Innovations in the Fund of Hedge Funds World

The fund of fund managers that have survived the redemptions stemming from the 2008 financial crisis have updated their methods of delivering value to investors.  There were five new ways listed in the September 16th issue of Pension & Investments, Managers in Midst of Metamorphosis article.  They are:

• Hedge fund mutual funds with daily valuation and liquidity - Aurora Investment Management LLC in Chicago has launched a hedge fund mutual fund in March with $145 million in assets under management 
• Hybrid hedge fund/private equity funds of funds with 3 to 5 year lockups - Mesirow Advanced Strategies Inc. has launched opportunistic hedge fund of funds using five strategies:  corporate liquidations, European credit and structured products, secondary collateralized debt obligations, distressed non-agency retail mortgage backed securities and distressed emerging markets debt arbitrage trades.  The lockup period allows for the manager to retain cash reserves in order to take advantage of mispriced markets while allowing for the manager to hold positions during times of market stress.
• Hedge fund beta strategies to be used with alpha generating hedge fund portfolios - GAM created the hedge fund beta portfolios based on Barclays PLC risk premium indices.  They actively manage left-tail risk during market downturns of 1 to 2 standard deviations.
• New investment capabilities to create broader alternative investment boutiques - Grosvenor Capital Management LP offers customized separate managed accounts across many alternative investment strategies
• Single strategy hedge funds with concentrated positions for institutional investors 

Timberland: Factors Are Positive for Investing

In the most recent issue of the Alternative Investment Analyst Review, there is an article regarding investments in a specific sector of real estate named Timberland Investing in the US: What You Need to Know Now.   It was written by three timberland asset managers:  Timothy Corriero, Managing Director at FIA Timber Partners; Tom Healey, also Managing Director at FIA Timber Partners and Scott Bond, Vice President and Director of Marketing and Client Relations at Forest Investment Associates.  They studied several topics on the state of timberland investing.

Historical returns can be split into 4 phases.  From the 1987 to 1998, returns ranged from 10% to 37% annually.  The asset class was new and there was little investor interest.  As was detailed in a separate post, the opportunity was presented to investors when corporations started selling their land in order to concentrate on their core businesses.  From 1999 to 2003, returns ranged from 4% to 10% due to the recession of 2001 even though timberland investment management companies were created.  From 2003 to 2008, returns ranged from 8% to 20% as the real estate bubble caused land values to rise.  Corporations sold their land at what we now would call inflated prices.  After 2008, returns ranged from 1% to 8%.  This coincides with the crash in the housing market which lowered the demand for timber.

These returns were further analyzed against inflation as measured by the Consumer Price Index over 10 year investment periods.  They always were higher.  The same cannot be said of the returns of equities and bonds.  Equities lagged during the credit crisis and in the 1970s.  Bond returns were lower in the 1980s.

Timber is split geographically by product:  Pacific Northwest and Southern.  The Pacific Northwest has been performing better in 2013.  This is due to its proximity to Chinese demand and lowered competition from Canada.  Canadian production has been cut in half by a pine beetle epidemic in British Columbia.

The future for timberland investing in the Pacific Northwest is promising.  The recent recovery in the housing market will cause increased demand for homebuilding, a main consumer of wood.  That, combined with the loss of Canadian wood, should cause timber and timberland land prices to rise.  The improved returns and ability to hedge against inflation make this an attractive asset.

Of Volatility and Tail Risk Management

On April 15, 2013, Pensions & Investments published a special volatility management section.  Ever since the credit crisis of 2008, institutional investors have been seeking protection against volatility.  In the article Investors adapting portfolios to volatile environment, Christine Williamson and Kevin Olsen identified eight ways investors were solving this:

• Portfolio diversification using traditional or risk factor asset allocation
• Liability-driven investment - have a bond portfolio to match the institution's liabilities and an equity portfolio for enhanced returns
• Risk parity - set target risk levels and divide equally across diversified, low volatility and uncorrelated assets; use leverage to enhance returns of the low volatility assets.  AQR Capital Management has $25 billion in assets under management with this approach.
• Invest in low volatility equities and bonds.  Some fund managers in this strategy are AJO LP ($1 billion in equities), Acadian Asset Management ($5 billion in equities) and GAM USA ($15 billion in fixed income).
• Invest in active volatility trading strategies to hedge against tail risks and to provide extra returns. PIMCO ($20 billion AUM) and Capula Investment Management are two funds in this sphere.
• Tail risk hedging from drawdowns of 20% or more
• Use derivative overlays to protect portfolios from downside volatility.  The practitioners in this space are Russell Investments ($5 billion) and NISA Investmtne Advisors ($20 billion).
• All-in-one solutions that use the some or all of the above methods

