Hedge Fund Portfolio - "The Nemesis of Any High-Octane Hedge Fund"

I don't put a blogroll on this site, but that does not mean I don't appreciate the high quality output carried on other hedge fund related blogs. A case in point is the "Hedge Fund Portfolio" written by Kris Chikelue, and which you can find at http://hfpf.blogspot.com. Although I haven't read all of them, I have yet to read a posting there I didn't think was good or excellent.  With his kind permission you can read Kris's latest posting below - Simon Kerr.



If you’re an investor focused on high-octane hedge funds, a high quality problem to have is to find that a small, young hedge fund you invested in has outperformed AND ballooned past $1B after a relatively short period. Believe it or not, even in today’s difficult fundraising environment, more than a few funds have achieved this feat (certainly many in credit-related strategies like MBS, Distressed, and Converts). This “problem” is a high-quality one; nevertheless it is a problem if you demand high-octane performance. Why is it a problem? Size. While this answer isn’t a surprise for most folks, what is an area of contention is the exact number at which size becomes a problem. I won’t weigh in on that debate; instead I will discuss other relevant topics.


First, exactly how can size impede performance? The most obvious is it introduces liquidity constraints on what a manager can trade. There is also a less obvious yet “structural” issue: a large fund has a narrower opportunity set of trades that meet a high-octane bogey. Let’s use a quick example: Imagine Warren Buffett has just $100M to invest; he would likely identify a long list of securities that meet his very strict investment criteria. At $40B, it gets substantially shorter. Finally, there are “soft” obstacles created by size: A large fund will likely have a sizable headcount and, as such, non-trivial managerial demands. A large fund will have a LP base that has diverse demands: some focused on performance while others are watching the fund’s correlation. In contrast, a small fund is more likely to have investors that are uniformly focused on high-octane performance (unless of course, you have family/friends that are there for unconditional support). To be clear, I am not against large funds; being big has its benefits including having access to first-class information on macroeconomic trends, etc. These advantages are important for large funds; yet they have not frequently translated into high-octane returns.


Let’s go back to the original problem – what should you do after a young superstar in your portfolio has outperformed and attracted substantial assets? I’ll be honest – my first instinct is to take some (if not all) chips off the table, particular if the size is greater than >$800 and the strategy is in stock picking or credit. However I think it’s important to diligently investigate a few issues before deciding. In particular, I think it’s relevant to first, determine how important high-octane performance is for you. With your superstar, you have achieved a level of comfort that another fund has to surpass. Is it worth leaving this comfort to search for another fund (and potentially fail in finding such a fund)? It also might help to determine the fund’s new bogey. Ideally your superstar has grasped his new context, (i.e. he has a smaller universe of applicable trades) and has made adjustments to his performance target, among other things. Finally, it might help to understand adjustments to the fund’s coverage format. Ideally your superstar has determined a robust format for covering his opportunity set and the appropriate headcount he needs.

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.   

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.

source:stockcharts.com

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.

Inferences from a List of Larger Hedge Funds

Looking through Barron's Market Lab I came across a table of the biggest hedge funds in their univese. There are nearly 1100 single manager hedge funds listed in the newspaper. As is typical in the analysis of hedge funds it may not definitively contain the biggest hedge funds – even the most comprehensive databases may be missing nearly 40% of the largest hedge funds in the top 100 I was told recently – but still it makes interesting reading.


Biggest Hedge Funds in Barron's Market Lab (all data as at end October 2009) 
Source: http://online.barrons.com/public/page/9_0210-hedgefundperformance_oct-hedgefundperformance.html



In terms of strategy representation, and taking account that Barron's reports CTAs separately, there are a several points worth making:

• Equity long-short is well represented, and it is striking that emerging market equity hedge funds make it to the list.
  
• Managers running strategies in fixed income are represented by a credit fund and two mortgage-backed securities funds. Five or maybe more years ago some fixed income relative value funds would be amongst the largest individual hedge funds.
  
• Global Macro remains a big strategy – three representatives of global macro present.
  
