Hedge Fund Risk Management is “A Work in Progress”

By Simon Kerr

For a long period I was unable to carry on reading SEI’s fifth annual global survey of institutional hedge fund investors beyond this summary point: “RISK MANAGEMENT IS A WORK IN PROGRESS. Only one in five of those we polled agreed that “most hedge funds do a good job of risk management.” ” The view embedded is a strong challenge to the proposition offered by those who run hedge funds.

In concept hedge funds do what they are supposed to because the managers are able to turn a fecund source of alpha into an attractive return series through an appropriate risk management framework. It is feasible to have an outstanding insight into companies/stocks/markets that enables a manager to run with an okay risk framework to produce the required return, but is extremely unusual, and, from experience, cannot be relied on to grind out returns. Rather a good risk management approach and processes are sine qua non for a successful hedge fund.

So the respondents in the survey of 105 investors in hedge funds, across a range of investor types, conducted by SEI are perhaps able to distinguish between the typical and the best in this area. In answer to the question “Do hedge funds generally do a good job of risk management?” One in five said yes, 28% disagreed and the rest were not committed.

The endowments, pension plans, family offices and consultants that completed the survey may have had in mind that hedge funds have produced losses in two out of the last four years so the recent evidence is that the typical hedge fund does not do a good job in risk management if the point of the risk framework is to produce the target return of absolute performance. However only a very small minority of capital in hedge funds is invested in “the typical hedge fund”, that is through replication or hedge fund index products. Rather there is a research process and hedge funds are actively selected.

There are around ten thousand active hedge funds today. An institutional allocation to hedge  funds might consist of as few as six funds*, but will run via, say, three funds of funds plus a few individual selections to a maximum of 100 single manager hedge funds for a large pension plan. The survey question “Do hedge funds generally do a good job of risk management?” addresses the 10,000. What if the question had been “Do the hedge fund managers you selected and allocate capital to do a good job in risk management?” Would the response have been the same?  

* see earlier article on an institutional mandate

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.

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 www.martinkronicle.com). 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.

Chart of the Day - Extremely High Correlation of Stocks - Implications for Hedge Funds

I'm doing some work on risk measurement/management at a hedge fund management company. The investment strategy of the hedge fund is long/short equity. Most of the work revolves around measurements at the portfolio level, and the aim of measuring and controlling risk is to produce steady returns for investors. This is only possible on a sustainable basis with a diversified portfolio, unless the hit-rate is unusually high. Whilst  I have met managers with very concentrated portfolios based on very stringent selection criteria, and who have very high career hit-rates (as high as over 90% in one case), most mangers (probably more than the 80:20 rule would suggest) run portfolios diversified by stock, sector and to some extent theme.

Effective risk management is partly about being aware what has a high probability of working and when. One of the lessons of the Credit Crunch for many in hedge fund land is that there are market circumstances in which the previously assumed risk controls will not work. That is, the manager has a series of limits and stops and processes which in combination will produce the desired outcomes for most market conditions. The rub, as revealed in 2008-9, is in the conditional "most". Managers have to be aware of in what market circumstances their approach to markets will not work.

For most equity long/short managers most of the time the key decision variables at the portfolio level are about managing the net exposures to market, and specifically about managing the net beta-adjusted exposure to the market. There is a sub-set of equity managers for whom this is not true - those which have a limit on their net exposure to markets, and are structurally close to net neutral, say a band of 0-20% net long. Often the latter funds are quantitatively-driven equity long/short funds, but some discretionary managers choose to be close to net neutral. For these net-constrained funds returns have to come from stock selection to a much greater extent than funds with wider investment powers. The corollary is often a larger gross exposure to markets - consistent with the formulation of information ratios of managers. Typically, funds with a small net exposure limit target lower absolute returns, and implicitly rank risk-adjusted returns as a higher goal than absolute returns. 

The majority of managers in equity long/short try to use the additional degrees of freedom they have in balance sheet disposition to produce higher absolute returns (than a net-neutral manager) though nearly always with higher volatility of returns. The tactical shape of the fund should be a function of two things: the market regime and the opportunity set for the particular investment style of the manager. There is a considerable range of understanding amongst managers of the necessity of taking these two dimensions into account in setting the net exposure of equity hedge funds. The best managers are good at both, but the majority of equity hedge fund managers are not. Yes, the majority.