Other investors are using the all-in-one approach.  Healthcare of Ontario Pension Plan (HOOPP) is using a liability hedged portfolio of liability-driven investment(government and real return bonds), portfolio diversification (real estate), equity derivative overlay and absolute return.  From 2003 to 2012, their annual return is 10.3% versus 8.9% for their benchmark.

The Fairfield County Employees' Retirement System is using liability-driven investing (leveraged fixed income portfolio and equities), portfolio diversification (real estate and commodities) and absolute return (global macro, multi-strategy and distressed credit funds).  Their 10 year return is 10.4%.

In the Alternative Investment Analyst Review, Andrew Rozanov, CAIA, Managing Director, Head of Permal Sovereign Advisory recommends using global macro hedge fund strategy to hedge tail risk instead of investing in a tail risk fund.  Global macro fund managers have more flexibility than tail risk managers.  They can be long or short volatility.  They are cheaper and have the potential for better returns.

Mike Sebastian, Partner at Hewitt EnnisKnupp, Inc. and Zoltan Karacsony, CFA, Investment Consultant at Hewitt EnnisKnupp, Inc. like low volatility equities, managed futures and global macro strategies for tail risk protection.  The issues with low volatility equities strategy are that it is difficult to predict the future volatility of a stock, trading costs weigh down returns, the strategy is not effective at all times and not proven to outperform the benchmarks conclusively.  Managed futures are good hedges in low volatility and bad markets.  They tend to underperform in high volatility and trendless markets.  They agree with Rozanov and like global macro for its flexibility.

Four people from SSgA:  Robert Benson, CFA, Senior Quantitative Research Analyst, Advanced Research Center; Robert Shapiro, CFA, CAIA, Investment Solutions; Dane Smith, Investment Strategist, Alternative Investments and Ric Thomas, CFA, Head of Strategy and Research, Investment Solutions analyzed nine variations of four tail risk strategies.  They were long volatility (VIX 1 month futures, VIX 5 month futures, variance swaps on the Standard & Poors' 500 for 1 month and 3 month 6 month contracts), low volatility equities (long low beta stocks and short high beta stocks of the Russell 3000 Index and short bias strategies), trend following (Barclays CTA Index) and equity exposure management (buy out of the money puts of the S&P 500 and go long/short when 10 month moving average is below/above the trend line).  The strategies with the highest certainty of protection and lowest performance drag were trend following and long low beta and short high beta stocks strategies.

Investors should take an overall approach that encompasses a diversified, risk-based model with sufficient hedging (against inflation, deflation and interest rate risk) plus a global macro allocation to be long volatility.

The sources for this article can be accessed below:

Investors adapting portfolios to volatile environment by Christine Williamson and Kevin Olsen

Investors keep a watchful eye on the horizon for risk by Christine Williamson and Kevin Olsen

Alternative Investment Analyst Review, Q1 2013

"Long Term Investors, Tail Risk Hedging and the Role of Global Macro in Institutional Portfolios" by Andrew Rozanov, CAIA, Managing Director, Head of Permal Sovereign Advisory

"Tales from the Downside:  Risk Reduction Strategies" by Mike Sebastian, Partner at Hewitt EnnisKnupp, Inc. and Zoltan Karacsony, CFA, Investment Consultant at Hewitt EnnisKnupp, Inc.

"A Comparison of Tail Risk Protection Strategies in the U.S. Market" by Robert Benson, CFA, Senior Quantitative Research Analyst, Advanced Research Center, SSgA; Robert Shapiro, CFA, CAIA, Investment Solutions, SSgA; Dane Smith, Investment Strategist, Alternative Investments, SSgA and Ric Thomas, CFA, Head of Strategy and Research, Investment Solutions, SSgA.

