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.