Notes from a Hedge Fund Survey - Part II

SEI and Greenwich Associates conducted a survey of institutional investors and hedge funds.  Part I was summarized earlier.  Part II was released later and dealt with issues on investing, institutional standards for fund evaluation, selection and monitoring.  105 investors participated in the survey.  They could be classified as endowments, foundations, family offices, corporate funds, public pension funds, consultants, union plans and non-profit organizations.  85% of the institutions are located in the US with some in UK, Canada and Scandinavia.  Their assets under management (AUM) fit into four bands:

• 42.2% had less than $500 million
• 15.5% had $500 million to $1 billion
• 25.4% had $1 billion to $5 billion
• 16.9% had more than $5 billion

The new top three challenge for investors is manager selection.  This is due to the increasing number of hedge funds being launched due to the recovery in the markets and Graham-Dodd legislation.  Many have indistinguishable strategies.  If a manager can define his unique strategy to investors in understandable terms, he is ahead of other funds.  In terms of the criteria for selecting managers, investors emphasize investment philosophy, the quality of the personnel on the investment team, risk management and having an identifiable, repeatable source of alpha.  AUM of a fund is low in importance for investors when choosing a fund.  20% have no AUM minimum and 15% have a $50 million to $100 million minimum.  The age of the fund does not seem to affect investors.  According to the survey, 14% would invest in a fund with no record and 24% in a fund with one to three year record.  Large institutions are more willing to hire emerging managers.  Smaller investors favor larger, more established funds.  Smaller investors also are more likely to hire investment consultants for their advice.  Larger investors are more likely to invest directly in hedge funds.

The other worries have remained the same since the credit crisis in 2008 - portfolio transparency, poor performance, leverage, risk management and liquidity.

Hedge Funds and ETFs

Some high profile hedge funds use ETFs (Exchange Traded Funds) and ETPs (Exchange Traded Products) as part of their investment strategy.  These luminaries include Bridgewater Associates, Eton Park Capital Management, Lone Pine Capital, Millennium Management, Oak Hill Investment Management and Paulson & Co. according to their 13-F filings with the Securities and Exchange Commission (SEC) in December 2011.  Why would these managers use these efficient and low cost securities, risking the ire of their investors who are paying them "2 and 20"?  They are used to:

• Used as a temporary investment while individual securities are picked.  They allow the manager to invest quickly in the space before establish stock specific positions.
• Invest in markets or sectors where the manager does not have the infrastructure for detailed research or specific knowledge
• Arbitrage a security
• Mask their trades by using a large ETF
• Invest based on macro opinions
• Get exposure on a sector level when individual securities' correlations are high
• ETFs have liquidity which allows managers to trade out of positions easily
• Establish a position in sectors or regions with low liquidity and buying securities is hard
• Hedge a position

Depending on the fund strategy, fund of fund managers and investment consultants view ETF usage as positive for global macro and systematic trading strategies and negative for fundamental stock pickers.  Equity long/short managers are receiving the "2 and 20" to pick securities, not to be an index fund.

Top 5 ETFs Held by Hedge Funds

• SPDR Gold Shares (GLD)
• Vanguard ETF Emerging Markets
• Market Vectors ETF Gold Miners
• Vanguard Total Bond Market ETF
• Powershares QQQ

Top 5 Shorted ETFs by Hedge Funds

• SPDR S&P 500 ETF SPY Index
• iShares Russell 2000 Index Fund IWM Index
• Energy Select Sector SPDR Fund
• Financial Select Sector SPDR Fund
• SPDR S&P Midcap 400 ETF Trust

The source for this article can be accessed here.

Farmland: the New Real Estate Investment

Institutional investors are becoming interested in a specialized real estate subsector:  farmland.  In today's low return market, its steady income plus appreciation has become attractive.  Looking at annualized returns for 1, 3, 5, 10 and 20 year periods (as of 12/31/2011), the income ranges from 6.59% to 7.90% while the appreciation returns 3.31% to 7.87%.  Total returns are from 9.9% to 14.88% according to the National Council of Real Estate Investment Fiduciaries (NCREIF).  In addition, agriculture has low correlations to other asset classes and is a hedge against inflation.

Some pension funds buying farmland in the past 1.5 years are Iowa Public Employees Retirement System ($100 million with UBS Agrivest), City of Alexandria (Va.) Fire and Police Officers Pension Fund ($5.5 million with Hancock Agricultural Investment Group), Oregon Public Employees Retirement Fund, the Los Angeles City Employees Retirement System and the Orange County (Calif.) Employees Retirement System.  Callan Associates, a consulting firm, has looked for farmland for investors eleven times in the past 1.5 years.  Between 2000 and 2010, they conducted one search.

