Opening China to Foreign Investors

The State Administration of Foreign Exchange of the People's Republic of China has eased the rules for investing in China's financial markets through the Qualified Foreign Institutional Investor program.  They eliminated the $1 billion limitation on investments and changed the minimum statistics of the investor.  The manager must have $500 million (amended from $5 billion) in assets under management and have a track history of at least 2 years (amended from 5 years).  The entire process to obtain entrance into the program is now about 7 to 8 months.  Previously, it would take a year and a half.  The changes have been targeted to long term investors such as sovereign wealth funds, central banks, monetary authorities, insurance companies, endowments and pension plans.  Fund managers with a high turnover rate, such as hedge funds, mutual funds and investment banks, were not included in the rules changes.  Overall, by 2015, consulting firm Z-Ben Advisors Co. Ltd. of Singapore is predicting that asset management firms and asset owners will dominate the landscape.  They will push out the investment banks, who now have 51% share in the program.  Also, last year the ceiling on the program was elevated to $80 billion from $30 billion.  About $6 billion has been invested since then.  It is expected that the remaining $44 billion will be invested over the next 2 years.

The article from Pensions & Investments may be accessed here.

Master Limited Partnerships: An Energy Alternative

Since the credit crisis of 2008, interest rates on traditional fixed income investments (bonds, CD's, savings, money markets...) have been at record lows.  On the other hand, there has been a boom in the natural gas industry as the extracting method of "fracking" has become accepted.  These two trends, combined with the fiscal cliff's tax increases scheduled for January 1st, are making Master Limited Partnerships (MLPs) attractive investments.

Like hedge funds, MLPs have grown dramatically over the last 15 years.  Including a dip in 2008, they have grown from $8 billion to $241 billion in market capitalization and trade volume has increased from $6 million to $600 million.  But it is still tiny compare to the S&P 500.  Initially, retail investors were the primary buyers but the institutional share has grown to more than 30%.  There are about 100 partnerships trading in "units" on the NYSE and NASDAQ.  They are managed by a General Partner (GP) who runs the partnership for the Limited Partners (LPs), much like a private equity fund.  Also, the GP is invested in the MLP and can earn a performance fee called Incentive Distribution Rights.

MLPs have a number of attractive characteristics for investors:

• They have a higher yield than bonds except for high yield
• Annualized returns for the standard index - Alerian MLP Index - are higher and have less volatility than the S&P 500, Russell 2000, GSCI Commodity and FTSE NAREIT Equity REIT indices
• Favorable tax treatment

On the negative side, investor must watch for:

• MLPs may be as volatile as equities and commodities
• Limited liquidity because of small market capitalization and the tax treatment attracts buy and hold investors
• High concentration of product.  The 10 largest MLPs make up 60% of the total market capitalization.
• Has a small correlation with equities than increases during a crisis
• Has regulatory and legislative risk on the tax exempt status
• As MLPs pass through their income to LPs, they can only raise money from the capital markets to grow their company
• Conflicts in interest between GP and LPs
• When all is said and done, this is an investment in the energy sector

The energy sector represents about 77% of public partnerships.  The remainder are in real estate or financial businesses.  To qualify for an MLP status, 90% of its income must be derived from either energy, real estate, natural resources or minerals sectors.  According to Greg Reid of Salient Partners, there are 80 energy MLPs with a total market capitalization of $300 billion.  Reid runs two publicly-traded closed end funds and is a Managing Director in charge of $1 billion.  MLPs' average yield is 6.2% and have a projected growth rate of 6.5%.  The high yield is paid quarterly, like a dividend.  It is accomplished because a high percentage of income (about 90%) is distributed to the LPs and because the MLP has favorable tax status.  It is exempt from corporate taxes.  Additionally, taxes on 80% of the distributions are deferred until the units are sold;  the other 20% is taxed as income.  A higher yield is given to the investor in exchange for passing the corporate taxes to them.

Some MLPs favored by investors are Plains All American Pipeline, Enterprise Products and Targa (Reid).  Jason Stevens, energy analyst at Morningstar, likes Enterprise Products and Energy Transfer Products.  John Tysseland of Citigroup likes Enterprise Products, Atlas Pipeline Partners, Genesis Energy, Magellan Midstream Partners and Western Gas Partners.  Stephen Massocca, chief investment officer of Wedbush Securities, likes Memorial Production and BreitBurn Energy Partners.

The sources for this article can be accessed at FINalternatives.com, the New York Times and an NEPC research report authored by Andrew Brett, CAIA, Senior Research Analyst and Tim Bruce, Senior Research Consultant.

The Future of Fund of Hedge Funds

Since the credit crisis of 2008 and the Madoff scandal, the percentage of assets being invested in hedge funds through fund of hedge funds (FOHFs) has decreased steadily to 34%.  For FOHFs to survive and thrive, they have to add enough value to justify their fees.  Two researchers at NEPC of Cambridge, MA - Kamal Suppal, CFA, Senior Research Consultant and Antolin Garza, Research Analyst - examine this issue.  The avenues to creating this value are manager selection and portfolio construction.  Portfolio construction may be executed by creating allocations for each investment strategy and finding managers to fill them or the reverse.  Find the best managers and then allocate to each strategy.  Other questions to resolve are the weights of the managers and assigning different portions to be strategic versus tactical allocations.

NEPC views the future of successful FOHFs in three forms:

1. Conservative FOHFs that protect against the downside and participate slightly on the upside.  They have "high-conviction ideas and dynamic portfolio allocations."
2. "Niche" FOHFs with tactical portfolio allocation that is used to complement the other hedge funds in the portfolio
3. Customized portfolios used to complement a portfolio

Portfolio construction rests on the investment philosophy of the FOHF and its business considerations.  For example, a philosophy would be to regard investments as the present value of future cash flows.  Business considerations include whether or not the FOHF is an asset gatherer or seeks to earn the performance  incentive fees.

Asset gatherers use strategic asset allocation as their value add.  An EDHEC study of 200 FOHFs from January 2000 to June 2007 found that 48.4% of managers added an average of 1.54% over the average return.  During the crisis timeframe of June 2007 to July 2009, 77.7% of managers added an average of 3.5%.  FOHFs using tactical asset allocation methods had more muted results.  During the calm period, 60.9% of FOHFs added 1.24% to the returns.  In the crisis period, only 30.9% added 1.86% of returns.  The downside was worse.  69.1% of FOHFs averaged losing 3.13% more than the average return.

FOHFs that use manager selection added the most value during the first period.  92.9% of FOHFs added  an average of 3.89% excess return.  During the crisis, 48.4% added 4.18%.  The remaining managers lost an average of 4.3%.  This high figure leads to the conclusion that strategic asset allocation is the safest bet.

The researchers examined more than 15 years of returns for 1,300 FOHFs in 2011 and discovered that 20% of them added value.  Of those managers selecting hedge fund managers, only 5% added value.  To find these managers, NEPC uses a "6P" process to explain the role of FOHFs in a portfolio and verify its performance.

• People - need to have well-rounded and diverse teams that knit together their knowledge and skill sets to deliver value
• Philosophy - an investment philosophy that provides managers with clarity on how to manage their portfolios in all situations
• Process - Consists of fund research, portfolio building and risk management;  need to have defined research criteria taking into account the size of the fund, specialist versus generalist advantages, different account structures, negotiating lower fees for transparency, more control and better liquidity and monitoring managers;  use diversification to reduce business and headline risk, having access to investments in different investment strategies, sectors and geographies to reduce volatility;  risk management consists of having risk mitigating strategies (global macro, commodities trading adviser, volatility arbitrage and tail risk investing), non-correlation of positions and limits on leverage.
• Performance -  absolute and relative, relative performance for a FOHF is compared against the HFRX (investible index)
• Price - fees charged should not be reduced for FOHF that add value
• Perpetuity - have stable personnel with low turnover and investors such as private clients and family offices

The source for this article can be accessed here.

