Friday, 23 December 2011

Translations of a Due Diligence Meeting for a Hedge Fund

A well prepared due diligence meeting has a subtext. The following translations will help hedge fund managers understand from where their interrogators (and potential investors) are coming.

Do you have any plans to add any employees? (Do you plan to re-model your house in the near future or are you going to back the growth of your own business?)

How concentrated is the list of your current investors? (We know if GAM pull you are you f****d)
I see you use an external compliance consultant. (I see you think that a small retainer to former FSA staffer can replace a core internal activity of an asset management business)

Is there a particular reason for the risk manager to be located in the annex? (We have spotted how frivolously you treat risk management that is not in your head)

Can you talk me through how you coped with October and November 2008? (What wholesale changes have you made to your risk controls to make sure that disaster zone of a return doesn’t happen again?)

Can I talk to your head of operations about that? (You clearly know nothing about what the back office does)

What was the background for your former partner to leave last year? (Who had the biggest ego between the two founders?)

Who bought the pictures in this meeting room? (Whose taste is THIS?)

These are nice offices and a great location. (This is a big overhead for a small business)

What a friendly dog!  (Having the principal’s name over the door was not just the default choice)

What is your experience of using this system for operations? (I’ve never heard of this supplier)

Can I deal with you directly from here on? (This third part marketer is a piece-of-work)

Wednesday, 7 December 2011

Hedge Fund Returns Are Path Dependent - As 2011 Illustrates

One of the things that is attempted on this website is to look at market action to help explain, or comprehend hedge fund returns. For example, two years ago a commentary was distributed on the significance of the quality factor in explaining returns in 2009 (see this article), and the impact of high correlation this year was explored  (here) too. This year has been a very unusual year in the macro background and in how markets have moved - year three of a recovery does not normally look like this one in economics or markets. 

The market events of this year have been a slalom course for hedge fund managers to negotiate (risk on/risk off), and the hedge fund indices reflect that. The HFRX Global Hedge Fund Index was down 8.58% for the year up to Monday (the 5th of December), and directional funds have fared a lot worse than non-directional strategies (the former are down 18% on an index basis).

Manager letters can be a good source of market context for hedge fund returns. In particular managers taking a quantitative approach are risk aware by nature and typically have a numerically stronger way of expressing the market conditions, and the suitability of their own methodology for extracting value from them.The overview reproduced below comes from Quant Asset Management of Singapore, managers of a portfolio of global equities.

Dear Investor,
It is unusual for us to add any written text to our monthly email other than the standard text in the newsletter. Since we apply a consistent, systematic investment methodology, once familiar with the methodology, the newsletter is normally self-explanatory. But because we are currently witnessing the biggest draw-down since the inception of the QAM Global Equities fund, 71/2 years ago, we’d like to use this opportunity to share some of our thoughts on this.

We now had a period of seven consecutive negative months with the fund being down 22% for the year. The main reasons for the negative performance are:
1) We use mostly fundamental factors when selecting our stocks from a global universe of over 6000 stocks. Fundamentals haven’t been driving markets in the past seven months. Macro-economic factors were driving markets and correlations have been at an all time high.
2) We use a trend following methodology that adjust factor weightings each period for what worked well in a certain past period (dynamic) before. This didn’t work well in the past seven months due to volatility spikes and trend reversals.
3) We use a hedging methodology whereby we are either 0% or 50% net exposed mostly based on aggregate earnings revisions number and some price performance related techniques. This hasn’t added value in the past seven months.

So the question arises if our methodology is still valid and when will it work again?          

First of all; all good investment methodologies go through periods where they struggle but as long as they add value over time and make logical sense, it makes sense to stick with them in order to achieve above average returns.

Furthermore we believe that systematically picking a large number of stocks on the basis of fundamentals (valuations, earnings growth and earnings revisions) combined with a factor adaption methodology, whilst hedging out a large part of the market risk, does add lots of value. Remember that the fund is up 154% since inception. This compares to 16% for the MSCI World in the same period.

We have always allowed volatility in our funds (around 20%, which is much more than most of our peers) in order to achieve higher returns than our peers. These high returns have been achieved and we have a strong belief that they can be achieved again. In order for this to happen one has to allow certain periods of under-performance. Draw downs are pretty natural and frequent in fundamental factor adaptation systems and one should be reminded that they can create opportunities too.

Kind regards,

The QAM Team

The letter is reproduced here to give some insight to market drivers of return this year, not to point fingers at a style or a particular manager. The general point is that the vast majority of managers take a specific approach to markets that they hope works most of the time and for most market conditions. The marketing conceit of an "all weather" hedge fund or strategy died in 2008. The returns delivered by a manager are a function of their own style and the opportunity set available from the market over the period. It is very striking  that the gyrations of markets in 2010 and 2011 made it very difficult for equity hedge fund managers to make positive absolute returns except when the equity market letter was written by the Fed and other central banks through the mechanism of QE2 (from August 2010 to March 2011). 

Hedge fund returns are path dependent, not independent of the direction of markets, nor independent of changes to intra-market or inter-market correlation, nor unaffected by the extent to which markets trend. The specific sequence of ups and downs, step-wise shifts in volatility, and how long a market regime lasts impacts the ability of the manager to harvest alpha in the way they are set up to address markets. So, for example, it would not just be relevant that markets were down 5% over a six month period, but in understanding outcomes it is more relevant that they appreciated by 11% over six weeks before losing 15-16% over 4 months (with specific volatility and correlation conditions). 

