Citadel increased earnings moe than fivefold

Citadel Investment Group LLC, thehedge-fund manager founded by Kenneth Griffin, said earnings by its two largest funds increased more than fivefold on gains fromdebt and energy investments. Net income at Citadel Kensington Global Strategies Fund Ltd.rose to $795.6 million in the first eight months of 2006 from$148.4 million in the year-earlier period, the Chicago-based firmtold investors this week in a prospectus for its first bond sale.The fund, which has $9.5 billion in assets, returned 7 percent inthe third quarter, compared with 3.1 percent a year earlier, whenits corporate-debt and energy bets lost money. ``Citadel hired a significant number of new investmentprofessionals since mid-2005 to strengthen both the global creditand global energy business,'' the Nov. 27 document said. Earningsat its Wellington LLC fund, which has $3.3 billion in assets,rose to $389.1 million from $54.3 million. The 363-page prospectus, a copy of which was obtained byBloomberg News, details the finances of the closely held firm,which oversees almost $13 billion for wealthy investors andinstitutions. Hedge funds, private pools of capital that allowmanagers to participate substantially in their investment gains,oversee $1.3 trillion, more than double what the industry'sassets were five years ago. Institutions such as pension funds and endowments havecontributed about $361 billion to hedge funds, according to anOct. 10 report by Bank of New York Co. and consulting firm Casey,Quirk & Associates LLC in Darien, Connecticut. That amount maytriple by 2010.

Kensington's Returns

Hedge funds have struggled to outperform market indexes as aflood of cash from investors has made it harder to make money.Kensington returned 17 percent this year through Sept. 30,compared with the average 8.8 percent for similar hedge funds,according to Chicago-based Hedge Fund Research Inc. The Standard& Poor's 500 Index, a benchmark for U.S. stocks, returned 8.5percent including dividends. Operating costs at Citadel's two main funds rose 20 percentthis year to $805.1 million, the prospectus said, as the companyhired 320 employees since the beginning of 2004. Performance-based compensation is a ``significant part'' of those costs. Thecompany currently has 1,070 employees, including 656 investmentstaffers. Unlike most hedge funds, investors in Citadel funds pay allexpenses. Their costs rose to 8.75 percent of assets in 2005 from4.66 percent in 2003, the prospectus said. Kensington had netwithdrawals of $657.6 million through Aug. 31. For all of 2005,the fund had net inflows of $61.7 million.

Using Leverage

Hedge funds seek to magnify their gains by using borrowedmoney to increase their bets. Citadel's funds borrowed 7.8 timestheir assets as of Aug. 31. Their investments include corporatedebt, energy, stocks, currencies and government bonds, andreinsurance. JPMorgan Chase & Co., the third-biggest U.S. bank, sold itshalf of Amaranth Advisors LLC's energy trades to Citadel for $725million less than two weeks after taking over the positions.Amaranth, reeling from more than $4.6 billion in losses,transferred its energy investments to JPMorgan and Citadel onSept. 19. Citadel bought JPMorgan's share of the natural-gas,power and oil trades on Sept. 29, Citadel said in its prospectus. Bryan Locke, a spokesman for Chicago-based Citadel, declinedto comment. Griffin, 38, started Citadel in November 1990 with $4.6million, three years after he began trading convertible bonds outof his dorm room at Harvard University. Kensington opened with$5.5 million in 1995.

First for Hedge Fund

Institutional investors and so-called funds of funds make upabout 62 percent of the firm's investment capital as of Sept. 30,according to the prospectus. Citadel principals and employeescontributed about 15 percent. Citadel plans to sell bonds as a means to cut its relianceon financing from Wall Street investment banks. In a first for ahedge fund, the firm may sell $500 million of the notes next week,said a person familiar with the offering. Citadel could raise asmuch as $2 billion over time, according to the prospectus. Citadel in January is scheduled to start Citadel SolutionsLLC, which will handle administrative chores such as settlingtrades and valuing holdings for its own funds and other hedgefunds. Citadel said it expects the move to cut fund expenses.

