Hedge Funds

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: http://www.advisoranalyst.com. 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.

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Hedge Funds – to be Feared or Favoured?

As the biggest hedge fund insider trading case comes to a close, we are reminded of the risks of investing in the asset class. Ever since generating losses in 2008, the reputation of these ‘absolute return’ vehicles has been damaged. The Madoff scandal which topped off the year did not help. Nevertheless, whilst clarity in the markets remains illusive and with a wider range of tools to exploit opportunities, are they a form of investment to be feared or favoured?

A Tainted Asset Class

Disappointed and disillusioned, many investors are reluctant to revisit the asset class run by managers once hailed as the new “masters of the universe”. Sold on the promise of generating positive performance in any market environment or at the very least preserving capital in times of stress, losses generated in 2008 came as a shock. With the Madoff scandal came the realization that even funds that did consistently generate steady returns were not immune to trouble. There is even an aptly named “Hedge Fund Implode-o-Meter” website tracking the number of major funds which have “imploded” since late 2006 (out of interest the number at last look stands at 117, although this includes all funds suffering any form of “permanent adverse change”, not just total shutdown).

But Not All Are Created Equal

Not all hedge funds should be tarred with the same brush and although grouped within the same category, they can differ tremendously. From the investment vehicles in which they invest to the stringency of their risk management, not all are created equal. The Hedge Fund Association summed the situation up succinctly with the assertion that “investment returns, volatility, and risk vary enormously among the different hedge fund strategies. Some strategies which are not correlated to equity markets are able to deliver consistent returns with extremely low risk of loss, while others may be as or more volatile than mutual funds.”

Losses Were Often Greater Elsewhere

Putting aside the often misleading ‘absolute return’ banner, the average hedge fund was better able to preserve capital through the market downturn than a regular ‘long-only’ mutual fund. Whilst the MSCI World Index fell 42% in 2008, the Credit/Suisse Tremont Hedge Fund Index fell 19%, More impressive still were the 21% of funds which posted positive returns for the year (the majority of which were up double digits). Crucially, over a more appropriate investment horizon of 3 years, according to figures by EDHEC Business School, “The majority of hedge funds delivered better returns than the S&P 500 index”. Hedge Funds have shown themselves able of generating highly attractive returns.

The Tide Has Changed

Investors have demanded more. In 2008 they ‘spoke with their feet’ and the hedge fund industry suffered $782bn of redemptions. The Hedge Funds had to listen. What was requested, according to a report by Scorpio Partnership, was “transparency, simplicity and liquidity”. Likewise, the Hedge Fund Scandals were a wake up call to investors and much more focus is being placed on operational due diligence, to avoid investing in any future hedge fund failures.

Investment Insight: Well-Positioned to Exploit Opportunities

With the risk of future macro shocks clouding the horizon (read: Japan, Middle East, EU Sovereign Debt), the direction of the markets is somewhat hard to predict. Therefore investing with flexible managers able to react to the quickly changing environment and nimble enough to exploit opportunities when they present themselves seems an attractive move. Not all investments are created equal, some are more equal than others.

The next Mis-Conception: UCITs

Always be a first-rate version of yourself, instead of a second-rate version of somebody else.  ~Judy Garland

The success so far of the UCITS framework (Undertakings for Collective Investment in Transferable Securities) cannot be under-estimated, with approximately €5.6 trillion raised from investor appetite and set to continue to rise. However, the risk lies once again in misleading investors and storing up the potential for disappointment further down the line. The appeal from both sides is clear – the promise of increased liquidity, transparency and regulatory oversight for investors creating enough demand to incentivise managers to set up such vehicles. But question marks have been raised over whether they can deliver and the suitability of such a structure to all the many different types of funds.

Areas of Contention

Replication: As we’ve seen recently, with the closure of BlueCrest’s Blue Trend UCITs Fund, the restrictions in place to comply with the framework do not allow a full replication of trades the offshore fund is implementing, leading to a widening tracking error and investors perplexed at why they are not getting the same returns.