It is up to the investor in hedge funds to put together portfolios of funds which take account of the various market conditions which may occur, in full knowledge of the manager style. Building such an efficient portfolio of funds can only be achieved when investors truly understand how their capital is being applied to markets by their managers. Provided the managers stick to their expressed style, there should be a limited number of surprises to investors in hedge funds given market conditions, and how market conditions change (the specific path markets follow). For any given market conditions and sequences the better investors in hedge funds will have a range of expected return per manager in which they are invested. As yet, the path dependency of hedge fund returns is not sufficiently well appreciated  - spread the word.

UCITS III Footnote - the offshore fund from QAM was down 23.49% over the period end Feb 2011 to the end of November. The onshore equivalent  - Quant Global Equities fund, a sub-fund of the Quant AM SICAV (a UCITS III type fund) - was down  27.77% over the same period. The onshore version launched in March this year.

Thursday, 1 December 2011

Winton's Futures Fund is primus inter pares

David Harding
There has been a lot of comment in the hedge fund industry on the asset gathering of Winton Capital this year. David Harding's firm has attracted inflows of over $7bn in 2011, which equates to over 10% of the whole industry's capital inflows. This is a remarkable market share of the growth for an industry of over 9,000 funds for investors to choose from.

There has been some commentary that the success of such brand-name big managers is down to the dominance of American institutional flows to the industry, and the limited vision of the investment advisors to those funds. There has been less consideration of the investment performance of the winners.

The tables below come from CM Capital Markets, a Madrid based CTA. Their fund is called CapiTrade Systematic Global Futures, and since they put together and distributed this analysis their three year old managed-account-turned-fund must stack up well on CTA performance criteria. And it does.

But so does David Harding's Winton Capital over the period covered (May 2008 to October 2011). It has been well observed that Winton scaled back risk assumption on their funds during the Credit Crunch, and that since then the funds (Futures Fund and Evolution) have been run with lower risk levels (leverage). It is therefore logical in down-years for the strategy that the Winton funds have smaller losing months and more shallow draw-downs than peer funds. But the success in producing returns this year go way beyond the conservation of capital.

Winton Futures Fund has done better than the peer group in several ways this year: 7 out of 10 positive months (versus 3 for the Newedge CTA index),  a worst-monthly-loss in that time of half of the typical loss of competitors, and a positive year to date return when most CTAs have struggled to make money.

Extending the data window back to May 2008 brings BlueCrest's BlueTrend Fund into the frame as a serious competitor on the basis of performance.  Leda Braga. who runs BlueTrend, is proud to state that she has never reduced the risk appetite of the fund. This has enabled BlueTrend to produce higher absolute returns than Winton over the last 40 months, though with a higher level of volatility. If an investor is willing to take the higher volatility of return and risk assumption, then BlueTrend is a viable alternative to Winton Capital 's Futures Fund. But for the more conservative (by risk appetite) investor Winton Futures Fund is primus inter pares.

Post Script of 2nd December:
Thanks to the two managers mentioned in the above article that came forward with amendments to the data given above by CapiTrend. I should reinforce the point that the returns for 2008 in the above table were supposed to be those from May to December of that year. The returns for some leading managers for the whole of 2008 were:

AHL up 29%
BlueTrend up 43%
Millburn Diversified up 22.36%
Winton up 22%

In addition, other data quoted for Millburn in the above tables are not recognised by the Millburn Ridgefield Corporation themselves. BarclayHedge gives the annual return series for the Diversified Fund as 2008 22.36%, 2009 -7.38%, 2010 12.58% and 2011 (to Oct) as -6.75%. 

Apologies to the relevant managers from me for distributing erroneous data. I hope the thrust of the article still applies, and there is a lesson in this about the source of data and the (mis)use of it!

Tuesday, 22 November 2011

Hedge Funds Positioning to Benefit from Euro Banks Spitting out Assets

"The Economist" (19th November 2011 edition) has just written about the market for assets being spat out of European banks. The article is reproduced below. For my part I see the market for leveraged loans in Europe becoming very attractive to buyers who know how to be selective, with, unlike the bank asset story, an inevitability about it. So part two of this article is my rejoinder to that in "The Economist".

Waiting to turn trash into treasure

“THIS is going to be the next great trade,” one American hedge-fund executive effused early this year. For more than two years funds have been salivating over the slew of assets that Europe’s banks will have to sell. Many have been opening offices in London and hiring to prepare for this “tidal wave” of opportunities.

Up for grabs will be distressed corporate loans, property debt and non-core businesses as European banks shrink their balance-sheets to meet stricter capital requirements. Huw Van Steenis of Morgan Stanley estimates that banks will have to downsize their balance-sheets by €1.5 trillion-2.5 trillion ($2 trillion-3.4 trillion) over the next 18 months. Funds have only about $150 billion to spend on distressed debt in Europe, he reckons, which means they should have their pick of assets.

For now the “next great trade” is not looking that good, mainly because there have been no fire sales. Most banks that are selling assets have priced them close to face value, providing little to entice buyers.