• There is only one CB arb fund in the list – five years ago there would have been several big CB arb funds in such a list.
  
• Event-driven funds are under-represented compared to the percentage of industry assets invested in them. Dedicated distressed bond funds are absent (pace universe bias). A couple of multi-strategy event-driven funds are large enough to get into this top 20.
  
• It is striking to see a fund in what is considered a niche investment strategy making it to a list of very large funds. The Dexia Index Arbitrage Fund deals only on the most liquid equity markets, and the asset size is a reflection of both the (loyal) client base of the managers, Dexia, and the steady return profile of the Fund.
  

To generalise from a small sample (1100 self-selecting funds from a universe of maybe 6000 single manager hedge funds):

• Amongst the very largest funds are multi-strategy funds running $3bn-plus of capital in a single fund structure. This reflects the industry trend towards multi-strategy replacing single-strategy funds in relative value investment strategies particularly.
  
• Emerging market investing is now a permanent part of the range of strategies employed by investing institutions, and even after the yo-yo performance and redemptions of the last two years emerging market hedge funds can still rank amongst the largest funds.
  
• Hedge funds investing outside the United States are amongst the largest. This particular ranking includes a European specialist (Odey European) and a UK specialist (Blackrock's UK Emerging Companies Fund) as well as emerging market funds. Asia investing is absent on a dedicated basis.
  

CB Arbitrage - is it becoming Institutionally Uninvestable?

In 2003 convertible bond arbitrage was a core hedge fund strategy. Everyone who invested in hedge funds invested in CB arb funds. There had not been a down year for CB arb funds since the year of the LTCM crisis, 1998. On an index basis CB arb had produced positive returns in 8 of the previous 10 years up to 2003, and in the positive years the returns were in the teens. It was indicative that 2003 was the year that a successful arb manager had a book about his strategy published. Nick Calamos of Calamos Advisors, LLC ran one of the largest firms utilising the CB arb strategy, and Wiley published his zeitgeist-capturing title “Convertible Arbitrage: Insights and Techniques for Successful Hedging”.

As a proportion of the capital invested in hedge funds convertible bond arbitrage peaked in May 2003. At that point CB arb funds constituted 8.4% of the (asset-weighted) benchmark Credit Suisse/Tremont Hedge Fund Index, having been less than 3% of the industry assets in 1997. Clearly CB arb funds had drawn in investors’ capital - a lot of it. According to Tremont Advisors, convertible arbitrage total market value grew from just $768m in 1994 to $25.6bn in 2002 – this gives a growth rate of 50% on average per annum.

The capital flows were the consequence of the returns generated, and were to become the source of the decline of the convertible bond arbitrage strategy. The 2003 CB arb index returns of nearly 13% were enough to draw in more capital in 2004, a result of the usual lag between returns and allocations. But 2004 returns from the strategy were disappointing – some managers were down a little bit and most were up a small amount. And, although the year began with four positive months in the strategy, there were only three positive months in the rest of the year. Investors began to withdraw capital from this “core strategy”.


In truly liquid strategies, with a multiplicity of participants in the particular market, redemptions will not hurt returns much. But the convertible market had become dominated by hedge funds by 2004. Some estimates had hedge funds conducting 90% of the trading in convertibles in 2004, and as most of their holdings are acquired swapped-out on issuance it is equally indicative that more than 70% of the convertibles issued in 2004 were sold to hedge funds. Hedge funds did not just have major influence on convertible bonds in this period, they were the market for convertible securities.

In the second half of 2004 the apparent value in the securities held by CB arb funds increased as their discount to their theoretical value widened a little. So the managers could make a case that their opportunity set was getting a little richer, but the signal event for the strategy arrived in 2005 to catalyse investor redemptions on a significant scale. General Motors had issued amongst the largest and therefore most liquid convertible securities in the market – they were widely held convertible bonds and a core position for CB arbs. Early in 2005 Kirk Kerkorian tendered for GM stock to increase his position in the company, and the arbs were caught short of stock. CB arb funds were fully invested (so leveraged) and had to sell positions to meet margin calls. In effect they created their own death spiral of forced position sales, lower marks, lower fund NAVs, and that led to more redemptions. There was no one else to buy their positions off them in any size.

