Innovations in the Fund of Hedge Funds World

The fund of fund managers that have survived the redemptions stemming from the 2008 financial crisis have updated their methods of delivering value to investors.  There were five new ways listed in the September 16th issue of Pension & Investments, Managers in Midst of Metamorphosis article.  They are:

• Hedge fund mutual funds with daily valuation and liquidity - Aurora Investment Management LLC in Chicago has launched a hedge fund mutual fund in March with $145 million in assets under management 
• Hybrid hedge fund/private equity funds of funds with 3 to 5 year lockups - Mesirow Advanced Strategies Inc. has launched opportunistic hedge fund of funds using five strategies:  corporate liquidations, European credit and structured products, secondary collateralized debt obligations, distressed non-agency retail mortgage backed securities and distressed emerging markets debt arbitrage trades.  The lockup period allows for the manager to retain cash reserves in order to take advantage of mispriced markets while allowing for the manager to hold positions during times of market stress.
• Hedge fund beta strategies to be used with alpha generating hedge fund portfolios - GAM created the hedge fund beta portfolios based on Barclays PLC risk premium indices.  They actively manage left-tail risk during market downturns of 1 to 2 standard deviations.
• New investment capabilities to create broader alternative investment boutiques - Grosvenor Capital Management LP offers customized separate managed accounts across many alternative investment strategies
• Single strategy hedge funds with concentrated positions for institutional investors 

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.

Trends in Tail Risk Investing

310 investors were asked their views on tail risk in today's market environment in a survey conducted by the Economist Intelligence Unit on behalf of State Street Global Advisors.  They were located in the US and Western Europe and consisted of institutional investors (asset managers and pension funds), family offices, consultants and private banks.  The definition of tail risk is an investment that moves more then three standard deviations from a normal distribution (think bell curve) of returns.  Since the 2008 credit crisis, these events have seemingly multiplied.  Adding tail risk protection is becoming part of more investors' asset allocation model.

Traditionally, most managers diversified across the standard equity and fixed income classes along geographic, capitalization and security type.  There was a reduction of 5% of investors in using this strategy, led by institutional investors.  Slightly more consultants, family offices and private banks are using diversification even though the credit crisis showed that all asset classes correlate to 1.  The other strategy to fall was fund of hedge funds due to poor returns, high management costs and the loss of confidence with the Madoff affair.

Strategy winners were managed volatility equity strategies, managed futures and alternative investments such as real estate, commodities and infrastructure.  Managed volatility was increased across the board by the investors with the largest increase by private banks.  There was a split decision on managed futures with private banks and consultants allocating more and institutional investors allocating less assets.  Risk budgeting was stable overall with the institutional investors decrease in that strategy offset by the increase by private banks.  Direct hedging was unchanged as institutional investors and private banks doing more and consultants and family offices doing less.  The same split occurred with hedge fund investing.

Seven main factors affected investors' choice of tail risk strategy.  They are, in order of importance, liquidity, regulatory issues, risk aversion, transparency, fees, understanding/persistency of returns and lack of understanding of new asset classes.  According to Bryan Kelly, assistant professor of finance and Neubauer Family Faculty Fellow at the University of Chicago's Booth School of Business, the best hedges are debt derivatives and credit default swaps.  However, they are not liquid as they do not trade over central exchanges.  They are not considered safe investments such as AAA sovereign debt or gold for the risk averse.  The cost and fees associated with tail risk assets is another consideration.  Most investors know that it will lower expected returns and be volatile.  Another issue is the mismatch in time horizons.  Many products are short term and are being bought by long term investors such as pension funds.

Since the credit crisis, investing has been influenced more by macro economic events.  This will continue into the near future as we continue to hear about possible regional and global recessions, the breakup of the Eurozone, the US fiscal cliff and unrest in the Middle East.  Investors are trying to find the best hedges as 80% of them agree that managing tail risk is part of their investment planning.  71% believe that an event is likely to happen within one year and it will be worse than in the past.

The source for this article can be accessed here.

