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Doug Kass: 15 Surprises for 2013

Surprise No. 4: A tax on securities transactions is instituted in exchange for an increase in Medicare eligibility -- its implementation has broadly negative ramifications for financial stocks and hedge funds.

  • Financial stocks underperform and miss profit forecasts.
  • The transaction tax forces a further consolidation in the hedge fund industry.
  • Hedge fund fees decline.

"Speculators may do no harm as bubbles on a steady stream of enterprise. But the situation is serious when enterprise becomes the bubble on a whirlpool of speculation."

-- John Maynard Keynes (when he first proposed a securities transaction tax in 1936)

In conjunction with Congressional Democrats (and in exchange for an increase in Medicare age eligibility), Senator Elizabeth Warren spearheads a successful campaign to force the House to introduce a financial transaction tax attached to all securities trades. The legislation is sold to Americans (and to the Republicans) as a way to:

1. curb market volatility;

2. reduce the disruptive role of high-frequency trading on the markets; and

3. increase tax revenue.

The ramifications of this tax are broad -- financial stocks suffer, and the hedge fund industry retrenches, consolidates and lowers fees.

The implementation of a financial transaction tax, weak capital markets, reduced merger and acquisition activity, continued pressure on net interest margins and poor loan demand lead to well-below-consensus bank and brokerage industry profits and underperforming stocks.

In 2013's macro-driven market, correlations remain at historically high levels (see below), rendering excess return generation hard to deliver by the hedge fund community. Moreover, the implementation of a financial transaction tax pressures trading-based and high-frequency-trading hedge fund strategies to close, and nearly one third of the existing hedge funds close shop in 2013.

As pressure on returns intensifies, a large institutional manager introduces a menu of low-fee hedge funds that further accelerate hedge fund closures. Hedge fund management fees move toward 1% (or lower), and performance fees move toward 10%, as the industry begins to resemble the traditional money management industry.

Several large hedge funds lower fees and structure fees to more resemble Warren Buffett's hedge fund in the 1960s, which charged no management fee but took in 25% on performance above a 6% threshold return.

Strategy: Short Financial Select Sector SPDR (XLF) and GS.

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