In the sell-off climax CB arb losses were around 3% for the month of April 2005, though some funds lost several times that amount. Although CB arb funds had lost only 3% for the whole of calendar 2005, between May 2004 and May 2005 they put in ten down months and the perception of a strategy able to deliver steady double-digit returns to investors had gone. Investors fled from the strategy. Over the course of the 12-months from April 2004 to April 2005 the asset weighting of convertible bond funds in the industry went from over 7% to around 4%. Convertible bond arbitrage as a core hedge fund strategy was dead.

From the start of 2001 to March 2006 the average return of CB arb funds was just under 8 percent versus broader hedge fund average returns of nearly 12% over the same period. These returns were produced with a volatility of just over 4% for the average hedge fund and just under 4% for the average CB arb fund. Since then the characteristics of return of convertible bond arbitrage as a hedge fund strategy have changed again, in particular in the last two years.

Last year the Credit Suisse/Tremont Convertible Arbitrage Index was down 31.6% and this year is up 40.0%. The last eighteen months have been an extraordinary time in finance and markets. But even so, for a leading manager like Whitebox to have CB arb funds that were down 24% and 36% last year, only to be up by 56% and 73% in an arbitrage strategy is a challenge to the investor perception of the strategy. To the credit of the managers at Whitebox, at least these funds have NAVs at all time highs on the back of their performance this year. The same is not true for the average CB arb fund.

To reiterate these are arbitrage strategies. One definition of arbitrage is “a trading strategy that is used to generate a guaranteed profit from a transaction that requires no commitment of capital or risk bearing on the part of the trader.” Whilst the definition cannot be applied as written to modern financial arbitrage, still and all, investors in hedge funds have classified arbitrage strategies as coming within the relative-value category. Given appropriate risk controls, arbitrage and relative-value strategies should produce a return stream of steady consistent profits with blow-out protection for down-phases for the strategy. This should give a high percentage of winning months (more than 80%) with similar order profits and losses. These characteristics have not been present in CB arbitrage funds for some time.

It is no wonder then that as capital in the hedge fund industry has stabilised this year the proportion of the capital in the industry dedicated to CB arbitrage has continued to decline. At the end of September 2009 convertible bond arbitrage funds constituted only 1.77% of the asset-weighted Credit Suisse/Tremont Hedge Fund Index. This is not just a result of passive neglect, from net inflows going to other strategies. There have been net outflows from CB arb in each month in the first half of the year according to HedgeFund.net’s analysis, and anecdotal evidence suggests that has probably continued into the third quarter on balance.

Just as the publication of the “how to” book signalled the peak of the strategy, has Dow Jones signalled another shift for the CB arbitrage? In January this year Dow Jones Hedge Fund Indexes, Inc. announced that it has suspended publication of the Dow Jones Hedge Fund Convertible Arbitrage Strategy Benchmark, until further notice. The decision to halt publication of the benchmark was made jointly by Dow Jones Hedge Fund Indexes and the investment manager of the managed-account platform that supports the Dow Jones Hedge Fund Strategy Benchmarks. As a consequence, the investment manager took steps to reduce the platform's exposure to the convertible arbitrage strategy and to reduce the number of managers on the platform that specialize in this strategy. What does this action tell us?



So at less than 2% of industry assets a new query is raised on CB arbitrage as a strategy – how investable is it for institutional investors? Is it becoming a marginal strategy for investors in hedge funds on the basis of the amount of capital it is possible to commit? Is it just too volatile now to be a mainstream strategy in an era dominated by institutional flows?

CB arbitrage may be following the precedent set by merger arbitrage in the last ten years: it went from being a core hedge fund strategy to a minor hedge fund strategy. Then it became an elective component for opportunistic funds with a multi-strategy capability. Is it only a coincidence that the proportion of the industry’s capital invested in multi-strategy hedge funds has gone up by 40% in two years?