Update on TXU Corporation LBO

In 2007, a group of private equity firms and investment banks bought TXU Corporation for $45 billion in the largest leveraged buyout transaction.  The company changed its name to Energy Future Holdings Corporation but the fact remains that it is in trouble.  This is due to lower gas prices (the U.S. fracking expansion) and demand (from the recession and jobless recovery).  Two years ago, the debt associated to the deal was trading at a discount.  As of March 31, 2013, KKR has thrown in the towel and is valuing the bonds at 0.05 of cost.

On April 15, the company proposed to re-structure its $32 billion in debt.  Equity owners would be wiped out and the senior debt owners and the original private equity consortium would split the company 85%/15%.  Already, distressed debt managers Franklin Templeton Investments, Apollo Global Management LLC, Centerbridge Partners and Third Point LLC are buying debt which would be converted to equity stakes in case of re-structuring or bankruptcy proceedings.

A few institutional investors were unlucky enough to have negotiated terms to invest directly in the buyout.  Others were only invested in the private equity funds leading the deal.  Some of them are the biggest pensions such as California State Teachers' Retirement System, California Public Employees' Retirement System, Washington State Investment Board, Oregon Public Employees' Retirement Fund, New Jersey Division of Investment and Pennsylvania State Employees' Retirement System.  According to TorreyCove Capital Partners LLC of La Jolla, California, KKR 2006, the fund with the TXU deal, will still have a higher return than the S&P 500 in 2012.  KKR 2006 returned 7.09% versus 3.25% for the index.  The privileged co-investors included California State Teachers' Retirement System and Government of Singapore Investment Corporation.  There is no word if either managed to offload their direct investments through the secondary market.

In another twist, some fund managers think that Energy Future Holdings could extend its debt into the future. Since 2009, the company has re-financed $25.7 billion of its debt.

The source for this article can be accessed here.

Gold: Is the Bubble Popping?

On Friday, May 17th, gold futures dropped to $1,358.30 per ounce;  retracing its steps from a high of $1,920 per ounce in September 2011.  Year to date, it has dropped about 18% on the COMEX in New York.  Money managers such as BlackRock, Northern Trust, Farallon Capital Management, Whitebox Advisers and Soros Fund Management have reduced or hedged against gold as represented by the exchange traded product:  SPDR Gold Trust.

BlackRock and Northern Trust sold more than 50% of their holdings and Soros Fund Management sold 12% as of March 31, 2013.  This follows a quarter where Soros Fund Management sold 55% of their gold position.  Whitebox Advisors sold 90% of their smaller position.  Farallon Capital Management used put options on the SPDR Gold Trust as their negative view.

On a high level, the number of short futures and options contracts on gold is growing.  According to EPFR Global of Cambridge, Massachusetts, $21.1 billion in gold and gold-related funds have been sold by investors.

On the other hand, Paulson & Company, Schroder Investment Management Group and Elliott Management have held onto or bought SPDR Gold Trust.  They are looking at increased demand from India and China as a catalyst for a recovery in the asset.

The source for this article can be accessed here.

Hedge Funds Want Retail Investors

The number of hedge fund mutual funds or liquid alternative funds has increased from 343 at year end 2007 to 838 at year end 2012.  Assets under management are $90.3 billion, an increase of 14% over the same timeframe.  Neil Siegel, Managing Director and head of global marketing and product development at Neuberger Berman, and Evan Mizrachy, head of retail alternatives at BlackRock Alternative Investments, believe that retail investors and their 401(K) and IRA accounts are under-served by and under-allocated to alternatives.  Expanding into this segment would diversity hedge funds' client base.  On the other hand, retail investors demand daily liquidity requirements which would limit their investment universe and, maybe, performance.

According to Morningstar, the strategies run by these funds are led by long/short ($25.8 billion), market neutral ($19.5 billion), multi alternative ($17.5 billion), currency ($11.7 billion), managed futures ($8.5 billion),  short ($6.8 billion) and trading ($449 million).  Of course, these assets under management are clearly miniscule when compared to the $13.1 trillion in US mutual funds according to the Investment Company Institute.

The oldest fund, Merger Fund, has been around for 23 years using merger arbitrage strategy to give investors assets with low correlation to stock markets and volatility.  Two major institutions, FMR and Blackstone have also moved into this space.  FMR, parent company of Fidelity Management, uses Arden Asset Management to manage their alternative vehicles while Blackstone Alternative Asset Management is building their business organically.  The largest manager by far is PIMCO but their investors are mainly institutional.

