEW YORK (Reuters) - Hanging tough seems to have been the right strategy for a good number of money managers now that it appears a stop-gap deal to avoid a federal debt default and reopen the U.S. government is on the verge of passing.
Hedge fund manager David Tawil said that, after living through the collapse of Lehman Brothers, many on Wall Street are now well-versed in telling a real financial crisis from one that is more of the smoke and mirrors variety and much more easily fixed.
The manager of the $60 million (37.6 million pounds) Maglan Capital, which trades mainly stocks, did not do anything particularly different with his portfolio during the three weeks Republicans and Democrats battled over a plan to reopen the federal government, and come up with an agreement for lifting the nation's debt ceiling.
"Those of us who invest on the basis of assigning probabilities to various outcomes, essentially gave this one a zero," said Tawil of the prospect of Congress not raising the country's borrowing ability and letting the federal government default on its debt obligations.
Tawil's hang tough strategy made a lot of sense with his fund up 34 percent this year, compared with a 5.6 percent gain for the average hedge fund.
Other money managers also said the political theatrics of the past few weeks were more of a nuisance than a real threat.
Some of that is because managers have already been through a series of politically provoked fiscal crises beginning with the 2011 debate to raise the debt limit, the battle to raise taxes on the wealthy and the more recent fight over sequestration and automatic budget cuts. In all of these situations, Wall Street saw a potential crisis averted by a last-minute deal hammered out by the political parties.
Others, meanwhile, said there were simply few opportunities to make money off the drama so it simply made more sense not to make big changes to their investment strategies.
Sander Gerber, chief investment officer for Hudson Bay Capital Management, a $1.6 billion hedge fund firm, said there had been worry, but not panic, about a possible default. He said there was more concern about a debt default in 2011.
During the current fiscal crisis, Gerber said his firm, which invests in stocks, bonds, convertible debt and merger arbitrage strategies, did not dramatically change its positions apart from adding some extra hedges in the event of a default.
"The majority of the fund world thought it was utterly inconceivable that the U.S. would default on their debt," Gerber said.
He said more damage was done to portfolios, in particular investments in bonds, by this summer's spike in Treasury yields prompted by fears the Federal Reserve would bring a quick end to its $85 billion in monthly bond purchases.
The Fed's bond purchases have helped stock prices all year by forcing investors into riskier assets. Even with a stopgap measure in place, talk about the Fed tapering those bond buys might be put on hold.
On Tuesday, Richard Fisher, the hawkish president of the Federal Reserve Bank of Dallas, told Reuters the fiscal standoff means even he would find it difficult to make a case for scaling back bond purchases at the Fed's policy meeting on October 29-30.
"My personal opinion is that it's not in play," Fisher said. "This is just too tender a moment."
And some on Wall Street are thinking tapering may get pushed even further out into next year.
Jason Ader, whose Ader Investment Management allocates money to a number of small hedge funds, said most of the money managers trying to gain a tactical advantage in the fiscal crisis were short-term traders. He said an indication that most managers were not particularly worried about a government default is that so-called crash protection on Standard & Poor's future contracts was still priced relatively low as of Wednesday.
Even as the hand wringing continued in Washington, Wall Street kept moving ahead, with the Standard & Poor's 500 gaining 3.6 percent in the last five days driven largely by the ups and downs in Washington with little regard to corporate earnings. On Wednesday alone, with a deal almost done, the S&P 500 rose 1.38 percent and the Dow Jones Industrials was up 205 points, or 1.36 percent.
Wall Street's fear factor, as measured by the CBOE Volatility Index, also remained in check, hovering around 15 on Wednesday, the middle of the typical 10 to 20 range when markets are calm.
But even as markets looked relatively placid, some fund managers took pains to describe to investors that they were not just doing nothing.
So while there was not a dramatic exit from stocks, some managers who did not want to be identified said they noticed some rotation into more defensive stocks. This helped names such as Johnson & Johnson (NYS:JNJ) rise nearly 4 percent and Procter & Gamble Co (NYS:PG) go up 2.68 percent in the last five days.
Jack Flaherty, an investment Director in the Fixed Income Investment team at GAM, which manages $123 billion, said managers who were trying to prepare for the worst were mainly buying put options on the S&P500, betting the index would decline at some point. If a deal does happen, investors would likely lose money on those put options, but probably not much.
"The actual outlay is not that much," Flaherty said. "A lot of the ‘shorts' in the market are of that nature, so it's not going to hurt anyone horribly when a deal is finally consummated."
One hedge fund strategy that might profit from market anxiety about a debt default, especially if a deal does fall apart at the last minute, are so-called volatility funds, which use complex trades to take advantage of pricing discrepancies caused by gyrations in global financial markets.
These funds earn big returns when volatility is high and bleed money when markets are calm.
But so far, volatility funds have not done well this year, not even in the weeks leading up to the debt ceiling deadline. To date, an index by brokerage Newedge that tracks 10 volatility funds is down about 2.5 percent for the year.
And today, with a deal almost at hand, volatility funds may have been hit particularly hard with the CBOE Volatility Index or VIX falling 21 percent - the biggest daily drop since August 2011.
(Reporting by Svea Herbst-Bayliss and Katya Wachtel.; Editing by Matthew Goldstein)