Favored Hedge Fund Strategies for 2016

In the Hedge Fund Outlook article in Pensions & Investments, the fund strategies most likely to outperform in 2016 were global macro, long/short equity and long/short credit.  The survey included chief investment officers, strategists and allocators.  Excess returns would be generated by several factors:  differences in the economic recoveries of developed and emerging markets, volatility and the current high yield credit and energy situations.

Let's review each of the strategies' opportunities:

• Global macro - Dominic Wilson, managing director and head of strategy and research for MKP Capital Management, likes going long in US dollar and Euro and shorting currencies in emerging markets countries that are reliant on commodity exports.  He predicts that developed countries' economic growth will be higher in 2016.
• Long/short equity - Christopher Pucillo, CEO and chief investment officer of Solus Alternative Asset Management is shorting energy, minerals and mining companies.  He sees that sector as being in distress. There are companies that would be a great value to buy.
• Long/short credit - William Ferri, group managing director and head of global products of UBS Asset Management, and Daniel Och, CEO and executive managing director of Och-Ziff Capital Management, are bearish on corporate credit.  UBS does not like it generically.  Mr. Och is focused on the energy sector and is predicting that " a lot of (energy) firms will be experiencing distress" and may be attractive investments in 2016.

A Look Ahead to 2016

In the December 28th issue of Pensions & Investments, a group of investment strategists was polled regarding their outlook for the markets in the new year.  The panel consisted of Krishna Memani, chief investment officer and head of fixed income of OppenheimerFunds Inc.;  James Paulsen, executive vice president and chief investment strategist of Wells Capital Management;  A. Gary Shilling, president and economist at A. Gary Shilling & Co. Inc. and Tim Hopper, managing director and chief economist of TIAA-CREF.

• Mr. Memani is modestly bullish on equities, predicting returns in the mid- to high single digits only.  He is negative on fixed income.
• Mr. Paulsen likes international equities and real assets - real estate, commodities, etc.  He is negative on fixed income. 
• Mr. Shilling likes 30-year Treasury bonds and the U.S. dollar.  He is short commodities.
• Mr. Hopper likes international equities.  He is negative on fixed income.

The issues discussed included the list below:

Factors for 2016

• U.S. economic growth
• Different actions by Central Banks
• Falling commodity prices
• China
• Geopolitics

US economic growth is being forecast between 2% and 3%.  Mr. Shilling is at the low end and Messrs. Hopper and Paulsen are at the high end of the spectrum.  Mr. Shilling views this as the continuing deleveraging process from the credit crisis.  "...we are eight years into..." a ten year process.

Much ado has been made about the Federal Reserve's raising the interest rate by a quarter point.  Elsewhere, in Europe, China and Japan, the central banks have been adding monetary stimulus to their economies.  Mr. Paulsen said, "...the U.S. is at full employment and is going to have to tighten...The U.S. has crossed over (into) full employment, while no one else is even close to it."  

The other stimulus for the world has been the fall in commodity prices, especially crude oil.  There has been an excess of supply in the world with U.S. shale oil production, Iranian sanctions to be lifted and no cooperation among OPEC members.

China will continue to slow down according to Mr. Memani and may place "deflationary pressures...That will depress prices and create intense bouts of volatility".  Mr. Shilling pointed out that it is still an export driven economy despite the efforts of the Chinese government to change to a consumer based economy.  If the western economies are growing slowly, then China and the emerging markets will be impacted.

The strategists did not view geopolitics as affecting investments, even with the ongoing U.S. presidential race.  Investors should be have enough diversification in their portfolios to handle any events.  Mr. Shilling did not agree.  Investors buy Treasuries and the U.S. dollar in these instances, same as in 2007.

Oil Drops 56% Since June: What to Do

The hot topic in the new year has been the falling price of oil.  A barrel of oil to $48 for West Texas Intermediate crude.  Fund managers are positioning their portfolios to take advantage and protect themselves from the situation.  Some opinions and investment ideas were presented in two articles in Pensions & Investments on January 12, 2015.

Winners:

• Countries that import oil in the emerging markets (Turkey, Indonesia and India) 
• Stocks in the consumer discretionary sector
• Infrastructure investments

Risky:

• Countries that export oil in the emerging markets (Russia, Venezuela and Nigeria)
• Oil industry stocks
• High yield bonds
• Index investors for UK and emerging markets

The sources for these ideas can be found here and here.

A Sampling of Hedge Fund Views on 2014

Hedge fund managers are predicting financial markets to be more volatile and, thus, afford them more opportunities for improved investment returns in 2014 according to articles in Pension & Investments 2014 Outlook report.

Central bank intervention from the Federal Reserve, European Central Bank and Bank of Japan has kept interest rates low and caused equity prices to rebound impressively in 2013.  Their policies, along with the US budget accord and a recovered housing market, will continue to help the world economy to strengthen.  This will give investors confidence to pursue more risky assets such as emerging markets and small cap stocks.

