Hedge Fund Performance 2009 09

Hedge funds as represented by the HFRI returned 17.01% year to date. In the same time period, the MSCI World returned 38.08% YTD. Global Bonds measured by the Barclays Global Bond Index (the old Lehman Agg) gained 8.14%, and the CRB Index (Commodities) gained 17.71%. Adding more granularity to the numbers, the volatility of the HFRI was 10.05%, the MSCI 34%, the Barclays Global Bond 5.5% and the CRB 30%.

Convertible arbitrage led the pack with a 53% YTD gain. Its not clear what the arbitrage is. Rising equity markets, tightening credit spreads and renewed issuance are driving long only performance to an extent that sidelines the need to hedge. And with the numbers, its not clear how much hedging is going on. Recent performance, 1 month and 3 month has been consistently robust.

Emerging market funds also performed well with a 34% YTD return. Given the performance of Asia and LatAm, its not surprising that these funds have done well. An accidental net long bias would quickly have turned into a windfall profit.

Equity hedge has done well as well returning 21% YTD. Volatility has been quite high, evidence of a net long bias in aggregate as some managers chased rising markets. Equity market neutral strategies’ performance was instructive. YTD they have gained a paltry 1.5% with a volatility of 3.8%. This year’s equity market volatility, the decline in the first 2.5 months followed by the strong rebound has been characterised by liquidity, central bank policy, macro economic recovery, market psychology, and a reversal of risk aversion. So, of the non market neutral managers, how much alpha have they been generating? How much alpha could they possibly generate under the circumstances? When will it become a stock pickers market again?

Distressed debt strategies returned 21%. It is not clear if this return is due to the specific execution of the strategy or if it is a collateral consequence of spread tightening and rising equity markets on a predominantly long biased strategy. The volume of workouts is still slow compared to the acceleration in defaults. There is risk of volatility in this strategy and certainly ample opportunity for later entry points.

Event driven strategies returned 20% YTD but then event driven strategies encompass a host of strategies, so generalization is not useful.

Merger arbitrage underperformed with a 9.44% YTD performance albeit at volatility of 4.7%. Developed market deals have been patchy. Deal flow has slowed considerably, particularly in value. Apart from a few high profile deals, Cadbury Kraft, Marvel Disney, Liberty Direct, Sun Oracle, much of the action has been smaller and cross border, EM outbound. The deals done in the current environment carry far less uncertainty and risk. Risky deals are unlikely to come to market at all. While deal spreads have been wider than usual, there has been a dearth of hostile, complex deals where the returns usually come from. Leverage has also been scarce even for friendly deals. The result is lower returns but at lower risk.

Global macro, the favoured strategy at the end of 2008 for its resilience and performance in a difficult year (for everyone else), returned 4.2% YTD in a lacklustre performance. Especially in the context of a 5% volatility. This is not surprising in one sense but surprising in another. Investors chase returns. The first half of 2009 saw an increase in the number of potential start ups in Global Macro to catch the impending cascade of capital, which never came. It all ended up being funnelled into a few established, high profile, large scale funds. The glaringly easy trades of 2008 were no longer. It was to be expected that global macro would struggle. On the other hand, many interesting opportunities exist. Confused, prevaricating central banks, uncertain inflation expectations, confused, prevaricating Treasuries, a restructuring in the trading market for sovereign debt, particularly hard currency sov debt, is ideal for macro. So, why the poor performance at the aggregate level? Mediocrity. The good quality managers continue to take advantage of a very interesting macro environment.

Fixed income arbitrage has had a good year. 20% YTD. The drivers for their returns are very much related to the performance of global macro. Confused, prevaricating central banks, uncertain inflation expectations, confused, prevaricating Treasuries, a restructuring in the trading market for sovereign debt, particularly hard currency sov debt. The problem lies in the benchmark index methodology which is self reported and thus self classified. The macro index is contaminated with CTAs which sometimes classify themselves as Macro.

