CCblog

President Obama’s bank bombshell of late January not only managed to explode the growing investor confidence in the first few days of the decade, but it created another cloud of speculation as to the likely impact  on banks and their hedge fund and private equity cousins.  We actually are quite positive on the development and here are the reasons why:

Restrictions on proprietary trading activity: it was a well known fact during the heyday for hedge funds that peaked in mid-2008 that the largest “hedge funds” on the street were in fact the proprietary trading desks of investment banks – operating with near boundless levels of leverage and limited constraints.  These pools of capital that operated behind the scenes created crowding in many strategies such as merger arbitrage and fears of front running.  The activities of proprietary trading desks have diminished significantly since the financial crisis of 2008, which has greatly improved the spread environment in previously crowded strategies, and also lessened the perils of short selling (financial stocks aside).  If these trading desks were to exit the market entirely  it would have two key consequences- a better spread environment in the short term, but more departures from banks to set up hedge funds in the medium term.  These are both salutary developments for the industry, and we will watch with interest as the opportunity set grows.

Restrictions on owning hedge funds and hedge funds of funds:  while the rationale behind a bank owning such a fund was clear – diversification, an in-house offering for private banking clients and exposure to the attractive annuity stream that the fees from these entities presented, the reality was probably a lot messier, as the former executives of Bear Stearns would attest.  In our experience hedge funds that were subsequently acquired by banks were already at the fatter, non-productive end of their life cycle and many were artificially shielded from market forces (e.g. the Goldman Sachs flagship quantitative product) only to shrink to insignificance later and ultimately close.  Banks no longer owning hedge funds is no great loss – but choking off the flow of seed and growth capital that is coming from the private equity arm of banks (e.g. the Goldman Sachs Petershill Fund) may hinder the institutionalization of certain entities.  We foresee a continuing wave of consolidation within the hedge fund industry as boutiques with low levels of assets struggle to survive, and with a whole sector of obvious buyers out of the market this may accelerate the inevitable slimming of the industry.  A statistic is circulating suggesting that $180 bn in Funds of Hedge Funds is controlled by banks, which is certainly a staggering statistic, but we do not see this huge pool of capital simply disappearing with the inevitable knock on effect on underlying funds.  We foresee spin-offs of these arms and a further reshaping of the industry.  Quite frankly, it will be refreshing to clear up this potential area of conflict for customers of the private banking industry.

Restrictions on sponsoring private equity funds:  unlike the hedge fund industry the private equity industry actually has a few gems of bank-sponsored groups (particularly in the buyout area), but their entanglement with the other parts of the bank has always raised sticky questions of conflict – on both sides.  We have no doubt, however, that these “gems” will spin out and operate effectively as standalone enterprises or will be adopted by large asset management houses. 

Prime brokerage relationships: the nature of prime brokerage relationships is also a muddled one, raising issues of front running and favoritism, and we see no reason why a prohibition on banks investing in hedge funds would not actually clarify and improve the state of affairs.  Typically the prime brokerage relationship is stacked in the bank’s, not the hedge fund’s favor (cf. the flexing of some prime brokers muscle to increase margin requirements to the swift demise of a hedge fund during the 4Q of 2008). 

Impact on liquidity of markets: this is one of those fears that often circulates with rather more smoke than fire, of course fewer participants in markets will lead to less trading, but that may actually mute the volatility in a positive way.  Lower liquidity levels have the greatest impact on forced sellers, but work to the benefit of longer term investors who can reap the illiquidity premium that they provide.  The exit of proprietary trading desks will lead to less crowding as we highlighted above.  Definitely not a concern of ours.

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Much has yet to be settled with respect to the reach and ramifications of this new action, and like the recent healthcare initiatives, there may be “many a slip twixt cup and lip”.  However, we look forward to the impact on the industry, which we think will only continue to benefit from the streamlining and upgrading process that has been in place for some time. 

A core debate in the media and among macro economic commentators is whether we are facing near term inflation or deflation.  This is being manifested in a curious disconnect between the demand for riskless assets (i.e. government bonds) which remains strong despite a notable pick up in risk appetite since March.  The fact that demand for government bonds remains robust suggests that the deflationary fears have not abated.  However, equity markets have risen by close to 50% since March and demand for riskier assets, especially commodities and emerging markets has been strong (albeit in fits and starts). 

