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 

Timberland: Factors Are Positive for Investing

In the most recent issue of the Alternative Investment Analyst Review, there is an article regarding investments in a specific sector of real estate named Timberland Investing in the US: What You Need to Know Now.   It was written by three timberland asset managers:  Timothy Corriero, Managing Director at FIA Timber Partners; Tom Healey, also Managing Director at FIA Timber Partners and Scott Bond, Vice President and Director of Marketing and Client Relations at Forest Investment Associates.  They studied several topics on the state of timberland investing.

Historical returns can be split into 4 phases.  From the 1987 to 1998, returns ranged from 10% to 37% annually.  The asset class was new and there was little investor interest.  As was detailed in a separate post, the opportunity was presented to investors when corporations started selling their land in order to concentrate on their core businesses.  From 1999 to 2003, returns ranged from 4% to 10% due to the recession of 2001 even though timberland investment management companies were created.  From 2003 to 2008, returns ranged from 8% to 20% as the real estate bubble caused land values to rise.  Corporations sold their land at what we now would call inflated prices.  After 2008, returns ranged from 1% to 8%.  This coincides with the crash in the housing market which lowered the demand for timber.

These returns were further analyzed against inflation as measured by the Consumer Price Index over 10 year investment periods.  They always were higher.  The same cannot be said of the returns of equities and bonds.  Equities lagged during the credit crisis and in the 1970s.  Bond returns were lower in the 1980s.

Timber is split geographically by product:  Pacific Northwest and Southern.  The Pacific Northwest has been performing better in 2013.  This is due to its proximity to Chinese demand and lowered competition from Canada.  Canadian production has been cut in half by a pine beetle epidemic in British Columbia.

The future for timberland investing in the Pacific Northwest is promising.  The recent recovery in the housing market will cause increased demand for homebuilding, a main consumer of wood.  That, combined with the loss of Canadian wood, should cause timber and timberland land prices to rise.  The improved returns and ability to hedge against inflation make this an attractive asset.

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.

Update on TXU Corporation LBO

In 2007, a group of private equity firms and investment banks bought TXU Corporation for $45 billion in the largest leveraged buyout transaction.  The company changed its name to Energy Future Holdings Corporation but the fact remains that it is in trouble.  This is due to lower gas prices (the U.S. fracking expansion) and demand (from the recession and jobless recovery).  Two years ago, the debt associated to the deal was trading at a discount.  As of March 31, 2013, KKR has thrown in the towel and is valuing the bonds at 0.05 of cost.

On April 15, the company proposed to re-structure its $32 billion in debt.  Equity owners would be wiped out and the senior debt owners and the original private equity consortium would split the company 85%/15%.  Already, distressed debt managers Franklin Templeton Investments, Apollo Global Management LLC, Centerbridge Partners and Third Point LLC are buying debt which would be converted to equity stakes in case of re-structuring or bankruptcy proceedings.

A few institutional investors were unlucky enough to have negotiated terms to invest directly in the buyout.  Others were only invested in the private equity funds leading the deal.  Some of them are the biggest pensions such as California State Teachers' Retirement System, California Public Employees' Retirement System, Washington State Investment Board, Oregon Public Employees' Retirement Fund, New Jersey Division of Investment and Pennsylvania State Employees' Retirement System.  According to TorreyCove Capital Partners LLC of La Jolla, California, KKR 2006, the fund with the TXU deal, will still have a higher return than the S&P 500 in 2012.  KKR 2006 returned 7.09% versus 3.25% for the index.  The privileged co-investors included California State Teachers' Retirement System and Government of Singapore Investment Corporation.  There is no word if either managed to offload their direct investments through the secondary market.

In another twist, some fund managers think that Energy Future Holdings could extend its debt into the future. Since 2009, the company has re-financed $25.7 billion of its debt.

The source for this article can be accessed here.

Gold: Is the Bubble Popping?

