Multi-strategy Funds Are Disappearing

Multi-strategy hedge funds have had a tough time lately due to poor performance and high redemptions since the credit crisis of 2008.  Several large funds have closed - Arrowhawk Capital Partners ($575 million in AUM), Drake Capital Management ($6 billion in AUM), Deephaven Capital Management ($4.5 billion in AUM) and Stark Investments ($7.2 billion in AUM).  The last and latest, Stark, is still running $1 billion in single investment strategies such as Stark Mortgage Opportunities and Stark ABS Opportunities fund.  Other funds have converted to single strategies successfully.  They include some of the more famous names:  SAC Capital Advisors, Highbridge Capital Management and Maverick Capital Management as well as Black River Asset Management, Halcyon Asset Management, Polygon Global Partners, HBK Capital Management and York Capital Management.  The challenges in the current environment for multi-strategy funds are:

• Difficult to generate excess returns (alpha) in all strategies at the same time
• High employee turnover
• Work culture is not collaborative across strategies.  Multi-strategy funds start in convertible arbitrage or event driven strategies and then add equity long/short and other strategies.  The mindsets needed to be successful in each strategy are different and not conducive to working together.

The source for this article can be accessed here.

Fund of Hedge Funds Continue Losing Market Share

Fund of hedge funds (FOHF) are under pressure due to poor performance in 2011 and their failures of 2008 - ability to give their investors liquidity and superior due diligence.  Many funds' liquidity was negatively affected by their hedge funds' imposition of gates and side pockets for poorly performing assets.  Confidence in FoHF's due diligence capabilities were lost in the Madoff ponzi scheme.

In 2007, 43% of hedge fund assets were invested through FoHFs.  In 2010, it was down to 34% (Statistics are from Hedge Fund Research.) as more investors started making direct investments into funds.  In absolute numbers, assets under management for FoHFs are down from 2010 to 2011 - $646 billion to $620 billion - despite the uptick in hedge fund assets.

Since 2008, private banking clients have divested themselves from hedge funds.  Insurance companies and endowments are investing directly into funds and family offices are using managed accounts and pension consultants instead of FoHF.

According to Peter Laurelli, vice president, research, eVestment Alliance in the article at finalternatives.com, “To an evolving landscape of hedge fund investors, it is increasingly difficult to showcase a clear, superior value provided by funds of funds, specifically using performance comparisons over every possible sub-classification, to other methods of accessing the industry.“Fund of funds’ core strength of single investment diversification to the hedge fund industry is moving towards a niche role as larger allocators to the industry become more comfortable investing directly, or working with consultants who may already be employed for traditional portfolios.”

The source for this article can be accessed here.

Hedge Funds Are Not An Asset Class

Capital Generation Partners (CGP), an investment advisory firm, analyzed portfolio diversification ideas.  They concluded that there are only three asset classes:  debt, cash and equity.  Alternative investments such as hedge funds should not be classified as an asset class.  They should be classified based on their underlying positions.  Hedge funds are merely investment strategies for these assets.  There are four strategies based on two points:  directional versus arbitrage and systematic versus discretionary.  These four strategies and three asset classes combine to create twelve buckets.

Equities
directional & discretionary - equity long/short, long only, real estate, private equity and 130/30 funds
directional & systematic - equity index trackers and quantitative funds
arbitrage & discretionary - equity market neutral and event/risk arbitrage
arbitrage & systematic - equity statistical arbitrage and systematic CTAs

Cash & Commodities
directional & discretionary - global macro, physical commodities and currency (carry) trading
directional & systematic - trend following CTAs, commodity ETFs and money market funds
arbitrage & discretionary - commodity/macro curve trading and volatility arbitrage
arbitrage & systematic - statistical arbitrage and systematic CTAs

Fixed Income
directional & discretionary - fixed income long/short and distressed debt
directional & systematic - bond indices
arbitrage & discretionary - global macro and structured credit
arbitrage & systematic - fixed income arbitrage and systematic CTAs

Proper diversification includes having non-correlated assets in a portfolio.  CGP analyzed returns from 2000 to 2010 for the twelve categories.  Their conclusions were:

• Alternative investments are not real diversifiers of a traditional equity/fixed income portfolio
• Hedge funds should be allocated across the twelve categories and not be treated as a separate asset class
• Fund managers should be closely monitored for style drift
• Correlation map indicates that larger allocations should be made to hedge funds

The correlation heat map from the paper confirms an earlier study by Welton Investment Management.  Global macro and managed futures (Barclays CTA Index in this case) are not correlated to other hedge fund strategies.  In CGP's chart, equity market neutral can be added.