This is further evidence of the schism in investor sentiment that is confusing investors and managers alike.  While the nascent economic recovery and recovery in asset prices will lead inevitably to a re-introduction of government tightening and ultimately inflation, investors have not been quick to shrug off the fears of deflation and a repeat of the economic crisis that faced Japan for decades. 

So how does an allocation to alternatives help investors to address the issue?  Let’s start with the easy part - real assets including real estate, commodities and other asset classes such as timber and oil and gas interests.  These “classic” inflation hedges should form a core part of every investor’s portfolio, although the true inflation hedging characteristics may be hotly debated.  Gold, having surpassed $1000 per ounce only last month is again breaking away from the commodities pack and is being used as a safe haven amid the uncertainty about future central bank action globally and a weaker dollar more specifically.  Private equity must be treated as a variation on the theme of traditional equities and these traditionally move in line with inflation. 

Fixed income is the classic deflation hedge, and the current ongoing demand for credit challenges the inflationist theorists.  So how are hedge fund managers positioning their portfolio in light of this inflation v. deflation debate?  Although we have witnessed many long/short equity managers who are increasingly adopting a macro overview in their investment analysis, there are actually very few managers who feel truly comfortable in the macro arena.  Career discretionary macro managers may express their view on inflation v. deflation through their tactical allocations to equities, fixed income and real assets such as commodities.   However, even these experienced multi-asset class practitioners shy away from taking a firm view on the outcome, and try to trade around and exploit inefficiencies amidst the views of other market participants.  Managers with less of a macro orientation have very little explicit inflation or deflation positioning at all – and are instead expressing this view through the equities of their underlying portfolio – e.g,. through companies poised to benefit from increased interest rates or rising/falling prices. 

So it is clear that despite the fact that the inflation v. deflation debate is at the centre of much media attention and high level macro-economic debate, we cannot expect hedge fund managers to offer many clues to solving this puzzle.  The overwhelmingly majority remain resolutely focused on maintaining their absolute return profile and prefer to be agnostic on such issues.  Investors will have to rely on their top down portfolio allocation to address this question. 

Today it was reported that Man Group had seen assets rise for the first time in over a year, and Peter Clarke, was quoted as saying     “There has been significant progress across our business over the summer… Investor sentiment is continuing to improve across the industry, the performance outlook is healthy and the prospects for sustained industry inflows are very promising.”

While the part about sustained industry inflows is perhaps overly optimistic, the comment does reflect the significant pick up in investor sentiment that we have also witnessed. We always like to sound a note of caution, and in this case we are cautious that some investors have failed to learn many lessons from the past 18 months and are jumping back on the bandwagon because of a desire not to miss out on the juicier returns that 2009 has presented.  For many investors the sharp losses (and liquidity issues) of 2008 should have hammered home the true profile of hedge funds and the fact that in many cases they are just not suitable for their risk/return profile or liquidity needs.  However, now that many hedge funds have altered their liquidity profile, they seem more accessible and more palatable - but in most cases nothing has changed about how they invest.  In the event of another crisis and liquidity crunch, the promise of increased liquidity might be an empty one.

Another grave danger is believing statements such as “the performance outlook is healthy”.  The year to date performance is healthy (very healthy in many cases), but the one investment truism that has stood the test of time is that past performance is no guarantee of future performance.  In some areas such as convertible bond arbitrage performance has been so robust as to suggest some borrowing from the rest of the year.  Many managers in all strategies who have nudged ahead of their high water marks may be minded to conserve capital now, and take risk off the table until the end of the year.  Huge uncertainty remains, and the current economic recovery is certainly a fragile one.  We are actually very cautious regarding hedge fund performance for the rest of the year.

And as for the “sustained” pace of inflows, we would say “not so fast”.  Whereas some of the impatient money may have already flowed back in to the sector already, the wary money may hold off for some time - and some of that impatient money may yet flow out again, taking advantage of some of the more generous liquidity we talked about earlier. 