According to Lee Ainslie of Maverick Capital, equity long/short will have better performance as the correlations between securities' returns will be lower.  Managers relying on fundamental analysis of corporates will have their positions less influenced by macro economic factors.  Other hedge funds are looking at complex strategies for returns.  Farallon Capital is investing in distressed European debt, event driven equity in merger arbitrage and US commercial real estate.  They are buying foreclosed properties and flipping them to other investors after rehabilitating and finding renters for them.  DW Investment Management will continue to hold positions in single corporate credit securities, structured corporate credit, residential and commercial mortgage backed securities and student loan backed instruments.  Magnetar Capital will invest in the US energy build out caused by the explosion of hydraulic fracturing.

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 

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.

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.

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.

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.

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.

A New Alternative Investment: Infrastructure

Institutional Investors are planning to invest directly in infrastructure projects such as fixing roads, bridges, water lines, sewage plants and dams.  Returns on these investments are above their benchmarks.  Ontario Teachers' Pension Plan was up 13% in 2010 versus 4% for their benchmark and Ontario Municipal Employees Retirement Systems was up 10.1% versus 8.5% for their benchmark.  Other investors looking at the $50 trillion market (over the next 25 years) include California Public Employees' Retirement Systems, California State Teachers' Retirement Systems, Abu Dhabi Investment Authority, China Investment Corporation and Government Investment Corporation of Singapore.

The source for this article can be accessed here.

When Will Asset Correlation Break in 2012?

According to Ned Davis Research, the monthly returns of eight diverse asset classes has become correlated almost 50% of the time when compare against the Standard & Poor's 500 Index.  In the 1990's, they never had the same returns.  The assets are MSCI indices for international and emerging markets stocks, spot gold prices, copper futures, three and ten year US Treasuries, the Euro and the Reuters-Jefferies CRB commodities index.  The correlation of large cap US stocks to the S&P 500 is at 85%.

According to Jane Buchan, chief executive of Pacific Alternative Asset Management, at the 2012 Reuters Investment Outlook summit the correlation will break at some point.  The key question is when.  She thinks that healthcare and technology sector stocks should diverge. Investors should position their long/short investments to take advantage of this.

According to FX Concepts LLC, a foreign currency hedge fund, the high correlation in 2011 was caused by low interest rates globally, the increase in the money supply by the Federal Reserve Bank and central bank support for the Japanese Yen and Swiss Franc.  For the Group of 10 nations (Belgium, Canada, France, Italy, Japan, the Netherlands, United Kingdom, United States, Germany and Sweden), the trading range for their currencies is within 6%.  Historically, it has been 20%.

The source for this article can be accessed here.

Investment Trends since the Credit Crisis

In the IMF's Global Financial Stability report for 2011, they find investment trends since the credit crisis in 2007-2009.  They are:

• 50% of assets under management (AUM) are in the US;  this is trending down
• 14% of AUM are in Japan (as of 2009); down from 23% in 1995
• More AUM are in investment funds (from 29% in 1995 to 40% in 2009); less are in pension funds and insurance companies
• US investors equity allocation is down 10% to 44%
• Asset allocations differ by country
• Generally, investors have pulled out of equity and debt investments
• Markets such as emerging markets with good long term growth predictions are receiving capital flows
• The equity allocation is being replaced by long duration debt securities
• Investors are analyzing the risk profile of their portfolio instead of the individual components

The source for this article is here.

An Investment Outlook on China

I was alerted to an article by Albourne Village written last month for a blog called hedged.biz.  The topic was Asian Economies and Investment Outlook.  The writer is forecasting several trends based on Asia:

China will build its infrastructure until domestic consumption grows - In 2009, US consumption of Chinese goods fell off a cliff.  To replace this activity, China responded with a infrastructure stimulus plan with $2 trillion being in special purpose vehicles called Local Government Funding Vehicles.  Eventually, this government sponsored program will end.  At the time, the Asian consumer will replace the US consumer - hopefully.  In China, domestic consumption will grow when income inequality becomes less and when enough people move into the "middle class" and have discretionary income.

Domestic consumption is the best strategy in China - The investor should be prepared for volatility when investing in this theme in the short term.  In the long term, it should have great returns.  There are three ways to approach this:  Asia exporters to China, Chinese domestic companies and Indonesian and Australian natural resources.

US Debt is Downgraded and Investors Buy...US Debt

In one of the more ironic turn of events, the Standard & Poor's downgrade of US debt on August 5th caused the S&P 500 Index to fall 6.7% and the 10 year Treasury bill rose 2% (as of August 25th).  Some strategists such as Liz Ann Sonders of Charles Schwab and Kevin Rendino of BlackRock are saying equities are oversold.  Many people are saying that the downgrade was not based on the economic situation in the world but on the political gamesmanship in Congress.  The fall in stocks was led by financials but also encompassed aerospace & defense, technology and energy sectors.  If a recession can be avoided, then equities are looking cheap.

