Syz’s Altin Zigs When Others Zag

ALTIN AG (LSE:AIA) (SWX:ALTN), the Swiss alternative investment company listed on the London and Swiss stock exchanges, discloses quarterly its entire hedge fund portfolio holdings as part of its policy of full transparency to investors initiated in 2009. Looking at the strategy allocation shifts of the fund of funds managed by Banque Syz makes an interesting contrast with the expressed biases of investors in hedge funds given in the Deutsche Bank Alternative Investment Survey.


Graphic 1. Net Allocation Plans by Strategy of Hedge Fund Investors

Source: 2011 Deutsche Bank Alternative Investment Survey

Asked in January this year, the respondents to the survey ranked as the top three strategies for receiving allocations of capital in 2011 as equity long/short, event driven and global macro. So it was striking that the Alternative Asset Advisors SA, the subsidiary of Syz that manages ALTIN AG, had acted in exactly the opposite way over the first three months of the year. As the fourth column in graphic 2 shows the largest reductions in strategy allocations made by 3A were in equity long/short, event driven and global macro.

Sometimes reductions in allocations in portfolios of hedge funds are effected through a passive route. That is as flows come in, net new subscriptions are allocated to preferred strategies, and the strategies or managers with sufficient allocations at that point are diluted. But ALTIN is a closed-ended investment company, so the capital available to invest changes with new capital raisings on the stock exchange and with leverage. There have been no capital raising (in fact shares in ALTIN AG have been bought back), and leverage at the portfolio level is broadly the same over the first three months of the year. So in this case the reductions in allocations to strategy are active decisions based on a number of possible factors. The factors are views on prospective returns at the strategy or individual hedge fund level, and (fund of funds) portfolio composition issues. That is reductions may be driven by bottom-up factors (marginally high allocations to a single fund that needs to be trimmed after very strong performance or changes at the firm), or driven at the highest level of management (portfolio level leverage as a function of hedge fund returns across all strategies), as well as at the intermediate level of strategy allocation. In this case the changes seem to have been made at the intermediate level because two funds have been added that invest using investment strategies that were not represented in the portfolio at year end.


Graphic 2. Breakdown of Capital by Investment Strategy of ALTIN AG

Source: Regulatory News Service of the London Stock Exchange

The two new funds are ZLP Offshore Utility Fund Ltd (an equity market-neutral fund) and Providence MBS Offshore Fund Ltd (a fund investing in mortgage backed securities (MBS), under Fixed Interest Strategy in table above). The first of the new funds is a sector specialist fund that adds value by the application of deep knowledge of one industry. The market-neutral fund, managed by Zimmer Lucas Capital of New York, should produce a return stream with a low correlation with traded markets. The managers of ALTIN know the managers of the fund very well – 3A were early backers of Zimmer Lucas Capital as far back as the year 2000.

The Providence MBS Offshore Fund Ltd is managed by Russell Jeffrey, founder of Providence Investment Management LLC of Providence RI. The $895m fund takes a relative value approach to residential MBS, and capitalizes on price dislocations in the agency MBS and related fixed income markets. The fund has a CAGR of 23.44 % since inception in 2004, and over the last 3 years it is ranked in the top 0.1% of all hedge funds for absolute returns.

The Deutsche Bank survey of investors in hedge funds showed no net interest in investing in either equity market-neutral or dedicated fixed income strategies in 2011. So it is not just in reductions in allocation to strategies that the managers of ALTIN zig when others zag, but also in new subscriptions to hedge fund investment strategies.

Selecting the Best Managers – a natural bias to hedge fund managers?

I carried out manager research for an American fund of hedge funds for several years early last decade. Manager research and portfolio construction is a team effort so I had to find a way to put across to my colleagues the merits of the managers I followed. We use a lot of inputs to understand how managers manage capital, so in our heads each of us has a multi-faceted view of the portfolio manager and his process, but it is not feasible to put it all across to someone else. So we have to find ways to summarise and capture the essence of our take on the hedge fund manager.