But overall for investors with the right time horizon (which should be at least medium term for hedge funds, we recommend) none of this is particularly relevant.  If entry is staggered and careful manager selection is undertaken at the outset, short term performance should be less relevant, and other investor flows even less so.

In a market with nowhere to hide, much has been made of the safe havens of, alternately, gold and government bonds.  Gold has always been perceived as the more alluring and glittering of the two.  It has been popular both during the commodities bull run and in its dramatic aftermath, as governmental policy points to a coming printing of paper money.  Today we read about prominent hedge funds taking a stake in the commodity itself as a hedge against the vagaries of central bank policy and the likely diminution in value of paper currency.

Our first instinct is to be somewhat apprehensive here . . we have seen this approach before - it was in fact commonplace in the midst of the commodities bull cycle (2003-2005).  Long/short managers holding the underlying commodity is almost always a flirtation with macro-style thinking - acceptable, perhaps, in moderation, but dangerous if it amounts to style drift. 

A difficulty with gold is its own identity crisis.  As a commodity it is often lumped together with other precious metals and traded as part of a commodities basket.  This would account for some of the selling during the dramatic sell-off in commodities in the current wave of deleveraging and the flight from risky assets.  However, it is the single commodity that should perhaps stand alone as a store of value and hedge against a flight to safety - and this is obviously as it is currently being perceived by the hedge fund managers buying it up.  We agree that gold deserves a place of its own in a portfolio - and a separate classification from other commodities.  However, it is not a silver (nor a golden) bullet for a portfolio with heavy market exposure, and is at best a hedge and deserves to be sized appropriately.

In recent years alternatives businesses have been viewed as the jewel in the crown of large diversified financial firms, and funds of hedge funds have stealthily fattened themselves up from small, boutique cottage industries to go on the block for take-out, preferably by a large asset manager.  We have seen private equity firms segway into the hedge fund area (only in many cases to stub their toe and probably wish they never tried). 

We have written before about the disproportionate attention that alternatives businesses attract from the media and investors.  The combination of mercurial personalities, eye-popping tales of wealth and excess, creativity and innovation (not to mention the odd fraud of extraordinary audacity) is an irresistible cocktail.  But whereas during the golden period for hedge funds and other alternatives traditional banks and asset managers may have wanted just a touch of this allure, as the allure has faded their alternatives businesses have become a thorn in their side.

This has worsened in the aftermath of the Madoff affair.  Established asset managers and banks have become deeply mired in the vortex of finger-pointing, investor anger and allegations of incompetence that have (rightfully) flown from the diabolical spectacle.  The funds of hedge funds businesses with Madoff exposure are being cast off, ostracised, shunned . . but still the poison can contaminate the parent - until the gangrenous limb is amputated (or so it is believed).  Some well-know European banks are rumoured to be about to exit the alternatives business entirely - Madoff led the way.  Other groups are reviewing the future of all of their fund of hedge fund businesses, suspending management fees in an act of contrition while the review gets under way. 

This is more than distressed selling - in fact selling might be a luxury.  Many groups would be just as pleased to simply “dump” their impaired businesses, write them down, and move on - slightly handicapped perhaps, with some “phantom pain” where the limb had once been, but ultimately rid of the poison.

This has accelerated the consolidation of the fund of hedge fund industry that was already underway, and we have seen some surprising candidates emerge as the acquirors.  In the merger and acquisitions arena, the term “Pac-Man defense” was coined for the scenario where a target, that is the subject of a hostile takeover bid turns around and attempts to purchase the stock of the would-be acquiror.  The analogy is with the video game character who being chased by “ghosts” can turn the tables upon the ingestion of an energy pill and chase (and gobble up) the ghosts.

The possible analogy here is slightly different: it is not that the new acquirors (whether funds of hedge funds, multi-strategy managers or hedge fund platforms) were previously being chased by the target - but they were certainly under siege - by market conditions, investor apathy, and perhaps some increasingly hostile prime brokers and other counterparties.  They, like all industry participants, were certainly well out of their comfort zone.  And what is the “energy pill” that has enabled them to become the consolidators? Nothing other than a slight edge over the acute distress of their prey.  This is a picture that we expect to run and run over the course of 2009.  It should be watched with great interest.