Tail Risk Strategy Profiting from European Debt Crisis

Hedge funds with investment strategies designed to generate positive returns during market shocks, tail risk or black swan funds, have been very successful in August and September.  Other funds have lost 4.8% since July 30th due to the European credit crisis.  The tail risk fund of Saba Capital Management has risen 15% in August and 11.5% in September.  Pine River Capital Management has risen 14.5% in August.  Other hedge funds that run this strategy are Capula Investment Management and Gramercy.

The VIX Index, a measure of market volatility, has doubled in the last two months.  Junk bonds have lost 4% in August according to a Bank of America Merrill Lynch index and the Standard & Poor's 500 lost 5.4% for the month.

The source for this article can be accessed here.

Protecting a Portfolio Against Inflation

I was directed to a research report written by AllianceBernstein about how an investor can prevent inflation from eating into real returns for a target date fund.  Target date funds are a relatively new asset allocation product that adjusts the percentages of each asset during the length of the investment.  This is called the glide path.  The asset mix is higher for riskier assets (i.e. equities) early.  As time goes by, the asset mix becomes more conservative with a heavier weighting in bonds as the fund approaches its target date.  Although the paper was written for target date funds specifically, it can be applied to any traditional portfolio.

Spikes in inflation can be considered a rare tail risk event (three times since World War I).  When it happens, they reduce the value of investment portfolios considerably.  Once the spike is identified as such, buying any protection skyrockets.  The addition of real assets can serve as a hedge against this event.

AllianceBernstein considers three factors when analyzing hedges:  sensitivity to inflation, reliability and cost-effectiveness.  The sensitivity is how an asset reacts to inflation.  Equities has a -2.4 sensitivity.  When inflation is up 1%, equities fall 2.4%.  20 Year Treasury bonds have a -3.1 sensitivity.  Treasury Inflation Protected Securities (TIPS) have a sensitivity of 0.3 to 0.8, depending on the duration of the bond.  Commodity futures have a sensitivity of 6.5.  The second factor, reliability, tells how often the sensitivity factor is correct.  For example, commodity futures have a reliability factor of 54%.  When inflation rises, then the futures may rise but it only does so half the time.  The chart shows that TIPS are the most reliable, then commodity stocks, REITS and commodity futures.  Buying these assets have an opportunity cost.  The investor is giving up returns to buy this insurance against inflation.

Here is a list of hedging assets:

• Equities - natural resource and real estate sectors
• Commodity futures
• Currency forwards
• Real Estate
• Gold
• Short term bonds
• TIPS

The report recommends a portfolio of commodity futures, equities and currency forwards.  The weight depends on the lifecycle of the investor.  Of the investor is still working, it should be about 5%-15%.  At retirement, 15%-35%.  After 10 years of retirement, 30%-50%.

Gaia Capital: A Lesson in Tail Risk Management

Gaia Capital, one of the larger hedge funds with $150 million in assets under management invested in Japan, has lost 75% of its assets after the earthquake, tsunami and nuclear power plant crisis.  At the end of March, the fund had $92 million in assets.  There was $32 million at the end of April due to losses and investor redemptions.  Gaia had been successful in prior years, returning 36.1% in 2009 and 21.7% in 2010 but it all unraveled after the natural disaster.  The losses were in derivative strategies such as swaps and put options.  The fund had placed a bet that the Japanese market would remain in a trading range i.e. they were short volatility.  As a result of the earthquake, the Japanese index, Nikkei 225, fell to 8,234.6.  The expected trading range was between 9,500 to 11,000.  Investors fled.  When the fund tried to exit its positions, there was no liquidity.  Gaia had to liquidate its positions at the bottom of the market.

Shorting volatility is exposed to event and/or tail risk.  A large downward move in the market causes large losses for the fund.

For more details, the source for the post can be accessed here.

