New Bottoms Up Approach to Hedge Fund Investing

Investcorp, an investor in hedge funds with $5 billion in assets under management, has created a proprietary, bottoms-up method for choosing the best managers.  Deepak Gurnani, the Chief Investment Officer, started the Alpha Project in 2003.  The research approach consists of reviewing the performance of trades for each hedge fund strategy.  For example, for merger arbitrage, Investcorp examined every merger since the 1990's and analyzed the performance of that classic trade.  These individual trades are compiled into fund returns.  The results are used for tactical asset allocation among different funds, manager selection and investing Investcorp's assets.  Its portfolio has a better risk adjusted return (as measured by the Sharpe Ratio) even after subtracting fund costs (i.e. prime brokerage and stock loan).  This is in stark contrast with traditional research that looks at the performance of equity markets, volatility, credit spreads and currencies to explain hedge fund returns. There are four issues with this approach:

• Fund strategy contributes to returns
• Investors only receive 25%-50% of alpha returns because of the 2 and 20 incentive fee structure
• Risk and transparency issues such as style drift, side pockets and insider trading
• Liquidity

Rare Earth Elements: New Commodity Bubble?

A new commodity investment bubble may be forming in Rare Earth Elements (REE).  In an article written by Steven Markusen of Archer Advisors for www.finalternatives.com, this is being driven by rising demand and a limited supply base.  There are many new applications for REE that account for the demand picture.  They are needed for rechargeable batteries for hybrid cars, hyper-efficient magnets for wind turbines and electronics (i.e. iPods and smartphones), oil refining and military uses.  Also, China, Japan and Korea are building strategic reserves of REE akin to the US Strategic Petroleum Reserve.

China dominates the world's supply with a 96% share but only 59% of the world's reserves are in the country.  The cost of production in China is much less than in the US, Australia, South Africa and Japan due to lax environmental laws and low labor cost.  This drove the industry to close the higher cost mines in the other countries.  REE extraction uses about 20 to 30 toxic chemical processes and has exposure to radioactive material such as thorium.  The process to turn an REE deposit into a productive mine takes 5 to 10 years.  Japan has begun a recycling program last year after China blocked shipments of REE during a diplomatic row in 2010.

There are about 30 publicly traded companies that mine REE such as Molycorp, Avalon Rare Metals and Great Western Minerals Group.

Insider Trading Trial: Jury Deliberation Starts on Galleon Case

The closing arguments by the prosecution and defense were made last week and jury deliberation for the insider trading trial of Raj Rajaratnam of the Galleon Group began today.  Two different portrayals of the defendant were made.  The defense said that Raj traded on public information and used the mosaic theory to put together the best trades.  The prosecution said that Raj wanted to "conquer the stock market at the expense of the law."  Here are some links to articles about the case:

Rajaratnam Case Goes to Jury
Jury Starts Deliberation on Galleon Case
Government's Closing Argument
Rajaratnam's Closing Argument

Advantages and Disadvantages of a Fund of Hedge Funds

In the prior post, I listed some of the advantages of investing in a fund of hedge funds as opposed to directly investing into a hedge fund.  The following may be added to that list:

• Regulation - Fund of hedge funds may be registered in countries that offer better investor protection
• Hedge currency - Offer shares in different currencies
• Leverage - Can provide leverage to investors
• Education - Teach investors about hedge funds

There was one disadvantage listed - the double layer of fees.  Additionally, there are:

• Performance fees - Calculated based on individual positions of the fund;  not on aggregate return
• Higher taxes - Because hedge funds can register as offshore funds
• Effects on other investors' actions - Redemptions and investments by other investors may change cash flow, leverage or fund manager's investment style due to monthly liquidity
• Control and customization - Ceded to the fund manager
• Lower returns - Due to lower risk

Advantages of a Fund of Hedge Funds

In a post earlier this month, I referred to a survey by the InvestHedge Billion Dollar FOHF Club which stated that there were inflows in the latter half of 2010 for funds of hedge funds.  The main disadvantage of funds of funds versus a hedge fund is the additional layer of management and incentive fees.  Average fees are 1% - 2% of assets under management, 0.5% for custodians and other services and performance fees of 20%.  The hurdle rate when the incentive fees are activated is around 10%.  The fund of funds managers are sometimes able to reduce the fees paid out to their investment managers because they have a large amount of liquid capital.