Oil stocks are signaling that crude prices may rebound to a record in 2007

Nymex IPO
Energy-related IPOs raised $3.7 billion in the U.S. lastyear. Just three years ago, no energy companies went public.
Nymex sold its shares for more than underwriters forecast inits initial share offering, and they still jumped more than 125percent the next day on the New York Stock Exchange.
Oil has rallied for almost five years as fuel needs rose,especially from China, leading to record prices. Oil ended lastweek at about $60 a barrel. Natural gas prices peaked at over $14per million British thermal units in December, up from an averageof $2 during the 1990s.
Energy companies are selling shares to finance new projects,including Reliance Industries Ltd., owner of India'slargest refinery. Reliance sold stock in its Reliance PetroleumLtd. unit earlier this year, raising $601 million forconstruction of a 580,000 barrel-a-day refinery.
Buyers ordered 50 times more shares than were available,according to the underwriters. Reliance Petroleum shares surged42 percent after their first day of trading. They have since lost21 percent.
"Oil companies will continue to do well because there is alot of expansion needed both in exploration and refining,'' saidPraveen Martis, an energy analyst at U.K.-based Wood MackenzieConsultants Ltd. ``The energy story is far from over.''
Good Market
We are in a good oil and gas market and investors aretrying to take advantage of that,'' said David Frischkorn, amanaging partner at Dahlman Rose & Co., a New York-basedbrokerage that specializes in energy and shipping. ``Cash flowshave been very, very good and will continue to be good.''
Investors shouldn't mistake a good IPO performance forunderlying strength in an equity, said T. Rowe Price Group Inc.energy analyst Tim Parker, whose firm bought Nymex shares.
"It's more a function of investor enthusiasm thanfundamental strength,'' he said in a Nov. 21 interview.
Parker says oil prices will stay around today's level forabout a year and then begin to rise. He expects Russia and othercountries outside of OPEC to add 1.5 million barrels of crude oilproduction capacity next year, helping to meet ever-risingdemand.
By the end of next year, $60 crude will ``feel more like afloor than a ceiling,'' he said. ``It'll be difficult for non-OPEC supply to consistently meet demand growth.''
The increase in energy IPOs reflect confidence that enoughoil and gas can be found to exploit today's high prices, saidDaniel Yergin, chairman of energy consulting firm CambridgeEnergy Research Associates and author of ``The Prize,'' thePulitzer prize-winning history of the oil industry.
"This is a growth period as the industry rebounds from thecontraction it went through five or six years ago,'' he said.

Bernanke's Programs May Dilute Greenspan's Intuitions

Inside the U.S. Federal Reserveheadquarters, a small team is testing a forecasting program thatdoes the work of hundreds of economists. Never before has the Fedbeen able to crunch in real time such a large mountain of data --as many as 150 indicators -- to divine where the economy isheaded. Chairman Ben S. Bernanke is pushing the ``factor model''program -- so named because it reduces everything from home salesto mining capacity into a few weighted averages for makingpredictions. The Fed could use the help: Its gross domesticproduct forecasts, which influence its interest rate decisions,have missed the mark by an average of 1 percentage point since2000. ``It's a powerful tool that can potentially improve theFed's forecasts,'' says Richard Clarida, a global strategicadviser at Pacific Investment Management Co. and ColumbiaUniversity economist who developed a factor model as an assistantTreasury secretary in 2001. ``Forecasting, especially in realtime, is a challenge, and these programs are not swayed by theemotions or the conventional wisdom of the moment.'' Bernanke called the models ``especially promising'' in aspeech in 2004. He should know. In 2000, as an economist atPrinceton University, Bernanke created one that examined 78economic indicators. He found that its short-term inflation andunemployment predictions were about as accurate as those producedby some 200 economists at the Fed, according to his publishedpaper.