Even where sales are agreed, financing is scarce. In July Blackstone, a large alternative-asset manager, agreed to buy a £1.4 billion ($2.2 billion) real-estate loan portfolio from Royal Bank of Scotland, but has yet to raise an estimated £600m to pay for it. Worse still, many banks may not be able to sell assets cheaply even if they wanted to, because it would force them to take losses that would erode scarce capital.

"We’ve been lying in wait for this opportunity since 2008. But it will come piecemeal. It will take years and years and years,” says Joe Baratta, head of European private equity at Blackstone. Some predict that Europe could go the way of Japan’s glacial deleveraging and take a decade or more to clean up its banks. Politics play a role too. European politicians, no hedge-fund lovers, won’t want to see them buying up assets at truly distressed prices and profiting from Europe’s gloom. It may even be “politically impossible” for banks that got a government bail-out to write down assets significantly, says Jonathan Berger, the president of Stone Tower, a $20 billion alternative-asset firm.

What could turn things around? Some fund managers hope a plan to recapitalise Europe’s banks to the tune of €106 billion by next June will at last force disposals at banks. So too may the introduction of Basel 3 rules that will require banks to hold more high-quality capital. Marc Lasry, the boss of Avenue Capital, a distressed-debt hedge fund, wants to buy from these “forced sellers”, because they will offer lower prices.

Banks aren’t the only prey that funds are hunting. A wave of refinancing that will hit private-equity-owned firms over the next few years may prove profitable for distressed-debt funds. And plans by some European governments to privatise infrastructure assets may also be enticing.

In the meantime, inventive fund managers are figuring out other ways to do deals. Some, such as Highbridge, a large American hedge fund that is owned by JPMorgan, and KKR are scaling up their lending operations as banks cut back. They are able to charge high interest rates, because companies are desperate for cash.
Banks are being inventive too. Unable to sell assets, they have come up with a compromise of sorts, and have started agreeing to “synthetic risk transfer” arrangements with hedge funds. For example, BlueMountain Capital, an American hedge fund, has agreed to take on some risks on a credit-default swap portfolio from Crédit Agricole, a French bank. Another hedge fund, Cheyne Capital, has reached an arrangement with two big banks in Europe to take the first 4% or so of losses from a securitised portfolio of loans, in exchange for a very healthy return.

For those hedge funds set on playing Europe, the main dilemma they face is how long to wait before buying. Steve Schwarzman, the boss of Blackstone, insists that it is important to stay put. “It’s like dating someone,” he says. “You can say let’s wait two years. But she probably won’t be around then.”

Comment from Simon Kerr
The deal flow resulting from the partly state-owned  British banks reducing their assets has been slower and smaller than many expected. This is partly because the banks have effectively lobbied to have new capital adequacy regulations phased in over a longer period than first thought, and because the regulations which seem onerous in high principle on their announcement seem less so when the detail means of implementation locally  are made public. In sum, along with accumulating retained earnings, there is less risk of a capital shortfall for these banks than there was, so the pressure to conduct asset sales does not come with a visible deadline.

Arguably the same could not be said for the European market for leveraged loans. The peak of loan origination, the previous peak of bank-financed M&A, was in 2007 - see graphic 1.

Graphic 1 - European Leveraged Loan & High-Yield Bond 
New-Issue Volume

source:S&P LCD

The recovery of issuance in 2010 versus 2009 was not as constructive as it at first looks for total volume. Nearly two thirds of all leveraged loan and bond issuance in 2010 was to refinance existing debt, whereas in 2007 the proportion was approximately 20%, when new buyout and recap activity dominated.

The economic environment over the last few years for European companies with leveraged loans is reflected in the default rate. Graphic 2 shows the inverse relationship between economic growth (with a lag) and the rate of defaults amongst companies using leveraged loans as part of their balance sheet.The inference of the two graphics of default rates is that some of the European takeover deals which are above average for size that have been financed by leveraged loans are beginning to unravel. 

Graphic2 - Default Rates for European Leveraged Loans
source: S&P LCD
That recent change has been a small negative is picked up by data for companies that are seeking to renegotiate their borrowings with their lenders. Graphic 3 shows a low level of restructurings and renegotiations, but against a background of some economic growth in Europe. 

Graphic 3 -  Number of new restructurings and covenant resets – European leveraged loans

source: S&P LCD

So there has been a build of new loan issuance in Europe to a peak in 2007 and then a large falling away of new issuance, except for re-financings. However, bank loans are not permanent capital, and the companies that take out the loans intend to re-pay them within 3-5 years and replace the loans with cheaper longer-dated financing when they can. However the state of the capital markets, and the conditions of the banks have both made this intended next phase difficult to execute. The consequence is that there is a maturity wall for leveraged loans beginning in the year after next - just 14 months away, if you needed reminding. The wall is illustrated in graphic 4.

Graphic 4 - Maturity & Rating Profile of Outstanding European Leveraged Loans

Fitch estimates that of the companies they provide shadow ratings on in Europe (approximately 300 borrowers representing €240bn debt), 60% by value is due to mature between 2013 and 2015. Just over half the debt currently has a shadow credit rating of B or above with an average leverage of up to 5.4x. On the basis the high yield bond market continues to support strong rates of issuance, these loans are more likely to be refinanced in a conventional manner. The remainder, €117bn, is shadow rated B- or worse and with a current leverage on average above 6.5x represents "a significant challenge" to refinance in today’s credit markets.

