Growing Emerging Hedge Funds

I have been invited to be a guest author on another blog:  Simon Kerr on Hedge Fund.  The article, seed capital for hedge funds, can be accessed here.

Barbell Allocation Model Causes Flight from Mutual Funds

Since the credit crisis where the Standard & Poor's 500 fell 37% in one year, there has been a flight from the traditional equity mutual funds to fixed income, index and alternative funds.  The old model, where an investor was diversified based on style (growth or value), capitalization and geography, is no longer performing well.  They are gravitating to a barbell model with allocations to passive indices and alternative investments.  According to eVestment Alliance, $90 billion and $29.3 billion were redeemed from US large cap growth and value equity funds.  This is pressuring traditional asset managers and subsidiaries of banks and insurance companies to change their practices.

For example, Francis Ghiloni, director of distribution and client management for Scottish Widows Investment Partnership (SWIP), noted that the barbell approach is more popular since traditional investments are encountering higher volatility and risk.  SWIP re-organized their investment team along global lines, replacing the former regional coverage model, and promoting their quantitative research team.  Aviva Investors is also moving assets from fundamental to quantitative analysis teams.

The source for this article can be accessed here.

Assets Surge into Activist Hedge Funds

According to an article in Pensions & Investments, institutional investors have started the trend of classifying their asset allocation to alternative investments based on their type of asset (equity, fixed income or commodities) instead of in a separate bucket.  This has fueled an increase of capital into activist hedge funds such as ValueAct Capital Management. Starboard Value and Cevian Capital in the second half of 2011 and first quarter of 2012.  The reasoning behind placing them into the equity classification is that they hold long positions.  The Florida State Board of Administration recently invested $125 million in Starboard.  The New Jersey Division of Investment, New York State Common Retirement Fund and Virginia Retirement System placed $600 million with Cevian Capital.  Overall, the investments in managers with a constructive approach are larger than the more aggressive approach favored by Bill Ackman of Pershing Square Capital Management and Daniel Loeb of Third Point.  Some of the larger funds that work with company management to improve their share price are Cevian Capital, JANA Partners and Paulson & Company.

Activist hedge fund managers keep their holdings for a longer period of time than other fund managers.  They need time for their campaigns to improve the value of the stock.  According to Stephen Nesbitt, CEO of Cliffwater LLC, the strategy has strong, uncorrelated returns in the last five years.  For a sample selection of eight funds, the return was 8.6%.  The Russell 3000 Index's return was 0% and the Morgan Stanley Capital International All Country World Index returned 2.8% for the same time period.  This is a natural attraction for pensions, endowments and foundations.

Managed Futures Selection Factors

Managed futures are marketed as having low correlation to stock and bond markets.  However, within the strategy, returns between managers (known as commodity trading advisors or CTAs) have varied.  According to David Kavanagh, CEO of Grant Park Managed Futures Mutual Fund, and Greg Anderson, Chief Investment Officer of Princeton Fund Advisors, returns are affected by four factors:  type of market securities, trading strategy, timeframe and research methodology.  They may trade in different futures covering currencies, energy, equity, fixed income, food or metals.  Obviously, the trading strategy - whether it is trend following or contrarian - affects returns.  Timeframes are how long a security is held.  They may be held for days or months.  Research methodology determines the trading signals for the manager.  They can be quantitative, top down or technical (charts).

According to Anderson, the four risks in the managed futures space are selecting the wrong manager, poor design of the investment portfolio, trading strategies becoming obsolete due to changing markets and tail risk.  Kavanagh adds understanding the edge of any CTA over its competitors.  The manager selection process considers several factors:  track record, trading strategy, fund's operations and back office, experience of the principals and fit within a portfolio.  On a more detailed level, Anderson would consider the interest income, cost structure (including trading commissions), trading results and an audited performance history.

This article can be accessed here at www.finalternatives.com.

New Opportunities in Collateral Management for Banks

Starting next year, derivative trades such as interest rate swaps will be traded over central clearing houses.  They are currently done as private transactions between two counterparties.  To protect themselves from losses if a counterparty should not pay out their revenue responsibilities, the clearing houses will demand collateral.  It is estimated that the collateral needed to cover these trades will increase by $2 trillion or 50% because many of these transactions are long term in nature.  Several banks are poised to take advantage of the new business - JP Morgan, Northern Trust, State Street and BNP Paribas.  There could be $2 billion in revenue at stake.

Already, there are several partnerships being agreed on to allow counterparties access to new assets and to optimize collateral at different firms.  BNP Paribas Securities Services and Euroclear, the European securities warehouse that settles trades, are allowing their clients to use collateral at BNP to finance trades on Euroclear.

The source for this article can be accessed here.

Will China Have a Soft Landing?

Paul Gambles, Managing Partner of MBMG International, discussed the state of China's economy last month in a television interview with the Money Channel and on his blog.  He believes that there will be a hard or very hard landing.  A soft landing is not an option.  This is due to a number of factors:

• Lack of transparency in the economy - Chinese economic data is not reliable because of strong central government control of the data and economy.  The government determines where capital is invested, regardless of returns.  There may be bad investments that are priced incorrectly due to government stimulus and forced lending (which often turn into bad debts).  The GDP growth of 8.9% may not be real if the underlying loans are examined.  An example of government influenced pricing is when the Huijin Sovereign Wealth Fund bought controlling positions in the four largest banks:  Agricultural Bank of China, Bank of China, Industrial & Commercial Bank of China and China Construction Bank as a show of support in 2011.  Nobody knows what these banks are worth.
• Foreign Direct Investment is slowing in China.  It has become less attractive to investors and holding $1.5 trillion in US assets.  Exporting to Europe to diversify away from the dollar has become difficult due to the Eurozone crisis.  If the government had spent the US dollars, it would have increased inflation or the value of renminbi.  China was unwilling to accept either consequence and had to hold US assets.  China is repeating what Japan did thirty years earlier and both are similar to a currency hedge fund that is overexposed to the US dollar.
• China is predicted to become the world's largest economy by 2020.  A closed government and controlled economy will make it difficult to pass the US.
• Xi Jinping, the President-elect and successor to President Hu, did not get approved by the military.

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.