Regulated Hedge Funds: UCITS and Mutual Funds

SEI published a white paper on the growth of alternative investments called Regulated Alternative Funds: The New Conventional.  Because of the credit crisis of 2008 and the current Eurozone crisis, more and more investors have clamoring to be able to invest in alternative investments to lower downside volatility and offer returns uncorrelated with long-only mutual funds. In the first 8 months of 2011, $61 billion flowed into these investments. $22 billion (39% of all investment capital) were invested UCITS funds. There are now more than 1,500 UCITS funds managing $254 billion. $39 billion were invested through US mutual funds and ETFs. They now compose 4.4% of mutual fund assets and are growing at a 17% rate since 2007 when they were 2.2% of mutual fund assets. There are approximately 730 of them with 118 launched in 2011. Mutual fund families such as Ategris, BlackRock, PIMCO, Nuveen and First Eagle have funds that invest in traditional hedge fund strategies such as managed futures, long/short, credit, commodities, arbitrage and absolute return fixed income.

Internationally, they are constructed in an evolving vehicle known as Undertaking for Collective Investment in Transferable Securities (UCITS). Success has brought on investors. There are established funds with good returns, transparent investment and risk management strategies, and strong brands. The largest fund is the Standard Life Investments Global Absolute Return Strategies with $13.6 billion in assets under management. Other large funds include Julius Baer BF Absolute Return, Newton Real Return, JP Morgan Income Opportunity and PIMCO GIS Unconstrained Bond.

Within the US, they are launched within mutual fund families and ETFs. The largest are, in order of size, the SPR Gold Shares ETF, PIMCO Commodity Real Return Strategy, Ivy Asset Strategy, and iShares Silver and Gold Trusts. For investors, both structures offer more transparent risk management, liquidity, counter party diversification and limits on leverage. Investors are seeking better returns, lower volatility and to protect capital. Mutual fund families are aggressively marketing to and educating investors and registered investment advisors through white papers, instructional videos, fact sheets, regulatory filings and road shows.

Mutual funds are seeking to increase their fee structure. Alternative asset managers are seeking to have a more varied investor base.

When new products are launched, rules are reviewed. They are on the third iteration for UCITS. In the US, the SEC has stopped approving new funds and ETFs to review the effects of derivatives on portfolios. Within Europe, Luxembourg and Ireland are expecting to conform with UCITS regulations with the bonus of having additional flexibility. This may make them preferable to certain investment strategies and investors.

Demand is growing from sovereign wealth and national pension funds in Asia, Latin America and the Middle East and US institutional, high net worth and retail investors.

First Quarter 2011 Scoreboard: S&P 500 Beats All Hedge Funds

The first quarter of 2011 is in the books and the S&P 500 Index is beating the Dow Jones Credit Suisse Hedge Fund Index by a score of 5.92% to 2.21%.  The best performing strategies:  convertible arbitrage and multi-strategy returned barely above 4%.  As expected, short strategy is the worst performer at -6%.  Only other strategy with a negative return is managed futures.  The chart can be viewed at Pensions & Investments.

Is Your Portfolio Truly Diversified?

During the credit crisis of 2008, all assets (equities, fixed income, real and alternative assets) declined in value.  Welton Investment Management wrote a research report regarding asset allocation.  According to Modern Portfolio Theory, the most efficient portfolios have assets that are not correlated.  This minimizes any excessive decrease in assets during a crisis.

They tested this theory by taking 24 indices representing the 4 asset types and calculated the correlation of returns over 10 years across 2.5 business cycles.  They discovered that 80% of alternative assets and 75% of real assets were correlated with stock returns.  The alternative assets were private equity, event driven, long/short equity, distressed securities, multi-strategy, fixed income arbitrage, convertible arbitrage and risk arbitrage.  Only global macro and managed futures were non-correlated.  For real assets, infrastructure, real estate and TIPS (Treasury Inflation Protected Securities) were correlated.  Commodities was the only real asset that had non-correlated returns against equities.

The 4 revised asset types should be:

• Equities, correlated alternative and real assets
• Global macro and managed futures funds
• Commodities
• Fixed income

The research report may be accessed here.

