Most Popular Hedge Fund Strategy is Relative Value

Assets under management for hedge funds using the relative value strategy have surpassed the equity long/short strategy for the first time in the fourth quarter of 2012.  As of September 30, both strategies had a market share of 26.7% of the $2.192 trillion hedge fund industry.  The next most popular strategies were event driven at 24.5% and macro at 22.1%.  To give you a sense of where equity long/short was coming from, it was 56.3% of all assets under management for hedge funds in 2000.  Several factors accounted for the shift:

• Investors reducing their exposure to equities to diversify and reduce their portfolios' volatility
• Investors investing directly into hedge funds and away from fund of hedge funds, which are heavily weighted towards equity strategies
• Underperformance of equity long/short strategy over the past five years

Year	HFRI Equity Index	HFRI Relative Value Index
2008	(26.65)%	(18.04)%
2009	24.57%	25.81%
2010	10.45%	11.43%
2011	(8.38)%	0.15%
2012	7.39%	10.04%

Funds that have experienced significant inflows include BlueMountain Capital Management, Pine River Capital Management, Marathon Asset Management, MKP Capital Management and Brigade Capital Management.

However, for 2013, several investors are reviewing the value proposition of equity long/short funds.  Fixed income returns are projected to be low and stockpickers will be in vogue again as macroeconomic moves such as Quantitative Easing 3 fade.

The source for this article can be accessed here.

A To Do List for Funds of Hedge Funds

In prior articles, I have noted that funds of hedge funds (FoHFs) are losing assets under management even as the assets of hedge funds have bounced to above pre-crisis levels.  The percentage of assets invested through FoHFs had fallen to 34% in 2010.  The SEI Knowledge Partnership conducted a survey of 220 institutional investors, investment consultants and FoHF managers in June 2012.  The main complaints of investors were the underperformance of FoHFs over the past three years, high fees, lack of transparency and portfolios that are correlated with other asset classes.

The research paper listed seven topics for FoHFs to address:

• Customization of reporting, portfolios (the underlying managers of a FoHF), transparency and liquidity to create complete investor solutions
• Investing in and seeding emerging managers
• Improved risk management during market collapses
• Overdiversification.  Investors are now interested in a "best ideas" portfolio.
• Creating account structures to handle investors' requirements such as separate managed accounts, derivatives, quantitative products and registered products (UCITS and mutual funds)
• Using their subject matter expertise to advise investors on manager selection, portfolio construction, asset allocation and special strategies
• Aligning the fee structure with the investor's interests such as raising the hurdle rate or charging a flat fee

To read the entire paper, the report may be accessed here.

Opening China to Foreign Investors

The State Administration of Foreign Exchange of the People's Republic of China has eased the rules for investing in China's financial markets through the Qualified Foreign Institutional Investor program.  They eliminated the $1 billion limitation on investments and changed the minimum statistics of the investor.  The manager must have $500 million (amended from $5 billion) in assets under management and have a track history of at least 2 years (amended from 5 years).  The entire process to obtain entrance into the program is now about 7 to 8 months.  Previously, it would take a year and a half.  The changes have been targeted to long term investors such as sovereign wealth funds, central banks, monetary authorities, insurance companies, endowments and pension plans.  Fund managers with a high turnover rate, such as hedge funds, mutual funds and investment banks, were not included in the rules changes.  Overall, by 2015, consulting firm Z-Ben Advisors Co. Ltd. of Singapore is predicting that asset management firms and asset owners will dominate the landscape.  They will push out the investment banks, who now have 51% share in the program.  Also, last year the ceiling on the program was elevated to $80 billion from $30 billion.  About $6 billion has been invested since then.  It is expected that the remaining $44 billion will be invested over the next 2 years.

The article from Pensions & Investments may be accessed here.

Master Limited Partnerships: An Energy Alternative

Since the credit crisis of 2008, interest rates on traditional fixed income investments (bonds, CD's, savings, money markets...) have been at record lows.  On the other hand, there has been a boom in the natural gas industry as the extracting method of "fracking" has become accepted.  These two trends, combined with the fiscal cliff's tax increases scheduled for January 1st, are making Master Limited Partnerships (MLPs) attractive investments.