Update: Boeing Pension Plan Performance

The pension plan of Boeing Company has returned 10% in 2012.  The mark for the plan is 7.75%.  The plan has $51 billion in assets.  To achieve its return, the asset allocation is as follows:

• Fixed Income - 53%
• Global Equity - 26%
• Private Equity - 6%
• Real Estate/Real Assets - 6%
• Hedge Funds - 5%
• Other Global Strategies - 4%

The source for this article can be accessed here.

Boeing and Ford Run Pension Plans Well

Two weeks I saw a post on allaboutalpha.com that listed the best corporate pension fund managers.  It was written by Charles Skorina and compared their performance with the more visible public pension funds and endowments in the US and Canada.  Looking at five year returns, the companies with the best returns are Boeing, NorthrupGrumman, Ford and AT&T.  All were above 5.4% for 2007 - 2011.  Harvard Management's return for the same period was 5.6%.  A simple 60% equities / 40% bond portfolio would have returned 3.2%.  The four corporations earned these returns with less risk - as measured by Sharpe ratios.  The only public plans to rival them were Alberta Investment Management Company (AIMCO) and Columbia University.  Harvard Management's Sharpe Ratio was well below the leading plans.  Surprisingly enough, financial services firms Bank of America and General Electric ranked among the worst.

The source for this article can be accessed here.

A New Strategy for Investing in Emerging Markets

The BNY Mellon Investment Strategy and Solutions Group published a paper in July 2012 about revising investments in emerging markets.  Emerging markets are now large enough to contain subcategories in the same manner as investors consider sectors as subcategories of the US equity market.  There are four of them:  Consumption, Commodities, Manufacturing and Investment.  Consumption are industries that serve consumers such as hotels, media, household products, pharmaceuticals and tobacco.  Commodities include industries such as oil & gas, chemicals and metals & mining.  Manufacturing are industries that produce goods an services for the global market such as machinery, computer & peripherals, semiconductors and leisure equipment.  Investment include industries such as banks, electric utilities, airlines and infrastructure.

These different themes allow investors to react to macroeconomic conditions.  When the economy is doing well, Commodities and Manufacturing perform better.  On the other hand, Investment does better when the economy is doing worse because government spending increases.  This helps Investment stocks outperform. Having these different choices allow investors to buy their best ideas and avoid or short their worst ideas.

The research paper goes into great detail on how they created their themes by country and sector/industry.  It also analyzes their performance, risk, correlation, drivers of the returns and relative valuations.  The entire report can be accessed here.

Allocation Targets of Public and Corporate Pension Plans

I found this interesting post on the AllAboutAlpha.com website that I access through my CAIA membership.    The author refers to two surveys on pension funds from Pyramis, a part of FMR Management, and JP Morgan.  In previous posts sourced from Pensions & Investments, pension funds are planning to allocate more assets to alternative investments.  The Pyramis study breaks down the pensions into public and corporate plans.  US public plans are allocating 13% while US corporate plans are allocating 5%.  Both figures are well below other western nations.  Canada and countries from the Nordic Region are planning a 20% allocation.

The JP Morgan survey looks at public pension funds, corporate pension funds and endowments/foundations.  Hedge funds, private equity and real estate are the major alternative investments.  Corporate pensions have a higher allocation in hedge funds (4.6% to 4.2%) while real estate (4.6% to 3.5%) and private equity (8.1% to 3.3%) are more popular with public pensions.

If Fund of Hedge Funds Are To Thrive...

Niki Natarajan, Editor of InvestHedge, surveyed the 103 funds of hedge funds that comprise of the InvestHedge Billion Dollar Club.  61% of respondents believed that consolidation would continue over the next five years while  76% of the same firms were planning to grow their funds internally.  On June 2007, 147 funds managed $956 billion.  In October 2012, 78 funds in the club had survived the credit crisis of 2008 and they managed only $538 billion.  The top ten funds in 2007 have lost 49% in assets under management.

The club members believe that they can grow by making acquisitions of other funds of hedge funds, merging into investment banking advisory or private equity firms, creating customized portfolios and sourcing new hedge fund managers.  Deals have made the biggest headlines this year.  The Man Group is buying Financial Risk Management.  Crestline Investors is buying Lyster Watson's fund of hedge fund business.  UBP Alternative Investments is buying Nexar Capital Group.  In the pipeline are mergers between  Kenmar Group and Olympia Capital Management and Rothschile & Cie Gestion and HDF Finance.  Some examples of funds joining advisory or private equity firms are ABS Investment Management joining Evercore and  Prisma Capital Partners joining KKR.

Blackstone Alternative Asset Management is the largest fund of hedge fund manager with $41 billion in assets.  Its growth strategy is customizing portfolios, advisory work and providing seed capital to emerging hedge funds.  Since 2007, its assets under management has grown 96%.

The source for this article can be accessed here.

Warehousing for a Commodities Trade

Traders from specialist commodities firms and, to a lesser extent, banks are buying warehouse in various port cities to store metals for "financing deals".  They buy metals from mining companies and sell it for delivery in the future.  This trade makes money when the market is in contango, when futures prices are higher than current (spot) prices.  The traders only have to ensure that storage costs are less than the profit from the trade.

The London Metals Exchange (LME) restricts how much metal can be shipped on a daily basis.  Meanwhile, buyers have to pay storage costs until they can be released.  Usually, metals manufacturing companies obtain their metals from producers using fixed long-term contacts.  If their business plan projections are too low, then they have to buy more on the market which has much higher prices than the LME.

For example, Pacorini Metals, a unit of commodity trader Glencore, has enough warehouses to store two million tons of aluminum - about 20% of the total stock.  Glencore will also buy 15.4 million tons of aluminum over the next seven years from Rusal, a Russian company.  There is an inherent conflict of interest that is being managed within the firms "Chinese Walls".  These firms have insight into one of the key pricing factors for the commodity, the amount of metals released as dictated by LME rules.  This gives them an edge when trading for their own accounts.  The LME is conducting a review of its processes.  Chief Executive Officer Martin Abbott believes that these warehouses are used primarily for "financing deals" and because the rate of delivery is low or because of the warehouse conflict of interest.

The source for this article can be accessed here.

Hedge Funds and the Credit Crisis

The RAND Group published a paper examining the role of hedge funds during the credit crisis of 2008.  The question was whether or not funds create or contribute to the systemic risk that caused it.  This was triggered when Lehman Brothers declared bankruptcy and caused the financial markets to melt down globally.  The researchers reviewed that crisis and the 1998 private bailout of Long Term Capital Management orchestrated by the Federal Reserve.  They found six areas of concern:

• Lack of information on hedge funds
• Lack of appropriate margin in derivative trades
• Runs of prime brokers
• Short selling
• Compromised risk management incentives
• Lack of portfolio liquidity and excessive leverage

Dodd-Frank legislation was passed to handle these issues to avoid new crises in the future.  To create more transparency on hedge funds, the reform was to require funds with $150 million in assets under management to register with the SEC.  However, there is a loophole as non-US hedge funds with no offices in the US and less than $25 million invested from US investors were exempt from the reporting requirement.  There is pending legislation from Europe that would affect those hedge funds but no reform in Asia is anticipated.  Funds are to submit the following data points:  assets under management, total leverage, counterparty credit risk exposure, trading and investment positions, asset valuation processes, asset types, side arrangements or letters with investors and trading practices.  Additionally, the SEC would have periodic inspections of the fund.  Since derivative trades were at the center of the crisis, swap trades need to be registered in a central repository. 

The CFTC and SEC would impose minimum capital restrictions on these trades and the funds must trade them on an exchange if possible.  To prevent funds from closing their prime brokerage accounts, their accounts would be segregated from the prime broker’s funds and rehypothecation of assets would not be allowed.  Rehypothecation is when the prime broker uses the hedge fund’s assets for its own business such as securities lending or as collateral. 

