Its time for another review of the State of the Craft. Is it going to be easier to make money? Is it going to be harder to make money? Where was money made? Where was it lost? What are investors looking for? What have investors done?
Its going to be harder to make money.
Equity and credit markets bounced and rallied hard in March. This has improved sentiment all round. Market commentators everywhere are split between those who see this as a bear market rally and those who say that the worst is over and that we have the beginnings of a recovery. The serious caution and skepticism is likely to prolong the rally.
Fundamentals, however, are themselves highly uncertain, so that it is difficult to say that the massive drawdowns in the markets now represent value in credit and equity markets. The opportunity for gain and loss is greater. That said, the dispersion of returns, an indicator of the level of idiosyncratic risk, has risen in equity markets, but fallen in credit markets. Has it become a stock pickers’ market in equities? And are credit markets in the midst of a wide based relief rally?
Hedge funds broadly maintained gross exposure but decreased net exposure despite rising markets. As a result, most hedge funds did not capture the full extent of the upside in March, and well they should not. If we wanted to bet the house straight up on 22, there are numerous casinos in Mayfair with much better service and investor relations personnel. There was broad rotation into higher beta cyclicals away from defensives, itself a bet that we are in the second half of the recession.
Its going to be easier to make money.
Money has not come back into arbitrage strategies and spread relationships are still not being policed. Until capital comes back in a big way, these relative value and arbitrage opportunities will persist. Hedge funds and funds of hedge funds are seeing slowing redemptions and even some cancellations of redemption orders. That said, the first quarter still saw net outflows. Many of the arbitrage funds reported strong numbers in the quarter simply due to a compression in bid ask spreads in the asset markets they trade back to more normal levels. As long as investors shy away from arbitrage, opportunities will be ample and returns will remain robust. As is usually the case, at some point, investors will realize that they have missed a good thing, pile in like a hoard of lemmings just about in time to provide the early investors a convenient exit.
Investor Appetite.
According to HFR, over 1400 hedge funds closed in 2008 while over 600 new funds launched. In Q3 2008 344 funds closed and 117 launched. In Q4 2008, 778 funds closed and only 56 launched. Redemptions continue but are slowing. The tide is turning but slowly. Capital introduction events have been well attended and while the interest is still embryonic, there are signs of interest. Earlier cap intro events were attended by investors more interested in a free breakfast or lunch. The large US multi strats renowned for their opacity and for being closed are actually marketing themselves at cap intro. Some of them are actually appointing independent administrators in a reluctant acquiesence to investor demands. Fund terms are also getting more generous.
Strategies.
Everyone wants distressed credit, global macro and CTAs. In our trend following industry, it is only a matter of months before the contrarian becomes the consensus. I had cautioned earlier that global macro had become a consensus trade which might disappoint. Soon this view will likely become the consensus view and investors will shy away from global macro. A strategy popularity index is likely to exhibit more volatility than the VIX in October 2008.
One area which was universally unloved was risk arb, in all investor surveys. Deal flow, however, has been remarkably strong despite the death of the LBO. Consolidation, strategic deals and valuation driven deals have continued to be active. Granted many of the deals are friendly or low premium but derivative strategies capitalizing on dislocated derivative markets is likely to provide interesting trade expressions. Its not clear if investors will bite. Probably not. Despite merger arbitrage being one of the better performing strategies in 2008.
Asset based lending should be doing well, barring investor redemptions. The dearth of credit makes direct lending a particularly lucrative prospect. Think of the prospect of establishing a new bank with no legacy assets to deal with. However, a few frauds here and there coupled with investors in common and funds in common and contagion quickly results. Direct lending funds will struggle to raise any money, what with poor liquidity, poor transparency and opaque valuations.
An investment analyst is a graduate with a ruler in search of two points.
The two points chosen depends on the length of the ruler.
The length of the extrapolation also depends on the length of the ruler.