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.

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

Flaws of Fund Manager Regulation – the 5 points you should know… Radio Clip

“The text is not perfect but texts are never perfect.” (MEP Jean-Paul Gauzès at a press conference in Brussels, October 2010)

Follow the link below to hear a 1.5 minute radio clip of my views on the The Alternative Investment Fund Managers (AIFM) Directive – Regulatory Standards for the industry. As you can hear from the intro, it was broadcasted on “The N@ked Short Club” on Resonance FM (2m+ listeners and growing!). Follow-on comment by Sophie van Straelen, Managing Partner of Asterias – check out her blog SVS. My main concerns are highlighted below.

1. FALSE IMPRESSION OF OVERSIGHT

2. COSTLY – Increased compliance costs (+32%) – passed on to investors – higher fees lower returns – reduce European competitiveness and leave. Already hearing about delayed launches. Could boost rather than end offshore – may lead to costly changes of legal structures and domicile.

3. REDUCED INVESTOR CHOICE – restrictions on those based outside the EU

4. MAY TRIGGER PROTECTIONISM, such as the US. Contradiction to conclusion from the April G20 summit, instructed world leaders to “promote global trade and investment and reject protectionism.”

5. INDISCRIMINATE – including small AUM funds and others of no relevance to stability of financial system or ‘systematically important’ funds – contradicting EU principal of ‘proportionality’); multinationals exempt – making others uncompetitive – costs do not match benefits for certain funds

BOTTOM LINEA SIGN OF A MORE INTRUSIVE REGULATORY REGIME – start forming a plan of action ahead of 2103 implementation (not carried out by enough yet)

Worth Remembering:

The Swedish Central Bank (The Riksbank) says of short selling:

“The benefits of short selling clearly outweigh the drawbacks. Short selling allows investors with a negative view on the value of a company to take a position that reflects that view. By doing so their information will be incorporated in the prices and thus, the price formation will be more efficient.” (June 09)

How to play the Bond Markets

“Our lives are defined by opportunities, even the ones we miss” (F. Scott Fitzgerald)

I think the above title is apt for much of life, including the investment world, and the credit crisis was one such opportunity which served to make or break many mangers out there. A “broad-based” bet on parts of the fixed income asset class was enough to extract alpha. Now things are slightly trickier…

Investing is no longer a call on the asset class alone, but rather an emphasis on specifics is coming more into play.  Spreads have narrowed, from their historically wide levels (see chart below from an excellent fellow blogger the Calafia Beach Pundit, Scott Granis, the former Chief Economist at Western Asset Management and Seeking Alpha certified) but Corporates are focused on managing and strengthening their balance sheets. Differentiation in returns can be seen between sectors and between names. Thus, the key going forward is credit selection and a focus on quality.

I remain cautious on the high yield space, concerned with the possibility of the default rate coming in higher than expected and with lower levels of credit available to struggling companies, the recovery rate disappointing on the downside. This again highlights the importance of being name specific when investing. With spreads narrowing as far as the above chart shows, the risk / reward profile of this part of the asset class is not as attractive.

INVESTMENT INSIGHT: Be name specific, focused on high-quality companies with strong balance sheets

 


A Sustainable Recovery? “What’s driving the markets and how should I invest?”

The recovery is “neither strong nor balanced and runs the risk of not being sustained,” (Olivier Blanchard, the IMF’s chief economist)

INVESTMENT INSIGHT: Closely monitor the economy/markets – look to exploit overreaction on the downside, but with protection against future market pullbacks (E.g. via managers able to short / hedge exposures quickly).


Highlights

SENTIMENT DOMINATES: Markets driven by sentiment, cash on sidelines desperate to be invested

STIMULUS TO DECREASE: Earnings growth driven by cost cutting (a limited stimulus), to fall

INVEST WITH PROTECTION: Investing but with downside protection

 

Answer

The aggressive fiscal policies we have seen and the possible stabilisation or even turnaround in some data points have given fuel to the bullish. Nevertheless, with markets rallying so far from their lows, strongly driven by sentiment and perhaps ahead of fundamentals with investors focused on good news only, the possibility of a pullback is even higher. The market is moving from pricing in stabilisation to looking for a sustainable recovery, which is very risky. Further support for the possibility of a pullback comes from the fact that the rally which took the market to its current level, from March to year end last year, was arguably a low-quality, high beta and short-covering rally driven by discretionary consumer names which should be the most negatively affected in a recessionary environment (see charts below). Notice that since this point, the World Equity Index is flat, but the sector disparity has continued to widen. Nevertheless, I am also aware that there is plenty of cash on the sidelines and many managers judged against a benchmark cannot afford to miss out on another rally.

MSCI World Index +73% since 2009 low. Source: Bloomberg

During the 2009 equity market rally, the MSCI World Index (white) appreciated in value by ~70% from March low to year end. US Consumer Discretionary (orange) rallied ~90% whilst Consumer Staples (yellow) rose ~41%. Source: Bloomberg

What drove this rally? Markets rallied on better-than-expected corporate earnings but

  1. analyst estimates were so low that companies were bound to beat them;
  2. they were driven by cost cutting which companies cannot continue indefinitely;
  3. there has been talk of a “new normal” with growth in earnings reaching only 3% instead of the 5% we have been used to (Bill Gross)[1]

Bill Gross cites a move to a high persistent level of unemployment as support for his view. With lower income, higher savings, rising foreclosures and a credit restraining banking system, there still remains a strong case for the Bears to cling to. Across the “Pond”, the fragility of the UK market was highlighted when the BoE unexpectedly announcing massive expansion of quantitative easing program back in May of last year.[2] Many are now focusing on the possibility of a “double dip”, questioning how governments will be able to exit from their fiscal stimulus programs without dragging a muted recovery back into recession. This is before we discuss Europe which is widely believed to make a slower exit from the crisis.

US Unemployment Rate (%) at a heightened level. Source: Bloomberg

President Obama himself was given a stern warning from investment guru Warren Buffett about the severity of the situation. “He said, ‘We went through a wrenching recession. And so we have not fully recovered. We’re about 40, 50 percent back. But we’ve still got a long way to go’,” (Obama, July 2010)[3].

The situation remains unclear. At present there is enough data out there for Bulls to find reasons to be bullish as well as enough for Bears to find support for being bearish.

 

INVESTMENT INSIGHT: Until clarity returns, continue to closely monitor the situation to look for good entry points to exploit overreacting on the downside, but with the ability to protect from future market pullbacks (E.g. via managers able to short / hedge exposures quickly).