Short selling rules will be enforced to prevent bear raids on a stock.  When a stock falls 10% or more in price from the prior day’s close, then the uptick rule will be triggered.  This rule restricts short sales to when the stock price is above the last sale or the best bid price.   In a short sale, the stock must be borrowed first.  These shares must be delivered by the settlement date (within three days) of the trade.  There must be monthly disclosure of short positions aggregated by stock. 

Dodd-Frank also limits bank investment in hedge funds to three percent of the fund’s assets and three percent of the fund’s tier 1 capital.  Hopefully, this will prevent banks from bailing out their funds.  This is true from a financial perspective but banks may be motivated to bail them out to mitigate reputational risk.  These restrictions are only applicable to US entities.

To address the liquidity and leverage concerns, large hedge funds with $50 billion or more of assets under management are candidates to be regulated by the Federal Reserve Bank.  These funds are determined by the Financial Stability Oversight Council who assesses them based on a wide range of factors; quantitative and qualitative, industry and firm-based and the Department of the Treasury.  If two thirds of the council plus Treasury agree, then the fund will be regulated.  There will be position limits on futures and options for physical commodities and annual stress tests for funds with $10 billion in assets under three scenarios – baseline, adverse and severely adverse.  Regulating the prime brokers of hedge funds indirectly addresses leverage.  They will have higher capital requirements and have less credit to extend to funds, limiting their available leverage.

The reforms are changing the way hedge funds operate.  This is ironic as they did not cause the credit crisis.  The gap is in the potential lack of portfolio liquidity and excessive leverage.   There is too long a time delay before reporting positions.  The number of funds covered are few.  Prime brokers and regulators will have incomplete data as funds use multiple brokers and home countries.   Of the other points, lack of information, lack of margin on derivative trades and runs on prime brokers are strongly addressed and short selling and risk management incentives are moderately addressed.  Regulators should continue analyzing the hedge fund universe to better understand and monitor their risk.

The source for this article can be accessed here.

The Chinese Yuan as a Reserve Currency

The rise of China to become the second largest global economy has allowed it to execute foreign trade and investments using the yuan.  This helps reduce transaction costs for Chinese importers and exporters and reduces volatility for commodities.  China would like to see a basket of possible reserves currencies such as the US dollar, yuan and euro.  Unfortunately, none of them alternatives are realistic.  The euro is facing a crisis and possible breakup.  For the yuan to graduate to become a reserve currency, China would have to increase the limits on capital flows into its markets - allowing securities, currency exchange rates and interest rates to float.  This would degrade the Politburo's control of the country's economic policy.

John Williamson, a senior fellow at the Peterson Institute for International Economics in Washington, identified two advantages of the dollar as reserve currency:  China's large holdings of US assets is used to maintain the yuan to dollar peg but encumbers their policies and the US can enforce financial sanctions.  Other than those items, the US has no freedom to manage its exchange rate.  He predicts that the US dollar will remain the currency for the next 25 years.

The source for this article can be accessed here.

The Yale Model for Individual Investors

A new strategy called "endowment in a box" has been attracting individual investors who want a diversified asset allocation that is predominantly in alternative investment.  It is based on the Yale model made famous by David Swensen at Yale and Jack Meyer at Harvard.  The strategy invests in equities and fixed income securities from around the world and has a high allocation to hedge funds, private equity, real estate and commodities.  Some of the more well known managers are HighVista Strategies, Makena Capital Management and Morgan Creek Capital Management.  I was privileged enough to hear Mark Yusko, CEO and Chief Investment Officer of Morgan Creek, speak at the Hedge Fund Roundtable last year.  Their goal is to have high returns with the least risk possible.

The article provided an inside look at HighVista Strategies which is run by Andre Perold, a former professor at Harvard Business School, Brian Chu, Jesse Barnes and Raphael Schorr.  It has $3.6 billion in assets under management.  It has outperformed the Standard & Poor's 500 index by 15.3% for the period between October 2005 to June 2012.  Dr. Perold has two main tenets:  don't lose a lot of money and get the highest returns.  HighVista invests in the top managers and uses index funds to balance their asset allocation.  56% of the portfolio is in hedge funds and private equity.  The remainder is in cash, global stock indices and bonds.  They are invested in 75 fund managers such as Convexity Capital (fixed income hedge fund), Berkshire Partners (private equity fund) and Xander Group (emerging markets hedge fund).  Another alternative holding is catastrophe bonds that pay off when there is a natural disaster such as a hurricane or earthquake.  For the traditional assets, the rule is:  the higher the risk; the higher the cash allocation.  The equities allocation is based on the VIX index which measures the option market's assessment of future volatility in the S&P 500 index.  The higher the VIX; the lower the equities holdings.

The article from Barron's can be accessed here.

Trends in Tail Risk Investing

310 investors were asked their views on tail risk in today's market environment in a survey conducted by the Economist Intelligence Unit on behalf of State Street Global Advisors.  They were located in the US and Western Europe and consisted of institutional investors (asset managers and pension funds), family offices, consultants and private banks.  The definition of tail risk is an investment that moves more then three standard deviations from a normal distribution (think bell curve) of returns.  Since the 2008 credit crisis, these events have seemingly multiplied.  Adding tail risk protection is becoming part of more investors' asset allocation model.

Traditionally, most managers diversified across the standard equity and fixed income classes along geographic, capitalization and security type.  There was a reduction of 5% of investors in using this strategy, led by institutional investors.  Slightly more consultants, family offices and private banks are using diversification even though the credit crisis showed that all asset classes correlate to 1.  The other strategy to fall was fund of hedge funds due to poor returns, high management costs and the loss of confidence with the Madoff affair.

Strategy winners were managed volatility equity strategies, managed futures and alternative investments such as real estate, commodities and infrastructure.  Managed volatility was increased across the board by the investors with the largest increase by private banks.  There was a split decision on managed futures with private banks and consultants allocating more and institutional investors allocating less assets.  Risk budgeting was stable overall with the institutional investors decrease in that strategy offset by the increase by private banks.  Direct hedging was unchanged as institutional investors and private banks doing more and consultants and family offices doing less.  The same split occurred with hedge fund investing.

Seven main factors affected investors' choice of tail risk strategy.  They are, in order of importance, liquidity, regulatory issues, risk aversion, transparency, fees, understanding/persistency of returns and lack of understanding of new asset classes.  According to Bryan Kelly, assistant professor of finance and Neubauer Family Faculty Fellow at the University of Chicago's Booth School of Business, the best hedges are debt derivatives and credit default swaps.  However, they are not liquid as they do not trade over central exchanges.  They are not considered safe investments such as AAA sovereign debt or gold for the risk averse.  The cost and fees associated with tail risk assets is another consideration.  Most investors know that it will lower expected returns and be volatile.  Another issue is the mismatch in time horizons.  Many products are short term and are being bought by long term investors such as pension funds.

Since the credit crisis, investing has been influenced more by macro economic events.  This will continue into the near future as we continue to hear about possible regional and global recessions, the breakup of the Eurozone, the US fiscal cliff and unrest in the Middle East.  Investors are trying to find the best hedges as 80% of them agree that managing tail risk is part of their investment planning.  71% believe that an event is likely to happen within one year and it will be worse than in the past.

The source for this article can be accessed here.