CTA’s have had a very tough year after a sometimes spectacular 2008. In 2009, they returned about 0% with nearly 10% volatility. I do not have the mathematical or statistical faculties to pretend to understand CTAs but it is rather disappointing to see a strategy so much in demand at the end of 2008 suddenly fall out of favour so quickly. I suppose in the absence of information, performance is the main determinant of investor demand.

On a risk adjusted basis, the MBS funds are hard to beat. 17.6% YTD with 5.6% volatility. Its hard to decline an invitation to feed at the trough filled by government monies.

Before we leave this, notice the difference in performance between HFRI and HFRI FOF. HFRI is an index of hedge funds while HFRI FOF is an index of funds of hedge funds. There appears to be a vast underperformance by funds of funds that cannot be simply explained by the additional layer of fees. Applying 1 and 10 fees on top of the HFRI still gets you to 14% YTD. The volatility of the funds of funds index, however, is 13% lower than that of the hedge funds index. If that is explained by cash, then the funds of funds index should still return around 12%. If we assume a much higher level of cash, say 24%, then we get to a ballpark of 10% YTD for funds of funds.

This appears to be what has happened. In the wake of the 2008 crisis, funds of funds raised more cash than they needed. They could not know how much cash they would need to meet investor redemptions and had to be conservative. 

All this together gives us an interesting picture of the hedge fund industry, the performance of strategies, the expectations and behavior of investors and funds of funds in their role as intermediaries and pooling vehicles.

Those of us faced with the reality of European hedge fund regulation will be familiar with UCITS III. You get points for knowing what UCITS actually means: Undertakings for Collective Investment in Transferable Securities, quite meaningless and proof positive of its European provenance.

In 2008, hedge funds lost money, on average some 20% of it in 2008. Traditional long only strategies lost about twice that but lets not split hairs. Some funds trafficking in illiquid investments when faced with high volumes of redemptions were forced to limit liquidity, gating or suspending redemptions in an effort to save their own businesses and or to save investors from selling off assets in a firesale. The need for liquidity and regulatory oversight thus brought UCITS firmly into the spotlight. Did Madoff really run a number of UCITS funds? Technically not. Madoff apparently never ran any funds UCITS or not.

In any case, in the wake of gates, suspensions, losses, regulators and investors are now looking towards more regulation. The hedge fund industry has proactively tried to head off what could be crippling regulation, first with active engagement of regulators by AIMA and the Hedge Fund Standards Board, and now with the embracing of UCITS III. Hedge fund managers have typically operated in an unregulated arena and are thus prohibited from marketing to individuals and are restricted to selling their funds to sophisticated investors such as institutional or professional investors. Naturally, hedge fund managers see UCITS as an alternative to onerous hedge fund regulation.

UCITS III, implemented in 2007, represents the third incarnation of the original UCITS directive which emerged in the mid eighties. This latest iteration is less restrictive than the original directive and allow managers the flexibility to use derivatives up to 100% of NAV for more than just efficient portfolio management and hedging purposes, the use of leverage within funds (up to 200% of assets), the creation of fund of fund structures and the ability to market the fund across international borders.

UCITS III allows previously long only portfolio managers the scope to utilise “short extensions” through the use of listed and OTC derivatives for more than simple hedging purposes. Quite how safe this is remains to be seen. It provides managers with powers hitherto out of their reach in order to introduce greater flexibility when constructing and managing portfolios. It also provides managers with powers hitherto out of their experience to introduce greater risk if misused, even and especially if unintentionally.

There are a number of important restrictions. Portfolio managers are not allowed to run net short or outright shorts. They can’t short sell stock or write uncovered call options. They have to demonstrate that they have sufficient risk controls to monitor exposure, including the OTC counterparty risk which is limited to 10% of NAV to a single counterparty. There are risk limits based on VAR and Tracking Error to some relevant benchmark.

Importantly, UCITS III provides hedge fund managers a regulated investment vehicle which may negate the need for further hedge fund regulation. This is the main attraction as regulators tighten regulation and investors are increasingly leery of unregulated investment vehicles.