Liquidity: A potential liquidity mismatch with underlying investments – even if not obvious now, to become apparent during periods of market stress. The high frequency redemption terms may not be able to be met – which would bring the very classification into repute.

Costs for Fund Managers: Compliance with the regulations involved may involve higher structural costs an concern has been raised over whether higher costs may translate into lower returns for investors

INVESTMENT INSIGHT

If you are allowed the luxury of being able to invest where you please, then it may be advisable to not become “UCITs-blinkered”. Being structurally AGNOSTIC can allow for the discovery of superior risk-adjusted returns, net of fees. Remain open to opportunities.

With algo’ trading and the weight of passive “on-off” money in the markets, how can judgmentally driven hedge fund managers compete? Radio Clip

“We will never have all the facts to make a perfect judgement, but with the aid of basic experience we must leap bravely into the future” – Russell R McIntyre

Click to listen to a ~1 minute clip of my views from the “N@ked Short Club”, Resonance Fm… The main points are highlighted below.

CONTEXT – A MARKET TREND

  • 1w late May this year ~60% of trades on NYSE were down to high frequency and algorithmic traders
  • Beginning of this month the ISE announced: opening up to algorithmic trading
  • Result – will account for an increasing share of trading volumes on EM exchanges & beyond

ASSESSING THE DISTINCTION – Algo trading vs. judgement driven

  • Humans are responsible for writing the code that identifies anomalies in stock prices
  • Based on assumptions about what a hypothetical efficient market should look like
  • Still at risk of errors – bugs in these systems – Flash Crash – May 6, 2010 when the markets crashed by 573bps in 5mins (a large order by broker via algo program was identified as the probable tipping point) but recovered fairly quickly- CFTC*/SEC says that early sell pressure was absorbed by algorithmic and high frequency traders – evidence of adding significant liquidity – beneficial (*Commodity futures trading commission)

AT RISK OF TRADING RESTRICTIONS? JUST THE REVERSE!

  • The SEC is considering a requirement that high-frequency traders keep buying and selling shares during periods of stress, instead of abandoning the market.

BOTTOM LINE – Judgment driven strategies retain their use.

  • NOT ENOUGH TO MAKE MARKET EFFICIENTstill opportunities / inefficiencies to exploit.
  • TRENDS BREAKDOWN – when do – it’s opportunistic players w uncorrelated returns that save a portfolio.
  • UNCERTAIN TIMES the flexible players willing to adapt to their judgment calls benefit

The Problems of “Absolute Returns”

“How often misused words generate misleading thoughts.”   Herbert Spencer (British social Philosopher, 1820-1903)

When it comes to discussing hedge funds, the quote above rings true. Mis-sold and mis-understood, investors have been left disillusioned. Marketed as being able to generate “absolute returns” in all environments, and tarred allwith the same brush in a “one size fits all” sell, appropriateness was often overlooked. All the catchy phrases and vague promises have mis-managed investor expectation and clients spoke with their feet. As we look to the future, with the next generation of “more highly regulated funds”, we must be wary to not fall foul of over-promising and under-delivering…

Common Misconceptions:

1. “Shorts” as a means of risk-reduction to balance “long” exposure vs. ability of funds to be hurt on both the long and short side together due to e.g. unexpected deal surprises. For example, in late October 2008 hedge funds lost £18bn in two days of trading due to a costly short call. Managers had bet on VW shares falling because of the global economic downturn but once Porsche revealed they had been secretly building their stake to a controlling share, they scrambled to cover their positions.

2. If so-and-so are investing, then sufficient due diligence must have been carried out”. Just take the Madoff ponzi scheme – half of UBP’s 22 fund of funds invested, HSBC provided finance to clients who invested, many successful individuals invested large amounts…. It comes back to the basic tenet – “Never invest in a business you cannot understand “ (Buffett)

3.  If I get nervous, I can always take my money out. Following on from point 2, without investigating a fund – the liquidity of its underlying investments, the commitment of major shareholders etc., many were shocked when fund of funds, in particular, implemented side-pockets and gates to limit the amount a client could redeem.