Asset Allocation Trends in Public Pensions

In the October 1, 2012 issue of Pensions & Investments, I noticed an interesting statistic in an article about the funding ratios of public pension plans.  The weighted average asset allocation of the top 100 plans in Pensions & Investments' universe for 2011 is as follows:

• US Equities - 21.6%
• Global Equities - 16.9%
• International Equities - 13.2%
• Fixed Income - 23.9%
• Private Equity - 7.5%
• Real Estate - 6.3%
• Hedge Funds - 2.3%
• Real Return - 1.2%
• Commodities - 0.4%
• Cash/Other - 4.4%

The target allocation for the same year was as follows:

• US Equities - 15.7%
• Global Equities - 23.6%
• International Equities - 9.7%
• Fixed Income - 25.2%
• Private Equity - 7.3%
• Real Estate - 7.6%
• Hedge Funds - 2.8%
• Real Return - 1.6%
• Commodities - 0.6%
• Cash/Other - 2.9%

The weighted average asset allocation 2007 is as follows:

• US Equities - 36.5%
• Global Equities - 6.0%
• International Equities - 17.4%
• Fixed Income - 25.3%
• Private Equity - 5.2%
• Real Estate - 5.7%
• Hedge Funds - 0.9%
• Commodities - 0.2%
• Cash/Other - 2.8%

The biggest losers from 2007 to 2011 were US and International Equities.  Global Equities, Private Equity, Real Estate, Hedge Funds, Real Return and Commodities were net gainers.  Based on the target allocations, we can expect more investment in Global Equities, Real Estate, Hedge Funds, Real Return and Commodities.

The source for this article can be accessed here.

Management Fees and Investor Alignment in Private Equity

In an article in Pensions & Investments, the Blackstone Group announced that it does not count management fees as one of the items that align general partner and investors' (i.e. limited partners) interests.  Instead, the company's investment in its own funds removes that issue - according to Steven Schwarzman, Blackstone founder, chairman and CEO.  During the company's twenty year history, it has invested $6 billion in its funds, alongside their clients.  For example, they committed $826 million in capital for the Blackstone Capital Partners VI LP, a $16 billion fund.

However, Blackstone is one of the few publicly traded private equity firms.  It is in the interest of management, who have large holdings of the stock, to maximize their management fees versus their performance fees.  The reason is that research analysts value these companies based on their management fees and/or assets under management.  Performance fees are too volatile and unpredictable to include in their analysis.  Instead of concentrating on a fund's performance, the company would be gathering assets.  Also, if performance fees are already high, there is less incentive to hit the hurdle.

Charging management fees was originally used to help private equity funds keep the lights on while investing capital.  For larger funds, the fees can be much more than the basic costs.  According to the Institutional Limited Partners Association, management fees should be based on reasonable operating expenses plus reasonable salaries.  In the second quarter of 2012, Blackstone had $373.4 million in fees, $113 million in expenses and $269 million in salaries.  Some institutional investors are pushing back on management fees and receiving fee discounts of 25 basis points if they invest $100 million or more.

The source for this article can be accessed here.

Effects of Pension Risk Transfer on Fund Managers

In the largest pension risk transfer deal of all time, General Motors offloaded $26 billion in pension liabilities to Prudential in exchange for $29 billion in assets.  This plan was executed in two stages.  First, a lump sum settlement was offered to 42,000 retirees which are about 33% of the entire beneficiaries.  For the rest of them, their pensions would be covered by annuities bought from Prudential.  The deal was created with help from Morgan Stanley, State Street and Oliver Wyman.  Other large corporations seeking to follow in General Motors’ footsteps are Alcatel-Lucent, Verizon, Ford and United Technologies.

With the rise of defined contribution plans like 401K’s, corporations have reduced or terminated their defined benefits plans.  Since 1975, the number had dropped from 250,000 to less than 30,000 – and 33% were frozen.  At the same time, pension funds have been reducing their risk profile by reducing their asset allocation to equities, doing buy-in deals (buying annuities to hold on their balance sheet) or buy-outs (doing a General Motors type of deal).  The giant deal is a harbinger of things to come.  In a survey of 500 global companies, Aon Hewitt discovered the following pension planning:

• 35% will offer lump sums to beneficiaries
• 6% will buy annuities to cover their payouts
• 6% will transfer their plan
• 4% will terminate their pension plan

Of the insurance companies involved in pension risk transfer, only Prudential and MetLife are able to take on General Motors-like transactions.  There is capacity to handle approximately $100 billion in pensions and General Motors has taken $26 billion of it.  Besides the big two, other firms that are participating in the business include MassMutual, Principal, American General and Mutual of Omaha.  Non-insurance companies such as JC Flowers and private equity firms are also targeting US companies.

These transactions may change the game in the financial services sector.  Asset managers of pension funds will lose assets to the insurers.  Managers specializing in long duration bond, liability driven investing, ETFs and alternative managers will gain.  So will consultants in risk transfer:  Aon Hewitt, Mercer and Towers Watson.  Corporate pensions currently hold twenty percent of US stocks.  As these assets are sold in exchange for bonds, there will be secular weakness in the stock market.  From a government point of view, the Pension Benefit Guaranty Corporation (PBGC) will be under pressure as only healthy pensions can transfer their risk, leaving underfunded pensions to be insured.

The source for this posting is the September 2012 article of ai-CIO.com.

Multi-strategy Funds Are Disappearing

Multi-strategy hedge funds have had a tough time lately due to poor performance and high redemptions since the credit crisis of 2008.  Several large funds have closed - Arrowhawk Capital Partners ($575 million in AUM), Drake Capital Management ($6 billion in AUM), Deephaven Capital Management ($4.5 billion in AUM) and Stark Investments ($7.2 billion in AUM).  The last and latest, Stark, is still running $1 billion in single investment strategies such as Stark Mortgage Opportunities and Stark ABS Opportunities fund.  Other funds have converted to single strategies successfully.  They include some of the more famous names:  SAC Capital Advisors, Highbridge Capital Management and Maverick Capital Management as well as Black River Asset Management, Halcyon Asset Management, Polygon Global Partners, HBK Capital Management and York Capital Management.  The challenges in the current environment for multi-strategy funds are:

• Difficult to generate excess returns (alpha) in all strategies at the same time
• High employee turnover
• Work culture is not collaborative across strategies.  Multi-strategy funds start in convertible arbitrage or event driven strategies and then add equity long/short and other strategies.  The mindsets needed to be successful in each strategy are different and not conducive to working together.

The source for this article can be accessed here.

Fund of Hedge Funds Continue Losing Market Share

Fund of hedge funds (FOHF) are under pressure due to poor performance in 2011 and their failures of 2008 - ability to give their investors liquidity and superior due diligence.  Many funds' liquidity was negatively affected by their hedge funds' imposition of gates and side pockets for poorly performing assets.  Confidence in FoHF's due diligence capabilities were lost in the Madoff ponzi scheme.

In 2007, 43% of hedge fund assets were invested through FoHFs.  In 2010, it was down to 34% (Statistics are from Hedge Fund Research.) as more investors started making direct investments into funds.  In absolute numbers, assets under management for FoHFs are down from 2010 to 2011 - $646 billion to $620 billion - despite the uptick in hedge fund assets.

Since 2008, private banking clients have divested themselves from hedge funds.  Insurance companies and endowments are investing directly into funds and family offices are using managed accounts and pension consultants instead of FoHF.

According to Peter Laurelli, vice president, research, eVestment Alliance in the article at finalternatives.com, “To an evolving landscape of hedge fund investors, it is increasingly difficult to showcase a clear, superior value provided by funds of funds, specifically using performance comparisons over every possible sub-classification, to other methods of accessing the industry.“Fund of funds’ core strength of single investment diversification to the hedge fund industry is moving towards a niche role as larger allocators to the industry become more comfortable investing directly, or working with consultants who may already be employed for traditional portfolios.”

The source for this article can be accessed here.

Hedge Funds Are Not An Asset Class

Capital Generation Partners (CGP), an investment advisory firm, analyzed portfolio diversification ideas.  They concluded that there are only three asset classes:  debt, cash and equity.  Alternative investments such as hedge funds should not be classified as an asset class.  They should be classified based on their underlying positions.  Hedge funds are merely investment strategies for these assets.  There are four strategies based on two points:  directional versus arbitrage and systematic versus discretionary.  These four strategies and three asset classes combine to create twelve buckets.