Here are the main advantages for fund of funds:

• Risk management - Diversification by investment strategy and the portfolios of the hedge funds
• Transparency and regulation - Better reporting on portfolio holdings, commentary from fund managers and documentation
• Minimum investment is lower - Allow access to multiple hedge funds at a lower capital level
• Access to closed funds - Hedge fund managers may allow fund of funds to invest in their closed funds because the fund of funds is a long term investor, has a good relationship with the manager or is a current investor.
• Liquidity - Monthly
• Portfolio management and monitoring - fund of funds manager invests in different funds, does due diligence and monitors funds for performance, risk and strategy

The source for this article is a Fund of Hedge Funds: An Introduction to Multi-manager Fund by Martin Fothergill and Carolyn Coke of Deutsche Bank.

Private Equity Investors Say Brazil Beats China

A survey by the Emerging Markets Private Equity Association and Coller Capital, a firm that invests in the private equity secondary markets, has ranked the most attractive markets over the next 12 months as:  1.  Brazil, 2.  China  and 3.  Other Emerging Asian Markets (i.e. not China and India).  Brazil offers better values than China right now.  156 institutional investors provided answers to the survey.

Using a Hypothetical IPO Performance Report to Gain Market Share

One of the pieces of information used by institutional salestrading and research sales to leverage more trading commissions from the buy-side was the profit and loss statement based on the performance of the bank's IPO's.  This was done by, at least, two banks and, probably, all of them.  The report was a scorecard of how much money the fund managers would have made (the hypothetical part of the exercise) if they would have held the IPO for 1 day, 30 days, 60 days, 90 days, 6 months and 1 year.  It was a relatively simple calculation.  For each of the intervals, the difference in that day's and the offering price was multiplied by the allocation received by the manager.  For example, a fund was given 1,000 shares, the offering price was $15 and the first day's closing price was $20.  The profit would be ($20 - 15) x 1,000 = $5,000.  The idea was to receive commissions equal to twice the hypothetical profit.  For a large investor involved in many deals, the report could become quite large.  During the technology bubble, some of the profit numbers were astronomical.  Of course, these numbers were quite theoretical as many funds sold parts of or the entire position before the timeframes used on the report.  It was the pursuit of the profit numbers that led to Credit Suisse $100 million settlement with the SEC in 2002.

Managed Futures: Risk Management

Since the credit crisis, fund managers have put more emphasis on managing their funds' risks.  The following managed futures article by Attain Capital lists the various methods of how Commodity Trading Advisors do this and diversify their investments.

• Money management - involves budgeting risks across different futures markets;  done by balancing the equity at risk for each trade
• Market selection - ensuring the position is liquid or using exchange traded futures to minimize counterparty risk
• Market diversification - investing in multiple, uncorrelated markets;  diversifying trades over different sectors or contract maturities
• Model diversification - using multiple trading models within the fund
• Timeframe diversification - creating trading models based on different timeframes
• Trade structure - using options to limit risk such as buying put options or spread trades
• Delta neutral - using spread trades to limit volatility
• Manager skill - using the manager's judgment;  this flexibility comes with a higher risk of large losses

First Quarter 2011 Scoreboard: S&P 500 Beats All Hedge Funds

The first quarter of 2011 is in the books and the S&P 500 Index is beating the Dow Jones Credit Suisse Hedge Fund Index by a score of 5.92% to 2.21%.  The best performing strategies:  convertible arbitrage and multi-strategy returned barely above 4%.  As expected, short strategy is the worst performer at -6%.  Only other strategy with a negative return is managed futures.  The chart can be viewed at Pensions & Investments.