Human Superiority

``That was widely regarded as a successful piece ofempirical work,'' says Princeton economist Mark Watson, a pioneerin the field. Bernanke, 52, also found that computers have their limits.As part of his research at Princeton, he ran a program to seewhat would have happened if a computer had set monetary policyfrom 1987 to '98. Forecasts from Bernanke's factor model were fed into theprogram, which adjusted rates based on certain rules. The result:Inflation and unemployment fluctuated by larger amounts than inreal life, proof that Fed officials are better than software atmaking calls on interest rates. ``We find this evidence for human superiority comforting,''Bernanke wrote. Columbia professor Edmund Phelps, winner of the 2006 NobelMemorial Prize in Economic Sciences, agrees. ``There's going tobe a huge element of uncertainty left that is not captured by thecomputer models,'' Phelps says. ``Now is a time when therehappens to be an unusual amount of uncertainty.''

Betting Against Recession

In February 2006, when Bernanke became Fed chairman, theeconomy was speeding ahead, expanding at a 5.6 percent annualpace, and inflation was holding steady. He gained credibility byhalting the two-year run of interest rate hikes in August asgrowth started to slow. Now, he faces a more daunting set offacts: A plummeting housing market has raised the specter of arecession while inflation has nudged up. Economists aren't providing much clarity. Their predictionsfor 2007 are sharply divided compared with their earlier callsfor 2006. JPMorgan Chase & Co. argues that inflation will spurbenchmark rate increases up to 6 percent. Goldman Sachs GroupInc., taking the opposite position, sees the distinct possibilityof a recession and rate cuts to 4 percent. According to themedian forecast of economists in an October-November BloombergNews survey, officials will lower rates by half a percentagepoint to 4.75 percent in 2007.

Worst Over?

The Fed is betting against a recession even after theeconomy expanded at an estimated pace of 1.6 percent in the thirdquarter. The central bank has held its rate at 5.25 percent sinceJune, hoping that growth is slowing just enough to bringinflation down to about 2 percent or lower. The drop in crude oil prices from July's peak of $78.40 abarrel and higher stock prices may provide a cushion for theeconomy, says former Fed Governor Laurence Meyer, now vicechairman of St. Louis-based Macroeconomic Advisers LLC. ``Theworst may be behind us,'' concurs New York-based Neal Soss, chiefeconomist at Credit Suisse Group. ``Consumer outlays have beenvery strong.'' Housing is a dark cloud in the calculations of othereconomists. Goldman Sachs says a recession is increasingly likelybecause this housing slump is worse than the last two, in 1995and 1998-2000. New single-family home sales fell 23 percent inthe third quarter, and the housing market has yet to hit bottom,says David Rosenberg, chief North America economist at MerrillLynch & Co. ``The chance of a recession is a coin flip rightnow,'' Rosenberg says.

Hard Time

The Fed isn't any better at GDP predictions than privateeconomists, though it does outperform them on inflation,according to research by the Federal Reserve Bank of St. Louis.``Economists have a hard time forecasting turning points,'' Fedeconomist William Gavin says. Factor models, which run on a basic desktop computer, mayhelp officials with those twists and turns in GDP, inflation andemployment. ``It makes it easier to see margins on which we couldimprove our reading on the ongoing state of the economy,'' saysJeffrey Fuhrer, research director at the Federal Reserve Bank ofBoston. The models emulate in a way how Bernanke's predecessor, AlanGreenspan, discerned economic trends from reams of data, saysPrinceton's Watson. ``Greenspan was someone who had greatintuition and understanding about the economy,'' Watson says. The central bank won't say when its factor model will beused to help set policy. For now, Bernanke will have to rely onhis old tool kit to try to avert runaway inflation or recession-- whatever the case may be.

Goldman warns!

