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.

ETFs That Replicate Hedge Fund Strategies

Murray Coleman of Barron's wrote about ETFs that gave the investor exposure to hedge fund strategies without paying to 2 and 20 fee or being a qualified institutional buyer.  The ETFs named in the article were Cambria Global Tactical ETF (GTAA), Credit Suisse Long/Short Liquid ETN (CSLS), Credit Suisse Merger Arbitrage Liquid ETN (CSMA) and WisdomTree Managed Futures (WDTI).

CSLS tracks hedge funds using long/short strategies and CSMA does the same for merger arbitrage funds.  GTAA holds about 80 ETFs in its portfolio and the fund managers change its allocations among them depending on the current investing environment.  WDTI invests in 24 futures in about 12 sectors.  It invests using the seven month moving average as an indicator of which contracts to short and go long.

The source for this post 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.

Event Driven Strategy - Merger Arbitrage and More

The event driven strategy invests in a wider range of situations than merger arbitrage.  Merger arbitrage managers are concentrated on mergers and acquisitions.  Event driven managers may invest in firms that are:

• In the middle of a reorganization
• Spinning off a division
• In bankruptcy
• Starting a share buyback program
• Distributing a special dividend
• Specific news announcements such as earnings restatements
• Significant market events

Again, the manager is trying to exploit mispricings of the company's securities due to these one-time events.  Another term for this strategy is special situations.  Some sources state that merger arbitrage is a substrategy of event driven.  I can see the logic behind this.  However, for these articles, I am using the definition promulgated by the Chartered Alternative Investment Analyst program (at www.caia.org) and has these as separate strategies.

Merger Arbitrage Strategy - Investing in Deals

The next group of hedge fund investment strategies that we will take a brief look is corporate restructuring.  The most well known is merger arbitrage.  In this strategy, sharp-eyed managers identify mergers that are happening or that will happen to profit on a paired trade.  The stock of the target firm will be bought and the stock of the acquiring firm will be sold.  When a merger is announced, the buyout price is usually at a premium to the current price of the stock.  The normal market action is for the price to rise in reaction (or anticipation) to the announcement.  Meanwhile, the price of the buying firm declines as the market anticipates a short term correction because the firm will need to use resources, cash and time to integrate the target firm.

In a cash acquisition, the manager would buy the target firm at a price lower than the bid.  When the transaction is closed, the profit would be the spread between prices.  In a stock for stock merger, the manager takes the positions described above:  short the buying firm and long the target firm.  When the transaction is closed, the target firms' stock is converted and used to close out the short position.  The profit is the spread between both positions.  The hedge fund also receives the short interest rebate.

To identify the best trades, managers will use a variety of information sources such as the financial statements, SEC filings, company and sector knowledge.  They will be well informed in regulatory and anti-trust issues.  They will need to know when and at what price to trade into the positions.  Depending on their investment thesis, rumored deals may be included in the portfolio.  Obviously, this is much riskier as trading desk rumors are rampant.

There are several reasons the deal may not be completed.  The merger may not be approved by all of the regulatory agencies.  Another firm may try to buy the target or acquirer.  The target may try to acquire another firm as a takeover defense strategy.  The shareholders may not approve the deal.  This is the risk.

In bad markets, there may be very little merger activity.  In times like these, the fund will invest in low risk fixed income vehicles until activity increases or may shut down the fund and return money to the investors.