Electronic Execution Services

One of the services that investment banks provide hedge and mutual funds is trade execution.  These fall under a variety of terms such as program trading, direct market access and algorithmic trading.  The services generally are automated services that are run by expensive technology.

Program trading is loosely defined as a transaction involving 15 or more securities worth at least $1 million in capital.  They are usually executed by computers but there are some that are done by traders.  A lot of program trading is involved in index arbitrage.  In this strategy, the investor finds discrepancies between the values of index futures and the stocks composing the index.  Based on the difference, the investor will short/long the futures and long/short the stocks.  The leading banks for program trading are Goldman Sachs and Morgan Stanley.

Direct market access allows fund managers to trade directly with an exchange instead of going through an intermediary such as a bank.  They do use applications created and managed by the banks but no trade is routed through a salestrader.  It gives them control over how a trade is executed.

Algorithmic trading is more popularly known as black box trading.  Here the fund manager implements a trading strategy that is executed by a computer.  The manager can set the timing, price and share amount of the order.  Investment banks give access directly to the manager or through a third party interface such as Bloomberg.  High frequency trading is when a computer program combs through market data to determine if certain preset conditions are met and initiates trades if it is.  Again, the rules come from the fund manager.  This approach has very short holding periods.  Since computers can recognize pricing patterns faster than humans, the fund gets first mover advantage.  Credit Suisse and Goldman Sachs have won numerous awards for algorithmic trading.

The advantages of these types of trading are lower commissions, privacy and speed.  Ten years ago, the pressure from new execution facilities and decimalization virtually broke the agency trading business.  The manager can compare trading performance of the program by comparing actual transaction prices against a benchmark.  There are two standard ones: volume weighted average prices (VWAP) and time weighted average prices (TWAP).

Distressed Debt Strategies for Private Equity

Distressed debt strategies can be classified three ways.  The investor can try to control the bankruptcy process by buying 33% of troubled company's debt.  Using this large position, the investor will take over the company by getting seats on the board of directors, obtaining ownership by wiping out the equity holders and converting the bonds into equity.  The large debt position allows the investor to influence any reorganization plan.  This is the riskiest strategy.  The investment period is two to four years and the target return is 20% to 25%.  The second strategy is to buy 33% of the bonds and use it only to map out the reorganization plan.  This is called an active investor not seeking control.  The holding period is one to three years and the target return is 15% to 20%.  The last approach is passive.  These investors buy distressed debt that is undervalued.  The debt may be used as part of a capital structure arbitrage strategy.  In this case, the investor buys the bonds and shorts the stock, hoping the stock will decrease in value more than the bonds.  The target return is 12% to 15% and the bonds are held for a year or less.

2010 Hedge Fund Industry Review

Credit Suisse recently published their 2010 Hedge Fund Industry Review.  In a previous post, we had mentioned that the Dow Jones Credit Suisse Hedge Fund Index had returned 10.95%.  The good performance of hedge funds has investors returning.  Hedge funds have returned 31.55% since the bottom of the markets two years ago.

Of the ten strategies tracked, eight had positive returns with Global Macro, Event Driven and Fixed Income Arbitrage leading the way.  Global Macro funds used two themes for investing ideas:  intervention by central banks and commodities.  Event Driven funds using the Distressed Debt strategy found better investments due to the European debt crisis.  Fixed Income Arbitrage managers took advantage of the intervention by central banks to find investing opportunities.

The most successful strategies:  Global Macro and Event Driven received the most interest from investors.  Global Macro had $16.8 billion in asset inflows and Event Driven had $13.8 billion.  Multi-Strategy had $16.9 billion in outflows.

Small funds with assets under management of $100 million have outperformed large funds (with $500+ million AUM) by 3.95% annually.  They may be nimbler than large funds - being able to quickly get in or out of positions due to the smaller size or less bureaucracy - or they may be riskier.  During major market moves, the outperformance is more pronounced.  When markets are quiet, large funds perform on a par with smaller funds.

The research report may be accessed here.