The risks for the Turkish Lira appear very skewed to the downside at current exchange rate levels. This doesn't mean we expect a mini-crisis like in Spring, but the potential for some TRY depreciation now appears larger than the carry gains on a tactical trade.
The general environment for EM assets appears to offer limited upside given current valuations. As Mike Buchanan and Salman Ahmed pointed out in their Global Daily this morning, a moderate deterioration in the US and global growth outlook could make current EM valuations look stretched. Yesterday's release of the latest reading of our Global Leading Indicator also points to further slowing in global growth momentum. Most recent data releases from around the globe confirm the idea of gradual slowing cyclical momentum. Most EM assets have ceased to strengthen since the middle of the week, while country specific factors have led to some weakness as in the case of Mexico (falling oil prices).
On the domestic front, Turkey continues to be exposed to significant tension in the external accounts. While the current account continues to deteriorate (our latest estimate for 2006 is 8.3% of GDP), strong speculative inflows have - so far - helped finance the deficit. These have been attracted partly by high local rates and the generally favourable environment for carry trades recently. However, our Yield Outperformance Slice indicates that carry trading has become less profitable recently with zero total returns since late October. Deteriorating performance of global carry trades could make it considerably more difficult to finance the Turkish the current account deficit. It is also worth pointing out that the TRY remains substantially overvalued according to GSDEER, and therefore any attempts to correct external imbalances through slowing domestic demand will remain an uphill struggle for the Central Bank. It may well be related to this factor that the Central Bank on Monday started again to buy foreign currency in daily operations against the TRY (up to $900mn per month) - another factor limiting the upside potential for the TRY from current levels. On the other hand, it is clear the TRY would have to weaken substantially before the CBRT would intervene to support the Lira.
Finally, there remain questions about the political outlook. The EU's Cyprus decision is due next month. And significant uncertainty and risk still surrounds next year's general elections and the question of who will become the next President.
Overall we think the downside for a long EUR/TRY trade is limited at these levels and it makes sense to pay the carry with most factors suggesting more weakness in the not-so-distant future.
Go long $/TRY with a 1-day stop on a close below 1.4300.

Julian Barrowcliffe's AnglianCommodities Fund exited the natural gas market almost a year before Amaranth Advisors LLC

Julian Barrowcliffe's AnglianCommodities Fund exited the natural gas market almost a yearbefore Amaranth Advisors LLC, another hedge fund, was destroyedby plunging energy prices. Barrowcliffe steered his $497 million fund, operated byVegaPlus Capital Partners Ltd., to metals. That helped produce a22 percent gain in the 12 months through October, according to aletter sent to investors in the New York-based fund. The GoldmanSachs Commodity Index has lost 14 percent over the same period. Like Amaranth, whose demise cost investors $6.5 billionafter a bad bet on differences in natural gas prices, Anglianinvests using a so-called relative value strategy. It attempts toprofit from price discrepancies between commodities, markets,delivery dates and locations. ``We decided natural gas was rather hot to handle,''Barrowcliffe, 44, said in an interview from the London offices ofVegaPlus. ``It seemed to us that there was a huge amount of moneychasing returns in the North American natural gas and power spaceand everyone was tripping over each other.'' Demand for commodities from China, where the economy hasexpanded 10 percent in each of the past five years, has helpedfuel prices for oil and raw materials, giving investors such asBarrowcliffe opportunities to exploit price differences. Metals have been the best commodity performers this year.Nickel and zinc have more than doubled while copper gained 55percent because of production shortages and worker strikes. ``The price moves clearly helped to create the anomaliesthat we were targeting to exploit,'' Barrowcliffe said.

Booms and Busts

No matter how a fund chooses to balance its commodityholdings, using a relative value approach is never risk-free,said Matthew Evans, who advises companies on commodity-riskmanagement at NERA Economic Consulting in New York. ``History tells us that commodity markets, particularlyenergy, are cyclical and prone to booms and busts,'' Evans said.``We have seen that price relationships can blow up, very quicklyand very decisively.'' Barrowcliffe so far is beating his declining benchmark indexwith consistency during some of the toughest times forcommodities investors. Anglian gained 11 percent in the third quarter, during aperiod when the Goldman Sachs Commodity index of 24 commoditieslost investors almost 16 percent. In September, as Amaranthcollapsed, Anglian returned 3.1 percent, according to the fund'sinvestor updates, compared with an 11 percent drop for theGoldman index.