Buyside Clients - Some Further Details

We have discussed the different types of buy-side firms in an earlier post.  Some of these firms are huge conglomerates with offices around the world.  The institutional sales force looks at these clients in terms of the broker vote.  A buy-side firm may interact with the bank at different desks.  For example, Deutsche Asset Management (DeAM) may have separate desks in Frankfurt, London, Milan, Madrid, Paris, New York, Tokyo, etc. and each desk would have their own vote.  Each product line may have a different organization.  Using DeAM, the vote for US stocks may be split between New York, Europe and Asia;  the vote for European stocks may be split between Frankfurt, London, Milan, Madrid, Paris and New York.

Each firm may interact at different levels depending on the role.  For example, Trust Company of the West may have offices in New York and San Francisco.  The two branches may have different portfolio managers handling separate funds but have one trading desk.  The salestrader would prefer to see this as one client.  The research salesperson would prefer to see this as two clients.

There are advantages to appearing as a larger, combined client such as preference on calls, more available resources and better allocations on IPO's.

Finally, there are specialist trading firms such as Williams Trading and Morgan Stanley Execution Services.  They handle trading for a number of small hedge funds and gives them the size and scale to get the attention of a broker/dealer.  On their own, the hedge funds are too small but, when their assets are aggregated, they appear as a larger fund.

Dutch Auction Initial Public Offering

In an earlier post, the traditional method of an initial public offering was summarized.  The price of the new stock is determined by the lead investment bank and the company.  Another method to set the offering price is to hold what is called a Dutch Auction.  This was pioneered by the boutique technology investment bank W.R. Hambrecht.  The bank sets the number of shares and share price for the IPO.  When the sales force engages their buy-side clients, they are given the number of shares wanted (indication of interest) and the price at which the client will buy the deal.  Once the minimum price is established, shares are issued to the clients that bid the minimum and greater.  The shares are at that price.

For example, the IPO may be set for 1,000 shares and $100 initially.  The aggregated bids from all investors may be:

• 200 shares at $100
• 400 shares at $95
• 300 shares at $90
• 400 shares at $85
• 500 shares at $80
• 500 shares at $75

The bids reach the 1,000 share level at $85.  The investors that bid $90 - $100 will receive 900 shares at $85.  The remaining 100 shares at $85 will be distributed to those investors proportionally.  If an investor asked for 100 shares, 100 x 0.25 = 25 shares would be allocated.  Any order under $85 would not be fulfilled.

This method is not popular with the banks because they receive a lower fee - about 2% of capital raised versus 7% - for the deal.  It is not popular with the buyside because it will usually not jump in price and pave the way for quick profit taking on the first day of trading.  On the other hand, the issuing company can get more capital from the IPO.

Interview with Managed Futures Manager

In Europe, managed futures funds have 20% of the assets under management for hedge funds.  In 2008, the strategy was the only one with positive returns.  There is an interview with Philipp Polzi of Qbasis, a fund with a return of 145% since 2008, on www.finalternatives.com.  Qbasis uses trend following and countertrend trading strategies within the fund.  It has a proprietary signal called early trend recognition to identify trades.  The manager has $50 million in AUM and can handle $2 billion before hitting capacity restraints.  His last comment is that the growth of managed futures means that investors believe in the performance of the strategy in the future.  But how much of that is money chasing after recent performance?

Is Your Portfolio Truly Diversified?

During the credit crisis of 2008, all assets (equities, fixed income, real and alternative assets) declined in value.  Welton Investment Management wrote a research report regarding asset allocation.  According to Modern Portfolio Theory, the most efficient portfolios have assets that are not correlated.  This minimizes any excessive decrease in assets during a crisis.

They tested this theory by taking 24 indices representing the 4 asset types and calculated the correlation of returns over 10 years across 2.5 business cycles.  They discovered that 80% of alternative assets and 75% of real assets were correlated with stock returns.  The alternative assets were private equity, event driven, long/short equity, distressed securities, multi-strategy, fixed income arbitrage, convertible arbitrage and risk arbitrage.  Only global macro and managed futures were non-correlated.  For real assets, infrastructure, real estate and TIPS (Treasury Inflation Protected Securities) were correlated.  Commodities was the only real asset that had non-correlated returns against equities.