The source for this article can be accessed here.

A Study on Infrastructure Investments

In recent years, a new asset class investing in the infrastructure of a nation has been classified for use in asset allocation models.  What is infrastructure?  It is commonly known as assets in the transportation, telecommunications, electricity and water sectors.  Emerging and developed nations need to build out their infrastructure for different reasons.  The former due to population growth and economic development.  The latter to upgrade and replace existing infrastructure.

Usually, these projects would be financed by local or national governments.  The developed world is still recovering from the credit crisis in 2008 and dealing with the continuing Eurozone situation.  The emerging world, other than China, does not have the financial resources.  They are unlikely to meet global need for infrastructure investments.  This could be as high as US $70 trillion for 2005 to 2030.  Hence, the call for private investors such as pension funds and private equity firms.

Investors may invest directly into infrastructure assets through Public Private Partnerships or project finance structures.  They are exposed to disadvantages such as liquidity risk, very long investment time horizon, political risk, concentration risk, regulatory risk and high capital requirements.  They can buy securities of companies directly or buy funds/indices in sectors related to infrastructure.  The reduces all risks except for political and regulatory.  Market risk is higher in this case.

In the article Risk, Return and Cash Flow Characteristics of Private Equity Investments in Infrastructure in the Alternative Investment Analyst Review, Florian Bitsch, research assistant at the Center for Entrepreneurial and Financial Studies; Axel Buchner, postdoctoral researcher at Technische Universitat Munchen and Christoph Kaserer, professor at Technische Universitat Munchen obtained detailed private equity deal information, including monthly cash flow data, from the Center for Private Equity Research for 363 infrastructure and 11,223 non-infrastructure deals from January 1971 to September 2009.  The deals had to be exited and spanned the alternative energy, transportation, natural resources, energy and telecommunications sectors.


From the data they find:

• Infrastructure investments have shorter time horizons
• Infrastructure investments are twice as big as non-Infrastructure deals
• Infrastructure does not offer more stable cash flows
• Infrastructure investments have higher returns and lower risks.  They have lower default rates and better returns than non-infrastructure deals.
• Brownfield investments of established companies have lower risk and default rates.  They have better returns than greenfield investments.  Private equity and venture capital deals were used as proxies.

The factors affecting fund performance were:

• Excess investment capital does not bid up asset prices for infrastructure deals as it does for non-infrastructure
• Data is inconclusive that infrastructure investments are an effective hedge against inflation
• Infrastructure deals are correlated to the markets
• Infrastructure deals are not correlated to the broader economy, as defined as GDP
• Infrastructure and non-infrastructure deals are negatively affected by interest rate changes
• Fund manager experience has no influence on returns
• Longer dated deals have better returns as poorly performing deals are exited quickly
• A fund requiring additional rounds of financing usually have poor returns
• The size of the deal does not affect infrastructure deal returns
• European infrastructure deals have the best performance
• Transportation is the best performing sector  

Investors Uncertain about BRIC Countries

Many investors believe that any future long term stock market performance will be driven by the BRIC (Brazil, Russia, India and China) countries in the emerging world.  Opinions on the short term outlook have changed.  There is a split among managers due to the continuing Eurozone crisis and slowing global growth.  The returns for the four countries are less than the MSCI Emerging Markets index which has underperformed the MSCI World index by 834 and 124 basis points for the past one and three years through May 31.  Below is a table comparing each country's return versus the MSCI Emerging Markets index for the same time period.

BRIC Country	One Year Return	Three Year Return
Brazil	-823 bp	-703 bp
Russia	-1,130 bp	-544 bp
India	-802 bp	-785 bp
China	-24 bp	-540 bp

The managers on either side of the trade are:

Pro

Richard Titherington, managing director and chief investment officer for emerging markets equity and JP Morgan Asset Management ($33 billion in assets under management) is aggressively overweight China and sees the pullback to lower valuations as a buying signal.