The successful shaping of the hedge fund balance sheet requires two attributes in the manager: an ability to read the market regime in multi-dimensions, and a high degree of self knowledge about the applicability (and effectiveness) of their investment processes. Around the time of the Tech Bubble the first required ability was demonstrated a lot by equity hedge fund managers. The monetary stimulus provided by Greenspan on fears of the Millennium bug was read by managers as a bull market condition green light, and most managers were very net long in 1999, and investors were gorged on the excellent returns produced. The reverse happened from March 2000 onwards. By the 3Q 2000 many equity hedge funds were net short on a tactical basis, i.e . the managers jobbed from the short side.  From 2003 to mid 2008 a net long bias and a buy-the-dips mentality were positive attributes for managers. Over the same period many new hedge fund managers joined the industry, and several big names closed down, citing the lack of shorting opportunities as a reason.

So coming into the Credit Crunch phase of 2008 only a minority of equity hedge fund managers expressed an ability to read the market regime by going net neutral or net short. A majority of managers had never been net short to that point, and many did not have that available as a choice because of their offering memoranda, or because the operational limits they gave themselves precluded it.  

Current market conditions have echoes of 2008-9: large daily declines in equity prices, volatility and rising fear gauges in the price of gold and the cost of interbank borrowing. These are difficult conditions in which to manage an equity hedge fund. Quite how difficult is in part reflected in today's chart of the day. Every manager can tell you about the level of market volatility reflected in the Vix Index. This captures the current level of volatility in the market on a traded basis. The actual volatility experienced in the market is lower than the traded level, though intra-day measured volatility can be higher than that indicated by the Vix.

All equity hedge fund managers are aware of how volatility shifts impact their style because they can see it in the daily P&L changes per position, and the same at the portfolio level, and they are aware of the Vix. Those managers who take risk measurement more seriously will be aware of the Value-at-Risk of their portfolios. The same portfolio will have a different measured risk dependent on market conditions - when markets are more volatile measured risk goes up for the same portfolio. What is less well explored is the other element that feeds into the risk measure VaR, that of correlation.

The inter-relatedness of positions has an impact on measured risk. The more related the positions the less diversification there is in a portfolio. Consequently managers structurally build diversification into their portfolios by having limits on sectors/industries/macro-related themes as well as limits to specific stock risk by constraining holding size. But correlation is not stable. Cross-sectional correlation varies through time. In up-trending markets (scenario 1) volatility drops and stocks tend to become less correlated. For sideways moving markets (scenario 2) two stocks in the same sector could quite feasibly act differently - one going up and the other staying the same price, or even falling. Scenario 1 is better for producing returns from net market exposure, and scenario 2 is a richer market opportunity for returns purely from idiosyncratic stock risk (selection).

However when markets fall for a period volatility rises and correlation increases. The correlation coefficients of stocks' betas go up - the market component of stock price changes goes up, and the sector effect increases and the idiosyncratic component of stock price changes declines. The chart of the day below illustrates that we are at an extreme for measured correlation amongst S&P500 constituents.

In such a market environment portfolio returns become a product of the net market exposure, driven by the weighted average of the portfolio betas. The extreme case illustrates the point - bank shares and commodity stocks have had the highest betas in the market for some years now. The return to the net exposure to these two sectors plausibly could have been the largest component of the return of individual equity hedge funds over the last three years. For net neutral equity hedge funds the net exposure decision on these two sectors over the last three years could have even been the decision that determined return outcomes.

For market conditions with high correlation between stocks it is just about impossible to drive returns from stock selection (idiosyncratic risk) alone. This has recently been explicitly recognised by one management team -  Ralph Jainz and Jonathan Sharpe of Ratio Asset Management wrote to their investors on closing their European equity hedge fund this month that "this year stock selection has not proved profitable." History suggests that it is difficult for diversified net neutral funds to make money when there is high correlation between stocks, and only managers who are adept at shaping the balance sheet of their hedge funds will actually make money, as opposed to defending their capital.  