PwC has commented that "The ability to refinance this wave of maturing loans is made more challenging by the fact that the majority of CLO investment vehicles (which were a key driver of market liquidity in the boom years up to 2007) will cease to be able to reinvest their funds just as the quantum of maturing loans reaches its projected peak...We expect that the majority of healthier corporates will be able to use high yield bonds and new leveraged loans to address their upcoming maturities. However, we expect there will be a significant number of companies who are forced to enter restructuring negotiations to resolve upcoming maturities."

So the European market for high yield and leveraged loans has some serious indigestion problems ahead of it. This will create some gross mis-pricings as the weight of paper needing refinancing relative to the size of the buyers is a considerable mis-match. Those buyers that are still active in the market will be able to be very selective, and they will have many opportunities and considerable work to do as the restructurings start to happen. 

Some market participants are starting to get ready now. GSO Capital Partners, the global credit management arm of Blackstone, only last month acquired the largest manager of leveraged loans in Europe, Harbourmaster Capital. The AUM of Harbourmaster, at €8bn will be attractive to GSO/Blackstone, but the juice in the deal is the capacity to analyse the opportunities that will arise as the wall of maturities approaches. This area of investment is not one in which one can acquire the necessary understanding quickly by adding a few bodies. Having a large team (40 professionals in the case of the new combined entity) will give GSO a capacity advantage that will belong only to them and the other early movers yet to emerge. This is an excellent strategic deal on Blackstone's part.

6th December 2011:

MKP Capital Management LLC, the New York-based global macro and structured-credit hedge fund with $4.5 billion in assets, is starting a credit team in London to invest in European debt. Steven Jeraci, a partner at MKP, will relocate to the firm’s London office to hire investment professionals and build the team’s infrastructure, the hedge fund said in a statement today. The team should be in place by the end of next year, the company said.(source: Bloomberg News)
Comment - the fact that a team will be put in place by the end of 2012 says something about when the opportunity to commit capital will be ripe for exploitation, and reinforces the point that to build a quality team will take some time.

25th January 2012:
Mesirow Advanced Strategies Inc., which allocates $14 billion to hedge funds, has been increasing the amount of cash it holds in the last couple of months in preparation for potential opportunities including those in the European credit markets. “What we want to have is the flexibility that if particular things do deteriorate, we can play offense relatively quickly, being able to put capital to work in interesting opportunities,” Marty Kaplan, chief executive officer of the Chicago-based fund of hedge funds manager.

Kaplan said Mesirow may also deploy more capital to relative-value strategies such as capital structure arbitrage, which seeks to profit from mis-pricing of different securities sold by the same company. Mesirow has redeemed out of some strategies that take more directional views on the markets, such as long-biased equity and event-driven hedge funds that bet on corporate activities such as mergers and acquisitions. “As the situation in Europe deteriorates, right now you don’t see tons of corporate activities because confidence in board rooms has declined,” Kaplan said. Mesirow generally favors credit over equities strategies, said Kaplan, and prefers structured credit, which tends to be mortgage-backed, over corporate credit.(source: Bloomberg News)

Tuesday, 8 November 2011

Through the Lag - Europe's Leading Hedge Funds Add Investment Staff

One of the ways of looking at the health of a hedge fund business is in staffing levels. Like many other businesses in finance hedge funds cut back on headcount in late 2008 and into 2009, and the cutbacks in London based hedge funds continued into 2010 (see this article for data on last year). The tables here are disaggregated and show that of the 48 largest indigenous hedge fund groups under the FSA's jurisdiction 28 added staff at the level of approved persons (APs) - those carrying out partner/director/AML and compliance/investment/CEO/COO/CFO type functions- over the period from August last year to August this year.

In aggregate the top 48 hedge fund managers (by assets) in London added 6% to professional numbers over the year to August. It was noted here a year ago that headcount, as captured by approved persons registered with the FSA, was still declining two years after the original Credit Crunch of this century. So at last in 2011 hedge funds have got far enough beyond the assets under management low of late 2009 to have sufficient confidence in the stability of their businesses to add to their staff numbers.

The hedge fund management groups that have shed the most staff are given in Table 2 below. Ignoring the firms that have reduced Approved Person headcount by one or two people, which may be just frictional changes or voluntary departures, many of the firms appearing at the lower end of the Table have undertaken significant change post the Credit Crunch.

The firm that has made the largest absolute number reduction in their professional staff is Brevan Howard, which has opened up a trading operation in Switzerland so that formerly London based staff can escape the increase in taxation in the UK.  The exodus was led by CIO Alan Howard who has been followed by co-CEO Nagi Kawkabani to Geneva. Up to a hundred traders may be based in Geneva in time. However the opening of the Swiss office is not the only development. Brevan Howard has reconfigured the investment capabilities of the traders/managers employed. Specifically BH has cut back on allocations of capital to equity markets and funds resulting in staff departures, including a manager recruited specifically to launch an Indian equity fund, and the departure of Fabrizio Gallo who is returning to the sell-side. Gallo's BH Equity Strategies Fund has been closed. Instead the emphasis has been on adding to capabilities in commodities and macro trading. This repositioning has resulted in a net reduction in London-based investment professionals, but an expansion of the number of traders for the whole firm. Further Brevan Howard funds have produced good performance this year, and the firm is expected to continue to add teams in order to increase capacity to manage capital.