2010 Annual Report: Hedge Fund Returns

Dow Jones Credit Suisse Hedge Fund Index had a return of 10.95% in 2010.  The index is composed of more than 8,000 funds.  The Global Macro strategy led the way with a 13.47% performance.  Other strategies that did well were:  Event Driven, Fixed Income Arbitrage and Managed Futures.  Details may be found here.

You can find an interesting side note here.  The Dow Jones Industrial Average outperformed the hedge funds with a return of 14.06%.

ADRs & GDRs: How to Access a Foreign Market

In a prior article about mutual funds, the investment strategy in the prospectus defines the universe of securities for the fund manager i.e. small cap growth stocks in the US.  Some companies cross list their stocks on secondary markets to access investors from another country.  In the example above, a non-US company would create American Depository Receipts (ADRs) and the fund manager could invest in it.

ADRs are administered by a depository bank.  Most of them are handled by BNY Mellon, JP Morgan, Citi, Deutsche Bank and ComputerShare Trust Company.  According to their website, BNY Mellon holds a 64% market share in ADRs.  The foreign company would deposit X amount of shares into the bank who then issues a ADRs.  This new security can represent any number of shares.  The only guideline is that the ADRs should be at least $10.  This is because some investors do not buy stocks under that price.

There are three levels of programs for ADRs:  Level I - OTC, Level II - Listed and Level III - Offering.  Level I is the least restrictive.  All the company has to do is be listed on a foreign exchange and publish an annual report in English using its home country's accounting rules.  But it can only be traded over the counter.  Achieving Level II allows the company to be traded over an exchange (NYSE and NASDAQ).  The company has to register with the SEC, file an annual report using US accounting rules and meet the exhange's listing requirements.  Level III is the highest and allows the company to raise capital by issuing shares.  It has Level II responsibilities plus file concurrent documentation in the primary and secondary countries and file an Offering Prospectus when issuing shares.

If the depository receipt is in any other country, it is called a Global Depository Receipt.

For hedge fund managers, this could be a simple relative value arbitrage trade where they compare the values of the securities in the primary and secondary markets by buying the undervalued security and shorting the overvalued security.  They would exit the positions once the two securities' prices were in equilibrium.

Non-Mainstream Hedge Fund Strategies

A couple of not so well-known strategies in the relative value universe are stub trading and volatility arbitrage.  In stub trading, the fund manager is identifying price discrepancies among stocks that own a large stake in another company.  This is based on the principle that the market does not recognize the additional value of the secondary company to the owning company's business.  When the market eventually sees this and prices the security accordingly, the manager can sell out the position.

Volatility arbitrage uses the same philosophy as other strategies - buy the undervalued and sell short the overvalued securities and profit when they converge.  Here the securities are options and warrants on an asset.  Using various mathematical models, the manager calculates the implied volatility of an asset.  The undervalued option can be identified using the Mean Reversion (compares implied and historical volatility of a security) or Generalized Autoregressive Conditional Heteroskedasticity (compares implied and forecasted volatility of a security) model.

Convertible Bond Arbitrage Strategy

The convertible bond arbitrage manager can create a portfolio that acts like a normal bond.  They establish a long position in convertible bonds and a short position in the equity of the bond issuer.  A convertible bond is a bond that has an option for the owner to exchange the bond for stock from the issuer.  The short equity position should be equal to the long convertible position.  The long position is equal to the amount of stock converted multiplied by a factor - called delta or hedge ratio.  This factor changes constantly and causes the fund manager to adjust their equity position frequently.

The fund has several sources of return:

• Change in convertible bond price - If the bond's price rises, then the return increases
• Change in stock price - If the stock's price falls, then the return increases
• Convertible bond's coupon - Interest paid from the bond increases the return
• Short rebate - Interest earned on capital from short stock position increases the return
• Interest paid on borrowed capital - Fund manager pays interest on borrowed funds, reducing the return

Fixed Income Arbitrage Strategy

The next group of hedge fund strategies are convergence trading or arbitrage strategies.  Fixed income arbitrage strategies is much like equity long/short.  The manager identifies cheap (undervalued) and expensive (overvalued) bonds and establishes long and short positions.  Returns are generated when they converge, the cheap position increases or the expensive position decreases.  Managers may use bonds such as US Treasuries, corporate, municipal and high yield bonds and mortgage backed securities.  Positions may be established at different maturity levels in the same bonds (yield curve arbitrage) or in different bonds that are similar.