A Different Way of Looking at the Current Investing Environment

Members of CAIA were invited to an event sponsored by the New York Hedge Fund Roundtable last week.  Mark Yusko, CEO and Chief Investment Officer of Morgan Creek Capital Management (with $10 billion in assets under management), presented on how to invest in the current low return environment that he called the 0-3-5 problem.  Cash is at 0%.  Bond yields are at 3% and stocks are expected to return 5%.  In order to attain returns in the high single digits that investors such as pension funds and university endowments need, he proposes that investors move to a skill based portfolio.  There were a multitude of themes presented.  They centered around the lack of returns in the developed world and the rise of the emerging markets.

The best portfolios will not have alternative investments as a separate asset class.  They will ignore these classifications and integrate them.  A traditional portfolio may be 50% US equity, 15% international equity, 30% fixed income and 15% in hedge funds.  The updated concept will ask where the hedge funds invest.  In this example, let's say the funds invest in US equity.  Then the asset allocation of the portfolio will look like this:

• US equity 65%
• International equity 15%
• Fixed income 30%

Adding assets with uncorrelated returns such as hedge funds "can boost expected returns, while reducing portfolio volatility."  Private equity returns for funds operating during a recession are higher.  Yusko encourages investors to take advantage while funds are having difficulty with fund raising.

That being said.  Investing in US markets will be difficult.  The US is in danger of mirroring Japan on government debt, low interest rates and low growth in GDP.  Investors should concentrate in Brazil, Russia, India and China (BRIC) with an overweighted allocation in Asia.  Over the last 10 years, this has returned 250% cumulatively.  The Standard & Poor's 500 and NASDAQ have negative returns.  Credit Suisse, the World Bank and PricewaterhouseCoopers have predicted that China will surpass the US as the world's largest economy by 2020.  The emerging markets have the same forces that propelled the US to become the largest economy in the 20th century:  population growth and low debt in local companies.

Commodity prices will rise as the emerging markets nations develop.  As China and India industrialize, oil demand will rise.  The best way to play this is to invest in oil services stocks or indices such as OIH (Oil Services Holders Trust Index) or OIX (CBOE Oil Index).  Gold prices will continue to reflect the rise in US government debt as a percentage of GDP.  Other commodities with rising prices are platinum, palladium, corn and wheat.

Yusko also commented on various risk factors in the current environment.  They were:

• Inflation - There will be none unless there is growth in the money supply.  The Federal Reserve Bank is putting money into the financial system but the banks are keeping it on their balance sheets.
• Valuation - Stock valuations have been above the historical average since the 1990s.  The market will be reverting to the mean.
• Monetary - The Fed's Quantitative Easing 2 Program will end on June 30th.  US equity markets will be discounting by 20% for that event before the date.
• Growth - Rise in unemployment may signal low growth in Gross Domestic Product.
• Wealth - Housing prices continue to fall in the US and developed nations (i.e. Western Europe).
• Demographic - The US is an aging nation that will spend and grow less.
• Government - Deficit levels are not sustainable.
• Default - Municipal bonds, especially in California, Illinois, New Jersey and New York are in danger of defaulting.
• Sovereign - There may be another debt crisis in Europe because banks own the bad debt of Portugal, Ireland, Greece and Spain.
• China - The renminbi was re-pegged to the US dollar in July 2008.  This caused the dollar to strengthen and commodity prices to collapse.
• Devaluation of the dollar - Largest risk for US investors

One old rule still applies - diversify your portfolio.  In addition to the ideas above, he listed other possible assets:

• International Real Estate
• Absolute Return Strategies as a substitute for bonds
• Distressed debt in US and Europe

Thanks for the roundtable for setting up the presentation and Mark Yusko for presenting their views.

Tail Risk Investing

There was an interesting article in the Economist magazine about tail risk investing.  There are some hedge funds that buy assets that should rise in market sell-offs.  These funds lose about 15% in a normal year.  When the market loses a lot of value, then returns average 50% to 100%.  Buyside firms like Black Rock and PIMCO and sellside firms such as Deutsche Bank have tail risk products.  Deutsche Bank has created the Equity Long Volatility Investment Strategy (ELVIS) index.  This index generates positive returns when market volatility is high.