Corporate reorganisations have played a role in the appearance of other firms in Table 2. The Approved Person  headcount given for *HSBC Halbis Capital Management was up to June 2011. At that point HSBC Halbis, the alternative asset management business of HSBC, was merged into HSBC Global Asset Management, and as ever in such a merger there was duplication of staff resulting in voluntary departures and redundancies.

Polygon Investment Partners has moved from a multi-strategy approach to running a series of funds dedicated to specific investment strategies. The flagship Global Opportunities Master Fund was finally closed earlier this year, after a two-year-plus wind up process, and the residual illiquid holdings are now in the Polygon Recovery Fund. The reduction in approved persons at Polygon took place in Aug-Sept 2010 as six people left in a short period, and head count has been stable amongst the professional staff since. 

At Rubicon Fund Management the spat between returning head honcho Paul Brewer and the two men who deputised for him as CIO for two years, Timothy Attias and Santiago Alarco, has led to the change in numbers. The former co-CIOs left in January and April this year to set up their own firm Sata Partners.

Altima Partners had its peaks in assets in mid 2008 and its peak headcount in early 2009. Asset under management were $4bn three years ago and are now thought to be around $1.9bn. The count of APs has followed a similar path, though with a lag as one would expect. 38 staff members were registered with the FSA in January 2009, and the present number is 23, down from 28 in August of last year. 

The third Table here ranks the firms amongst London's largest hedge fund managers that have added the most Approved Persons with the FSA  over the period August 2010 to August 2011. In percentage terms Henderson's takeover of Gartmore has increased the Approved Persons count in a step-change by 45%, or 29 individuals.  In hedge fund terms there was some overlap in the geographical areas invested in by the two companies when separate, but the styles used to run the European equity funds, for example, were very different. This has allowed Henderson to keep most of the Gartmore investment staff, though there are bound to be some who lose out in jockeying for position in such a takeover.  

There are more themes at play in the Table listing those firms expanding than in the Table ranking those firms with declining investment and senior staff. Losses of staff numbers may be for idiosyncratic reasons, but firms add to their payroll when they have been growing their revenues for a while. In the hedge fund industry that growth in revenue can come from performance fees, based on better investment returns than a previous period, or, more likely, from higher assets under management (from subscriptions plus investment growth on existing assets). So the firms adding investment staff in 2011 would be expected to be those that have performed well enough to attract new assets.

The investment strategies that are represented in the list of expanding firms are clustered. The first cluster is in global macro/CTAs/commodities -  Capula, Man AHL, BlueCrest, Armajaro and Clive Capital. There are some multi-strategy winners - Mako Investment Managers, Arrowgrass and CQS, but perhaps a less obvious winner is in credit management. The third cluster consists of Finisterre Capital, James Caird Asset Management, and Chenavari Financial Advisors/Credit Partners - all with a considerable credit aspect to their investments.

The increase in staff numbers at Europe's largest hedge fund groups over the year to August 2011 is far from dramatic at 6%. It does come after nearly three years of decline. The strategic thrust of the global hedge fund industry has been to expand in numbers in Asia and/or emerging markets rather than Europe (or even the United States). So it is good to observe some growth in headcount in the London-based part of the industry. The fact that the owners and managers of those businesses have shown caution in adding to their cost base via the headcount in the last year should serve the industry's employees well, as tricky times have returned from the middle of this year. Although there are the highest level of redemption notices for the year in place for the end of this quarter, I don't expect even a majority of them to be acted upon. And consequently I expect the employment levels in the London hedge fund industry in the first half of next year to be similar to those we are seeing now. Some stability would be be very welcome.

Wednesday, 26 October 2011

Macro Managers Coming Through at Last

One of the disappoinments this year has been the performance of global macro managers. At the stage of half way through the year, it seemed that if a manager in this strategy had ridden the wave of QE2 inspired up-moves in equities and commodities then they gave it back by staying too long at the party, as the effects of monetary stimulus dissipated in May and from that month onwards. Those that lost a little in the 1Q may have made a bit back by mid-year, but there seemed to be too few managers that were able to ride markets in one direction and then the other with enough conviction or timing to make money across the whole of their books.

The pattern seemed to be if you made money early in the year you gave it back later. If a manager had a positive P&L in equities, they lost enough money in FX to be left around flat for the year. To be fair to the macro managers the market action this year, whether in fx or commodities or equities, has oftentimes not been in a pronounced trend for long. So it is that CTAs, the ultimate feeders off markets exhibiting trending behaviour, did not make good money until the last few months. Further, reversals have been sharp and volatility high - which makes it hard to hold onto gains even when they have been chiselled out of recalcitrant markets. The exceptions to the generality amongst global macro traders were those that tend to specialise in fixed income - the likes of Brevan Howard - for whom the trend was their friend for long enough for decent gains to be made by end of July.  