On Friday, May 17th, gold futures dropped to $1,358.30 per ounce;  retracing its steps from a high of $1,920 per ounce in September 2011.  Year to date, it has dropped about 18% on the COMEX in New York.  Money managers such as BlackRock, Northern Trust, Farallon Capital Management, Whitebox Advisers and Soros Fund Management have reduced or hedged against gold as represented by the exchange traded product:  SPDR Gold Trust.

BlackRock and Northern Trust sold more than 50% of their holdings and Soros Fund Management sold 12% as of March 31, 2013.  This follows a quarter where Soros Fund Management sold 55% of their gold position.  Whitebox Advisors sold 90% of their smaller position.  Farallon Capital Management used put options on the SPDR Gold Trust as their negative view.

On a high level, the number of short futures and options contracts on gold is growing.  According to EPFR Global of Cambridge, Massachusetts, $21.1 billion in gold and gold-related funds have been sold by investors.

On the other hand, Paulson & Company, Schroder Investment Management Group and Elliott Management have held onto or bought SPDR Gold Trust.  They are looking at increased demand from India and China as a catalyst for a recovery in the asset.

The source for this article can be accessed here.

Hedge Funds Want Retail Investors

The number of hedge fund mutual funds or liquid alternative funds has increased from 343 at year end 2007 to 838 at year end 2012.  Assets under management are $90.3 billion, an increase of 14% over the same timeframe.  Neil Siegel, Managing Director and head of global marketing and product development at Neuberger Berman, and Evan Mizrachy, head of retail alternatives at BlackRock Alternative Investments, believe that retail investors and their 401(K) and IRA accounts are under-served by and under-allocated to alternatives.  Expanding into this segment would diversity hedge funds' client base.  On the other hand, retail investors demand daily liquidity requirements which would limit their investment universe and, maybe, performance.

According to Morningstar, the strategies run by these funds are led by long/short ($25.8 billion), market neutral ($19.5 billion), multi alternative ($17.5 billion), currency ($11.7 billion), managed futures ($8.5 billion),  short ($6.8 billion) and trading ($449 million).  Of course, these assets under management are clearly miniscule when compared to the $13.1 trillion in US mutual funds according to the Investment Company Institute.

The oldest fund, Merger Fund, has been around for 23 years using merger arbitrage strategy to give investors assets with low correlation to stock markets and volatility.  Two major institutions, FMR and Blackstone have also moved into this space.  FMR, parent company of Fidelity Management, uses Arden Asset Management to manage their alternative vehicles while Blackstone Alternative Asset Management is building their business organically.  The largest manager by far is PIMCO but their investors are mainly institutional.

The source for this article can be found at Pensions & Investments.

Dark Trading Pools

In the April 2013 issue of ai-CIO, there is an article about the growth of dark trading pools.  These are private exchanges where investors trade anonymously.  Their nicknames include non-displayed markets, private markets, off-exchange trading or upstairs trading.  In 2008, they made up 6.5% of the total trading volume in US Equities.  In 2012, they have grown to take up more than 13%.

The main advantage of the dark pools is privacy.  An institutional investor getting into or out of a large position would not move the stock price much.  On the exchanges, a large order would be noticed and the price would move against the investor.  To hide their order, it would have to be split into many smaller orders by a sell-side salestrader.  Dark pools are not foolproof.  The stocks are usually limited to those with the highest trading volumes.  The operator of the dark pool could use the information to trade ahead of the investor or sell it to another trader.

Since 2007, investment banks have created dark pools such as Credit Suisse's Crossfinder and Goldman Sachs' Sigma X.  To generate additional revenue, they have given access to algorithmic traders in the quest to find discrepancies in security prices among exchanges.  If dark pool trading volume in more numerous trading venues grows, then the prices on public exchanges may no longer be accurate.  More pools means that investors would have search harder to find the other side of the trade.  It seems that the solution for one issue has created others.