Equities
directional & discretionary - equity long/short, long only, real estate, private equity and 130/30 funds
directional & systematic - equity index trackers and quantitative funds
arbitrage & discretionary - equity market neutral and event/risk arbitrage
arbitrage & systematic - equity statistical arbitrage and systematic CTAs

Cash & Commodities
directional & discretionary - global macro, physical commodities and currency (carry) trading
directional & systematic - trend following CTAs, commodity ETFs and money market funds
arbitrage & discretionary - commodity/macro curve trading and volatility arbitrage
arbitrage & systematic - statistical arbitrage and systematic CTAs

Fixed Income
directional & discretionary - fixed income long/short and distressed debt
directional & systematic - bond indices
arbitrage & discretionary - global macro and structured credit
arbitrage & systematic - fixed income arbitrage and systematic CTAs

Proper diversification includes having non-correlated assets in a portfolio.  CGP analyzed returns from 2000 to 2010 for the twelve categories.  Their conclusions were:

• Alternative investments are not real diversifiers of a traditional equity/fixed income portfolio
• Hedge funds should be allocated across the twelve categories and not be treated as a separate asset class
• Fund managers should be closely monitored for style drift
• Correlation map indicates that larger allocations should be made to hedge funds

The correlation heat map from the paper confirms an earlier study by Welton Investment Management.  Global macro and managed futures (Barclays CTA Index in this case) are not correlated to other hedge fund strategies.  In CGP's chart, equity market neutral can be added.

The source for this article can be accessed here.

A Study on Infrastructure Investments

In recent years, a new asset class investing in the infrastructure of a nation has been classified for use in asset allocation models.  What is infrastructure?  It is commonly known as assets in the transportation, telecommunications, electricity and water sectors.  Emerging and developed nations need to build out their infrastructure for different reasons.  The former due to population growth and economic development.  The latter to upgrade and replace existing infrastructure.

Usually, these projects would be financed by local or national governments.  The developed world is still recovering from the credit crisis in 2008 and dealing with the continuing Eurozone situation.  The emerging world, other than China, does not have the financial resources.  They are unlikely to meet global need for infrastructure investments.  This could be as high as US $70 trillion for 2005 to 2030.  Hence, the call for private investors such as pension funds and private equity firms.

Investors may invest directly into infrastructure assets through Public Private Partnerships or project finance structures.  They are exposed to disadvantages such as liquidity risk, very long investment time horizon, political risk, concentration risk, regulatory risk and high capital requirements.  They can buy securities of companies directly or buy funds/indices in sectors related to infrastructure.  The reduces all risks except for political and regulatory.  Market risk is higher in this case.

In the article Risk, Return and Cash Flow Characteristics of Private Equity Investments in Infrastructure in the Alternative Investment Analyst Review, Florian Bitsch, research assistant at the Center for Entrepreneurial and Financial Studies; Axel Buchner, postdoctoral researcher at Technische Universitat Munchen and Christoph Kaserer, professor at Technische Universitat Munchen obtained detailed private equity deal information, including monthly cash flow data, from the Center for Private Equity Research for 363 infrastructure and 11,223 non-infrastructure deals from January 1971 to September 2009.  The deals had to be exited and spanned the alternative energy, transportation, natural resources, energy and telecommunications sectors.


From the data they find:

• Infrastructure investments have shorter time horizons
• Infrastructure investments are twice as big as non-Infrastructure deals
• Infrastructure does not offer more stable cash flows
• Infrastructure investments have higher returns and lower risks.  They have lower default rates and better returns than non-infrastructure deals.
• Brownfield investments of established companies have lower risk and default rates.  They have better returns than greenfield investments.  Private equity and venture capital deals were used as proxies.

The factors affecting fund performance were:

• Excess investment capital does not bid up asset prices for infrastructure deals as it does for non-infrastructure
• Data is inconclusive that infrastructure investments are an effective hedge against inflation
• Infrastructure deals are correlated to the markets
• Infrastructure deals are not correlated to the broader economy, as defined as GDP
• Infrastructure and non-infrastructure deals are negatively affected by interest rate changes
• Fund manager experience has no influence on returns
• Longer dated deals have better returns as poorly performing deals are exited quickly
• A fund requiring additional rounds of financing usually have poor returns
• The size of the deal does not affect infrastructure deal returns
• European infrastructure deals have the best performance
• Transportation is the best performing sector  

Investors Uncertain about BRIC Countries

Many investors believe that any future long term stock market performance will be driven by the BRIC (Brazil, Russia, India and China) countries in the emerging world.  Opinions on the short term outlook have changed.  There is a split among managers due to the continuing Eurozone crisis and slowing global growth.  The returns for the four countries are less than the MSCI Emerging Markets index which has underperformed the MSCI World index by 834 and 124 basis points for the past one and three years through May 31.  Below is a table comparing each country's return versus the MSCI Emerging Markets index for the same time period.

BRIC Country	One Year Return	Three Year Return
Brazil	-823 bp	-703 bp
Russia	-1,130 bp	-544 bp
India	-802 bp	-785 bp
China	-24 bp	-540 bp

The managers on either side of the trade are:

Pro

Richard Titherington, managing director and chief investment officer for emerging markets equity and JP Morgan Asset Management ($33 billion in assets under management) is aggressively overweight China and sees the pullback to lower valuations as a buying signal.

Allan Conway, head of global emerging markets equities at Schroder Investment Management $23.2 billion in AUM); Manu Vandenbulck, senior investment manager and ING Investment Management ($3.3 billion in AUM); Christian Deseglise, managing director and head of institutional sales in the Americas for HSBC Global Asset Management ($32.2 billion in AUM) and Gary Greenberg, head of emerging markets at Hermes Fund Managers ($740 million in AUM) are overweight China.  They are relying on China's government to cushion any economic downturn.  The lower valuations of the Chinese stock market lessen market risk.  The BRIC countries are becoming non-correlated with the developed world.

Gaurav Mallik, portfolio manager for global active quantitative equity at State Street Global Advisors ($6 billion in AUM), is buying smaller companies in Russia and China.

Con
Todd McClone, portfolio manager at William Blair ($9 billion in AUM), says that lower commodity prices, the Eurozone crisis, inflation and slowing economies are negatively affecting the markets in BRIC countries.

Paul Bouchy, managing director and head of research at Parametric Portfolio Associates, is underweight BRIC and overweight in the frontier countries.

The source for this article can be accessed here.

How Hedge Funds Perform When the VIX is High

In a recent article  published in the Alternative Investment Analyst Review, Mikhail Munenzon, CFA, CAIA, PRM and Director of Asset Allocation and Risk at the Observatory, researched how different hedge fund strategies performed during periods of volatility over twenty years.  The data came from the Center for International Securities and Derivatives Markets Indices.  The strategies covered were convertible arbitrage, distressed, merger arbitrage, commodity trading advisor, macro, equity long/short, equity market neutral, emerging markets and event driven.  He looked at the indices for traditional assets too:  S&P 500 Index, JPM Morgan Aggregate Bond Total Return Index, SP GSCI Commodities Index and the FTSE EPRA/NAREIT US Total Return Index, a real estate index. Volatility was measured by the VIX index from 12/31/91 to 1/29/10.  Munenzon created six categories:  less than 20, 20-25, 25-30, 30-35, 35-40 and more than 40.  The VIX was under 30 90% of the time and under 20 50% of the time.  Based on the data, it does not jump randomly from being quiet to being volatile.  They remain calm or volatile at times and remain so for the near future.  Each index's return was analyzed during the same timeframe.  Here are the most important points:

• Only four of fourteen indices had positive returns in all conditions:  commodity trading advisor, macro, equity market neutral and JPM Morgan Aggregate Bond Total Return Index
• Superior long term performance of hedge funds are due their ability to limit their losses during times of market stress due to unconstrained investing.
• This affirms an earlier study by Welton Investment Management stating that macro and commodities are the two strategies that are not correlated with the stock markets

Please note that data is based on indices.  Individual portfolios of funds may have different results.