The source for this article can be found at Pensions & Investments.

Dark Trading Pools

In the April 2013 issue of ai-CIO, there is an article about the growth of dark trading pools.  These are private exchanges where investors trade anonymously.  Their nicknames include non-displayed markets, private markets, off-exchange trading or upstairs trading.  In 2008, they made up 6.5% of the total trading volume in US Equities.  In 2012, they have grown to take up more than 13%.

The main advantage of the dark pools is privacy.  An institutional investor getting into or out of a large position would not move the stock price much.  On the exchanges, a large order would be noticed and the price would move against the investor.  To hide their order, it would have to be split into many smaller orders by a sell-side salestrader.  Dark pools are not foolproof.  The stocks are usually limited to those with the highest trading volumes.  The operator of the dark pool could use the information to trade ahead of the investor or sell it to another trader.

Since 2007, investment banks have created dark pools such as Credit Suisse's Crossfinder and Goldman Sachs' Sigma X.  To generate additional revenue, they have given access to algorithmic traders in the quest to find discrepancies in security prices among exchanges.  If dark pool trading volume in more numerous trading venues grows, then the prices on public exchanges may no longer be accurate.  More pools means that investors would have search harder to find the other side of the trade.  It seems that the solution for one issue has created others.

Frontier Markets - the Next Growth Investment?

Five professional investors from four buyside firms believe that frontier markets have a greater opportunity set than emerging markets.  They carry less risk (i.e. less volatile) and have less correlation with the developed world markets.  According to Andrew Brudenell, portfolio manager at HSBC Global Asset Management, they are cheaper and have higher dividend yields.  Chad Cleaver and Howard Schwab, portfolio managers at Driehaus Capital Management agree.  In addition, the best opportunities are in small and mid cap stocks and in markets with native consumers.  These ideas have outperformed the MSCI BRIC index handily.  Since the summer of 2009, this index is flat or down slightly.  Other customized indices based on the above investing themes include ASEAN index, ANDEAN index and a consumer stock index.  The ASEAN index is comprised of Thailand, the Philippines and Indonesia.  It is up 70% for the same timeframe.  The ANDEAN index is comprised of stocks from Colombia, Peru and Chile and is up 65%.  An index comprised of consumer discretionary and consumer staples securities (50%/50% split) is up 75%.

Kemal Ahmed, portfolio manager at Investec Asset Management, adds another wrinkle to the frontier markets theme.  He has coined the term horizon markets which consists of frontier markets plus the 14 smaller countries in the MSCI Emerging Markets index.  He calls them Smaller EM.  The seven larger countries account for 80% of the index's capitalization and are called Large EM.  The BRIC nations make up 60% of the index.

According to David Stein, chief investment officer at Parametric, the correlations within the frontier markets has remained low (approximately 0.3) while they have been rising between countries in the developed and emerging markets.  While investing in a particular country in the frontier markets may be riskier, diversification among country risks should lead to safer and less volatile returns.

These factors make frontier markets a compelling alternative to a standard investment in the BRIC countries.

CalPERS Reviews Hedge Fund Strategy

The California Public Employees Retirement Systems (CalPERS) is in the midst of changing its allocation strategy for its hedge fund investments.  There are $5.2 billion in assets out of a total of $254.9 billion.  As part of its total portfolio, it is not that important but the absolute dollar numbers are impressive.  They are seeking to reduce their equity exposure by investing in assets that are not correlated with long only funds, private equity and high yield bonds.  Edigio Robertiello, senior portfolio manager of absolute return strategies, has proposed the following changes:

• CalPERS will have to raise the percentage of assets allocated to hedge funds to much more than currently
• Classifying the hedge fund allocation separately from the global equities allocation
• Limiting the beta to global equity markets to 0.20 
• Setting a standard deviation target for returns to 8%

While CalPERS is considering Robertiello's recommendations, he is reviewing the current hedge fund investments and making the following changes:

• Reducing the number of hedge funds to concentrate assets in fewer strategies
• Reducing the fund of funds allocation to 15% from 29%.  Emerging fund of funds will have a 10% allocation.
• Reducing the investments in Asia and Europe to 5% from 19%
• Increasing the allocations to equity market neutral and global macro to 10% each
• Adding an allocation to event driven to 5%
• Increasing the allocation to equity long/short to 15%

Since the portfolio has underperformed its internal benchmark by 2% since it was begun, Robertiello is hoping that the changes will improve its performance.  Against this backdrop, CalPERS is evaluating whether or not passive management is more efficient than active management.

