Month: June 2011

How to handle hedge fund investing

Whilst at GAIM, the world’s largest alternative investment & hedge fund conference, it was hard to ignore both the issues the hedge fund industry face and the opportunities from which they can profit. So how can you, as an investor, handle hedge fund investing? Be strategic, be sensible and speak up….

Fees – How can you challenge them?

Bigger isn’t always better. Instead it was the larger funds that had trouble liquidating large positions to meet redemptions in 2008 and this was amplified in Fund of Funds structures. The resulting side pockets and gates, which locked up investor capital, burned bridges. Therefore, funds merely offering access to large ‘star’ fund managers with limited attention to downside and liquidity risks no longer appear to be as wise an investment as once perceived.

A due diligence downfall.  Some funds of hedge funds had exposure to Madoff and other hedge fund failures. Therefore, ‘outsourcing’ hedge fund investment to a dedicated fund manager did not always reduce risk.

Strategy choice – Does it matter?

A ‘typical’ hedge fund does not exist. A hedge fund index is an artificial averaging of a wide range of performance data. In fact, over the past 2 years, the best performing hedge fund strategy has generated 160% more return than the worst. Yes, 160%! Even year to year the rankings change. By investing in completely different assets, implementing vastly different investment processes, hedge funds can perform in entirely different directions in a variety of market conditions.

Source: Hedge fund strategies ranked by performance each year, showing the variability in strategy leadership.

Value – How can hedge fund investments benefit your portfolio?

Well-equipped. With doubts over the sustainability of the ‘recovery’ in the developed world shaking equity markets; turmoil in the middle east creating volatility in commodities and the sovereign debt crisis rocking the bond markets, having a wider range of tools to exploit the uncertainty is valuable

A diversifier.  Widespread fear and the increase of speculators in certain markets has resulted in heightened correlation between asset classes, for example, equities and commodities have been moving inline…. An active manager who can provide uncorrelated returns to diversify a portfolio and steady the return profile again is attractive

Differentiating. In contrast, correlations between investments within each asset class are falling. The FT recently reported that the correlation between stocks in the S&P 500 index has fallen to levels not seen since June 2007. This means there is a widening divergence between returns.  Therefore, the ability to differentiate between opportunities within a subset is a strength of active over passive investing.

So what can you do?

Be strategic: strategy choice matters so utilize your views on the macroeconomic environment to help determine which strategies in which to invest

Be sensible: ensure funds deserve the fees they are charging, e.g. are focused on portfolio construction, generating returns from niche strategies, and structured appropriately with the redemption frequency matching the liquidity of the underlying investments.

Speak up: it is as important for BOTH sides to manage expectations to avoid redemptions from investors, and side pockets from funds.

The Greek Tragedy: Could a ‘Haircut’ Help?

Debate has been raging as to whether the Greek economy can avoid bankruptcy. Just how big is the problem, what are the options and how is this impacting financial markets? 

Background to the Problem

Greece is around €300bn in debt. Putting that into context, its budget deficit is one of the highest in Europe and last year amounted to more than four times the Eurozone limit at 13.6% of GDP. This more than supports the country’s inclusion in the infamous ‘PIIGS’ acronym (Portugal, Ireland, Italy, Greece and Spain) used to refer to the areas of sovereign debt concern.

What’s Going On?

Despite the jobless rate reaching 16% (and a horrific 42.5% for youth), the Greek economy has seen only marginal deleveraging. Instead, people are depending on consumer credit to maintain their levels of expenditure and service their debts (i.e. paying credit card bills with other credit cards). Moreover, whilst many in the UK struggle to obtain loans from banks, the overall banking sector in Greece actually increased their credit availability, with the most significant increase going to the government itself.

Attempted Solutions

Last Thursday, Jean-Claude Trichet, President of the European Central Bank, announced that they would lend Greece €45bn in new loans. However, this alone, they acknowledge, is not enough. The ECB wants to see structural reforms and a good deal of privatization, with the claim that €50bn could be generated over 3 to 5 years to reduce debt/GDP from 160% to 140%.

What are the Complications?

Loans to ‘bailout’ struggling countries are partially funded by taxpayers from different countries within the EU. Therefore, the problem is not an isolated one. Furthermore, even after this loan and the privatization contributions, there will be a financing gap of €170bn between 2012 -14 which will need filling. European banks have to refinance €1.3tn maturing debt by end 2012 and are owed over €200bn already by the PIIGs for refinancing ops.

Could a Good ‘Haircut’ Help?

With so much talk of a ‘restructuring’, i.e. bond holders sharing some of the pain, it is interesting to hear the views of Lorenzo Bini Smaghi, an ECB executive board member on the subject. He maintains that these are not the tools by which Greece can save its economy but could cause a “Depression” and “banking system collapse”. Furthermore, those pointing to a compromise of a voluntary or ‘soft’ restructuring appear to be fooling themselves. According to him, there is “no such thing as an ‘orderly’ or ‘soft’ re-structuring” since ‘haircuts’ (a percentage knocked off the par value of a bond) would have to be forced by governments. Crucially, any type of restructuring would cause a panic in the markets and cause credit events reducing the value of these investment vehicles either way.

Yield on a 10 year Greek Government Bond (Orange), 10 year German Government Bond (white) and the spread between the two (yellow) - showing the higher premium demanded by investors for holding Greek debt, near historical highs - highlighting a heightened risk perceived by the markets.

So, What Are the Options?

As previously mentioned, a default on some of its debts would have dire consequences but the prospects for sustainable financial solvency appear weak with such a substantial deficit and the habits of borrowers and lenders not much improved. Most worrying, from the perspective of European stability is the recent comments from a Greek EU Commissioner that “The scenario of removing Greece from the euro is now on the table”. Therefore, although in stark contrast to statements by Greece’s Prime Minister and with France and Germany still heavily exposed to EU laggards, which together make a break up of the euro unlikely in the short-term, it is a fear weighing on investors minds.

How are the financial Markets Reacting?

Risk aversion is back on the rise. Investors are worried and, understandably, demanding higher premiums to lend to Greece. That’s not all. Other markets are suffering. “All sophisticated indicators of systemic risk, cross correlations of CDS and yield spreads show a high sensitivity to restructuring moves and are at levels higher than in September 2008”.

The Investment Insight: What Can You Do?

This has two consequences. Firstly, investors should be more cautious of an indiscriminate sell-off but secondly, this can be used as an opportunity to pick up high quality assets at a lower price. Be wary but remain opportunistic.