Unlike equity long/short, the individual positions produce small returns.  Hedge funds that use this strategy use leverage to enhance returns.  This can be done by direct borrowing from their prime broker or using derivatives like swaps.

Most famous fund is Long Term Capital Management.  You can read a complete and concise account of the firm in When Genius Failed:  The Rise and Fall of Long-Term Capital Management by Roger Lowenstein.

Hedge Fund Strategy: Regulation D

Regulation D (Reg D) securities are sold by companies that are raising capital through a private offering without having to register with the SEC.  Reg D contains a list of rules allowing companies to be exempt from filing.  There are three main rules 504, 505 and 506.

As part of an investment strategy, hedge funds are mainly interested in micro and small capitalization companies.  There are two reasons for participating in the offering:

• The offering price is at a discount to the current market price
• Since there is a price discrepancy in publicly traded and Reg D stocks, the manager can establish a simple arbitrage position of shorting the public stock and going long on the Reg D stock.

The advantage to the issuer company is the ability to raise cash quickly.

Distressed Securities Investing

Hedge funds using the distressed securities strategy invest in companies that are being reorganized, going thorough bankruptcy proceedings or going through some poor performance.  These companies have the lowest credit ratings from such companies as Moody's and Standard & Poor's.  The notes below are a summary of the article "Hedge Fund Investing in Distressed Securities" by T.Casa, M. Rechsteiner and A. Lehmann that was part of CAIA's curriculum.

There are five main sub-strategies:

1. Short
2. Long/short
3. Capital structure arbitrage
4. Value
5. Rescue financing

For stocks, the first has been tackled in a prior article.  A manager can be short by buying the derivative instrument credit default swap (CDS).  To sum up, the manager is obligated to pay a counterparty a fixed amount on the bonds of the distressed company.  In return, if the company has something known as a credit event, the counterparty pays the manager a fixed amount.  The details of the fixed amounts and credit events are listed in the CDS contract.  As the company's situation worsens, the CDS appreciates in price or the hedge fund receives the payment.

Long/short using bonds instead of equities but the premise is still the same.  The manager will establish a position in undervalued bonds and be short in overvalued bonds.

Capital structure arbitrage is similar to long/short except that positions are taken within the same company's securities.  The manager takes a long position in the senior securities such as senior bonds and a short position in junior securities such as stocks.  In the bankruptcy process, senior securities are favored if any assets are recovered.  In theory, the net value of the long and short positions should be positive i.e. the short position should decrease more than the long position.

Value managers take a long position in the company before it announces a reorganization plan to court.  They hope to profit from the rise in prices after the plan is approved by the company's creditors.  They can also take a long position after the plan is approved as other investors will not take the risk at this stage.

In rescue financing, the hedge fund lends money to distressed companies right to prevent bankruptcy filings or establishes a long stock position.

The above five substrategies differ in their approach and timing.  There are five stages in the lifecycle of a distressed company and each substrategy (in parentheses) invests during a certain stage:

1. Pre-default:  the company is restructuring  (rescue financing)
2. Early bankruptcy:  the company tries to restructure its finances;  usually by giving creditors an equity stake for debt reduction or extension  (short, long/short, capital structure arbitrage)
3. Mid-bankruptcy:  balance sheet is stabilized  (short, long/short, capital structure arbitrage)
4. Late bankruptcy:  company is almost recovered  (value)
5. Emergence:  company is recovered  (value)

In 2007, there were $105 billion in estimated assets in distressed securities; up from $30 billion in 2002.  With the market turmoil in 2008, this strategy will grow as there will be more distressed situations to invest in.

Maybe we can examine the bankruptcy process later.  There were many interesting articles in the Wall Street Journal about it during the General Motors and Chrysler crises in 2009.