Marketing and Product Positioning:

As investors fled risky investments in the wake of 2008, it has shifted bargaining power in favour of investors away from hedge fund managers. Liquidity terms are moving to be more in line with portfolio liquidity rather than the size of the ego of the manager. Liquid portfolios are matched with liquid terms and illiquid portfolios with liquidity constrained terms. Fee compression has become more of a reality.

The knee jerk reaction to all these developments, assuming that one hadn’t disenfranchised all one’s investors and had a queue of redemptions equal to 100% of NAV, has been to:

1. Keep running the hedge fund. Improve liquidity terms if possible but certainly not to run a liquidity mismatch. Consider lowering fees or redesigning fees for better alignment and less optionality. Try to raise capital for the hedge fund.

1. Offer managed accounts.

1. Launch a UCITS III fund.

1. Think the unthinkable.

Offering multiple products is not an enterprise to be taken lightly. It is one likely to be taken lightly given the DNA of the hedge fund manager who concentrates on the management of investments instead of product positioning and pricing.

Consider this; you have a product for which demand has shrunk and margins of which are likely to come under pressure. You have the capability of offering a similar product which is currently an emerging market where pricing strategy in the industry is uncertain. The marginal cost of offering the product is low as it is effectively the same product in a different wrapper, delivered to a customer base where there is considerable overlap in one area plus a previously untapped market. The new product is highly scalable and is likely to be more of a volume driven rather than margin driven business. How should you position your products to maximize profits.

The market for your existing product is or was highly inelastic. It is likely that the market has become more price elastic. How do you position the existing product? You can treat the market as highly efficient and homogenous (which it isn’t) and equate marginal cost to marginal revenue, push down pricing and try to capture market share. You can decide that the market is highly inefficient and heterogeneous (which it is in the world of skill based investing), hold up pricing, but more importantly try to move up the value chain and offer more specialized and bespoke product, avoiding the commoditization of the product, and try to equate marginal cost and marginal revenue in each sub-market for your product, effectively defining your own markets. This would include providing bespoke mandates, managed accounts, with bespoke liquidity terms and fees, targeting the professional and institutional investor. A balance between bulk pricing and bespoke mandate pricing is struck but it is struck with each client and is transparent only to each client and not to the market.

The market for the new product is likely to be inelastic as it is a new market. The natural conclusion jumped to is that the new product being offered to a wider retail audience is more price elastic. Given the general opacity in retail investment products, this is not clear. Retail products typically measure cost based on a total expense ratio. Hedge fund fees and expenses would naturally inflate this number relative to traditional UCITS funds. On the other hand, retail and mass affluent investors might be appreciative of absolute returns.

In this nascent market for UCITS III hedge funds, pricing and product positioning is still uncertain. A first mover only has an advantage if they can confront the issues and plan strategically for the eventual maturity of the market.

Hedge Fund Leverage. Too much or too little?

Every time there is a hedge fund crisis the subject of leverage comes up. But how does one define leverage in a hedge fund? Is it the same definition you would use for a proprietary trading desk being allocated risk?

Let’s deal with fixed income and credit strategies separately as there are peculiarities which complicate. Let’s begin with the familiar equity long short strategy. Some managers measure leverage as total gross exposure as a percentage of NAV. That is, how many dollars long plus how many dollars short, divided by net assets. Another measure of risk, the directional risk of the portfolio, is the net exposure. This is the long exposure less the short exposure divided by net assets. Investors and managers tend to agree that the gross and net exposures are the accepted measures of static risk. Some managers use a ratio which is the long short ratio being the long exposure divided by the short exposure. It gives a sense of the directionality of the portfolio.

Gross and net exposures are useful metrics of leverage, but there are other interesting metrics. Consider the balance sheet of a fund.

Assets:

The assets of the fund include the equities held long, and cash whether the cash is from short sales, drawings on credit facilities or from the equity contributions.

Liabilities:

The liabilities of the fund include the equities borrowed for shorting, the mark to market P/L of the short positions, and any credit facilities for the purposes of leverage.

Shareholders Equity:

Shareholders equity is self explanatory.

Here is a snapshot of what a balance sheet would look like:

This one shows 90% long and 90% short exposure, effectively a market neutral book with a gross of 180%.