Study Shows CDS Trading Increases Bankruptcy Risk

In a previous post, we looked at the bankruptcy and re-structuring process through the court system.  We detailed that the debt holders are converted into equity holders.  Any debt holders with a 33% position have a blocking position to approve any deal.  At the same time, they can hedge their holdings by purchasing credit default swaps (CDS).  Since the recovery rates for a re-structuring range up to 65%, a March study by Marti Subrahmanyamy of New York University's Stern School of Business, Dragon Yongjun Tang and Sarah Qian Wang of the University of Hong Kong's School of Economics and Finance indicates that fully insured and over-insured investors push the company into bankruptcy to recover 100% of their bonds' value.  They are called empty creditors.  They have "an economic interest in the firm's claims but no risk alignment with the other bondholders..."  Companies with empty creditors have higher bankruptcy rates due to less monitoring.  This may lead to higher risk taking by the borrowers.  Finally, companies that have CDS traded on them have more debt holders or lenders.  This impedes the re-structuring process.

The authors analyzed data for 901 CDS for North American companies between June 1997 to April 2009.  Of the 1,628 firms that filed for bankruptcy, 60 had CDS traded.  They reviewed the 3,863 companies that had their credit rating downgraded by Standard & Poor's.  Statistical analysis confirmed the following after CDS began trading on those firms:

• Majority of firms are A or BBB rated
• S&P ratings fall for investment grade firms (A, AA or AAA) and more firms become non-investment grade (BBB and below)

When a company is the underlying for a CDS, it is more likely to be downgraded by a rating agency as a precursor to bankruptcy.  This occurs more readily when there are more CDS contracts traded and when re-structuring does not trigger a payout on the contact.  The probability of bankruptcy is 0.33% versus 0.14% for a non-CDS traded company.

The source for this article, with the authors' statistical analyses, can be accessed here.

Growing Emerging Hedge Funds

I have been invited to be a guest author on another blog:  Simon Kerr on Hedge Fund.  The article, seed capital for hedge funds, can be accessed here.

Barbell Allocation Model Causes Flight from Mutual Funds

Since the credit crisis where the Standard & Poor's 500 fell 37% in one year, there has been a flight from the traditional equity mutual funds to fixed income, index and alternative funds.  The old model, where an investor was diversified based on style (growth or value), capitalization and geography, is no longer performing well.  They are gravitating to a barbell model with allocations to passive indices and alternative investments.  According to eVestment Alliance, $90 billion and $29.3 billion were redeemed from US large cap growth and value equity funds.  This is pressuring traditional asset managers and subsidiaries of banks and insurance companies to change their practices.

For example, Francis Ghiloni, director of distribution and client management for Scottish Widows Investment Partnership (SWIP), noted that the barbell approach is more popular since traditional investments are encountering higher volatility and risk.  SWIP re-organized their investment team along global lines, replacing the former regional coverage model, and promoting their quantitative research team.  Aviva Investors is also moving assets from fundamental to quantitative analysis teams.

The source for this article can be accessed here.

Assets Surge into Activist Hedge Funds

According to an article in Pensions & Investments, institutional investors have started the trend of classifying their asset allocation to alternative investments based on their type of asset (equity, fixed income or commodities) instead of in a separate bucket.  This has fueled an increase of capital into activist hedge funds such as ValueAct Capital Management. Starboard Value and Cevian Capital in the second half of 2011 and first quarter of 2012.  The reasoning behind placing them into the equity classification is that they hold long positions.  The Florida State Board of Administration recently invested $125 million in Starboard.  The New Jersey Division of Investment, New York State Common Retirement Fund and Virginia Retirement System placed $600 million with Cevian Capital.  Overall, the investments in managers with a constructive approach are larger than the more aggressive approach favored by Bill Ackman of Pershing Square Capital Management and Daniel Loeb of Third Point.  Some of the larger funds that work with company management to improve their share price are Cevian Capital, JANA Partners and Paulson & Company.

Activist hedge fund managers keep their holdings for a longer period of time than other fund managers.  They need time for their campaigns to improve the value of the stock.  According to Stephen Nesbitt, CEO of Cliffwater LLC, the strategy has strong, uncorrelated returns in the last five years.  For a sample selection of eight funds, the return was 8.6%.  The Russell 3000 Index's return was 0% and the Morgan Stanley Capital International All Country World Index returned 2.8% for the same time period.  This is a natural attraction for pensions, endowments and foundations.

Managed Futures Selection Factors

Managed futures are marketed as having low correlation to stock and bond markets.  However, within the strategy, returns between managers (known as commodity trading advisors or CTAs) have varied.  According to David Kavanagh, CEO of Grant Park Managed Futures Mutual Fund, and Greg Anderson, Chief Investment Officer of Princeton Fund Advisors, returns are affected by four factors:  type of market securities, trading strategy, timeframe and research methodology.  They may trade in different futures covering currencies, energy, equity, fixed income, food or metals.  Obviously, the trading strategy - whether it is trend following or contrarian - affects returns.  Timeframes are how long a security is held.  They may be held for days or months.  Research methodology determines the trading signals for the manager.  They can be quantitative, top down or technical (charts).

According to Anderson, the four risks in the managed futures space are selecting the wrong manager, poor design of the investment portfolio, trading strategies becoming obsolete due to changing markets and tail risk.  Kavanagh adds understanding the edge of any CTA over its competitors.  The manager selection process considers several factors:  track record, trading strategy, fund's operations and back office, experience of the principals and fit within a portfolio.  On a more detailed level, Anderson would consider the interest income, cost structure (including trading commissions), trading results and an audited performance history.

This article can be accessed here at www.finalternatives.com.

New Opportunities in Collateral Management for Banks

Starting next year, derivative trades such as interest rate swaps will be traded over central clearing houses.  They are currently done as private transactions between two counterparties.  To protect themselves from losses if a counterparty should not pay out their revenue responsibilities, the clearing houses will demand collateral.  It is estimated that the collateral needed to cover these trades will increase by $2 trillion or 50% because many of these transactions are long term in nature.  Several banks are poised to take advantage of the new business - JP Morgan, Northern Trust, State Street and BNP Paribas.  There could be $2 billion in revenue at stake.

Already, there are several partnerships being agreed on to allow counterparties access to new assets and to optimize collateral at different firms.  BNP Paribas Securities Services and Euroclear, the European securities warehouse that settles trades, are allowing their clients to use collateral at BNP to finance trades on Euroclear.

The source for this article can be accessed here.

Will China Have a Soft Landing?

Paul Gambles, Managing Partner of MBMG International, discussed the state of China's economy last month in a television interview with the Money Channel and on his blog.  He believes that there will be a hard or very hard landing.  A soft landing is not an option.  This is due to a number of factors:

• Lack of transparency in the economy - Chinese economic data is not reliable because of strong central government control of the data and economy.  The government determines where capital is invested, regardless of returns.  There may be bad investments that are priced incorrectly due to government stimulus and forced lending (which often turn into bad debts).  The GDP growth of 8.9% may not be real if the underlying loans are examined.  An example of government influenced pricing is when the Huijin Sovereign Wealth Fund bought controlling positions in the four largest banks:  Agricultural Bank of China, Bank of China, Industrial & Commercial Bank of China and China Construction Bank as a show of support in 2011.  Nobody knows what these banks are worth.
• Foreign Direct Investment is slowing in China.  It has become less attractive to investors and holding $1.5 trillion in US assets.  Exporting to Europe to diversify away from the dollar has become difficult due to the Eurozone crisis.  If the government had spent the US dollars, it would have increased inflation or the value of renminbi.  China was unwilling to accept either consequence and had to hold US assets.  China is repeating what Japan did thirty years earlier and both are similar to a currency hedge fund that is overexposed to the US dollar.
• China is predicted to become the world's largest economy by 2020.  A closed government and controlled economy will make it difficult to pass the US.
• Xi Jinping, the President-elect and successor to President Hu, did not get approved by the military.