Like hedge funds, MLPs have grown dramatically over the last 15 years.  Including a dip in 2008, they have grown from $8 billion to $241 billion in market capitalization and trade volume has increased from $6 million to $600 million.  But it is still tiny compare to the S&P 500.  Initially, retail investors were the primary buyers but the institutional share has grown to more than 30%.  There are about 100 partnerships trading in "units" on the NYSE and NASDAQ.  They are managed by a General Partner (GP) who runs the partnership for the Limited Partners (LPs), much like a private equity fund.  Also, the GP is invested in the MLP and can earn a performance fee called Incentive Distribution Rights.

MLPs have a number of attractive characteristics for investors:

• They have a higher yield than bonds except for high yield
• Annualized returns for the standard index - Alerian MLP Index - are higher and have less volatility than the S&P 500, Russell 2000, GSCI Commodity and FTSE NAREIT Equity REIT indices
• Favorable tax treatment

On the negative side, investor must watch for:

• MLPs may be as volatile as equities and commodities
• Limited liquidity because of small market capitalization and the tax treatment attracts buy and hold investors
• High concentration of product.  The 10 largest MLPs make up 60% of the total market capitalization.
• Has a small correlation with equities than increases during a crisis
• Has regulatory and legislative risk on the tax exempt status
• As MLPs pass through their income to LPs, they can only raise money from the capital markets to grow their company
• Conflicts in interest between GP and LPs
• When all is said and done, this is an investment in the energy sector

The energy sector represents about 77% of public partnerships.  The remainder are in real estate or financial businesses.  To qualify for an MLP status, 90% of its income must be derived from either energy, real estate, natural resources or minerals sectors.  According to Greg Reid of Salient Partners, there are 80 energy MLPs with a total market capitalization of $300 billion.  Reid runs two publicly-traded closed end funds and is a Managing Director in charge of $1 billion.  MLPs' average yield is 6.2% and have a projected growth rate of 6.5%.  The high yield is paid quarterly, like a dividend.  It is accomplished because a high percentage of income (about 90%) is distributed to the LPs and because the MLP has favorable tax status.  It is exempt from corporate taxes.  Additionally, taxes on 80% of the distributions are deferred until the units are sold;  the other 20% is taxed as income.  A higher yield is given to the investor in exchange for passing the corporate taxes to them.

Some MLPs favored by investors are Plains All American Pipeline, Enterprise Products and Targa (Reid).  Jason Stevens, energy analyst at Morningstar, likes Enterprise Products and Energy Transfer Products.  John Tysseland of Citigroup likes Enterprise Products, Atlas Pipeline Partners, Genesis Energy, Magellan Midstream Partners and Western Gas Partners.  Stephen Massocca, chief investment officer of Wedbush Securities, likes Memorial Production and BreitBurn Energy Partners.

The sources for this article can be accessed at FINalternatives.com, the New York Times and an NEPC research report authored by Andrew Brett, CAIA, Senior Research Analyst and Tim Bruce, Senior Research Consultant.

The Future of Fund of Hedge Funds

Since the credit crisis of 2008 and the Madoff scandal, the percentage of assets being invested in hedge funds through fund of hedge funds (FOHFs) has decreased steadily to 34%.  For FOHFs to survive and thrive, they have to add enough value to justify their fees.  Two researchers at NEPC of Cambridge, MA - Kamal Suppal, CFA, Senior Research Consultant and Antolin Garza, Research Analyst - examine this issue.  The avenues to creating this value are manager selection and portfolio construction.  Portfolio construction may be executed by creating allocations for each investment strategy and finding managers to fill them or the reverse.  Find the best managers and then allocate to each strategy.  Other questions to resolve are the weights of the managers and assigning different portions to be strategic versus tactical allocations.