Given that nowadays few managers can demonstrate an ability to read the market regime in multi-dimensions, and have a high degree of self knowledge about the applicability of their investment processes, I expect negative returns from the strategy for the current market. What is particularly disappointing is that the number of managers who can show they truly learned lessons from 2008-9, and can make money now, are so few. Maybe investors have to exhort their managers to take some off some of the net exposure restrictions - or do investors doubt that their managers have sufficient skills to handle wider investment powers?



   

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?

 

Top Macro Manager Talks Through Set-Ups, Triggers and Sizing Positions

This week I heard a presentation by a senior trader at one of the large global macro hedge funds which has been in business for nearly 20 years. He put across several insights into the way of working of those who engage in the strategy. The particular trades under discussion were in foreign exchange, in the Euro/U.S. Dollar, during last year.



Fundamental Set-Up

In FX there are three elements to the fundamentals that should be aligned for putting on a position, according to the trader. The first is valuation. In FX there are several valuation models which are commonly used though each has limitations. Purchasing power parity (PPP) for a currency pair is a value which is unobservable in markets, and is a conceptual level that actual FX rates pass through without pausing. Extreme deviation from PPP is taken as an under or over-valuation. The Economist uses the price of the ubiquitous McDonald's meal to calculate the "Big Mac Index", a guide showing how far from fair value different world currencies are. The Big Mac theory, which is based on an observable purchasing-power parity, says that exchange rates should even out the prices of Big Macs sold across the world.

The second element of the fundamentals to consider is the interest rate differential between the two countries on each side of the currency pair. This is not a static element, as the FX markets (spot rate) move with forward forward rates. So expectations of future interest rate differentials are what count. The relative growth outlooks of the two economies is what the senior trader emphasised in getting a handle on interest rate differentials. For my part I would say that the perceived prospects for medium term inflation are now taking a much bigger role in the mind of the market than hithertofor in looking at interest rate differentials.

The third fundamental element to a good FX set up for a macro trader is the policy environment. Last year presented a classic opportunity (in looking at Euro related trades) in that European politicians/central bankers commented on levels and movements in traded rates (CDSs as well as bond auctions and FX parities). Some of the great macro trades have been set up by governments attempting to talk down markets when their policy objectives clash with what the markets discount as sustainable. So last year was a classic of its type in this regard, though interest rate policy specifically was a stale issue according to the bulge-bracket macro trader. That is, changes to interest rate policy were not expected to be a driver of the market condition for the trade under consideration in the time-frame envisaged. For trades at the market level like those illustrated here, and particularly in FX it is very important to understand the market drivers at the time. The graphic below indicates what the macro trader stated were the major drivers for the €/$ level last year through the different phases.

Technical Set-Up

The technical set up for a macro trade can be about flows and positioning by the various categories of market participants (say hedgers, speculators and governments). For example, the Commitments of Traders report for listed US futures showed there were very high levels of Dollar bear positions just before the monthly employment report for July 2010 released on the 6^th August last year. So the positioning in the market shifted the odds of the labour market data being bad enough to move the Euro up further versus the Dollar. That date marked an interim top for the Euro versus the Dollar.

The other form of commonly used technical set up is pattern recognition, which in its crudest form is chartism. Along with the rest of the market, the senior trader from the well-known global macro firm was onto the break in the multi-quarter uptrend for the Euro (versus the Dollar) that occurred in December 2009. The Greek debt crisis powered the multi-month fall in the Euro which lasted into the middle of 2010. The break in trend of itself is often a good entry point for a trade, but as FX markets have lots of minor reversals against the major trend traders have to have tools to identify the second and third high quality entry points as the new major trend unfolds. In the middle of January 2010 there was a good secondary entry point on such a short term reversal – as is typical the secondary entry point corresponds to a support/reversal level on the previous major trend – in this case around 1.45 on the €/$ in the period 13-15^th January.

This secondary, high-quality entry point can be illustrated in another trade mentioned on this website – in Gilt futures (see here and here).

Technical Set Up for Trade in Gilt Futures Showing High-Quality Entry Point

The significance from a money management perspective is that the second entry point - as the security price accelerates away from a key support or resistance level - can be a higher conviction entry point than the first. This is because the investment hypothesis ("the market is going to go down", say) has been tested by market action and passed the test. So depending on style, the macro trader can trade in several risk units at the second entry point. In no way is the second entry point a secondary entry point!