Allan Conway, head of global emerging markets equities at Schroder Investment Management $23.2 billion in AUM); Manu Vandenbulck, senior investment manager and ING Investment Management ($3.3 billion in AUM); Christian Deseglise, managing director and head of institutional sales in the Americas for HSBC Global Asset Management ($32.2 billion in AUM) and Gary Greenberg, head of emerging markets at Hermes Fund Managers ($740 million in AUM) are overweight China.  They are relying on China's government to cushion any economic downturn.  The lower valuations of the Chinese stock market lessen market risk.  The BRIC countries are becoming non-correlated with the developed world.

Gaurav Mallik, portfolio manager for global active quantitative equity at State Street Global Advisors ($6 billion in AUM), is buying smaller companies in Russia and China.

Con
Todd McClone, portfolio manager at William Blair ($9 billion in AUM), says that lower commodity prices, the Eurozone crisis, inflation and slowing economies are negatively affecting the markets in BRIC countries.

Paul Bouchy, managing director and head of research at Parametric Portfolio Associates, is underweight BRIC and overweight in the frontier countries.

The source for this article can be accessed here.

How Hedge Funds Perform When the VIX is High

In a recent article  published in the Alternative Investment Analyst Review, Mikhail Munenzon, CFA, CAIA, PRM and Director of Asset Allocation and Risk at the Observatory, researched how different hedge fund strategies performed during periods of volatility over twenty years.  The data came from the Center for International Securities and Derivatives Markets Indices.  The strategies covered were convertible arbitrage, distressed, merger arbitrage, commodity trading advisor, macro, equity long/short, equity market neutral, emerging markets and event driven.  He looked at the indices for traditional assets too:  S&P 500 Index, JPM Morgan Aggregate Bond Total Return Index, SP GSCI Commodities Index and the FTSE EPRA/NAREIT US Total Return Index, a real estate index. Volatility was measured by the VIX index from 12/31/91 to 1/29/10.  Munenzon created six categories:  less than 20, 20-25, 25-30, 30-35, 35-40 and more than 40.  The VIX was under 30 90% of the time and under 20 50% of the time.  Based on the data, it does not jump randomly from being quiet to being volatile.  They remain calm or volatile at times and remain so for the near future.  Each index's return was analyzed during the same timeframe.  Here are the most important points:

• Only four of fourteen indices had positive returns in all conditions:  commodity trading advisor, macro, equity market neutral and JPM Morgan Aggregate Bond Total Return Index
• Superior long term performance of hedge funds are due their ability to limit their losses during times of market stress due to unconstrained investing.
• This affirms an earlier study by Welton Investment Management stating that macro and commodities are the two strategies that are not correlated with the stock markets

Please note that data is based on indices.  Individual portfolios of funds may have different results.

Study Shows CDS Trading Increases Bankruptcy Risk

In a previous post, we looked at the bankruptcy and re-structuring process through the court system.  We detailed that the debt holders are converted into equity holders.  Any debt holders with a 33% position have a blocking position to approve any deal.  At the same time, they can hedge their holdings by purchasing credit default swaps (CDS).  Since the recovery rates for a re-structuring range up to 65%, a March study by Marti Subrahmanyamy of New York University's Stern School of Business, Dragon Yongjun Tang and Sarah Qian Wang of the University of Hong Kong's School of Economics and Finance indicates that fully insured and over-insured investors push the company into bankruptcy to recover 100% of their bonds' value.  They are called empty creditors.  They have "an economic interest in the firm's claims but no risk alignment with the other bondholders..."  Companies with empty creditors have higher bankruptcy rates due to less monitoring.  This may lead to higher risk taking by the borrowers.  Finally, companies that have CDS traded on them have more debt holders or lenders.  This impedes the re-structuring process.

The authors analyzed data for 901 CDS for North American companies between June 1997 to April 2009.  Of the 1,628 firms that filed for bankruptcy, 60 had CDS traded.  They reviewed the 3,863 companies that had their credit rating downgraded by Standard & Poor's.  Statistical analysis confirmed the following after CDS began trading on those firms:

• Majority of firms are A or BBB rated
• S&P ratings fall for investment grade firms (A, AA or AAA) and more firms become non-investment grade (BBB and below)

When a company is the underlying for a CDS, it is more likely to be downgraded by a rating agency as a precursor to bankruptcy.  This occurs more readily when there are more CDS contracts traded and when re-structuring does not trigger a payout on the contact.  The probability of bankruptcy is 0.33% versus 0.14% for a non-CDS traded company.

The source for this article, with the authors' statistical analyses, can be accessed here.