4.  “Larger funds are always safer” In actual fact it was many of the larger funds that found it hard to meet redemptions – needing to liquidate a larger amount in the market and slower to implement changes in strategy as markets sold off back in 08. Instead it was the smaller, more nimble players that were able to adapt quicker to navigate the markets better, and able to meet redemption requests more easily and avoid having to implement side-pockets or gates.

5. “Paying an extra layer of fees is worth the diversification benefits of a fund of funds investment – although still true in some instances, many fund of funds are merely “best of breed” funds with less emphasis on portfolio construction and therefore less of an uncorrelated nature. In addition, those that paid less attention to the liquidity of their underlying funds were squeezed when these funds gated whilst they were receiving redemption calls.

What can we do with this information?

1. More accurately assess the risk profile of a hedge fund investment, size and position allocations accordingly

2. Ensure a full due diligence process has been carried out

3. Assess the liquidity of the assets the fund is investing in and interview large fund shareholders – a managed account is not always necessary, the emphasis should be on appropriateness – daily liquidity is suitable for a large-cap global equity fund but a more private equity-type fund could suffer from too much focus on managing flows than managing the money itself.

4. Look for the sweet spot that exists at the point when a fund’s running costs are comfortably covered and there are low operational concerns, whilst the manager still has the hunger to perform before becoming complacent and managing more than he is best at handling.

5. Watch the correlation of the fund to other parts of your portfolio and to the managers within the same asset class to ensure sufficient diversification benefits – mitigating some of the volatility for steadier returns.

MANAGE CLIENT EXPECTATIONS

Hedge Funds – The Root of All Evil?

“We cannot forget how in 1997-98 American hedge funds destroyed the economies of poor countries by manipulating their national currencies.” – Dr. Mahathir Bin Mohamad, (former Prime Minister of Malaysia, during the emerging market crisis).

The Hedge Fund industry has come under major scrutiny in the past few years. Blamed for stock market crashes, manipulating the markets and threatened with a ban on short selling, if a scapegoat was needed, they were ‘shortly’ targeted (!). Chargers of high fees and notoriously opaque – people naturally fear the unknown, and an expensive unknown even more so. Nevertheless, as Richard Wilson pointed out in his blog – back in 2007 the head of the Financial Services Authority (FSA) said that:

hedge funds were not the catalysts or drivers of (that) summer’s events.”

Hedge funds trading in the financial markets can increase liquidity and aid price formation. Jed Emerson wrote a great piece at the end of last year taking he argument away from a debate between “good” and “evil” and instead concluding:

“fundamental fund of hedge fund investment strategies, when managed appropriately, may represent an emerging though as yet not realised opportunity for investors to pursue both full,  commercial  rate  returns  and  affirm  relevant  aspects  of  Sustainable  investment practice.”

Although I question the assertion the fund of hedge funds industry is emerging – since in some cases it seems to be retracting, I agree they offer an opportunity for returns and the claim of affirming sustainable investment practice balances the opposition’s argument.

What seems to be a rarely discussed topic is the value the industry provides the wider economy, outside the financial markets. Below I highlight some impressive information, sourced from a great article by Open Europe….

BOTTOM LINE: Job and tax contributions should not be under-estimated.

Benefits of PE / HF Industry to EU Economy

  • Contributed ~ 9 billion (£7.9 billion) in tax revenues in 2008 – could fund the EU’s overseas aid budget for twelve years, or the regional budget for Poland,
  • Directly employ 40,000 people in the EU – 18,000 of whom are employed in the UK (before taking those involved in real estate funds or dependent on the industry)

Benefits to UK Economy

  • €6.1 / £5.3 billion tax income raised in the UK alone
  • Enough to pay for over 200,000 nurses or 165,000 teachers.
  • Tax revenues generated over 2 years could pay for the entire 2012 London Olympics.
  • If the revenues were lost, would take 20% increase in av. council tax bill to make up

SK