One of things that surprised me at the half way stage in the year was that so few macro managers had made much at all. Some of these big-picture managers tend to have core fixed income books, and others express their views on Chinese growth in the fx markets or in commodities. But they all may be positioned long or short, and they decide their own timing and sizing. So there is a lot of scope for the universe of macro managers to have completely different directional bets in the same market. Those that don't do much in energy, might concentrate on time spreads in softs or run a big book in credit trading. The point is they need not have correlated returns at all - in fact logically the universe of global macro managers should always have the biggest dispersion of returns amongst hedge fund strategy groups, and most of the time it does. By happenstance, taking all these different views and putting on unrelated trades across a wide selection of markets, hardly any macro managers had made good returns by the end of June this year. However the market gyrations of August and September have allowed a different story to be told for the period since.

Only this week Luke Ellis of Man Group was commenting that there was a very wide dispersion of manager returns amongst hedge funds in August. In September there was an historic extreme of dispersion of returns amongst managers running hedge funds. So for observers of, or investors in, hedge funds the returns of August and September become much more about which managers you were in, rather than which strategies you were allocated to. And practically it means that index or industry level returns for hedge funds for those two months start to be quite unrepresentative. We are well used to seeing headlines about "Hedge funds failing to deliver this month/on the year to date" based on index level returns, and sometimes (more usefully in this context) about returns across a hedge fund database being "good" or "bad" or generally different from returns on the underlying markets at an asset class level.

When the YTD numbers are close to zero, the next data point has a big impact on YTD returns. That is what has happened to hedge fund returns this year, and for some global macro funds in particular. The tables shown here are from "Absolute Return" magazine  and pick out amongst US-based managers the best returns produced last month. It is pleasing to see the marked presence of macro managers at the top of the rankings after the year they have had.  

These are good returns of specific managers in the global macro investment strategy. However, today I see that The Greenwich Investable Hedge Fund Indices give the index level returns for macro managers as -0.79% for September and -3.72% for the year so far. My experience of dealing with investors in hedge funds is that they are looking at what their specific hedge fund managers have done for them. There will be nearly no one who has experienced a return from their macro managers of -3.72% in the year to date (for reasons of position sizing and the timing of subscriptions and redemptions, if nothing else). Given the extreme dispersion of returns in September, and that macro managers have the widest dispersion of returns amongst any hedge fund investment strategy I can confidently say that no-one except an index investor has actually got a return of -0.79% from their macro managers last month. The inference is that the returns of the last two months will tell investors a lot about the quality of manager selection amongst their advisors and consultants, and amongst funds of funds. And not just in global macro.

(Dec 7th 2011) Reuters posted an article headed "Global macro hedge fund returns fail to impress". The full article is posted here. The article mentions Louis Bacon's Moore Global Investments, Fortress Investment Group, Tudor Investment Corporation, Caxton Associates and Brevan Howard.

Monday, 10 October 2011

Risk Managers are the Social Workers of Asset Management?

Recent research has shown that in the UK 86% of youth workers/social workers time is spent in completing forms for reporting, and in attending meetings about clients and how the services are run. Only 14% of time is spent with clients. 

This skewed sense of priorities came to mind when I read the 2011 Risk Management for Asset Management survey from Ernst & Young. In the survey there is a section about how risk managers in asset management companies use their time. The collated responses are in figure 1.

Figure 1. Relative priorities for risk management in terms of time

Source: Risk Management for Asset Management Ernst & Young Survey 2011 (page 35)

If this survey reflects the reality of how risk managers are spending their time risk monitoring takes up 10.8% and risk reporting takes up 9.7% of risk managers' time. I would like to think that the label "general risk management and client contact" applies to time spent with portfolio managers and analysts, but it is more likely to be with the Head of Equities or Chief Investment Officer, or in some client meetings.

Rather like IT spend in an asset management business, it seems that most of the budget (budget of the time in this case) is on the hygiene factors - the necessary operational systems (activities). At the moment there is lot of hygiene stuff to take care of in risk management in asset management businesses -  tax related issues, KIIDs, increased burden of regulatory reporting and compliance, liquidity issues and not least counterparty issues.

But where is the main event at the moment? Is it not in the markets  - the challenges to the business models of asset management businesses, real time stress tests of portfolio managers and their approaches to markets, the very viability of the financial sector in Europe?

What are risk managers spending time on?: regulatory affairs and contacts with regulators are taking up twice as much time as risk monitoring; country risk assessment is taking up less time than fraud risk.

In an inversion of the prevailing norm in social work, in a project in Swindon that works with chaotic families 60% of the budget is now going on selected face-to face service provision. This puts a bigger priority on the work that is the raison d'etre of the service, rather than its reporting processes and management.
A good risk manager can be a very positive influence on keeping the assets under management. The risk management function should help avoid blow-ups and gap risk, and assist finding useful hedges at the company level as well as the portfolio level. Good risk management is a long way from being just a quasi-compliance officer with a numerate degree. But the priorities and resources have to be agreed and in place for a fully realised risk management function to work as it can. Asset management companies should do a Swindon.