In my case I used a numeric score of what I considered then, and still do now, the key drivers of performance. So I gave each manager a score between 1 and 10 for each of source of alpha and for risk management. Risk management included portfolio construction, position sizing, diversification, risk measurement, downside risk and use of stops. The source of alpha score took into consideration the added value of the specific person/people pulling the trigger, the breadth and depth of research, whether there was a unique or unusual information source being used, the sustainability of the manager's edge, how adaptable the approach was to change, and the richness of the opportunity set being addressed. A mid-ranking manager would score 6 for each, in the way I used the scales, but this was a closed marking system. No manager ever got 10 for either metric. I never gave any manager a score less than 4 for alpha or risk management in the time I carried out manager research. At the bottom end it is easy to understand why: managers setting up a hedge fund have nearly always has significant success previously in trading or investing. They are not neophytes; and though some learn on the job about managing capital in the hedge fund format, they have all managed capital before.

After a while meeting managers, and hearing how they do what they do, I realised that whilst the alpha score was important, risk management was a bigger differentiator. So getting into risk management issues early in the process saved a lot of time and effort: if a manager didn't have discipline and a consistent process in risk management it was time to move on to another hedge fund.

A legacy of this time is that I remain interested in how to assess managers – it is useful in my consultancy work, at the least. In the book I am reading at the moment – "Investing with the Grand Masters" by James Morton – I am engaged to see what criteria the author used for selection of the managers.

So I was interested to read about the Skandia Investment Group's Best Ideas fund range. Skandia has a fund platform and operates multi-manager funds, but the Best Ideas funds are not a standard fund of funds. Neither are they portfolios of pure hedge funds. These are portfolios of funds (mostly long-only funds) run by well-regarded portfolio managers who have been given the freedom to invest in their highest conviction investment ideas on a dedicated basis.



The lead manager on Skandia Investment Group's Best Ideas fund range, Lee Freeman-Shor, applies four key pieces of academic investment research to his selection process. These are:

1. High conviction investing: Research from Randy Cohen of the Harvard Business School, Christopher Polk and Bernhard Silli of the London School of Economics suggests that the bulk of fund manager's returns come from their highest conviction ideas. As a result the Best Ideas managers are limited to holding only ten stocks, their ten highest conviction ideas.

 2. Kelly Criterion: a formula first described in 1956 by John Larry Kelly to determine the optimal betting size to maximise wealth. Perhaps the most famous Kelly practitioner is Warren Buffet who once said: 'Why not invest your assets in the companies you really like? In 1972 Buffet had 42% of Berkshires assets in American Express. Freeman-Shor allows the managers to apply Kelly to the extent that they can invest up to 25% in a single stock.

3. High Active Share: this measures the proportion of a fund's assets that differ from the benchmark index. In their 2009 paper 'How Active is your fund manager? A new measure that predicts performance' Martijn Cremers and Anti Petajisto indicated that running a fund with a high 'active share' delivers the highest and most repeatable returns. The European Best Ideas Fund has a high active share, currently 83%.

4. Behavioural science: Research by Andrea Frazzini in 2006 showed that the best performing managers realise the highest proportion of losing trades. Freeman-Shor's job as overall portfolio manager is to be a coach and work with the Best Ideas managers to ensure they do not succumb to, amongst other things, sunken cost bias when they are losing and are thus executing their ideas appropriately.


In a good hedge fund there is a competition for capital between the investment ideas – that is, all full sized positions are conviction ideas. So the concept of high conviction investing is seen in the hedge fund world. The Kelly Criterion applies in several hedge fund strategies – event driven investing, activist investing, and to a lesser extent in global macro investing. The third piece of applied research might just say why hedge funds have inherent qualities relative to long only strategies, as 100% of many hedge fund portfolios are active bets. There are no index constraints in hedge fund portfolios, though the presence of positions held only to hedge impacts the percentage of the portfolio applied to seek alpha.

The fourth piece of academic research applied to the Skandia Best Ideas funds has a very strong resonance for me. The conclusion from Frazzini is that the best performing managers realise the highest proportion of losing trades. From my work with traders I know that this can be applied with minor tweaks in hedge funds: the best traders realise their losses either early, or in line with their stated stop-loss policies. This allows winners to run, and losers to be cut. This characteristic is also often seen in systematic approaches to markets, particularly by CTAs. With good money management it is feasible to run a successful CTA with a hit-rate (percentage of winning trades) of only 35%. The hit-rate in a discretionary money manager has to be a lot higher, and for a fundamentally driven manager with a long holding period the hit-rate can get into the high 80's as a percentage.

