Tuesday, 31 August 2010

Best Performing Hedge Fund Strategy in Next 6 Months - Poll Results

For most of this month a poll has been running for visitors to vote for what they see as the best performing strategy over the next six months. The strategy range was taken fron the Dow Jones Credit Suisse Hedge Fund Indices, and the results were, in order of votes (percentage of votes) and YTD return:

CB Arbitrage 0 (0%), 4.92%

Emerging Markets 0 (0%), 2.69%

Equity Market Neutral 2 (7%), -2.95%

Event Driven 7 (25%), 3.43%

Fixed Income Arbitrage 4 (14%), 6.79%

Global Macro 5 (18%), 4.88%

Equity Long/Short 3 (11%), -0.77%

Managed Futures 4 (14%), -1.24%

Multi-Strategy 2 (7%), 2.15%

Although it would be easy to suggest that the poll results reflect only the performance of the first seven months of the year, as three of the top four performing strategies YTD were selected as expected to be the best over the next six months, that is not the whole story. 
It is pleasing to see some contrarianism amongst the readership - managed futures, by now long overdue for some solid absolute returns, attracted more votes than multi-strategy and equity long/short.

As always, even with vox pop forecasting, there is some insight in it. The hedge fund investment strategy most commonly expected to out-perform the others in the next six months is the event-driven category (distressed, risk abitrage and multi-strategy) .  It is no coincidence that that is the strategy that is mentioned by investors in hedge funds when they are asked by marketers and pollsters where they are currently looking for managers. 

Does this mean investors in hedge funds don't believe that the US economy is in the process of double-dipping? The change in prices of distressed securities are negatively correlated with the economic cycle with a lag, and risk abitrage deal volumes are a function of the capital markets cycles.   

Thursday, 26 August 2010

Another Year Another Challenge for Funds of Funds

In 2008 the fund of funds industry had a tough time producing returns for investors because only 30% of hedge funds produced a positive return. For 2009 things were tough for funds of funds as they couldn't get out of the hedge funds that had let them down by making losses in 2008, because of limited liquidity in the funds, suspended redemptions, and sidecars. Further, few of the funds which made money in 2008 made good money in 2009. So if funds of hedge funds stayed loyal to their winners of 2008 it probably cost them in 2009. There was even a reversal of the size effect on hedge fund returns in moving from 2008 to 2009. 

Before looking at hedge fund returns in 2010, and factors that will impact fund of funds returns, let's look at single manager hedge fund returns in 2008 and 2009 from an absolute and relative perspective.

2008 was an absolute disappointment in terms of hedge fund returns- a loss of around 16%. Last year hedge funds produced their best returns since 1997, at up 19%, by the Greenwich Global Hedge Fund Index. And year to date through July, the same hedge fund index has a small positive return (up 1%), which is not good in isolation as an absolute return over seven months. 

The returns from equities put the absolute returns of hedge funds into some context. Using the S&P500 as a proxy for the equity asset class, the hedge fund returns of 2008-9 look very different. The S&P500 was down 38.5% in 2008, the year hedge funds at an index level lost 16% in a liquidity crisis with high volatility and fraud in the industry, and even so 30% of hedge funds were up.

In 2009 the S&P500 was up 23.5% and hedge funds were up 19%, which given the constrained directionality (beta to markets) is as good as it gets for the alternative funds. Over 70% of hedge funds produced positive returns in 2009.  

This year the S&P is down 4.3% at the time of writing, whilst representative indices of hedge funds are up a small amount.  However the context for hedge fund returns in 2010 is even tougher in some regards than the previous two years. To begin with, let's look at the trajectory of the equity market this year. Below is a one year chart of the S&P500.


The rally of the second half of 2009 actually peaked in the first few weeks of 2010, and thereafter the stock market has been a rollercoaster of epic proportions, meaning a serious of precipitous falls followed by sharp rises. Monthly index level changes of 7-8% have not been unusual since the outbreak of the Credit Crunch, but the sequences have changed: we had a string of big down months in the bear market to the low in March last year, then a series of big up moves in the massive rally of the last three quarters of last year. In 2010 we have had big up and big down moves alternately. Given that managing the net exposure is typically the biggest risk control variable of most hedge fund strategies (bar the market neutral strategies), this year has been amongst the most difficult market direction background I can recall, as the market was aggressively moving one way and then the other by turns.

Persistence of market movement, or propensity to trend, is different from volatility in traded markets. It turns out that the actual volatility of the S&P500 index, as a proxy for global equity markets, has been both unusually low and then high  this year. The chart below shows 30-day historic or actual volatility of the S&P500.

source: Bloomberg LLP

A level above 25% historic volatility (as opposed to traded volatility) has been uncommon in equity markets, except for short periods, and except for the last two years. The shifts in volatility seen this year would probably have hurt more hedge fund strategies than they helped. Pure volatility strategies should have benefited from the April/May shift in volatility, and the delta hedging of CB arbitrage funds should have had a good background in March and after the June peak in volatility . Overall 51% of hedge funds by number had produced positive absolute returns at the half way point of the year. This hurdle was exceeded by 68% of hedge funds at the end of the first quarter of the year, so the year has got progressively tougher as it has gone on - that falling success rate persisted into the end of August

Hedge Fund Returns by Strategy
source:Greenwich Alternative Investments

Returns by strategy are for the most part marginally profitable or loss making this year. As this is the case, differences in index and sub-index construction and scope have produced different outcomes. What one index provider has as a strategy with a positive return, another shows a negative return for.  Lipper's series of hedge fund strategy indices has only two strategies out of 13 given producing positive returns this year.  Greenwich Global Hedge Fund Indices show only three strategies with negative returns in the YTD (out of a total of 15). Both index providers agree that Long/Short Credit and Convertble Bond Arbitrage are amongst the best strategies for returns so far this year.