Wednesday, 5 October 2011

The Dangers of Mixing the Functions in a Hedge Fund Management Company

In an in-depth due diligence questionnaire of a hedge fund manager there is often a question about the outside business interests of the principals. For an organisation with a broad team of decision makers managing investments this is less of a concern. To the extent that there is a single presiding talent who sets the tone and manages the largest allocation of capital, it is an issue if an individual has executive duties in other companies, or has too many non-executive directorships or Board positions. Think of SAC - if Steve Cohen more actively pursued his art interests at the expense of time at the firm would that that impact the returns produced by the whole firm? Undoubtedly, yes. But there are other ways in which hedge fund investment managers can be distracted from their main event.

I was reading about companies' management structure (link here, with thanks to author Daniel Dupree), perhaps a hangover from my Business Studies degree, and  was reflecting on how the construct applied to the hedge fund business. The article was about levels of management:

Management levels within an organization exist to demarcate different roles within the organization or company, and to help establish a chain of command. Broadly, there are three main levels of management. You can think of the levels as a triangle, or pyramid. At the top level, there are fewer people, but they have more say in the overall direction of the company — they have more authority. This level is often called the administrative level. At the second level of management, you have those who have some authority over certain departments or projects. This is called the executory level, since those who populate it are involved in executing so that the aims of the organization are met. Finally, at the bottom of the pyramid, is the supervisory level. These are managers that have more direct contact with workers, and are mainly involved in encouraging performance, and monitoring employees. 

The article then goes on to describe the scope of work in each level. Here are the descriptions of the top two levels:

Top Level: Administrative

The top level of management in most organizations is the ultimate authority. Administrative level managers can give authority to other managers in the organization, delegating to, or directly promoting, other managers. The top level of management consists of board of directors, top officers in the company, and directors in the company. Some of the functions of those at the top level of management include:
  • Setting out the goals, benchmarks and big picture for the organization.
  • Prepares policies for the organization, and sets forth consequences for their violation.
  • Promotes and appoints others to fulfill various roles in the company.
  • Coordinates activities for the whole organization, making sure that different departments are working in tandem to reach the organization’s goals.
  • Usually in charge of making public statements on behalf of the organization, as well as making appearances so that the community is aware of what the company is doing.
  • Directs broad changes in company direction.
  • Shows accountability to shareholders and other stakeholders in the company.
  • Ultimately responsible for the success or failure of the organization and its enterprises.
Those in the top level of management are often well-compensated for their efforts, due to the fact that, in theory, they have great responsibilities. It can be difficult to make it to the top level of management, since those positions are often scarce, and the competition for them is fierce. However, with hard work, good ideas, competence, and an ability to network, it is possible to reach the top level of management.


Middle Level: Executory

Depending on the size of the company or organization, middle management can be bigger or smaller. In some of the smaller organizations, the functions of the middle level and lower level of management are combined. However, in larger organizations, middle level management often requires additional divisions into senior and junior levels.
At this level, managers are in charge of branches or departments. Their job is to come up with sub-plans that contribute to the success of the company when meeting its goals. Middle managers are often involved in making sure that the steps to achieving the larger aims of the company are carried out. Some of the other duties that those at the executory level of management might be required to carry out include:
  • Training lower management, and training employees.
  • Coming up with incentives for employees and lower level managers.
  • Coordinating projects within the departments and branches.
  • Evaluating employee and lower manager performance.
  • At more senior positions in middle management, sometimes it is necessary to interact with the public, or issue statements.
  • Report to members of the top level of management. This might include in-person reports, or written reports and memos.
  • Enforce policies handed down from top management, and sometimes discipline lower level managers, or employees.
The owners of hedge fund businesses carry out all the tasks of Top Level Management as given above. However, it is quite usual for the largest shareholders of a hedge fund business to be carrying out the main activity of the company, that of carrying out research and making investment decisions. That is, the principals of a hedge fund management company carry out the Executory Level activity as well as fulfill the roles of those in the Administrative Level. Even where there is a separate CEO in a hedge fund, the CIO whose name is over the door is highly likely to be involved in decision-making related to how the business is run as well as how the investments are run.

Switching Modes

For many senior figures running portfolios this involves looking at a trading screen and taking company and investor meetings until the end of the trading day, and then switching modes to take Executive Committee meetings and Board Meetings into the early evening. If there are not those formal meetings there will be job interviews and looking through (management information system) reports on the business after the Bloomberg screen has gone dark.

I had a reminder of the duality of the lives of the senior executives running hedge fund companies when I bumped into one of them off Davies Street in Mayfair yesterday. In the course of  our exchange he disclosed that the meetings and reading of documents associated with the expansion of his business was taking up some of his normal trading screen time. He said "I've cut back on the number of markets I'm actively tracking, and, to be honest, even in those I'm relying on what I researched earlier this year for the core of my views."

This chimed with what I had read about events at Touradji Capital Management this year. Paul Touradji is the former head of commodities trading at Tiger Management who set up his own firm in 2005. Just over two years later Touradji Capital was running $3.5bn in commodity related funds. But the progress of the firm has not been smooth since the Credit Crunch.