The global macro trader also disclosed the use of a particular tool to assess sentiment – the world wide web. The fund monitored the occurrence of the phrase "quantitative easing" on the web in August, September and October to ascertain the degree of dominance in the minds of investors.


Trigger

Global macro trading is often about assessing the persistence of action by the various actors in the market drama. It was interesting that the senior macro trader said that the trigger for putting on the position was often the behaviour of the markets themselves. Note that the crucial observations are across markets, not necessarily from market action within the market under consideration. So for the €/$ last year the maturity of the Euro rally that began in June was under consideration in August by the trader because the co-movements of the S&P500 (as a proxy for global equities) and the fx rate diverged. The €/$ and the SPX had synchronised price changes for a period of some months, but over the first few trading days of August days the S&P was flat whilst the € was still appreciating against the $. For the macro trader this signalled a change of behaviour was imminent for the Euro/Dollar relationship because the S&P action signalled at least a pause in the driver for the FX rate (the slowing US economy). To quote the trader directly, "divergences between markets are the best clue for market behaviour. A correlation break that lasts for one-to-two days and can indicate a movement to follow that lasts for 2-3 months." He also stated that more than 50% of a macro trader's insight comes from understanding the message of the markets, that is the behavioural inference is key. Like many traders, including those with a macro framework, the presenting macro trader only puts capital to work if the market has already started to move in the direction he wants to play.


Sizing

Sizing of positions in macro is usually a function of risk/reward and correlation. The senior trader didn't mention correlation himself in this regard, so we'll concentrate on the potential profit and loss as the key input to position sizing. The target price and stop loss levels for positions in markets are typically placed at or near significant support and resistance levels – the difference between current price levels and these two levels gives the upside/downside ratio for the potential trade. The potential loss between current levels and the stop is used to scale the maximum position size. A loss of say 5% on a position that is 20% of the gross equity of the fund would give a portfolio level loss of 1%. If two percent loss at the fund level for a single position is the outer bound then a 3% loss to the stop would equate to a 24% of equity maximum position size. The principle is determine how much you are prepared to lose – "anything else is bad discipline, or has ego in it," admonishes the trader.

This particular macro fund also uses drawdown from peak as an additional risk limiter at the level of the individual trader. So the risk capital of the trader will be reduced if his P&L is down 5% from his own peak, and he will be out of the market for a period if he loses 10% from his peak P&L, even if he is still positive on the year.


Closing the Position

The macro trader acknowledged his belief in the concept of reflexivity – Soros' concept that positive price changes themselves impact how positively investors think about the market – such that prices can waterfall down or continue upwards way beyond most expectations. Conceptualising potential price changes and unusual market impacts helps macro traders mentally prepare for a range of market outcomes. But still an all, positions have to be closed even after exceptional profits – so what feeds into the decision making at the closing of a trade? "A position should be reviewed when a price target is hit, and should be closed for sure when a lot of the market has joined you in that position."

How do you make money in macro trading? – "You need to take risk aggressively to make money, but you need to take it well." 



One of the reasons I posted this article is that the trader uses several methods I use in my own style of investing. If you run a hedge fund and would welcome input on your processes (investment, research and risk management) from my consultancy or want to persuade me to share my expertise full-time contact me on s-kerr@tiscali.co.uk 

Chart of the Day – Funds of Hedge Funds Flat-line in Asset Flows in North America

My Chart of the Day comes from The Eurekahedge Report which looks at 2010 hedge asset flows and investment returns. The chart compares the monthly asset flows to North American hedge funds and funds of hedge funds since the start of 2008. The contrast in flows in the recovery phase is very striking: single manager hedge funds net redemptions stopped four months earlier than net redemptions to funds of funds; and there have been net subscriptions to single manager funds in most months since April 2009, and net subscriptions to funds of funds have flat-lined over the same period.

Monthly asset flows to North American hedge funds vs North American funds of hedge funds

The North American component of the hedge fund story is very constructive at the single manager level. Not only have NAVS recovered well since the Credit Crunch but in doing so last year the Eurekahedge North American Hedge Fund Index was ahead of the S&P 500 until the last month of the year. Over the last three years North American single manager hedge funds produced annualised returns of just over 7 1/2 %, versus 5 1/2 % for the Global Eurekahedge Index. Indeed American hedge funds produced better returns than funds managed from other developed regions in each of the last three years. So American single manager hedge funds have done better in performance terms than those in other regions.