The fruit of the application of these concepts has been good – the Skandia European Best Ideas Fund has shown some strong out-perfromance. On the third anniversary since launch the fund was 17% ahead of the MSCI Europe index and 15% ahead of its peer group (Morningstar European Large Cap Blend), putting it in the top 5% of European funds since inception and 1st quartile over all time periods.

There are a number of hedge fund managers and managers of absolute return funds amongst the roster of managers employed by Skandia in the Best Ideas Funds. In fact I would go so far as to say that there is a disproportionate number of such managers amongst the portfolio managers used (see tables below). Would that be because hedge fund managers tend to apply the best portfolio management practices given by Skandia more than long-only managers?

 

Past the Low Point for Funds of Hedge Funds

It has been a tough time for funds of hedge funds post the Credit Crunch. At last it looks like the aggregate assets under management are beginning to emerge from the prolonged bottoming phase. Three months ago there was a comment here on the flat-lining in asset flows for North American funds of hedge funds. But the latest survey evidence from Preqin shows a rather more constructive outlook. 

Whilst the aggregate is little changed:

Graphic One: Aggregate Fund of Hedge Funds Assets under Management

 

Source: Preqin

The detail shows that more of the fund of funds sector is experiencing positive changes in AUM:


 

Graphic Two: Changes in Fund of Hedge Funds' Assets under Management since 2007

Source: Preqin

• The proportion of funds of funds experiencing a fall in assets has gone from a substantial minority last year (42%) to only a small minority (17%) this year.
  
• Much more of the industry has experienced stability in AUM this year – 55% of FoFs have seen no change in assets so far this year compared to last year.
  
• The proportion of funds of hedge funds having an increase in assets is up to 28% in the 1Q of 2011.
  

If these trends continue the total AUM for funds of funds could rise towards $950bn by year end, in Peqin's estimation. This would be a good fit with evidence suggesting that institutional investors will be increasing their allocations to hedge funds. According to the recent Deutsche Bank survey on hedge funds, in aggregate institutional investors do expect to increase their allocations to hedge funds in 2011. The majority of investing institutions (77%) expect to keep their allocations as they were, but more (21%) expect to increase allocations in 2011 than decrease them (2%).

 

The outlook for funds of hedge funds is the most positive we have seen for at least 3 years. Preqin's version is

 

"The fund of funds landscape is markedly different to the pre-crisis industry. Assets under management for the industry as a whole are much lower and there is a bimodal distribution of firms emerging, with peaks at the lower end of the scale as the smaller niche boutiques appeal to the maturing hedge fund investors, and at the larger end of the spectrum the "brand name" multi-strategy firms still prove appealing to the newer investor. After a difficult few years for funds of hedge funds, the managers that have appropriately adapted to retain investors from the institutional market have regained some lost confidence and numerous new funds are poised to be launched this year. Growth of industry assets is again in positive territory and if this new era of revived investor interest in funds of funds continues then aggregate AUM will begin to climb towards the $1 trillion mark."

The fund of funds part of the hedge fund industry is not going to return to growth in the way it experienced it before – not all funds of funds will benefit in this more mature phase of the industry. But in aggregate the low point for the sector has been passed.


 

Consulting Two - No Explicit Cost v Negative Carry Option Strategies

In my consultancy work I have been surprised by the frequency with which I have come across zero-cost strategies in options. Traders and portfolio managers find them more alluring than they should. It is as if these strategies intrinsically have more merit and deserve more attention. They don't.

To take on an options strategy, in say an equity index, the trader or PM must have a view on the underlying. To have an informed view the trader must follow the instrument closely – this allows them to attach probabilities to the possible broad scenarios behind taking a view via options. So the thinking may be that the index has had a good run and is beginning to act tired; that is there is limited upside from the current level. Or it could be that a particular share has formed a double bottom, there is good value in them and selling might begin to dry up. The first scenario is one that might suit an over-writing of call options. The second might fit an underwriting near current levels by selling put options.