Notes from a Hedge Fund Survey - Part II

SEI and Greenwich Associates conducted a survey of institutional investors and hedge funds.  Part I was summarized earlier.  Part II was released later and dealt with issues on investing, institutional standards for fund evaluation, selection and monitoring.  105 investors participated in the survey.  They could be classified as endowments, foundations, family offices, corporate funds, public pension funds, consultants, union plans and non-profit organizations.  85% of the institutions are located in the US with some in UK, Canada and Scandinavia.  Their assets under management (AUM) fit into four bands:

• 42.2% had less than $500 million
• 15.5% had $500 million to $1 billion
• 25.4% had $1 billion to $5 billion
• 16.9% had more than $5 billion

The new top three challenge for investors is manager selection.  This is due to the increasing number of hedge funds being launched due to the recovery in the markets and Graham-Dodd legislation.  Many have indistinguishable strategies.  If a manager can define his unique strategy to investors in understandable terms, he is ahead of other funds.  In terms of the criteria for selecting managers, investors emphasize investment philosophy, the quality of the personnel on the investment team, risk management and having an identifiable, repeatable source of alpha.  AUM of a fund is low in importance for investors when choosing a fund.  20% have no AUM minimum and 15% have a $50 million to $100 million minimum.  The age of the fund does not seem to affect investors.  According to the survey, 14% would invest in a fund with no record and 24% in a fund with one to three year record.  Large institutions are more willing to hire emerging managers.  Smaller investors favor larger, more established funds.  Smaller investors also are more likely to hire investment consultants for their advice.  Larger investors are more likely to invest directly in hedge funds.

The other worries have remained the same since the credit crisis in 2008 - portfolio transparency, poor performance, leverage, risk management and liquidity.

Hedge Funds and ETFs

Some high profile hedge funds use ETFs (Exchange Traded Funds) and ETPs (Exchange Traded Products) as part of their investment strategy.  These luminaries include Bridgewater Associates, Eton Park Capital Management, Lone Pine Capital, Millennium Management, Oak Hill Investment Management and Paulson & Co. according to their 13-F filings with the Securities and Exchange Commission (SEC) in December 2011.  Why would these managers use these efficient and low cost securities, risking the ire of their investors who are paying them "2 and 20"?  They are used to:

• Used as a temporary investment while individual securities are picked.  They allow the manager to invest quickly in the space before establish stock specific positions.
• Invest in markets or sectors where the manager does not have the infrastructure for detailed research or specific knowledge
• Arbitrage a security
• Mask their trades by using a large ETF
• Invest based on macro opinions
• Get exposure on a sector level when individual securities' correlations are high
• ETFs have liquidity which allows managers to trade out of positions easily
• Establish a position in sectors or regions with low liquidity and buying securities is hard
• Hedge a position

Depending on the fund strategy, fund of fund managers and investment consultants view ETF usage as positive for global macro and systematic trading strategies and negative for fundamental stock pickers.  Equity long/short managers are receiving the "2 and 20" to pick securities, not to be an index fund.

Top 5 ETFs Held by Hedge Funds

• SPDR Gold Shares (GLD)
• Vanguard ETF Emerging Markets
• Market Vectors ETF Gold Miners
• Vanguard Total Bond Market ETF
• Powershares QQQ

Top 5 Shorted ETFs by Hedge Funds

• SPDR S&P 500 ETF SPY Index
• iShares Russell 2000 Index Fund IWM Index
• Energy Select Sector SPDR Fund
• Financial Select Sector SPDR Fund
• SPDR S&P Midcap 400 ETF Trust

The source for this article can be accessed here.

Farmland: the New Real Estate Investment

Institutional investors are becoming interested in a specialized real estate subsector:  farmland.  In today's low return market, its steady income plus appreciation has become attractive.  Looking at annualized returns for 1, 3, 5, 10 and 20 year periods (as of 12/31/2011), the income ranges from 6.59% to 7.90% while the appreciation returns 3.31% to 7.87%.  Total returns are from 9.9% to 14.88% according to the National Council of Real Estate Investment Fiduciaries (NCREIF).  In addition, agriculture has low correlations to other asset classes and is a hedge against inflation.

Some pension funds buying farmland in the past 1.5 years are Iowa Public Employees Retirement System ($100 million with UBS Agrivest), City of Alexandria (Va.) Fire and Police Officers Pension Fund ($5.5 million with Hancock Agricultural Investment Group), Oregon Public Employees Retirement Fund, the Los Angeles City Employees Retirement System and the Orange County (Calif.) Employees Retirement System.  Callan Associates, a consulting firm, has looked for farmland for investors eleven times in the past 1.5 years.  Between 2000 and 2010, they conducted one search.

To give you a frame of reference for the price appreciation of farmland, the NCREIF Farmland index's market value in the fourth quarter of 2006 was $1.4 billion.  In the fourth quarter of 2011, it was $29 billion - an increase of 107%.  The increase is driven by strong farmer profitability and competition for land.  It is not driven by the institutional investors coming into the real estate market.  The index only represents 1% to 2% of the $2 trillion in total farmland value.

The source for this article can be found here.

Investment Ideas in Real Estate Markets

As a member of the Chartered Alternative Investment Analyst (CAIA) Association, I am fortunate enough to attend various learning events.  Last week, I listened to four investment professionals about their views on the Real Estate Markets.  Real estate may be termed the original alternative asset.  They were Rod Hinze, Founder and Portfolio Manager of Keypoint Capital Management;  Richard Adler, Managing Director and Co-founder of European Investors Inc;  Michael Stratta, Investment Analyst of Aviva Investors and Scott Yetta (sic) of Cerberus RMBS Opportunity Fund at Cerberus Capital Management.  They have different viewpoints on the markets.  Hinze manages an equity long/short hedge fund.  Adler invests in REITs and directly in real estate.  Stratta manages funds of funds and private equity funds.  Cerberus has launched a fund that invests in structure finance.

Keypoint's portfolio is market neutral.  It seeks absolute return by investing in real estate related securities.  Hinze was long on several subsectors such as student housing, data centers and movie theaters.  He was short on big box retailers, toxic debt structures in mortgage REITs and the standard overvalued securities.  Last year, the real estate appeared correlated to the equity markets.  But if the subsectors were analyzed, there was much variation.  Class A malls and self-storage were up and banks were down.  Keypoint's beta or correlation to the markets ranges from 0.1 to 0.2.

On the private equity side, Stratta is seeing a continuation of a trend for better liquidity terms for investors.  The preference is for an open-ended fund with quarterly availability for redemptions.  The classic closed-end fund with a ten year lockup is losing its popularity as more investors are looking for yield and dividends; not for appreciation.  Stratta covers the Americas and has investments in Brazil (Sao Paolo and Rio de Janeiro).  He is already looking at opportunities in what he terms the next emerging markets:  Panama, Peru, the Dominican Republic and Colombia.  Canada is divided into two parts:  Vancouver and everywhere else.  Asian banks control most of the real estate transactions in Vancouver.  Other banks cannot crack the market.

European Investors Inc's regional allocations are:  overweight in Asia, underweight the US and standard weighting for Europe.  Adler invests in REITs and real estate.  They have a portfolio of $1.5 billion in direct investments.  He spoke extensively about the increased volatility and correlation to financial stocks of REITs.  Due to the new ETFs on REIT indices, electronic arbitrage trading is causing large market moves in the same manner as the equity markets.  Regarding investment ideas, he is positive on Thailand, the Philippines, Turkey, Israel and Brazil because the general or macro conditions are favorable.  Mortgage REITs, such as Annaly Capital Management, have a 15% interest rate.  He expects that to retreat to the upper single digits - which is sustainable over the long term.  There is a also a new REIT asset class with the single family house rental as the underlying.  These homes may be a straight lease or lease to buy.  In five years, there are projected to be two to three million homes in this category.  The expected returns for this investment is 8%.  The first deal in this REIT was in April 2011 in a deal co-sponsored by Fannie Mae and Credit Suisse.