The three year annualised returns of North American funds of funds are negative according to Eurekahedge, just as the MSCI North America had negative returns over the same period (to end November 2010). Further the 3-year annualised standard deviation of returns of funds of funds is the same as that for single manager hedge funds. So that on a three year basis funds of funds have not delivered absolute returns, and the volatility of returns over that period has not been lower than single manager funds (which historically had previously always been the case). So the return-for-risk argument is weak for funds of funds relative to single manager funds in North America.

As a source of capital for the whole hedge fund industry American investing institutions have become dominant. Survey evidence shows some recovery of appetite amongst institutional investors in hedge funds – questions on investment intentions produce a net positive balance from respondents on a consistent basis since the end of 2009, with US investors more positive than investors in other regions. But the "intentions" have turned into net positive flows only for single manager hedge funds in aggregate (though around 30% of funds of hedge funds report net inflows in the second half of last year). There several plausible explanations for the contrast in flows depicted in the chart.

The gap in performance between single manager hedge funds and funds of funds may have got too wide for investing institutions to bear. Historically there were a few years, over the course of decades, in which multi-manager hedge funds out-performed single manager hedge funds. So in those years there was a (relative) pay-off for strategy allocation and avoiding the under-performers and blow-ups – which is for what investors pay funds of funds. It was commercially crucial that funds of funds did that in the key year of 2008, and they didn't, as a whole. It is now many years since funds of funds in aggregate even got near single manager returns.

Given the return records for single manager and multi-manager hedge funds the additional layer of fees in the latter cannot be justified in the minds of institutional investors. Fund of funds' management fees have been falling for more than a decade, reflecting the balance of supply and demand over that time. In contrast single manager fees have held up much better, with the exception of the immediate post Credit Crunch period. Indeed Eurekahedge record that the average management fees for single manager start-ups in 2010 was higher than for 2009's start-ups.

A third plausible explanation for the difference in asset flows to the two hedge fund sectors in North America is the increased accumulated knowledge and experience of the investing institutions there. The model seems to have shifted. For most of the last decade funds of funds were the mechanism for investing institutions to allocate to hedge funds, but a knowledge transfer has taken place. The senior staff at institutions now have a familiarity with hedge fund concepts and can interpret hedge fund data readily. Whilst funds of funds companies can demonstrate advantages in due diligence process, depth of understanding of investment strategies, and risk management and portfolio construction of funds of funds compared to the dedicated resources available to most investing institutions, the latter can now comfortably find these capabilities on an out-sourced basis. External advisors for strategic decision making and tactical monitoring of hedge funds have usurped the role of the dedicated funds of funds. The same tasks are being carried out, but maybe by a combination of a very small dedicated in-house team with input from an external advisor on a fixed fee basis. A number of funds of funds companies may be retained by investing institutions to give a plurality of opinion and form of analysis, for benchmarking, but experienced investing institutions may not feel the need to pay the old fee scales. Plus the marginal increases in allocations to hedge funds by pension plans is increasingly going to direct investing in single manager funds.

In each of these regards the North American part of the industry is in the vanguard. Most of the assets of the hedge fund industry are managed by managers in the United States. For a U.S. investor to visit (and allocate to) an American hedge fund manager is a lot easier than for a Japanese investing institution – hence there will always be a place for funds of funds for Japanese investors in hedge funds. American investing institutions are the largest contributors of capital to the hedge fund industry at the moment, and will be for some time. Given all the above - relative performance, regional strengths, fee structures etcetera - plus the fact that large, branded hedge fund groups are highly likely to be American, is it any wonder that 85% of the global flows into hedge funds are going into American single manager hedge funds? 





To see more postings on multi-manager hedge funds click on "funds of hedge funds" in the LABELS gadget on the lhs of the page.
 