Returns from the funds were disappointing in the last two calendar years - up 4.5% in 2009 and then up 2% in 2010 against a background of bull market conditions in commodities. Investor redemptions took capital down to below $2bn this year. The senior management team has not been stable. Gil Caffrey came on board from FrontPoint Partners to be CEO at Touradji Capital Management, only to decide last year to walk across the hall back to Tiger Management. Julian Robertson's Tiger Management shares office space with Touradji Capital on Park Avenue, New York. Sang Lee was brought in as President of Touradji Capital in October 2010 as part of a handover of day-to-day management of the firm from Caffrey. But that transition was not successful.

It was announced last month that President and Chief Operating Officer Sang Lee and CFO Tom Dwan will leave the firm, and a search is on for high calibre replacements. In a letter to his investors Paul Touradji wrote "Simply put, the daily operation of the firm must go from being a major time and energy drain on me to an integral support function for our entire team, allowing us to concentrate our full attention on investment performance." The flagship fund of Touradji Capital Management was down 17% in the first 8 months of the year.

Touradji Capital Management is not a start up or a very small hedge fund management company. But events there illustrate that non-investment issues can be a drain on the capabilities of professional investment staff at the very top level of hedge fund companies. Even very capable people have to be careful about how they allocated their time and intellectual bandwidth. To consume the creative thinking time of a well-paid investment professional at the top of his game with the banalities of failed trades and who is doing the cash reconciliations this week is a failure of management resource and structure.

Potential investors in hedge funds sometimes go to great lengths in due diligence to fully appreciate the state of play at a hedge fund management company. I heard a comment this week that there is something of an arms race in due diligence processes amongst funds of hedge fund companies, as they try to differentiate themselves on something other than results. But there is a risk in a small company that the scarce resource of management time can move from the mission critical (investing) to the necessary (operations and company oversight) and that is something of which a prudent investor should be aware.

Wednesday, 28 September 2011

Hedge Fund Credit & Risk

A couple of weeks back I joined in a presentation put on by PRMIA (The Professional Risk Managers International Association) at Imperial College, London. The sessions were on hedge funds and credit risk, and so I tapped into my experience as a risk manager in a single manager hedge fund and what I observed during the Credit Crunch of 2008/9 and explored the contrast in credit conditions for hedge funds between the period before and the period after the Credit Crunch. These are the slides I used:

Tuesday, 27 September 2011

Book Review for "The Inner Voice of Trading"

A successful trader or investor in financial markets succeeds through a combination of factors. There is the "what they know" part; there is the trading format the trader or investors uses; and there is the less well explored element in the mix - the "other" of the trader besides technical/factual knowledge. Michael Martin's new book "The Inner Voice of Trading" (FT Press) is an exposition on this last element.

Michael Martin has been a market professional on the sell-side, a trader of his own account in stocks and commodities, and someone who has been a trader trainer for a living. He has also interviewed great traders seeking insights into the ways of working that made them great (see his website This background makes him well equipped to explore what seems to be the hardest part of trading in which to excel.

Financial markets are full of smart people with MBAs, CFA qualifications, and, increasingly, PhD's.Quite sophisticated trading systems can be bought off the shelf for really very little outlay (hundreds of dollars rather than thousands). Logically there could be many more successful traders than there are. So there is an argument to be made that this last element of trading - the soft factors, and focusing on knowing yourself as an investor/trader - is one that is under explored and developed. This is the gap this book is seeking to fill.

Martin's progress through the psychology of successful trading is reinforced by evidence and quotations from prominent traders. This gives the thrust of the book credibility if not authority. In an era of the "me first" society his focus on development of the individual's own trading culture should find appeal, but though this is part self-help book, be aware that this not a step one-step two guide to to how to do it. The book has well-observed pointers but is not a manual for trading.

That written, Michael Martin's book will have resonance for those already operating in financial markets on the buy-side, and will be extremely helpful to the neophyte trader. This is a welcome addition to the oeuvre of investment books, and its' focus makes it a good companion text for those who like the "Market Wizards" series and their ilk.  

For other views of this title see the Amazon page for it.

Friday, 2 September 2011

UK Focused Hedge Funds to Benefit from More QE and More Devaluation

This short opinion piece from SVM's Colin McLean was so brief and on-the-money I thought I should share it. The third paragraph in particular is worth absorbing.

"The summer stockmarket sell-off caught most investors by surprise.  Expectations changed sharply as a good company reporting season in July gave way to a vacuum in US and EU political leadership in August. There are now mixed signals on the global economy, pointing to new risks.  But the crisis is throwing up new opportunities as well as dangers.

While some data is contradictory, evidence is mounting that global growth will disappoint.  Expectations are changing most rapidly in Europe, but in all regions scope for further effective stimulation is limited. Governments cannot re-run the unprecedented stimulation of 2009.

However, the UK can still do more than most to tackle the slowdown.  It has currency flexibility and an independent monetary policy, allowing it to move more rapidly than the US or Europe. Before the year end, another round of quantitative easing seems likely in the UK, and a further devaluation of the Pound by around 10% is possible.  This will immediately benefit Britain’s exporters and other global businesses listed in London. Stimulation would be a catalyst for money on the sidelines to buy shares. Hedge funds generally have had poor returns this year and will be eager for a rally. Portfolios need to be positioned ahead of this."

Net market exposures are currently low, and cash levels very high amongst hedge funds. There is a potential for a partial re-run of the equity rally provoked by the last round of Q.E., though markets never repeat exactly.