NEPC views the future of successful FOHFs in three forms:

1. Conservative FOHFs that protect against the downside and participate slightly on the upside.  They have "high-conviction ideas and dynamic portfolio allocations."
2. "Niche" FOHFs with tactical portfolio allocation that is used to complement the other hedge funds in the portfolio
3. Customized portfolios used to complement a portfolio

Portfolio construction rests on the investment philosophy of the FOHF and its business considerations.  For example, a philosophy would be to regard investments as the present value of future cash flows.  Business considerations include whether or not the FOHF is an asset gatherer or seeks to earn the performance  incentive fees.

Asset gatherers use strategic asset allocation as their value add.  An EDHEC study of 200 FOHFs from January 2000 to June 2007 found that 48.4% of managers added an average of 1.54% over the average return.  During the crisis timeframe of June 2007 to July 2009, 77.7% of managers added an average of 3.5%.  FOHFs using tactical asset allocation methods had more muted results.  During the calm period, 60.9% of FOHFs added 1.24% to the returns.  In the crisis period, only 30.9% added 1.86% of returns.  The downside was worse.  69.1% of FOHFs averaged losing 3.13% more than the average return.

FOHFs that use manager selection added the most value during the first period.  92.9% of FOHFs added  an average of 3.89% excess return.  During the crisis, 48.4% added 4.18%.  The remaining managers lost an average of 4.3%.  This high figure leads to the conclusion that strategic asset allocation is the safest bet.

The researchers examined more than 15 years of returns for 1,300 FOHFs in 2011 and discovered that 20% of them added value.  Of those managers selecting hedge fund managers, only 5% added value.  To find these managers, NEPC uses a "6P" process to explain the role of FOHFs in a portfolio and verify its performance.

• People - need to have well-rounded and diverse teams that knit together their knowledge and skill sets to deliver value
• Philosophy - an investment philosophy that provides managers with clarity on how to manage their portfolios in all situations
• Process - Consists of fund research, portfolio building and risk management;  need to have defined research criteria taking into account the size of the fund, specialist versus generalist advantages, different account structures, negotiating lower fees for transparency, more control and better liquidity and monitoring managers;  use diversification to reduce business and headline risk, having access to investments in different investment strategies, sectors and geographies to reduce volatility;  risk management consists of having risk mitigating strategies (global macro, commodities trading adviser, volatility arbitrage and tail risk investing), non-correlation of positions and limits on leverage.
• Performance -  absolute and relative, relative performance for a FOHF is compared against the HFRX (investible index)
• Price - fees charged should not be reduced for FOHF that add value
• Perpetuity - have stable personnel with low turnover and investors such as private clients and family offices

The source for this article can be accessed here.

Update: Boeing Pension Plan Performance

The pension plan of Boeing Company has returned 10% in 2012.  The mark for the plan is 7.75%.  The plan has $51 billion in assets.  To achieve its return, the asset allocation is as follows:

• Fixed Income - 53%
• Global Equity - 26%
• Private Equity - 6%
• Real Estate/Real Assets - 6%
• Hedge Funds - 5%
• Other Global Strategies - 4%

The source for this article can be accessed here.

Boeing and Ford Run Pension Plans Well

Two weeks I saw a post on allaboutalpha.com that listed the best corporate pension fund managers.  It was written by Charles Skorina and compared their performance with the more visible public pension funds and endowments in the US and Canada.  Looking at five year returns, the companies with the best returns are Boeing, NorthrupGrumman, Ford and AT&T.  All were above 5.4% for 2007 - 2011.  Harvard Management's return for the same period was 5.6%.  A simple 60% equities / 40% bond portfolio would have returned 3.2%.  The four corporations earned these returns with less risk - as measured by Sharpe ratios.  The only public plans to rival them were Alberta Investment Management Company (AIMCO) and Columbia University.  Harvard Management's Sharpe Ratio was well below the leading plans.  Surprisingly enough, financial services firms Bank of America and General Electric ranked among the worst.

The source for this article can be accessed here.