Consulting One - Team Working in Hedge Funds

There is no such thing as a perfect hedge fund – we are all trying. So in my role as a consultant to hedge fund portfolio managers (PMs), I am usually carrying out remedial work in some dimension. Sometimes it can be about the positioning of hedge funds commercially, but usually it is about what the portfolio managers are doing. I'm going to write a series of articles about my consulting work – this is the first.

One of the key elements I have to investigate in my consulting work is the relationship between team members. I'm going to discuss one project I did with two joint-portfolio managers of an equity long/short hedge fund. This discussion is to raise issues and to describe ways of working. The team in this case comprised two members, PM "A" and PM "B", and they ran reasonably successful long-only products. There are three topics in this snapshot – the ground rules were not well established in this example, there were some important differences in style (personal and investment style) that got in the way of successful team working, and one of the portfolio managers had an unusual trait which had a bearing on his money management style. Finally I have included some of the solutions I gave to the portfolio managers and their boss.



Ground Rules

It is not unusual for a team to move from running long-only money together to managing a hedge fund. In doing so there will, of necessity, have to be new rules of engagement. Clarity of the decision making process is very important, for internal purposes (for accountability and reward), and for external parties like potential investors. It is important that there is agreement about the specific roles to be taken, and that there is a buy-in from the off of the structure adopted. A successful agreement or understanding will have a level of detail in it that may surprise some.

One of the most basic areas not made explicit in this case was the fund's objectives and the consequences that follow from that. The two portfolio managers did not have a common, agreed understanding of what returns would make the fund they both ran commercially attractive. Therefore they did not feel the need to measure their portfolio level risk and monitor it - where they taking too much or too little risk? They just didn't know.

Another consequence of this lack of commerciality in terms of return profile is that they had no notion of what was a the worst monthly loss they could sustain without putting themselves out of active consideration by investors. The worst monthly loss is a key metric both internally and externally. Internally the metric gives an implication of where portfolio level stops should kick in. Externally it is one of a number of measures that give investors an idea of what the whole risk profile should be like – number of winning-to-losing months, drawdown, recovery period, and what is a good and bad month for the style of investment.

One of the issues which provoked some tension in the relationship between the managers was how they split between them the sectors of the equity market they worked on. It was fine, and indeed seen commonly elsewhere, that the market was split into two – one half invested in by one portfolio manager. The tension, such as it was, arose because PM B did not want to be excluded from investing in some of the sectors covered by PM A. It was never satisfactorily covered in discussion at inception in the mind of manager B, and that oversight hung over discussions in the ensuing two or three years.

It is quite usual for a PM in a team of portfolio managers to be able to initiate positions without reference to their partners. But how the team will react to change for the positions (in size or price) does need to be covered in the ground rules. Is there any right of veto, is there a different scale of decision made when the partners don't agree? Once a position is owned is it subject to hard or soft stops – do both partners have to adhere to review and exit levels? For the fund and team under discussion one of the partners was much more engaged in challenging the positions initiated by the other partner. Whilst the partners whose positions were under discussion saw this as a personal style point (one partner was just more vocal/forthright than the other), the other partner saw such challenging discussions as part of the investment process. This difference in perception and therefore activity could easily undermine a relationship under pressure because of returns.



Differences Between the Portfolio Managers

Having had some preliminary discussions for an overview, and discussed at some length how the two portfolio managers spent their time and what structure they had in place in their investment process, some clear points of difference came through. To explore these further I conducted separate structured interviews – asking the same questions to each portfolio manager gave a chance to compare attitudes, preferences, and perceptions of the two team members. To put the following list of differences into context I quote from my written report on the managers: "The managers have fantastically complementary philosophies on the market. They get on very well on a personal basis. In fact they have worked incredibly well together with some quite significant differences in tactical approaches (strategy being broadly agreed)."



Differences in Time-Frame

PM B is more comfortable with the shorter term time-frame that running a L/S hedge fund usually requires. Specifically B is much more willing to incorporate the current implications of market action into his market view by stock than PM A.



Differences in seeing Companies and Stocks

They have a similar level of respect for each other's views on companies (specifically differentiating between stocks and companies). However, when looking at equities of companies (shares) portfolio manager B can be as dispassionate about shares as he can about companies. This is in contrast to PM A – who is still prepared to argue with markets when he likes the company, even when the share price action is saying that the market does not agree with the positive (or negative) view of the company in the short term. So the feedback loop from owning the shares – the P&L – is negative for the position and getting worse (e.g. if it is a short the shares are going up) and that message from the markets, even if it is just about short term timing of the position, is being ignored.