The 4 revised asset types should be:

• Equities, correlated alternative and real assets
• Global macro and managed futures funds
• Commodities
• Fixed income

The research report may be accessed here.

Risk Measurement for Managed Futures Funds

There are five main types of risk management formulas that apply to managed futures funds.  Each has their limitations and caveats.  They also are separate measures.   They are:

• Margin-to-equity ratio:  This is the initial margin (in cash or Treasury bills) needed to establish the portfolio divided by the amount invested.  A low percentage means high leverage.  This may be misleading as the manager may have long and short positions or may be trading across different exchanges.
• Capital at risk:  When managers add a position, they attach a stop-loss rule to limit their losses.  This ratio calculates the total of the portfolio's losses if each position triggers the rules and divides it by the amount invested.  This is not an exact number because of the terms of the stop-loss rule.  The rule begins a transaction when the price is hit.  In a extremely volatile market, the actual trade price may be very different from the stop-loss price.  Capital at risk also does not account for offsetting long and short positions.
• Value at risk:  The potential loss for a given period and confidence level.  For example, a 95% one month figure of $10 implies that the portfolio has a 5% chance of losing more than $10 and 95% of losing less than $10.  Since the credit crisis of 2008, this has been the subject of some papers as measuring tail risk inadequately.  This is because the calculation is based on a normal distribution.
• Maximum drawdown:  This figure calculates the largest percentage loss for an investor for a specific period.
• Stress test:  This calculates a portfolio's losses by running different scenarios on the individual holdings to determine the effects on each scenario.

Funds of Hedge Funds: Making a Comeback

According to the InvestHedge Billion Dollar FOHF Club survey in March 2011, funds of hedge funds with more than $1 billion in assets under management (AUM) gained approximately $29 billion in assets in 2010,  despite outflows in the first half of the year.  They ended the year with total assets $625 billion.  Of this figure, more than a third ($226 billion) is in the hands of the 10 largest funds.  Globally, there are 109 managers with $1 billion or more in AUM.  In the second half of 2010, AUM grew by 4.8% with the ten largest firms adding 9.6%.  Here is the list of the largest funds:

John Paulson Performance: 1st Quarter 2011

There was an article at www.finalternatives.com about the performance of John Paulson's hedge funds in the first quarter of 2011.  Three of the funds (Advantage, Advantage Plus and Gold) were in negative territory after a disappointing March.  On the other hand, the smaller funds (Partners, Enhanced, Recovery and Credit Opportunities) were up for the quarter.

Managed Futures Basics

Managed futures funds invest in futures and forward contracts on currencies, commodities, financial indices and ETFs.  The funds, called commodity pools, are run by a commodity trading advisor (CTA).  The management fees are between 0% to 3% of assets under management (AUM) and the incentive fees are between 10% to 35% of profits.  The fees are also called "2 and 20".

Most CTAs use a black box to establish trading rules.  There are managers that act as mutual fund managers and create their positions.  They are a minority though.  The rules are not static and adjusted constantly due to copycats, poor trade execution, AUM growth and changing market conditions.  The three types of black boxes are trend following, non-trend following and relative value.

Trend following strategies are based on action of the asset prices; much like technical analysis for stocks.  The moving average strategy uses the average price of an asset to buy or sell.  The moving average may be calculated in various ways:  any number of days or different weighting of prices.  If the current price is higher than the moving average, the fund buys.  If the current price is lower, the fund sells.  This strategy works well when the asset moves steadily in one direction.  It does not work well in a volatile market or a market in a narrow trading range.  The break-out strategy uses the same buy and sell signals as the moving average strategy.  Instead of using the average of prices to trigger the trade, the fund uses the price range of the asset.

Non-trend following strategies include countertrend and pattern recognition strategies.  Countertrend strategy uses models to identify trades.  Pattern recognition is similar to technical analysis of stock charts where the CTA will find trading opportunities based on the price action of the asset.

