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.

Hedge Fund Hopes for 2015

Since the global credit crisis of 2008, the central banks of various nations have been using various utilities (i.e. non-existent interest rates, quantitative easing and expanding their definitions of conservative debt) to prop up asset values to protect the banking industry according to Frank Brosens, co-founder and risk manager at Taconic Capital Advisors in New York.  These actions reduced asset price volatility and hedge funds' opportunities to produce alpha.  This is now ending.  The last three months of 2014 saw increased volatility and portfolio managers are predicting it to continue in 2015.

Managers with different strategies are seeing good investments:

• Long/short
• Joel Greenblatt, managing principal and co-chief investment officer of Gotham Asset Management in New York, believes there are "..good opportunities on the short side with currently very expensive stock prices if the market drops."
• Eric Mindich, CEO of Eton Park Capital Management in New York, is long in Japanese and Chinese markets.  Both countries will benefit from cheaper oil prices and valuations are very low in China.
• Global macro - Kenneth Tropin, chairman of Graham Capital Management in Rowayton, Connecticut, is monitoring the quantitative easing initiated by Japan's and European central banks, the improvement in the US economy and unrest in various political hotspots around the world.
• Multi-strategy - Michael Hintze, CEO and senior investment officer of CQS (UK), sees short trades based on geopolitical situations (i.e. Ukraine and Russia), failling oil prices and terrorist activities.
• Credit - Several fund managers are positioning their funds on different themes.  The most interesting one is from Paul Twitchell, partner and global head of event strategies of Whitebox Advisors.  He is looking at energy-related distressed debt.  He is interested in "...supplying secured debt to energy companies at a certain price..."

The source for this article can be found at here.

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.

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.

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.

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.

Global Macro: A Star Performer In Times of Market Stress

In the December 2011 issue of the Hedge Fund Journal, Mark van der Zwan, portfolio manager, and Radha Thillainatesan, investment analyst, of the Morgan Stanley Alternative Investment Partners Fund of Hedge Funds wrote a research paper on the Global Macro strategy. During times of stress (current credit crisis, technology bubble and Russian default of 1998), it has one of the top two returns for hedge fund strategies. Global macros returned 4.7% and 15.5% (as defined by the HFRI Macro Index) for the credit crisis and technology bubble while the Standard & Poor's 500 returned -51% and -44.7% respectively. No numbers were given for the Russian default. Correlation of returns also drop during these times. In the credit crisis, the statistic is -17%.

Obviously, investors should use global macro funds to diversify their assets from the standard equity and fixed income funds. In the current volatile markets, investors should think about the high volatility of returns for the strategy, the wide variety of macro strategies and the subsequent wide variety of returns. As macro strategies lose their investing edge, managers are specializing in their investment strategies either through asset class (commodities, currencies, etc.), technical trading signals or length of holding (as measured within the same trading day). This causes the wide range of strategies and returns. With proper research, the global macro portfolio can be diversified and perform well during market crises.

The article can be accessed here.

I would like to thank the Chartered Alternative Investment Association (CAIA) for providing a free subscription to the Hedge Fund Journal.

Hedge Funds Struggling in First Half of 2011

Hedge fund indices have underperformed the regular indices year-to-date through June 30th.  The S&P 500 is up 6%;  the MSCI World Index is up 5.62%; and the Barclays Capital Aggregate Bond Index is up 2.72%.  Meanwhile, for the same period of time, the Dow Jones Credit Suisse Hedge Fund Index is up 1.65% and the HFRI Fund of Funds Composite Index is down 0.33%.  Despite this, investors added $29.5 billion into hedge funds in the second quarter.  Of all the investment strategies, Global Macro has had the most difficult year as there have been no market trends in the current economic environment as it lurches from crisis to crisis.  However, this message is not coming across to the investors as 64% of them will seek to invest in these underperforming funds, according to a survey of 2,700 institutional investors and hedge fund managers by Prequin Research.

The source for this article can be accessed here.

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.

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.

Hedge Funds Are Back!

Investors poured $6.6 billion into hedge funds in December 2010 according to a joint report by Trimtabs Investment Research and BarclayHedge.  It was the sixth month in a row that funds experienced inflows and brings assets under management by hedge funds up to $1.7 trillion.  Winning strategies are emerging markets ($5.8 billion), global macro ($3 billion) and fixed income ($2.5 billion).  Fund of hedge funds had redemptions of $1.3 billion.

Managers are also doing better in 2010 with 50% of them collecting performance/incentive fees.  60% of them have recovered losses from the credit crisis in 2008.

The article can be read 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%.

Global Macro: Go Anywhere, Do Anything

Many investors view global macro as the Wild West of strategies.  Managers following this strategy can invest in any country, market or security.  Macro is short for macroeconomics.  By studying these statistics such as interest and foreign exchange rates, commodity demand and political conditions, managers identify price movements and invest to exploit them.

They can be split into two types:  discretionary and systematic.  Discretionary managers invest by forming a thesis and creating trades to profit from their thesis.  They may understand the emotional intelligence of investors and identify irrational and/or inefficient market conditions.  They can analyze data at the microeconomic level that has not percolated up to the macroeconomic level.  Systematic managers use trading rules to follow trends as their thesis.  Oftentimes, these trades are triggered by quantitative models monitored by computer software.  This is sometimes be called the "black box" as the rules are proprietary to the manager.  These rules may exploit differences in interest rates (carry and yield curve trades), currencies (purchasing power parity), stocks and volatility (option pricing models).  Some funds use a combination of both types.

Global macro funds' flexibility allows them to invest in any category but may produce funds that do not have an investment specialty.  Since many institutions invest using an asset allocation model, it is difficult to monitor them.  They can invest in anything and may break the allocation rules of the investor.

The most famous manager using this strategy is probably George Soros and his most famous trade "broke the Bank of England" in 1992.  A recent manager, who emerged from the housing crisis, is John Paulson.  You can read more about him in Greg Zuckerman's The Greatest Trade Ever.  For additional information about the crisis, Michael Lewis' The Big Short is great reading.  For more information - including references to other books and white papers, please go to this article.