The Fall-back Input - is it Technical or Fundamental?

(or to put it another way "short-term or long-term" or even "stock market or real world")?

Through the structured interviews of the portfolio managers it is possible to tease out where there are differences between the team members on research time. For example, in this case PM A suggested that they needed to have 300 company meetings a year, PM B thought that 100 meetings a year with company management was enough. The different perceptions of what was needed fed through to the weighting given to the fundamentals. Or, as likely, reflected the biases the managers brought into the discussion. Under pressure PM A will rely on the fundamentals to win out, whilst PM B will listen to the message of the markets and will be prepared to cut losing positions.



Conviction or Confidence?

Operators in markets, particularly traders, but to a significant degree portfolio managers as well, bring with them the baggage from their previous life experience to their decision making. So sometimes in analysing a team it is not that there are subtle style differences so much as one of the team is coming from somewhere else attitudinally (or characteristically). There can be a one-sided difference, if you like. Portfolio manager X brings with them epsilon, whilst portfolio manager Y has acquired a trait of zeta.

Through the structured interview it came through very strongly that PM A (or the Alpha member!) had a strong conviction that the most important characteristic of a successful portfolio manager was confidence. It is true that someone operating in markets has to have the belief in themselves sufficient to take on the markets, but the very strong emphasis on confidence manifested itself in the investment process in this case. This happened in two ways.

The first expression of individual confidence, if you like an assertion of confidence of an investment view, was in position sizing. Having done the analytical work PM A would take what I would consider a large position for his initial holding in a stock. Almost by definition the stock was bound to be perceived as under-valued by the market at the point of taking the initial position. If the market further under-valued that (long) position by marking the shares down (causing a loss) this would create a "better" (cheaper) buying opportunity, so PM A would have some bias to expressing confidence in his initial view of the shares by buying more. But the more important point is the size of the initial holding – he may or may not add to the position. Portfolio manager B would take an initial position of less than half the size of that taken by PM A, and look to add to it.

The second expression of confidence was the maintenance of positions of large size. PM A would always look for a further up leg in longs he owned for fundamental medium-term reasons. PM B would have a bias to trim successful positions as the positive momentum waned (to top and tail the positions). There was clear anchoring by PM A in sticking to previously successful positions, and to cut them would, in his mind, be an expression of a lessening confidence in the initial research.





Recommendations and Suggestions to Address the Issues Raised

In this particular case I wrote a 30-odd page report to the CIO of the firm as well as presented my conclusions to the portfolio managers that ran the equity long/short hedge. In the report I made a series of tiered written proposals – key recommendations, other recommendations, and finally at a more elective level, some suggestions. In response to the issues raised above here are some of the Recommendations and Suggestions forwarded:

• You should select what you consider to be "high potential" company meetings for both PMs to attend. This will enable higher conviction positions to be established at an earlier stage with a common background on the company.
  
• Be very clear and explicit (shared between you) on the reasons for having a position in a stock. Indeed there may be five potential drivers for a stock to go up (or down), but you must be clear why you own it (are short of it). The stock position should be in a portfolio for reason of how it will contribute to the portfolio characteristics (factor bets) as much as any stock specific reason (factor). This allows you to control portfolio shape in an informed way. Drift in any one position may not matter, but when aggregated across a portfolio, factors like capitalisation effects will turn you into heroes or zeroes promptly in the hedge fund format. Own positions for a reason and stick to it.
  
• You both have to have the capacity to invest in all sectors of the market.
  
• You need a few mechanistic rules that you can apply to take even more of the emotion out of decision making:
  

1. Automatic locking in profit/reducing exposure after a stated return. So a trading position that gives a 15% plus return in two weeks is completely sold, an investment position that gives 25%-plus return in a couple of months is halved automatically. The trading position can be bought again if it is equally attractive at some point. If the fundamentals still justify a larger position (they have improved since original position taken) then the investment position can be made larger.
   