Looking across other index providers (Dow Jones Credit Suisse, and Hedgefund.net) it looks as if a small majority of hedge fund indices for strategies produced positive returns in the first seven months of the year. This hit-rate for positive returns by strategy in combination with the dispersion of returns within the strategy has some interesting implications. 

Dispersion of Hedge Fund Returns Within Strategies January-July 2010
source: Lipper, a Thomson Reuters company, TASS database

The dispersion of returns within the investment strategy categories of hedge funds is lower this year than last year. However this year the dispersion ranges for each strategy includes a significantly proportion of negative returns. This is a very different outcome from 2009, when the spread of returns by strategy may have been wider than this year, but returns were overwhelmingly positive. 

The read through to funds of hedge funds will be interesting. Another way of looking at the last two calendar years is that positive returns came from CTA and global macro in 2008, and those two strategies significantly lagged the other hedge fund strategies in 2009. So there were significant returns to active strategy allocation/weightings for investors in hedge funds in both years, though the positively contributing strategies were not consistent through time.

This year, given the dispersion of hedge fund returns within strategies, and with a fair amount of funds with losses as well as funds with profits within each strategy, fund of funds relative returns will be impacted much more by manager selection within each strategy silo than we have seen for a while. Strategy allocation will still have a part to play, but the 2010 ranking of returns from funds of funds will be about old style returns - driven from the bottom up.     

Of course all funds of funds claim that manager selection is a key skill. It will be interesting to see if those managers that make a special play of their abilities at manager selection in their client presentations come through with top ranking returns in 2010.

Sunday, 22 August 2010

Investing Jargon

Bear Market --- A 6 to 18 month period when the kids get no allowance, the wife gets no jewelry and the husband gets no sex.
Bull Market --- A random market movement causing an investor to mistake himself for a financial genius.
Call Option --- Something people used to do with a telephone in ancient times before e-mail.
Cash Flow --- The movement your money makes as it disappears down the toilet.
Day Trader --- Someone who is disloyal from 9-5.
Financial Planner --- A guy who says to client: "I've reviewed your financial picture, and if we manage your money properly, there should be plenty for both of us."
Institutional Investor --- Past year investor who's now locked up in a nut house.
Long Term Investment --- Short Term Investment that failed.
Market Analyst --- An expert who will know tomorrow why the things he predicted yesterday didn't happen today.
Market Correction --- The period after you buy stocks.
Momentum Investing --- The fine art of buying high and selling low.
P/E Ratio --- The percentage of investors wetting their pants as the market keeps crashing.
Stock Analyst --- Idiot who just downgraded your stock.
Stock Split --- When your ex-wife and her lawyer split all your assets equally between themselves.
Value Investing --- The art of buying low and selling lower.


Thursday, 5 August 2010

Information Edge Five - Speed & Selectivity

Last year I wrote four times* on hedge funds utilising an information edge. The edge has to be exploitable and and through repetition become significant to the return series of the fund. This applies whether it is an edge in understanding (say the ability to extrapolate from few data points or read across from related industries) or more pertinently an edge in receiving proprietary information not generally available. There can also be an edge in hedge funds in the speed of reciept of information.

This last (superficially unlikely) edge is exploited by high frequency trading algorithms and stat arb managers. The extreme case of this need for speed is evident in the clustering of server farms near the exchanges. There can be a milli-second advantage of signals being received and sent over short physical distances between the computers generating trades and the exchanges fulfilling the orders down the pipes, whether on dark pools or electronic books on the bourses.  These systems are blind with no emotional or subjective inputs, but rely on accurate, logical and continuous pricing. As such, automatically traded capital is subject to event risk - if you like, the news on companies and sectors can get in the way of treating shares as trading chips for playing with minute-by-minute. 

This topic came to mind in reading a press release from Selerity, which describes itself as a low latency, real-time fact aggregation and event data company that caters to sophisticated investment firms including hedge funds, banks and proprietary trading firms. The Selerity technology searches and extracts "event data" from real-time primary sources, and delivers to clients machine-readable, actionable input.

In a new development Selerity software can now work with earnings pre-announcement event data as part of its content offerings to allow traders to use or avoid unexpected, market-moving events in their trading strategies. Corporate preannouncements are real-time, breaking updates released by companies regarding changes in their outlook or guidance ahead of scheduled earnings announcements, and as they are unscheduled fundamenal inputs these announcements can be disruptive to cluster trading, pairs trading and other high frequency trading strategies.

One of the essential tasks managers of high-frequency trading strategies (and nearly all quant managers) is to define their universe to exclude the outliers, anomalous stocks - those subject to corporate activity, and those having scheduled news releases for example - and make an effort to leave in their programmes only suitably qualified stocks by their criteria. Promptly identifying stocks that are subject to unexpected changes in earnings guidance from company management would help algorithmic traders and traders who deal in whole portfolios from being left marooned with unintended idisyncratic risk in the holdings/portfolios. 

There are many hedge funds that engage in event-driven strategies. The larger and more sophisticated ones use software systems to trawl through court documents, SEC Filings and other lengthy documents to find the few nuggets of information they seek. It is the document equivalent of conference delegates that come away with two or three quality pieces of insight or new understanding from a whole day sitting listening to presentations. The more deep and diverse the information inputs a manager uses in their process the more applicable are these tools.

The Selerity product is a specific example of a delivering appropriately framed and focussed information on a timely basis to a hedge fund or  investor of risk capital. But nearly all hedge fund managers need information of that sort, whether it is delivered via human vectors or software crawlers and spiders. The information edge has to supported and developed, and have a thorough process behind it.

* http://simonkerrhfblog.blogspot.com/2009/12/creative-way-to-build-hedge-fund-brand.html