Over 2007 and 2008 portable alpha was decidedly in vogue.  The notion, for those who have forgotten, was to establish exposure to the beta of traditional asset classes via swaps, options or futures (largely unfunded instruments) and then to “port” a layer of alpha in addition to this.  The alpha was often sought through use of an absolute return fund of hedge funds (perhaps mistakenly thought of as a reliable “alpha” source).  Portable alpha providers offered both turnkey solutions – which packaged both the alpha and beta sources together, or simply the alpha component, with investors encouraged to seek their beta exposure from alternative providers.

We had issues with the notion of portable alpha and its widespread marketing as a flexible kind of financial engineering, and were somewhat alarmed by the rapid traction that the concept seemed to be gaining among pension funds and other large institutional investors.  Our issues related to first the notion that alpha was itself readily identifiable and persistent in any asset class.  We have spent years conducting due diligence on hedge fund managers and know first hand that alpha is an essentially evanescent being.  The first question that must always be asked is alpha relative to what – we have seen many long/short managers with small and mid-cap portfolios cite their alpha relative to the S&P 500.  There might be outperformance – but it may simply be beta to the Russell 2000.  The other question is whether alpha persists in any one trade or strategy – with the rapid pace of crowding in the hedge fund arena (at least prior to the fallout of 4Q 2008) it became clear that alpha could quickly become arbitraged away, and nimble hedge fund managers had to move on to the next opportunity.  Finally, the notion that funds of hedge funds represented pure alpha was surely misguided.

The next fundamental issue related to the hidden leverage in portable alpha solutions – primarily via the use of swaps, futures and options to obtain the beta exposure desired.  It was never clear to us that this embedded leverage was fully disclosed or understood.

Perhaps the success of portable alpha solutions in recent years signaled the ultimate complacency with both the fund of fund value proposition and leverage – both of which have been thrown into question over the course of the fourth quarter.  With fund of fund performance under strain (and most displaying sharp correlation with equity markets) investors appear to have lost on both sides of their beta and alpha solution.  The embedded leverage has also been shown to have a sting in its tail. 

All in all, the message on portable alpha has died down – and we welcome this development.  We hope that investors never again become too presumptuous about the Greeks.

Multi-strategy managers.  You either love ‘em or hate ‘em.  

Their appeal is obvious – they are usually large, institutionalized hedge funds, often regulated, with substantial investment staffs and infrastructures.  It is the model that some of the most established managers in the field have adopted, and they appear to offer a form of internal diversification – by strategy and also across the life cycle of opportunities.  In 2002 many moved significantly into the distressed arena, shifting resources away from the then moribund area of merger arbitrage.  When distressed topped out in 2004, many moved into equity special situations and other equity based strategies – which involved a subtle shift into more of an equity–like return profile.  As they have grown, multi-strategy managers have increasingly positioned themselves as the “go to” solution providers for large institutional investors.  Some flirted with public listings, some went all the way . . all experienced sharp rises in assets over recent years and (coincidentally?) some drop off in returns relative to their historical profile.

Many funds of funds have questioned using multi-managers however.  They cited their overdiversification and relatively lack lustre return profile and considered that it was their job to tactically shift assets between strategies – not the multi-strategy managers.  Maybe they were mindful of the competition that they presented too.  We have always supported their use – particularly for investors new to “going direct” or for portfolios not large enough for the optimal number of managers (15-20 in our view). 

Now many are under scrutiny – in part because of the disappointing performance that some have delivered over 2008.  Some investors suggest that multi-strategy managers (with their professed flexibility, deep teams and broad reach) should have fared well in the past few months.  This is, perhaps, wishful thinking.  Multi-strategy funds may be broad – but they are far from nimble.  The very size of their assets dictates broadly diversified portfolios with little concentration.  Position sizes must be large to make any kind of meaningful impact on the portfolio which raises the “deal size threshold” of what deals can be considered.  Such funds now operate more akin to merchant banks – like large diversified financial institutions with sizeable teams that are not as flexible as the firms would like us to think.  We do not think that they could have been expected to make money by being dramatically short credit or financials once the slide of Q4 2008 became apparent.  Their very size would have prohibited a swift move into this area.  However, this is not to excuse the disappointing performance that has been turned in 2008.  The depth of the teams and the size of the firms suggests that they should have had some kind of an edge – whether with prime brokers or in market insights.  They should be held to a high bar.