Futures

Hedge funds, which manage $1.3 trillion worldwide, areloosely regulated pools catering to wealthy investors andinstitutions, and invest in a range of assets to profit whethermarkets rise or fall. About 8,000 hedge funds trade globally,based on estimates from Hedge Fund Research Inc. in Chicago. Like most hedge funds, VegaPlus doesn't disclose detailsabout the weight of various holdings in its funds. The Anglianfund, which has increased 8.7 percent this year, instead tellsits investors how each holding has affected returns. Metals holdings have returned 16 percent a year sinceAnglian was founded in 2004. Reducing power and gas holdingshelped the fund mitigate annual losses in those commodities to 5percent, according to reports to investors. Natural gas has beenthe worst-performing commodity this year, plunging 60 percent asinventories rose. Anglian also buys and sells commodity futures ranging fromgold to cattle by using computers to help decide when to investabout 25 percent of the fund. Futures are contracts to buy orsell a commodity on a specific date at a preset price.

Price Discrepancies

The fund invests up to 15 percent of its capital in energy,mining and shipping companies, as well as utilities, according tothe marketing documents. As many as 24 out of 100 commodity hedge funds followrelative value strategies, according to Rian Akey, chiefoperating officer of Chicago-based Cole Partners LLC, whichinvests in commodity funds. The remainder uses a mixture of thatstrategy and so-called directional trading, which involvesbetting on prices rising or falling, he said. Spotting relative value differences is Anglian's advantageover traders of so-called physical commodities, who are better atanticipating price movements, Barrowcliffe said. The strategyinvolves trading on price discrepancies, for example, betweencrude oils in different markets, such as West Texas Intermediate-- the U.S. benchmark -- and Brent in the North Sea.

Looking for Wrinkles

``We look for wrinkles in the markets,'' he said. ``I amtrading against guys with storage terminals, tankers, refineriesand who have government relationships. I had to find somethingthat they didn't do. I try to find ways of trading that didn'tfocus on day-to-day price moves.'' Barrowcliffe himself started out in 1985 as a crude oiltrader at Shell International Trading Co. and later headed globalenergy-trading desks at Merrill Lynch & Co. and Bank of AmericaCorp. Born in Peterborough, U.K., he graduated from LoughboroughUniversity with a bachelor's degree in business administrationand French. The Anglian hedge fund, named to refer to ``old England,''was started by Barrowcliffe with money from Madrid-based VegaAsset Management LLC. Vega Asset Management then spun offVegaPlus, which has $2.5 billion in assets, including the Anglianfund. Vega Asset Management also runs Vega Select Opportunities, ahedge fund whose investors sought to pull about $400 millionafter it fell almost 11 percent in September. Vega AssetManagement's capital now accounts for only 2 percent of theAnglian fund, according to an investor letter.

Shifting Risk

Barrowcliffe operates from what he describes as a ``roomwith a bunch of screens and money,'' in contrast to physicalcommodities traders who get access to information on underlyingassets such as shipments or refineries before other traders. Hisfive-person team includes Uday Narang, previously Europeanpresident of Entergy-Koch LP, and Toly Spheeris, who co-foundedGreenwich Energy Partners in 2002. Shifts in Anglian's portfolio are indicated by the fund'sreports on value at risk, or VAR, which investors use to measurethe potential a company or fund may lose on a given day. Formetals, the fund's VAR rose to 0.35 percent from 0.09 percent,according to a letter sent to investors. The fund's VAR innatural gas was cut to zero from 2.3 percent in the past year. Funds that were less prescient paid the price. The plunge ingas prices also led to the closure of MotherRock LP, a $400million New York-based hedge fund, in August. While Barrowcliffedeclined to comment on failed funds such as MotherRock orAmaranth, he said that having a nose for gas trends has so farvindicated his strategy. ``You had a lot of people throwing lots of money at naturalgas, drawn to the volatility,'' he said. ``There's volatility andchaos and there's a fine line between the two and if the marketis teetering on the brink of chaos you might not want to bearound for it.''