A Quick Note about Sovereign Wealth Funds

Sovereign Wealth Funds (SWFs) are one of the less well-known types of institutional clients.  They are mainly in commodity rich states, such as Abu Dhabi Investment Authority or Norway's Government Pension Fund or may be located in various countries - predominantly in Asia, such as the Government of Singapore Investment Corporation or Temasek Holdings.  There is a recent article at Zawya.com that can be accessed here.  It states that SWFs are increasing their holdings in hedge funds and other alternative assets as well as corporations.  An example of the latter is China Investment Corporation's investment in Morgan Stanley.

I was alerted to this news article by Albourne Village, a site for alternative investing.  Other good websites that I subscribe to are FINalternatives, Hedgeworld News and HedgeFundBlogger.com.  They are all free and deliver news to your email.

Hedge Fund Strategy - Emerging Markets

A hedge fund manager investing in emerging markets concentrates on securities from markets that are moving from a centralized, government controlled economy to a western-based capitalistic system.  The manager may be using any of the normal investment strategies such as long/short or global macro (according to Richard Wilson at HedgeFundBlogger.com in his article at this link).  Because of the risks involved, the volatility of the returns is high.  Some of them include:

1. Government intervention
2. Political instability
3. Lack of liquidity
4. No accounting standards for financial statements
5. Currency risk
6. No regulatory oversight organizations such as the SEC or FSA
7. Inability to hedge because shorting securities is prohibited

Now, you may be asking why a manager would invest in such a minefield instead of investing in the US, Japan or Western Europe.  It is because emerging markets are inefficient and the smart manager has more opportunities to uncover under or over-valued securities.  For example, Altria (ticker: MO) is covered by an army of research analysts.  They are experts on every aspect of that company.  The idea that a manager will uncover a bit of news that is unknown to them is not probable.  However, emerging markets are covered by few analysts.  The same logic applies to mid-cap, small cap and micro cap companies.

One last note - emerging markets may be subdivided into frontier markets.  Frontier markets include western Africa, sub-Saharan Africa, Central America and parts of the Europe, Middle East and Asia (such as Croatia, Pakistan and Vietnam).

The Activist Hedge Fund Strategy - Improving a Company from Within

Compared to the long/short strategy, there are few hedge funds using the activist strategy.  This involves building a large position in the company and then, using that ownership weight, to improve corporate governance of the company.  This will make the company more attractive and raise the share price.  These funds will hold only 5 to 15 companies at one time.  The portfolio is very concentrated and may experience high volatility - although you could say that about any investment.

Activist managers may try to change corporate officers through a proxy battle, change the amount of equity or debt assumed by the company, cut costs, initiate a share buyback plan or special dividend to shareholders.  They can liquidate assets (such as real estate), spin-off non-performing divisions, sell divisions unrelated to the company's core business, etc.  Unlike other hedge fund strategies that are secretive in nature, the plans of activist managers are in the public domain.  This information is available in the Schedule 13D filing with the SEC.  There are seven sections in the 13D.  The most important are the Purpose of the Transaction and Materials to Be Filed as Exhibits.  The first section states why the fund is buying the position.  The materials section adds the details behind the goal of the fund and has any communications to the senior management of the company.  13D's must be filed when the hedge fund has taken a 5% position (called a beneficial ownership).  This must be done within ten days.

The methods are quite similar to private equity or Warren Buffett except they do not buy the whole company.  An example of an activist hedge fund manager is Bill Ackman of Pershing Square Capital Management.

Insider Trading Investigation - Latest Events

There have been much news recently about the FBI's insider trading investigation.  Several hedge funds' offices were searched earlier this week, other hedge and mutual funds have been issued subpoenas and an executive at a expert network firm was arrested.  Expert network firms give access to industry and company experts to fund managers and analysts.  This is similar to the corporate access sponsored by investment banks at conferences and roadshows.  Unlike the sponsored events, these experts are not company officers.  Corporations usually have investor relations representatives who coach the executives on what to say and what not to say.  Below are a set of informative articles regarding the latest updates in the insider trading investigation:

• Insider Trading Probe and Expert Networks
• Insider Trading Probe Leads to Charges
• Expert Network Executive is Arrested

Short Strategy

Short selling has accumulated a lot of bad press during the financial crisis of 2008.  In this posting, we will look at the strategy of short hedge funds.  The strategy is simple.  The fund manager shorts stocks of companies that they believe will go down in value.  Any unused capital is usually invested in a safe security such as Treasuries. The value of the short positions is greater than the long positions unlike the long/short strategy.  They are the opposite.  They are net long.

According to Filippo Stefanini (Investment Strategies of Hedge Funds, 2006), a company that is a candidate for shorting would have management that lies to investors, insider trading, destruction of value, deteriorating fundamentals or changes in the equity structure.

Jim Chanos of Kynikos Associates Ltd is a prominent short seller. He is one of the managers who exposed Enron Corporation.

Introduction to Equity Long/Short Strategy

When the words hedge fund are used, most people associate it with the long/short equity strategy.  The fund manager constructs a portfolio of stocks in two components:  long positions in attractive/undervalued stocks and short positions in unattractive/overvalued stocks.  Additionally, there can be positions in derivatives such as stock options, index options or index futures.

Managers specialize in three distinct areas:  concentration, market capitalization and geography.  Concentration relates to the sector of the stocks.  Market capitalization is the size of the company and geography is the region/country of the company.  A manager can specialize in one sector, market cap or region/country or across multiple sectors, market caps or regions/countries.

Managers may use fundamental or quantitative stock picking strategies.  The traditional fundamental strategy involves knowing a company inside and out when making an investment decision.  This includes financial statement analysis, talking to company officers (such as the CFO), learning about the company's industry, gathering intelligence on the company from conferences and meeting with the company's day-to-day points of contact (such as their clients, vendors, supply providers, competitors, etc.).  The analyst or manager collects this data and forms an opinion of the company's prospects based on the mosaic theory.  Hedge funds mainly concentrate on mid and small cap stocks because they have limited coverage from the sell side.  A large cap company such as Coca-Cola has many analysts covering it and lots of public information available compared to a mid or small cap company.  In the latter case, there is a better opportunity to spot an undervalued and underappreciated stock price.  The sell side institutions base their business model on this strategy.  Many hedge funds and a majority of mutual funds use it.

Another fundamental strategy is known as the top-down approach.  Here managers study the economic drivers to forecast the prospects for different sectors of the economy.  From here, they would predict how individual companies would fare.  They would look at statistics such as Gross National Product, inflation, interest rates, import/export figures, etc.

The quantitative approach uses factors as a way to screen out unsuitable stocks for investment.  Some examples of factors are P/E ratio, price to sales ratio, price to book value ratio, etc.

Technical analysis can be used for the price momentum strategy.  Managers may use price charts to find stocks that are outperforming or underperforming the market and establish long or short positions.

Those are the mainstream long/short strategies.

Prime Brokers and the Hedge Funds They Serve

I have found a very thoughtful blogger who had researched the relationships between prime brokers and their hedge fund clients.  He had discovered that certain investment banks specialize in serving different investment strategies i.e. Barclays cover many funds using Fixed Income Arbitrage.  The article is here.  He has written other posts which, I will admit, are more advanced that what we have covered so far.  If you want to look at hedge funds from an investor point of view, they are all good reading.

PS  There is also a good comment attached to the article