Finally, we think that their role will continue to be an important one – however, they should be viewed more like lumbering supertankers – they cover a broad area, and will capture a wider part of the opportunity set than single strategy managers or smaller firms.  They may identify smaller niche strategies earlier than less well resourced managers but they may not be able to pursue them with much impact.  However, in the current uncharted territory – bigger may not always be better, but they may seem safer.  And, after the year we have had, the security of a safe harbour should never be underestimated.

We are not chartists.  Not by a long shot.  We believe that market timing is notoriously difficult, and that history does not necessarily repeat itself.  We rarely utter the phrase “reversion to the mean”.  We generally prefer managers who focus on deep, distinguished, fundamental analysis than technical or quantitative analysis.  But the events of 2008 have caused us to stray outside our traditional comfort zone, especially in the all important area of credit. 

There is little doubt that credit is the opportunity on everyone’s lips, and eye-popping yields in senior bank debt are jolting even the most shell-shocked investors back to life and back to the table.  However, the punchline seems to be (or should be) . . . Not So Fast.  One industry veteran quipped that this is the fourth time in fourteen months that investors have been apprised of the opportunity of a lifetime.  But in a world where according to investment banking executives one in 10,000 year events can happen for three consecutive days, it is not unreasonable to see more than one “once in a lifetime opportunities” over a short few months.  

On a fundamental basis credit is cheap, but keeps getting cheaper.    We have observed two distinct schools of thought as to when to enter the area - one body of investors believes that until default rates tick up and credit actually “bottoms” there is just too much mark to market risk at stake.  The other believes that with yields this good today on an unlevered basis they can afford to be early (and give up as much as 20% of the upside) and still make a decent return, given the breadth of the margin of safety at today’s prices.

We believe that whatever the investor’s tolerance for volatility and mark to market losses, technical factors will have a huge impact on the current credit cycle.  Outstanding US distressed mortgage paper is estimated to be $2 trillion.  Other distressed credit is estimated at $4 to $8 trillion - a wide range indeed.  But in a buyer’s markets without buyers (up to 60% of the demand for leveraged loans - CLOs, SIVs and other structured products has essentially disappeared), prices may fall below their “historic recovery rates”.  So the opportunity is plentiful, certainly relative to the amounts of funds currently being raised, but the technical pressures will be immense, unpredictable and likely to last for some time.

We have recently launched a white paper for clients entitled “Playing the Credit Card”, which examines the opportunities that we perceive will evolve over 2009 for institutional investors.  A summary will appear on our website shortly.

In May 2007 we first wrote about hedge fund replication in our monthly newsletter.  Then we said:

Just as children nowadays inevitably “grow up too fast”, industry observers have been quick to herald the “maturation” of the hedge fund industry.  They base this assertion on the surge of assets dedicated to the area, a growing concentration among service providers and the predicted (but not currently realized) deterioration of returns mentioned above.  Against this backdrop hedge fund index products have proliferated, offering a smorgasbord of treats for the disenchanted hedge fund investor.

The original product was the investable hedge fund index, which is built using actual underlying managers and aims to be diversified and representative of the industry average.  These products have had a difficult beginning mainly because of challenges in getting fair representation among their components without the spectre of negative selection.  To be included in an index a manager must usually offer monthly (if not more frequent) liquidity, a sizeable amount of access and meaningful transparency.  Needless to say, the star performers of the industry are not clamouring for inclusion in these indices.  However, over time, increased diversification and improvements in construction methods will improve the return profile and appeal of these products. 

Hedge fund strategy indices – based on synthetic replication of common strategies such as volatility arbitrage, merger arbitrage and convertible arbitrage have been sprouting for some time, but remain unproven.  By definition any basket trade in those strategies (some of which have experienced meaningful crowding) will be little more than the lowest common denominator return with no room for additional alpha.  Given the poor fundamentals in most of these areas we doubt that the strategy indices will hold much appeal.