The source for this article can be accessed here.

Private Equity: End of Life Fund Assets

The traditional methods of exiting private equity investments (i.e. IPO) are not working for many investments bought in 2006 to 2008.  These companies were acquired using unrealistic projections or at high prices and have no buyers.  They are perhaps the last holdings of a fund.  According to Andrew Hawkins, CEO and Founder of NewGlobe Capital Partners, there are $75 billion worth of companies in this category.  NewGlobe and two other firms, Vanterra and Hamilton Lane, will buy these assets, allowing the private equity fund to close and return cash to its investors.  This allows the fund manager to start up a new fund.  What does NewGlobe receive?  Oversight of the new fund and a chance to invest in the new fund.

There are two other exits that are available:  (master limited partnerships (MLPs)) and employee stock option plans (ESOPs).  The fund would sell the company to the MLP.  Then the MLP would offer an IPO.  This would be a good resolution for a company that is still too small to be publicly traded or have a low valuation.  The ESOP route would sell the asset to the employees and management of the firm.

The source for this article can be accessed here.

Increased Risk Appetite Leading to More Block Trades

As the conditions in the equity markets have improved in 2013, the sell side has been engaging in riskier transactions.  In a Reuters article written by Anthony Hughes and Stephen Lacey, an increasing percentage of the Equity Capital Markets business has gone the route of the block trade.  This is a secondary or follow-on offering of a stock where the bank buys the shares and sells them to the buy side within the same or next day.  Another term for the trade is capital commitment.

The sources of stock in 2013 are private equity firms seeking exits from past leverage buyouts.  In the past, they would be early investors in or founders of a company seeking to diversify their investments.  Think Bill Gates and Microsoft.  Some large divestments in February of private equity deals include $1.8 billion for HCA (KKR and Bain Capital), $1.5 billion for LyondellBasel Industries (Apollo Group), $500 million for Sensata Technologies (Bain Capital), $321 million for Team Health Holdings (Blackstone) and $930 million for NXP Semiconductors (KKR).  Through February of 2013, follow-on offerings comprise of 40% of the entire capital markets business.  The share was 24.5% in 2012 and 18% in 2011.

Since the shares are owned by the bank, it is exposed to increased risk.  If the offering price was not above the buying price, the bank would suffer large losses.  Since the stock market has experienced rising returns, low volatility and investor optimism, there is an increased appetite for risk.  As one banker said in the article, "It is going to keep working until someone gets their face blown off."

Timber, a Natural Resource Alternative Asset

In the February 2013 issue of ai-CIO, there were two articles about timber, the natural resource investment. In Paula Vasan's article, she states that the returns of this asset type were 15% per year during the period from 1987 to 2010.  This statistic was sourced from the National Council of Real Estate Investment Fiduciaries.  The returns for the Standard & Poor's 500 were only 11.5% per year.  The future is also bright as Jeremy Grantham of GMO Capital predicted that timber prices will rise 6.5% annually for the next seven years.  In the current interest rate environment, those returns are stellar.

The second article, named Location, Sustainability, Growing Trees, was an interview with TIAA-CREF's timberland investing team:  Jose Minaya, Managing Director and Head of Global Natural Resources and Infrastructure Investments, and Sandy LaBaugh, Senior Director, Portfolio Manager - Global Timberland and GreenWood Resources' timberland team:  Clark Binkley, Ph.D., Managing Director and Chief Investment Officer and Jeff Nuss, President and Chief Executive Officer.  I have compiled a short summary of important points.

Institutional investing in timberland started in the late 1970's when companies in the forest products sector sold their land in order to concentrate on their core businesses.  Assets under management grew approximately 20% per year until 2005.  The growth rate has slowed as there are less assets for purchase.  The goals for investing were to earn good risk-adjusted returns with some cash flow, diversify into a non-correlated (with equities and fixed income) asset and have a hedge against inflation.  There are three ways to invest:  1.  the manager owns the land and hires timberland specialists to manage the timber, 2.  buy timber funds or assets or 3.  buy Real Estate Investment Trusts (REITs) that have timberland exposure.