To simplify market activity there are three broad outcomes possible – a trading range, a further significant rise, or a significant fall. Lesser directional movements are captured in the trading range scenario. The money manager or trader will have views on the likelihood of each of these, or to put it another way, if pressed most money managers could attach probabilities to the three broad outcomes. The money manager might have a view that the odds of a significant decline are small, say 10%, but having had a good run the odds of a trading range to consolidate the rise is quite high, say 60%. And the chances of further significant upside are greater than the chances of a significant fall, given the evidence of new buyers – so the odds of a significant rise are 30%. Whatever the exact percentages, the trader will have his own take on what the probabilities are of the three possible outcomes. It is his own probabilities which need to be fed into the construction of an option strategy to make it a fit of his view.

Of course the further significant rise might follow an intermediate pause for refreshment in the price of the shares or index. The extent of time taken to consolidate or pause is a key point. This is the time frame factor, and all managers have a time frame in which they add most value. This is the period over which they generate alpha. If they are a scalper, they shouldn't be taking a view over the next quarter, and a fundamentally-driven stock selector should not be looking to implement a view over the next couple of days. If a manager has a variant perception on earnings, for example, that would normally emerge over several quarters rather than over a week. All option strategies have a time frame, fixed around the months of the option maturities. To be a good fit for the trader the option strategy has to take place over the right forecasting horizon for them.

In a commodity market traders will know the price level at which industrial users will be highly likely to come in to buy. They may know the price zone when commercial hedgers have historically increased their open interest. In the world of equities a manager will have a clear idea of where value is emerging in a particular stock, and where companies buy-in their own stock. In fixed income traders will know at what interest rate funding becomes attractive to a particular category of market participant. So the portfolio manager or trader will have his own mental map of the significant levels of the markets they follow as they see them. In contrast, traded options are bought and sold for strike prices set at intervals by the rules of the exchange on which they trade.

The currency of option trading is volatility. So it might be said that the vol on a class of options is at least a couple of points rich compared to its recent history. Or that the smile of the volatility curve is particularly skewed because of a recent freefall in prices, meaning that out-the-money puts are expensive relative to those with strike prices near-the-money. The 3-D volatility surface is what the options market maker takes his view on.

The users of options may or may not have a view on volatility per se. The users may have opinions on levels and how long it might take for moves to develop and mature, and what probabilities they attach to scenarios for their markets. Professional traders will have a view on vol. Portfolio managers who read a lot of fundamental research and meet company managements are unlikely to have a strong or well-informed view on option volatility by class, never mind by strike. So having done option training, PMs will know what implied and realised volatility are, but it is not the element on which they are typically able to take a well informed view. It is not their currency.

So it is that option strategies are often expressed in the language of levels – strike prices plus or minus net premium. For simplicity pay-off graphs tend to illustrate possible outcomes at maturity. This makes the marketing of strategies more straight forward, and expresses strategies in terms closer to those most readily understood by the widest number of portfolio managers. It does little for suitability or fitting with a manager's market view. And so we come to "zero cost" option strategies.

Zero-Cost Strategies

 

Zero-cost strategies would not matter much were it not for the frequency with which they are implemented. After all the PMs are all grown-ups and they can always say no to an options strategy proposal. But the allure of the cachet of no explicit cost seems to be very strong with the buy side. So a disproportionate number of strategies are created, sold and implemented based on the appeal of no up-front premium outlay.

The typical circumstances are that, for a give maturity, the premium attached to a near-the-money strike option happens to be twice the premium for an out-the-money strike option. This means that, taking account of one side being on the bid and the other on the offer, an investor can receive as much premium for selling two lots of options O-T-M as they pay for buying one lot of A-T-M options. The payoff profile is rising profit through to the OTM strike, and from that level out a declining profit.

Sometimes the ratio between the strikes dealt in is not 2:1, but say 5:2, but overwhelmingly in reality the zero cost collar or put protection is sold and implemented using a ratio of 2:1. The outcomes are then much more intuitive to comprehend (and pitch).

In the process of putting the strategy together the strike levels and maturity of options are selected to fit the template that the purchased premium outlay should be offset by the premium received from the options sold. Occasionally, when the term sheet is put together by a less experienced sell-sider, the O-T-M option is struck further out in time than the near the money option. This diagonal call spread/put spread is less elegant to sell and understand, and utilises two time horizons.