The final speaker from Cerberus Capital had recently launched a $1 billion hedge fund focused on Residential Mortgage Back Securities (RMBS).  For a fund manager, he gave a surprising amount of detail to non-investors.  He split his investment universe into agency and non-agency securities which are a $10 trillion market.  Agency securities are created by government sponsored entities such as Ginnie Mae, Fannie Mae and Freddie Mac.  Their main risk is pre-payment of loans and mortgages.  Non-agency securities have credit and interest rate risks.  The fund managers analyze RMBS based on a number of factors:

• Yield is analyzed based on the behavior of the borrowers.  Of the universe of borrowers within an RMBS, they look at how many will pre-pay (i.e. re-finance), pay late, get loan modifications or default.   Scott is seeing value in borrowers with hybrid loans such as the 5/1 homeowner loan where the first five years are fixed rate and then the rate floats.  The most interesting borrowers are two to three years into the floating rate period.  They are pre-paying their loans by re-financing into fixed rate loans at historically low rates.  Many of these loans may be found in a mezzanine tranche.
• The recovery value of houses liquidations is viewed on a state by state basis because of differing state foreclosure laws.  A house in California can be foreclosed without going through court approval;  not so in New York and Florida.  The shorter the period, the higher the rate.
• Built in expectations that there will be another 10% drop in real estate
• Investors need conservative assumptions on the above three factors as a cushion for credit risk.  2011 returns were down because of two macro events:  the Eurozone crisis and the delay in the selling of Maiden Lane II, a huge loan portfolio of the Federal Reserve Bank of New York.  In the third and fourth quarters, funds hedged against a drop in RMBS - anticipating that Maiden Lane II would cause an oversupply of this product.  They hedged using residential indices such as the ABX and Prime Index, commercial index (CMBX) and high yield/investment grade indices.  Paying for the loss protection caused real estate hedge funds to underperform the market.
• Documentation and loan servicers are understaffed and large institutions are selling their units
• Government policy directly affects agency securities.  Cerberus has some insight into the federal government by having Dan Quayle and Jack Snow as staff and by owning GMAC.

Thank you, CAIA, for organizing this great event.

Status Report: Institutions Increasing Allocations to Hedge Funds

According to an article at Pensions & Investments, several pension funds are increasing their portfolio allocation to hedge funds.  The favored strategies are equity long/short and credit strategies.  Florida State Board of Administration, State of Wisconsin Investment Board and North Carolina Retirement Systems have invested in equity long/short.  The funds winning these mandates can be found here.  Despite negative returns for equity long/short in the HFRI Equity Hedge Fund index for 2011, investors are not planning any withdrawals.  The total amount being invested is $2.5 billion.

There are several reasons for institutions to increase their allocations:

• Hedge funds are no longer a discrete asset class but are classified as equity or fixed income based on their holdings
• Equity long/short funds reduce the volatility of returns
• Fixed income long/short funds generate excess returns (alpha) on the long and short sides of trades

The Costs of Changing Investment Funds

Institutional investors change the composition of their portfolios due to their funds' poor performance, style drift, change in key personnel, etc.  When a fund is replaced, securities will have to be sold and bought.  The investors will try their best to minimize any costs and manage any risks.  The costs can be split into these categories:

• Direct - fees to hire a transition manager, trading commissions and taxes
• Indirect - bid and offer spreads and market impact
• Opportunity - prices of held securities being adversely affected by other traders
• Administrative expenses - finding the replacement manager, legal fees, rewriting fund documents and marketing material and custody fees

It is suggested that a transition manager be used if 2 or 3 of the following criteria apply to the portfolio:

• Transaction volume is more than $50 million
• Complex transition across asset classes or with daily valuations requirement
• Investor does not have resources for executing transition
• Out of the markets risks are higher because of allocation or settlement cycle differences
• Low tolerance for out of the market risks

The manager is usually rated by "implementation shortfall".  This compares the target portfolio's performance against the transition portfolio's performance.  This shows actual return versus theoretical return if there was an instantaneous switch to the new portfolio.

The source for this article, written by Freeman Wood and Paul Sachs of the Mercer Sentinel Group, can be accessed here.

Notes from a Hedge Fund Survey - Part I

Last month, SEI and Greenwich Associates published part 1 of the Fifth Annual Global Survey of Institutional Hedge Fund Investors.  There were several themes that emerged from the report for investors.

• Allocations to hedge funds are rising but at a slower rate than last year.  In 2012, they are projected to be 17.8% of investor portfolios.  They were just 12% in 2008.  The increase is led by endowments.
• The top goal for institutions for hedge fund investing is absolute return in 2011.  This was in response to the poor performance of the HFRI Index.  In prior years, the goal was to mitigate risk by investing in non-correlated assets.
• Investors use hedge funds to manage their investment risks through diversification among investments to decrease volatility
• More institutions are investing directly into hedge funds rather than funds of hedge funds.  According to Citi Prime Finance, investors are unhappy with paying an additional layer of management and incentive fees, are concerned that funds of funds are too diversified and want to have more control over their portfolio.  The larger institutions have the resources to invest directly.  Of the smaller ones (less than $500 million AUM), 64% use funds of funds.
• Most popular strategies are the simpler ones:  equity long/short, event driven and credit
• Limited interest in re-allocating to UCITS or mutual funds
• The most important challenge for hedge fund investors is having performance expectations met.  This is probably in response to the 2011 performance.  In 2010, when returns were good, then transparency was important.

Longevity Swaps: A New Product for Pension Funds

Pensions & Investments reported that more and more funds in the United Kingdom are using longevity swap trades to hedge their pension payout risk. This product was first traded in 2009 and, in 2011, had a notional amount of $10.7 billion in contracts traded. Pension funds are guarding against retirees living longer than their actuarial predictions where they would be responsible for extra payments. The companies selling this risk include insurance companies such as Swiss Re, Prudential Financial Incorporated and Legal & General Group and investment banks such as Goldman Sachs, Deutsche Bank, JP Morgan Chase and Credit Suisse.

The swap trades are easier for pension funds to execute than other hedging vehicles known as buy-ins or buy-outs. These transactions also transfer the pension payout risk but need large upfront payments. Sometimes, the institutions have to sell assets to afford the payments.

The source for this artivle can be found here.

Most Popular Hedge Funds for Institutions

Pension & Investments recently compiled a list of 35 hedge fund and 10 fund of fund managers that had the largest capital inflows in 2011. To join the club, the funds had to have at least an additional $100 million. Bear in mind that these investments were made by institutional investors (pension funds, endowments, foundations and sovereign wealth funds) and are only part of the entire investment picture. Many new investments and the assets invested are not reported. As an example, BlueMountain Capital Management garnered $323 million according to the study but, according to its founder and president, had $1 billion from institutional investors.

The most popular hedge fund strategies were credit/fixed income, multi-strategy, long/short, activist and global macro based on the number of funds. Based on new assets under management, multi-strategy led the way; followed by credit/fixed income, activist and long/short. Capula Investment, a multi-strategy fund, added $825 million to rank number one. Next inline were D.E. Shaw Group ($555 million), Trian Fund Management ($500), ValueAct Capital Partners ($500 million and Ascend Capital ($465 million). Other famous names lower on the list are Brevan Howard Asset Management, Carlson Capital Management, Avenue Capital Group, Och-Ziff Capital Management Group, GSO Capital Partners (a part of the Blackstone Group), Astenbeck Capital Management and Saba Capital Partners.

The fund of fund list was led by Prisma Capital Partners ($666 million), Permal Group - a subsidiary of Legg Mason ($507 million), Blackstone Alternative Asset Management ($506 million) and Pacific Alternative Asset Management ($400 million). Three funds - Prisma, Blackstone and Pacific Alternative Asset Management - are recipients of an increased allocation by Kentucky Retirement Systems ($400 million each) that vaulted them to the top of the rankings. There were three trends affecting the allocation to fund of funds. Public and corporate pension plans are increasing their investments to diversify their fixed income portfolios. Fund of funds are expecting non-US pension plans to invest in alternative assets.

The source for this article can be accessed here.