Relative value strategies invest in related futures contracts that have experienced a short term price difference. The manager may perform an arbitrage trade as the prices return to their historical relationship.

Further information on managed futures can be accessed at Attain Capital's managed futures blog.

Commodities: Some Basic Ideas

Commodities can be valuable holdings for an investor because their returns are not or negatively correlated with the stocks and bonds.  Instead of buying physical commodities directly, the investor can purchase futures contracts based on an index composed of different commodities.  This is the same as a stock index where the prices of stocks create the index price.  Some examples of commodities indices are the S&P Goldman Sachs Commodity Index, Dow Jones-AIG Commodity Index and Reuters/Jefferies-CRB Index.  Each index contains different commodities, weights and manners of settling expiring and buying new contacts.

In a period of high inflation, commodity futures provide downside protection because the underlying commodity prices increase and securities decrease. The CAIA study material and Mark Anson's Handbook of Alternative Assets cite a study from 1990-2008 where a 60%/40% investment in the S&P 500 and US Treasury bonds are compared to a 55%/35%/10% investment in the S&P 500, US Treasury bonds and a commodity index.  On the general, the average monthly return remains the same but the summary chart shows the following benefits:

• Steadier monthly returns
• Less months with negative returns
• Average negative return is lower

Insider Trading Trial: Raj Rajaratnam of the Galleon Group

For the past three weeks, Raj Rajaratnam, former head of the Galleon Group, has been on trial for insider trading.  It has been estimated that $45 million in profits or avoided losses were garnered by the hedge fund.  Last week, a portfolio manager, Adam Smith, testified about how the hedge fund tried to avoid detection.  The traders would make misleading transactions such as selling a portion of their position when they were tipped off on negative news.  They would create emails designed to operate in the opposite direction of the inside information. The true intent of their trading would be conducted through faxes.

Two trades were mentioned specifically:  ATI Technologies and Goldman Sachs.  The ATI trade was made based on information from a Morgan Stanley investment banker.  The Goldman Sachs trade was made based on information from a Goldman Sachs director, Rajat Gupta.

The news sources for the article are at:
Bloomberg article on ATI
Bloomberg article on GS
Reuters article on GS

Introduction to Commodities

One of the hedge fund strategies that have not been detailed before is managed futures.  This strategy actively invests in futures and forward contracts on currencies, securities (such as stocks, bonds, ETFs and indices) and commodities.  This article will touch on the latter.  Commodities are used in the economy to produce finished products.  Some examples of raw commodities are gold, silver and oil.  Some finished products are cars, computers and cell phones.  An investor may buy/sell commodities through six vehicles.

An investor can purchase the commodity.  For most of them, it is not realistic as the investor would have to transport and store the commodity somewhere.  When it is sold, then it would have to be delivered.  It is easy to do when an ounce of gold is involved;  not if it is several hundred barrels of oil.

A more conventional way is to buy securities of companies that buy, produce and sell commodities.  Additional risks are introduced using this method.  Stocks and bonds are influenced by stock and debt market conditions that have little relationship to the commodity markets.  They also are affected by corporate events such as mergers, buyouts, bankruptcies, etc.  Finally, as part of companies' risk management efforts, they hedge their positions against the commodity.

A third way is to buy or sell futures contracts that are sold on public exchanges.  This is an option that allows the investor to buy or sell the commodity at the strike price at the expiration date.  Settlement is done in cash. There is inherent leverage in futures as investors can put up 10% of the price to buy them.  This is called the initial margin.  Depending on the value of the contracts, investors may be subject to margin calls to maintain a minimal investment amount.

The investor can buy or sell private option contracts called swaps or forwards.  These are between two counterparties with no exchange involvement.  These are customized but have much less liquidity than futures. The investor is subject to the risk that the counterparty may default.

The fifth vehicle is a commodity-linked note.  These are intermediate-term debt securities that may or may not have their principal protected.

The last one is an ETF.  It can be bought on an exchange and is just like an equity ETF.  For example, GLD gives the investor a position based on the price of gold.