TIAA-CREF investments into timber are split 75%/25% U.S./non-U.S. geographically.  They are currently looking at assets in Chile, Brazil, Uruguay, Europe and any supplier close to China.  The team likes the fact that there is a finite supply of timber and the corresponding effect on prices.

Greenwood Resources is a forest manager that works with institutional investors to maximize their returns on timberland.  They are seeing more investment in international timber and greenfield plantations.  The latter is when they plant trees for harvesting.  They are not harvesting old forest growth which is fraught with social and political risks.

Housing Recovery Makes Mortgage Bonds Attractive Investments

At the beginning of the year, there was a consensus among sell side analysts, mutual fund managers and hedge fund managers that mortgage bonds that were not tied to Fannie Mae and Freddie Mac (non-agency) were the most attractive fixed income investment for 2013.  Non-agency bonds backed by subprime mortgages of the pre-2007 vintage jumped 41% last year.  High yield bonds gained 16% and agency debt gained 2.6% for the same period.  These returns were sourced from bond indices run by Barclays and Bank of America Merrill Lynch.

Major hedge funds investing or invested in these securities are Goldman Sachs Group, D.E. Shaw, Angelo Gordon, Hayman Capital and Elliott Management.  Elliott Management only sold their bonds because their yields had fallen too low.  The giants of fixed income mutual funds:  PIMCO, TCW and DoubleLine believe prices will continue to run up even though more and more investors are buying the asset class.  Projected returns for non-agency mortgage bonds are 8%.  Compare that to high yield projections (7%) and investment grade projections (3%).

The source for this article can be accessed here.

Most Popular Hedge Fund Strategy is Relative Value

Assets under management for hedge funds using the relative value strategy have surpassed the equity long/short strategy for the first time in the fourth quarter of 2012.  As of September 30, both strategies had a market share of 26.7% of the $2.192 trillion hedge fund industry.  The next most popular strategies were event driven at 24.5% and macro at 22.1%.  To give you a sense of where equity long/short was coming from, it was 56.3% of all assets under management for hedge funds in 2000.  Several factors accounted for the shift:

• Investors reducing their exposure to equities to diversify and reduce their portfolios' volatility
• Investors investing directly into hedge funds and away from fund of hedge funds, which are heavily weighted towards equity strategies
• Underperformance of equity long/short strategy over the past five years

Year	HFRI Equity Index	HFRI Relative Value Index
2008	(26.65)%	(18.04)%
2009	24.57%	25.81%
2010	10.45%	11.43%
2011	(8.38)%	0.15%
2012	7.39%	10.04%

Funds that have experienced significant inflows include BlueMountain Capital Management, Pine River Capital Management, Marathon Asset Management, MKP Capital Management and Brigade Capital Management.

However, for 2013, several investors are reviewing the value proposition of equity long/short funds.  Fixed income returns are projected to be low and stockpickers will be in vogue again as macroeconomic moves such as Quantitative Easing 3 fade.

The source for this article can be accessed here.

A To Do List for Funds of Hedge Funds

In prior articles, I have noted that funds of hedge funds (FoHFs) are losing assets under management even as the assets of hedge funds have bounced to above pre-crisis levels.  The percentage of assets invested through FoHFs had fallen to 34% in 2010.  The SEI Knowledge Partnership conducted a survey of 220 institutional investors, investment consultants and FoHF managers in June 2012.  The main complaints of investors were the underperformance of FoHFs over the past three years, high fees, lack of transparency and portfolios that are correlated with other asset classes.

The research paper listed seven topics for FoHFs to address:

• Customization of reporting, portfolios (the underlying managers of a FoHF), transparency and liquidity to create complete investor solutions
• Investing in and seeding emerging managers
• Improved risk management during market collapses
• Overdiversification.  Investors are now interested in a "best ideas" portfolio.
• Creating account structures to handle investors' requirements such as separate managed accounts, derivatives, quantitative products and registered products (UCITS and mutual funds)
• Using their subject matter expertise to advise investors on manager selection, portfolio construction, asset allocation and special strategies
• Aligning the fee structure with the investor's interests such as raising the hurdle rate or charging a flat fee

To read the entire paper, the report may be accessed here.