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.

Longevity Swaps: A New Product for Pension Funds

Pensions & Investments reported that more and more funds in the United Kingdom are using longevity swap trades to hedge their pension payout risk. This product was first traded in 2009 and, in 2011, had a notional amount of $10.7 billion in contracts traded. Pension funds are guarding against retirees living longer than their actuarial predictions where they would be responsible for extra payments. The companies selling this risk include insurance companies such as Swiss Re, Prudential Financial Incorporated and Legal & General Group and investment banks such as Goldman Sachs, Deutsche Bank, JP Morgan Chase and Credit Suisse.

The swap trades are easier for pension funds to execute than other hedging vehicles known as buy-ins or buy-outs. These transactions also transfer the pension payout risk but need large upfront payments. Sometimes, the institutions have to sell assets to afford the payments.

The source for this artivle can be found here.

Most Popular Hedge Funds for Institutions

Pension & Investments recently compiled a list of 35 hedge fund and 10 fund of fund managers that had the largest capital inflows in 2011. To join the club, the funds had to have at least an additional $100 million. Bear in mind that these investments were made by institutional investors (pension funds, endowments, foundations and sovereign wealth funds) and are only part of the entire investment picture. Many new investments and the assets invested are not reported. As an example, BlueMountain Capital Management garnered $323 million according to the study but, according to its founder and president, had $1 billion from institutional investors.

The most popular hedge fund strategies were credit/fixed income, multi-strategy, long/short, activist and global macro based on the number of funds. Based on new assets under management, multi-strategy led the way; followed by credit/fixed income, activist and long/short. Capula Investment, a multi-strategy fund, added $825 million to rank number one. Next inline were D.E. Shaw Group ($555 million), Trian Fund Management ($500), ValueAct Capital Partners ($500 million and Ascend Capital ($465 million). Other famous names lower on the list are Brevan Howard Asset Management, Carlson Capital Management, Avenue Capital Group, Och-Ziff Capital Management Group, GSO Capital Partners (a part of the Blackstone Group), Astenbeck Capital Management and Saba Capital Partners.

The fund of fund list was led by Prisma Capital Partners ($666 million), Permal Group - a subsidiary of Legg Mason ($507 million), Blackstone Alternative Asset Management ($506 million) and Pacific Alternative Asset Management ($400 million). Three funds - Prisma, Blackstone and Pacific Alternative Asset Management - are recipients of an increased allocation by Kentucky Retirement Systems ($400 million each) that vaulted them to the top of the rankings. There were three trends affecting the allocation to fund of funds. Public and corporate pension plans are increasing their investments to diversify their fixed income portfolios. Fund of funds are expecting non-US pension plans to invest in alternative assets.

The source for this article can be accessed here.

Positioning a Fund for Slowing Growth in China

Some European hedge funds are predicting that China's growth will slow down in 2012.  The GDP growth forecast has been lowered to 8.7% for the fourth quarter of 2011.  From 2003 to 2007, growth was at least 10%.  One chief investment officer, Javier Pina of Javelin Capital, says that China is forced to stop their credit expansion.   According to Pedro de Noronha, managing partner at Noster Capital, he has noted the following reasons for the downturn:

• The US has not returned to pre-crisis consumption levels
• Lack of corporate governance in China
• Bad bank loans
• Real estate bubble

Other managers have positioned themselves to profit from the slowdown by:

• Shorting Chinese equity markets using futures
• Short positions in the yuan
• Buying credit default swaps on companies that export to China
• Shorting natural resource companies that export to China

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.

An Alternative Fixed Income Investment: Senior Secured Loans

The standard security for a Fixed Income investor is the bond - government, corporate, high yield or otherwise. Since bond interest rates are at all time lows, their income is low and their potential for price appreciation has disappeared. An alternative way to invest is through corporate loans made to companies that are rated below investment grade. These loans have a variable interest rate of LIBOR plus a spread. Bonds are generally fixed rate instruments. Their value will rise and fall according to the market interest rate.

Loans are less likely to default and are also first in line to recover losses if the company becomes bankrupt, being senior to bonds, preferred securities and equities. They recover 60%-70%. Bondholders recover 25%-40%. Why is that? Loans are secured by real assets and protective covenants. These covenants may give the investor the right to accelerate loan payments, update the loan terms if the borrower's credit changes and buy the loan at a discount to par.

They may be used to create collateralized loan obligations (CLOs).  One hedge fund in Dallas, Carlson Capital I think, used this strategy six or seven years ago.  Hearsay data from a banker that I shared an elevator with.

Loans may be a more efficient fixed income instrument in the current low interest environment. They are paying investors more than bonds for taking on less credit risk and are a hedge against a rise in interest rates.

The source for this article, along with additional information, can be accessed through here.