The current hype, however, is based around the high profile launch of factor based indices, which attempt to capture “hedge fund beta” (i.e., the return of an industry hedge fund index, such as HFRI) through a rules based investment process that uses liquid beta factors such as the S&P 500 and the Lehman Agg.  The algorithm used is derived through a regression analysis against the benchmark and offers the advantages of daily liquidity and unlimited capacity, as well as somewhat lower fees than fund of hedge funds might charge.  The backtests, as might be expected, look robust but it is worth pointing out a few things. 

Regression based processes are notoriously limited due to their focus on historical data, which will cause them to at best trail an index which captures only an average (not a top quartile) hedge fund return.  Volatility has been low in recent years, which might have made the tracking process relatively easy – should this revert to the higher levels of a few years ago this process might be scuttled.  However, even if volatility remains low, there will still be market shocks.  Individual hedge fund managers may (or may not) forecast these shocks and act accordingly – a trailing factor index certainly will not.  Furthermore, if one looks a little more closely at the composition of these indices, at any one time they may be significantly exposed (60-70%) to T-bills, with a little bit of S&P, US dollar and Lehman Agg thrown in.  Even if the fees are lower than funds of funds, at around 1% flat fee they still seem very high for a portfolio so heavily exposed to the risk free rate.

However, we do not want to be accused of snobbery in this area.  At their core, factor indices are likely to deliver a decent (if average (and trailing)) rate of return that echoes that of hedge funds.  Most investors use hedge funds to deliver a steady spread over the risk free rate that is more or less uncorrelated to market factors, and factor indices have arisen in response to the intuitive appeal of this return pattern.  To use a food analogy, if hedge funds are caviar – a product made by the elite for the elite, hard to source and expensive to purchase - index products are baked beans.  They don’t look as good and don’t taste as good, but they don’t cost the earth and will still fill an empty stomach.  And sometimes that is all that matters. 

So 18 months on, where are they now?

The groundswell of disappointment, deleveraging and general chaos in the hedge fund industry at present has pushed these products firmly out of the limelight - to the extent that they ever enjoyed it.  We were recently at a conference where they were discussed, however, and what is stark is the dispersion in returns between the different products.  Maybe choosing a replication product was not like choosing between different tins of baked beans after all.  According to the model used and the benchmark tracked, some products have struggled, while others (particularly those with the hedging benefit of look back straddles) have preserved capital reasonably well.

Of course, as the industry undergoes an existential crisis as we have discussed previously, the question moves from whether hedge fund returns can be replicated to whether they should be!  There are two possible outcomes - either returns will continue to disappoint and replication products will be go the way of the dodo, or some of the models will survive as not replication products but as viable investment products in their own right.  Watch this space.

Before this year any investor conducting due diligence on a fund of hedge funds will (or should) ask that wince-inducing question. . “Any blow-ups?”  To some investors the answer can be a deal-breaker.  Perhaps, that is, until now.

A blow-up was typically understood as a total (or near total) loss in a portfolio, or even a significant loss (-30/-40%) that would lead to a liquidation.  Some stemmed from fraud, others wild style-drift, others over concentration and simple mismanagement.  But in general they were few, and far between, and the the wall of shame was a relatively short and well-known one (e.g. Amaranth, Durus, Bayou).

2008 and its fallout may have changed all of that, as double digit losses of staggering enormity (-50%/-60%) become commonplace, and liquidations do not necessarily follow - or at least not yet.  Some funds with these losses are fighting for their lives, but they are assuredly not dead yet.  While there is often no fraud, there may or may not be mismanagement and it is now getting easier to cite the exogenous factor of global financial collapse as the ”bogey man”.  No fund of fund has escaped having a least one hit in the portfolio and some are nursing a number of casualties.   To many investors this (alongside disappointing performance) has indeed been a deal breaker, and they are voting with their feet.  We do expect a little more indulgence from investors though and maybe in this new numb state in which many investors are stranded, there will be fewer winces in explanation.

So when is a blow-up not a blow-up?  Perhaps when it occurs in 2008.