Liquidity Risk in the Bond Markets

According to an article in the March 21 edition of Pensions & Investments, hedge fund strategies focused on bonds such as relative value and long/short credit are facing increased liquidity risk due to unintended consequences of regulations such as Dodd-Frank and Basel III.  This is especially true in the junk bond arena.  The legislation closed the proprietary trading desks of the banks and increased capital reserve levels have caused a liquidity crunch.  In the past, the proprietary trading desks were the primary trading counterparties for hedge funds.  Some funds that have closed include Claren Road Asset Management, Third Avenue Focused Credit Fund, and Lutetium Capital.

Fund managers have responded in a variety of ways.  They have traded in smaller amounts, reduced their leverage and expanded their counterparties.  According to Aaron Dalrymple, head of credit at Cliffwater, smaller transactions of $5 million in capital are easier now.  There has been some outreach to pension funds and endowments as new trading partners, either directly or through a dark pool in Liquidnet.

Until the liquidity issue is resolved, firms are scaling down or closing credit strategies.  Investors have agreed.  In the second half of 2015, alternative investment data provided eVestment stated that there was no demand for credit strategies.

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.