The asset to equity ratio is picking up the 10 cash assets hence the discrepancy. Gross exposure is still a good measure as the cash assets exhibit no volatility.

From this position, consider mark to market P/L in the long and short books and the impact on the leverage ratios:

Here Long MTM is positive if in profit and Short MTM is positive if in loss.

Observations are:

• An unrealized loss on the long book increases leverage. Short exposure increases more quickly than long exposure decreases.  
• An unrealized loss on the short book increases leverage. Short exposure increases more quickly than long exposure. 
• An unrealized gain in the long book decreases leverage. Short exposure decreases more quickly with profit than long exposure increases.  
• An unrealized gain in the short book decreases leverage. Short exposure decreases more quickly with profit than long exposure.

What this highlights is that losses and gains on the long book and or on the short book necessitate adjustments to both long and short books to arrive back at the desired level of leverage.

Risk, Volatility and Correlation:

Equity = E, L = Longs, S = Shorts and C = Cash.

E = L-S+C

Let’s assume that Cash has no volatility or correlation to the long and short books.

Thus the variances are V(E) = V(L) + V(S) – 2 Cov (L,S), for a fixed level of E.

Risk management of the NAV, what is important to investors, would have to take into account the volatility of the longs, the shorts and the correlation between the two sub portfolios. This is nothing extraordinary or novel and is how the industry already looks at risk. Not always is the risk decomposed this way and there are other decompositions of V(E). If the covariance between longs and shorts is low, the volatility of the NAV is a function of the sum of the volatilities of the assets and liabilities.

From the portfolio manager’s perspective, it is important to manage the liabilities of the fund as well. Liabilities will need to be managed to the Assets less the Equity of the fund. Thus the uncertainty or volatility of the liabilities must be a function of the volatility of the assets + the volatility of the equity less twice the covariance between assets and equity. Assuming that the correlation between assets and equity is zero, the variability of liabilities is an increasing function of the sum of the volatilities of Assets and Equity.

If the manager is targeting to create a long book and short book that is highly correlated so that one is a hedge for the other, then the variability of the liabilities is reduced. If the manager is creating highly independent long and short book, then the reduction in variability from the covariance term becomes negligible. Its just a point to note when a manager represents the style of management of the portfolio.

It is time for central banks to back away. Not from raising or cutting rates. It is time for them to extricate themselves from any activities that might distort market prices.

It is time for governments to back away. The economic purpose of government should be to provide frameworks and systemic infrastructure, and to only provide goods and services that the free market is unable to provide. Beyond that government should back away.

As long as regulators and policymakers maintain a safety net, there is no interest for the private individual to be prudent or diligent.

There is no interest to save for the future. No interest to invest for the future. No interest to assess the risk of an endeavor. No interest to live within one’s means. No responsibility for one’s own actions.

Without a safety net would we take out that mortgage we could not service on that house we could not afford, or buy that car or that watch?

Would we invest in the stock of that company we didn’t understand, that fund we didn’t do due diligence on, that structured product without reading the prospectus?

Ex Fed Chairman Greenspan’s statement that he would not act pre-emptively to deflate bubbles, since he could not recognize a bubble, but would instead step in to rescue a post bubble economy is nothing more than an explicit guarantee of state aid to the economy and asset prices. The asymmetry of such policy and the moral hazard it creates is remarkable. As remarkable is the market’s propensity to regard the policy as prudent.

The current situation is no different from the era of the Greenspan Put. While in 2008 it was necessary to intervene in the markets to maintain orderly function of the key infrastructure of finance, that time has long passed.

It is not beyond logical contemplation to ascribe the crisis to active central bank policy. While inflation fighting was a useful function some 2 decades ago, the signaling power of central bank policy overtook the real impact of policy. Expectations of effective policy in maintaining price and economic stability led to excessive risk taking and irresponsible financial planning by the private sector.

Ironically, the existence of a lender of last resort and a unilateral determinant of short term interest rates with a mandate for maintaining economic stability, while effective in the short run can be and has proven to be de-stabilizing in the long run.