To give you a frame of reference for the price appreciation of farmland, the NCREIF Farmland index's market value in the fourth quarter of 2006 was $1.4 billion.  In the fourth quarter of 2011, it was $29 billion - an increase of 107%.  The increase is driven by strong farmer profitability and competition for land.  It is not driven by the institutional investors coming into the real estate market.  The index only represents 1% to 2% of the $2 trillion in total farmland value.

The source for this article can be found here.

Investment Ideas in Real Estate Markets

As a member of the Chartered Alternative Investment Analyst (CAIA) Association, I am fortunate enough to attend various learning events.  Last week, I listened to four investment professionals about their views on the Real Estate Markets.  Real estate may be termed the original alternative asset.  They were Rod Hinze, Founder and Portfolio Manager of Keypoint Capital Management;  Richard Adler, Managing Director and Co-founder of European Investors Inc;  Michael Stratta, Investment Analyst of Aviva Investors and Scott Yetta (sic) of Cerberus RMBS Opportunity Fund at Cerberus Capital Management.  They have different viewpoints on the markets.  Hinze manages an equity long/short hedge fund.  Adler invests in REITs and directly in real estate.  Stratta manages funds of funds and private equity funds.  Cerberus has launched a fund that invests in structure finance.

Keypoint's portfolio is market neutral.  It seeks absolute return by investing in real estate related securities.  Hinze was long on several subsectors such as student housing, data centers and movie theaters.  He was short on big box retailers, toxic debt structures in mortgage REITs and the standard overvalued securities.  Last year, the real estate appeared correlated to the equity markets.  But if the subsectors were analyzed, there was much variation.  Class A malls and self-storage were up and banks were down.  Keypoint's beta or correlation to the markets ranges from 0.1 to 0.2.

On the private equity side, Stratta is seeing a continuation of a trend for better liquidity terms for investors.  The preference is for an open-ended fund with quarterly availability for redemptions.  The classic closed-end fund with a ten year lockup is losing its popularity as more investors are looking for yield and dividends; not for appreciation.  Stratta covers the Americas and has investments in Brazil (Sao Paolo and Rio de Janeiro).  He is already looking at opportunities in what he terms the next emerging markets:  Panama, Peru, the Dominican Republic and Colombia.  Canada is divided into two parts:  Vancouver and everywhere else.  Asian banks control most of the real estate transactions in Vancouver.  Other banks cannot crack the market.

European Investors Inc's regional allocations are:  overweight in Asia, underweight the US and standard weighting for Europe.  Adler invests in REITs and real estate.  They have a portfolio of $1.5 billion in direct investments.  He spoke extensively about the increased volatility and correlation to financial stocks of REITs.  Due to the new ETFs on REIT indices, electronic arbitrage trading is causing large market moves in the same manner as the equity markets.  Regarding investment ideas, he is positive on Thailand, the Philippines, Turkey, Israel and Brazil because the general or macro conditions are favorable.  Mortgage REITs, such as Annaly Capital Management, have a 15% interest rate.  He expects that to retreat to the upper single digits - which is sustainable over the long term.  There is a also a new REIT asset class with the single family house rental as the underlying.  These homes may be a straight lease or lease to buy.  In five years, there are projected to be two to three million homes in this category.  The expected returns for this investment is 8%.  The first deal in this REIT was in April 2011 in a deal co-sponsored by Fannie Mae and Credit Suisse.

The final speaker from Cerberus Capital had recently launched a $1 billion hedge fund focused on Residential Mortgage Back Securities (RMBS).  For a fund manager, he gave a surprising amount of detail to non-investors.  He split his investment universe into agency and non-agency securities which are a $10 trillion market.  Agency securities are created by government sponsored entities such as Ginnie Mae, Fannie Mae and Freddie Mac.  Their main risk is pre-payment of loans and mortgages.  Non-agency securities have credit and interest rate risks.  The fund managers analyze RMBS based on a number of factors:

• Yield is analyzed based on the behavior of the borrowers.  Of the universe of borrowers within an RMBS, they look at how many will pre-pay (i.e. re-finance), pay late, get loan modifications or default.   Scott is seeing value in borrowers with hybrid loans such as the 5/1 homeowner loan where the first five years are fixed rate and then the rate floats.  The most interesting borrowers are two to three years into the floating rate period.  They are pre-paying their loans by re-financing into fixed rate loans at historically low rates.  Many of these loans may be found in a mezzanine tranche.
• The recovery value of houses liquidations is viewed on a state by state basis because of differing state foreclosure laws.  A house in California can be foreclosed without going through court approval;  not so in New York and Florida.  The shorter the period, the higher the rate.
• Built in expectations that there will be another 10% drop in real estate
• Investors need conservative assumptions on the above three factors as a cushion for credit risk.  2011 returns were down because of two macro events:  the Eurozone crisis and the delay in the selling of Maiden Lane II, a huge loan portfolio of the Federal Reserve Bank of New York.  In the third and fourth quarters, funds hedged against a drop in RMBS - anticipating that Maiden Lane II would cause an oversupply of this product.  They hedged using residential indices such as the ABX and Prime Index, commercial index (CMBX) and high yield/investment grade indices.  Paying for the loss protection caused real estate hedge funds to underperform the market.
• Documentation and loan servicers are understaffed and large institutions are selling their units
• Government policy directly affects agency securities.  Cerberus has some insight into the federal government by having Dan Quayle and Jack Snow as staff and by owning GMAC.

Thank you, CAIA, for organizing this great event.

Status Report: Institutions Increasing Allocations to Hedge Funds

According to an article at Pensions & Investments, several pension funds are increasing their portfolio allocation to hedge funds.  The favored strategies are equity long/short and credit strategies.  Florida State Board of Administration, State of Wisconsin Investment Board and North Carolina Retirement Systems have invested in equity long/short.  The funds winning these mandates can be found here.  Despite negative returns for equity long/short in the HFRI Equity Hedge Fund index for 2011, investors are not planning any withdrawals.  The total amount being invested is $2.5 billion.

There are several reasons for institutions to increase their allocations:

• Hedge funds are no longer a discrete asset class but are classified as equity or fixed income based on their holdings
• Equity long/short funds reduce the volatility of returns
• Fixed income long/short funds generate excess returns (alpha) on the long and short sides of trades

The Costs of Changing Investment Funds

Institutional investors change the composition of their portfolios due to their funds' poor performance, style drift, change in key personnel, etc.  When a fund is replaced, securities will have to be sold and bought.  The investors will try their best to minimize any costs and manage any risks.  The costs can be split into these categories:

• Direct - fees to hire a transition manager, trading commissions and taxes
• Indirect - bid and offer spreads and market impact
• Opportunity - prices of held securities being adversely affected by other traders
• Administrative expenses - finding the replacement manager, legal fees, rewriting fund documents and marketing material and custody fees

It is suggested that a transition manager be used if 2 or 3 of the following criteria apply to the portfolio:

• Transaction volume is more than $50 million
• Complex transition across asset classes or with daily valuations requirement
• Investor does not have resources for executing transition
• Out of the markets risks are higher because of allocation or settlement cycle differences
• Low tolerance for out of the market risks

The manager is usually rated by "implementation shortfall".  This compares the target portfolio's performance against the transition portfolio's performance.  This shows actual return versus theoretical return if there was an instantaneous switch to the new portfolio.

The source for this article, written by Freeman Wood and Paul Sachs of the Mercer Sentinel Group, can be accessed here.

Notes from a Hedge Fund Survey - Part I

Last month, SEI and Greenwich Associates published part 1 of the Fifth Annual Global Survey of Institutional Hedge Fund Investors.  There were several themes that emerged from the report for investors.

• Allocations to hedge funds are rising but at a slower rate than last year.  In 2012, they are projected to be 17.8% of investor portfolios.  They were just 12% in 2008.  The increase is led by endowments.
• The top goal for institutions for hedge fund investing is absolute return in 2011.  This was in response to the poor performance of the HFRI Index.  In prior years, the goal was to mitigate risk by investing in non-correlated assets.
• Investors use hedge funds to manage their investment risks through diversification among investments to decrease volatility
• More institutions are investing directly into hedge funds rather than funds of hedge funds.  According to Citi Prime Finance, investors are unhappy with paying an additional layer of management and incentive fees, are concerned that funds of funds are too diversified and want to have more control over their portfolio.  The larger institutions have the resources to invest directly.  Of the smaller ones (less than $500 million AUM), 64% use funds of funds.
• Most popular strategies are the simpler ones:  equity long/short, event driven and credit
• Limited interest in re-allocating to UCITS or mutual funds
• The most important challenge for hedge fund investors is having performance expectations met.  This is probably in response to the 2011 performance.  In 2010, when returns were good, then transparency was important.