Now going back to the portfolio manager's use of options, he or she should use traded options when they efficiently implement their views on markets, and within their style of investing/trading. Their views come in several aspects: their own take on what the probabilities are of the (three) possible outcomes in the specific market; their own mental map of the significant levels of the markets;  and they should take views via option positions over a time-frame that has a resonance with their own horizon for adding value.

Explicitly stating the elements going into the views on markets makes plain how specific they are to the trader or portfolio manager. It may well be possible to express the market view of a portfolio manager using options – so the time frame, probabilities and significant levels match what can be achieved and structured in the options market. That can be guaranteed to happen using over the counter options; that is, using bespoke instruments. To a degree using pre-existing strikes, dates and a given volatility surface of traded options will always be a compromise versus that ideal fit.

Lay on top of that that zero-cost strategies are put together when there is a conjunction of option maturities, skewness and strikes that just happens to give a ratio of 2:1 in premiums, and the impartial observe can see that zero cost strategies are a very artificial construct. Further it is plain that in order to put them on portfolio managers or traders are quite conceivably having to compromise their own market view in some dimension to accommodate the implied view of the zero-cost option strategy. So the real cost of the zero-cost strategy is not the premium expended, which by definition is nil, but the potential for a significant compromise with the actual market view of the risk taker. This mis-match is too often the cost of the zero-cost option strategy.

Using Negative Carry Strategies

 

Parenthetically, the inverse of the driver of the zero-cost options strategy, has produced great returns in some hedge funds. Rather than be a net seller of gamma (through being short one unit of O-T-M delta) some of the most successful trades of all time have been long long-dated optionality. Being net long of option premium comes at a cost – there is time-value erosion to cope with. But for some patient investors there is a big attraction in having a negative carry trade which gives well defined upside/downside parameters.

The "greatest trade of all time" is the definitive example of the successful negative carry trade. Mortgage backed securities have embedded optionality in pre-payment risk, but through derivatives on MBS specific tranches and indices it was possible to construct trades that would benefit from no payment risk – when mortgagees hand back the keys on their houses. So it is that the likes of John Paulson and Kyle Bass made billions on the subprime meltdown. There was an explicit cost to the trade, but the downside was known from the outset, and at least in the mind of the originator of the trade the real risks were in rolling over the positions – the collapse was going to happen at some point, though its exact timing was not foreseeable.

A similar set up was seen by Mark Hart of Corriente Capital of Fort Worth Texas. Like Paulson he created a dedicated vehicle to run a long long-dated option strategy to play one specific investment idea for the medium term. In the case of Hart, the fund he created in 2007 with the founders of GavKal, the European Divergence Fund LP, owned credit default swaps on European sovereign risk. Hugh Hendry of Eclectica is hoping for a similar payoff (7:1 and better) from using CDSs for taking negative views on China-related plays.

Another successful manager that uses negative carry options is Jerry Haworth of 36 South Investment Managers of London. 36 South has a diversified fund, the Kohinoor Fund, that only uses long-dated options and which has a 10 year track record. Haworth has also set up funds to benefit from specific tail risk events that use the same approach – for example the Black Sawn Fund that made 234% in 2008.

For each of these managers the use of negative carry option strategies gives a very useful attribute - the left side of the distribution of returns is truncated. That is the range of possible outcomes is limited on one side, which is the classic desirable skewed distribution of hedge funds.

Finally, some successful managers will not engage in negative carry trades with optionality on a structural basis in their fund. Rather for some long established and successful managers they see themselves as earning the right to start to use these strategies once they have passed a return threshold for the year. So once they have earned 8 or 10% (and therefore have every chance of producing a double digit year as a minimum) they will invest some of their profits to give a shot at making a banner year.

When I was Head of Derivatives at Clerical Medical I used to tell the investment professionals there that derivatives should be used to implement their views on markets when the instruments allowed that to be done economically. So in specific circumstances, for a particular money manager, a zero-cost collar may exactly fit their market/stock view. But the investment concept invested in, and the fit of the option tactic with the view is more important than the explicit cost, as the successful examples of the use of negative carry option strategies show. 




The first article in this series on consulting in the hedge fund business can be found at Consulting One