The source for this post is here.

Absolute Return Funds: Shelter from the Storm?

Absolute return fixed income strategies have a goal of a positive return in all market environments.  It may be a real return over cash or a nominal return.  Since the downgrade of US debt by Standard & Poor's, all markets have suffered as investors are rushing to the safest investments such as gold and, ironically enough, US Treasuries.  There is a general de-risking across the board.

Absolute return funds do not have to be hedge funds.  They may be separately managed accounts.  Investors buy into this strategy to manage interest rate risk, increase diversification and enhance their returns.  There are many ways an absolute return fund may be run.  The manager's positions must be liquid.  The fund must follow a disciplined investment process across all its exposures (alphas).  The manager must be experienced in shorting assets.

The source for this article can be accessed here.

What to Invest In During the Debt Crisis

Roger Nusbaum has a good blog at www.randomroger.blogspot.com that was highlighted in one of Money magazine's Best of issues.  On Friday, he wrote a good article on how to handle investing in regards to the debt ceiling crisis in Washington D.C.  The ideas came from David Rosenberg of Gluskin Sheff through another blogger Barry Ritholtz at http://www.ritholtz.com/blog/2011/07/rosie-7-investment-strategies-for-recession/:

1) “High-quality corporates” plus companies with “A-type” balance sheetsand “BB-like yields.”

2) Reliable dividend paying Stocks (including preferreds).

3) Low debt-to-equity ratios, high liquid asset ratios, good balance sheets, no heavy debt.

4) Hard assets: Oil and gas royalties, REITs – focus on income stream.

5) Sectors / companies with “low fixed costs, high variable costs, high barriers to entry/some sort of oligopolistic features, a relatively high level of demand inelasticity.” This includes utilities, consumer staples + health care.

6) Alternative assets that do not rely on “rising equity markets” or are independent of volatility trades.

7) Precious metals. Specifically, he puts a $3,000 target on Gold.
 
Roger's specific post can be accessed here.

Family Offices and Hedge Funds

I read a recent post at Simon Kerr's Hedge Fund Blog about family offices.  They are not included in the institutional investor universe but have several advantages investing in hedge funds.  The firm Rothstein Kass polled 151 family offices.  85% are in hedge funds and 90% of them are planning to increase their investments.  On the other hand, only 50% are invested in private equity.

There are two types of offices:  Wealth Creators (71%) and Wealth Preservers (29%).  Creators are more likely  to add to their hedge fund investments.  Many of them lost capital during the credit crisis and are trying gain it back.  The most popular strategies were equity long/short, distressed and arbitrage.

Simon summarizes the advantages as follows:

• Family offices tend to have long-term investment horizons. 
• They tend to want to live with decisions for some time – as a source of "sticky money" they won't flip a multi-year investment proposition after a couple of bad quarters.
• The investment decision making is often quicker than either funds of hedge funds or institutional investors that use consultants to select hedge funds.
• Due diligence of family offices is less invasive and time consuming than for investing institutions.
• They typically require less client servicing resource than other investors in hedge funds.
• They tend to have less restricted selection criteria than institution al investors – family offices can invest in niche strategies, emerging managers and small funds.

The source material for Simon's article can be accessed here.

A Study of Passive Hedge Fund Replication Techniques

The prior post was about new ETFs that tracked different hedge fund strategies.  There are other techniques used to replicate hedge fund returns without the negatives associated with such funds.  Fund investments are not liquid, are opaque, have high fees and weak regulations.  There are two methodologies to hedge fund replication:  factor-based and payoff distribution replication.  The study Passive Hedge Fund Replication: A Critical Assessment of Existing Techniques by Noel Amenc, Walter Gehin, Lionel Martellini and Jean-Christophe Meyfredi of EDHEC studied both to determine their effectiveness.

The factor-based approach involves identifying the risk factors of hedge fund returns to build a portfolio that mirrors its performance.  The difficulty lies in finding the right factors to build a model.  They may be market factors such as interest rates, indices and credit risk or style factors such as futures and options.  Most of the portfolios underperformed hedge funds and were more volatile.  There were a number of causes for this.  It is hard to create the proper model of risk factors.  The factors are linear in nature.  Hedge funds hold investments such as options with non-linear returns.  Fund managers change their portfolio frequently.  The factors cannot follow their changes accurately and timely.

The payoff distribution approach tries to replicate the distribution of hedge fund returns by finding an index return that matches the hedge fund return and pricing the payoff function using a standard option pricing model such as the Black-Scholes model.  Amenc's study finds that the replication strategy works for a timeframe of six years or longer.  It does not mimic the time-series properties of hedge fund returns.