2. You need a review level and hard-stop level per position. I suggest a 10% loss on book should be a review level, and 15% is a hard stop level (sell whole position, no exceptions). As a reminder the ABC Large Cap Fund has a hard stop at 8% for non-core positions and a hard stop of 10% for core positions, and the ABC Europe Fund has 5 and 10% respectively.
   

• Either can initiate a position, as at present. However there must be a vote before ADDING to a position – both PMs must agree.
  
• Just as you need to know yourself to be an investor, you need to know your partner if you have joint and several decision-making, rather than having a presiding genius. Because you demonstrate some differences in personal style, there are times when you don't understand where your partner is coming from. I suggest that you complete a Myers-Briggs Model™ (Extravert, Introvert, Intuitive, Sensor, Thinker, Feeler, Judger, Perciever) questionnaire. This is particularly relevant for times of stress – we each revert to a fall-back way of operating and this is the kernel of what you need to know of each other for managing money as a team. If you understand more about where each other is coming from (not intellectually but in personal style) then you will be able to tolerate the differences more easily.
  

All Credit to Moore Capital for This Year's Bounce Back

One of the biggest decisions that hedge fund managers in any investment style have to make is how they respond to significant losses, even if they are relative in nature. So think back to the response last year of Paul Tudor Jones in reconfiguring the capital allocations within his funds. Even though he made good money in 2009, his flagship BVI Global Fund was up 16.51% last year, he rejigged allocations - reducing some systematic strategies, cutting out some emerging market exposure altogether and increasing the classic opportunistic trading element. This was intended to be something of return to its roots for the Global Fund, as Tudor Jones himself managed a bigger proportion of the assets, and macro in total was re-emphasised as it made up 88% of Fund assets from the 3Q of last year. The call was that the markets environment would be more suitable to that big-picture type trading that served Tudor Investment Corporation so well in the 90's, as QE created a time-warp.

This re-think of capital allocations to strategy enabled Tudor to be more nimble in moving capital around in the year since, and since part of the rationale was to enable capital preservation, in that he has broadly succeeded. Tudor’s flagship BVI Fund is up about 3% year to date.

Like systematic CTAs, global macro hedge funds like to ride emergent trends. Macro funds give themselves some scope to argue with markets to a degree, so they will try to buy/sell around turning points of assets based on a macro-economic viewpoint, but the big money money is made from being on trends that persist more so than catching a bottom or top.

Given the switch-back nature of some markets there has been scope to win and lose out of equity exposure. Hard commodities have had both bull and bear phases this year, and softs have become the new game in town for those that didn't know what a bushel or crop report was a year ago. Put these market outcomes together and no wonder that we have a good range of returns within the universe of macro managers. The meaningless average return was over -5% at the end of July for global macro funds.

As ever there is a path dependency in macro returns - how did the managers respond to their changes in P&L; when did they lock in the gains; and to what degree did they argue with markets? -  the responses determined outcomes over the year. One bulge bracket firm that had this challenge this year was Louis Bacon's Moore Capital Management. 

Moore Global Investments, the flagship fund is now up 2.75 per cent for the year as of October 14. The average hedge fund was up 4.8 per cent for the year as of the end of September, according to Hedge Fund Research. Although the gain at Moore Global Investments is modest relative to the hedge fund industry average, it reflects a significant bounceback for the fund from its nadir in May, after the fund was hit by a 9.15 per cent loss in a single month  - the worst ever month for the fund.

A Long Hard  Look

After such a significant loss even as experienced a hand as Louis Bacon, with a 20-year track record with his own firm, will have had to take a hard look at where their tactics went wrong. The scale of the loss was such that risk management disciplines would have been reviewed for appropriateness, and the allocations of capital within the firm and across the markets assessed in the light of the depletion of investors capital.

Having checked through all these inputs, Louis Bacon took the toughest of the range of responses available. The natural thing to do, indeeed the classic response to preserve capital, is to cut the extent of risk taking. Not just trimming the curve risk of the portfolios - the positions which are outliers in risk terms - but hacking into the core of the portfolio to take Value-at-Risk down by, say, a half. The traditional concept of trading is to take down risk whilst re-assessing the fit of the inherent view of the porfolio with the market environment. This allows more dispassionate views to be taken of the state of play, and the traders can then put risk back on with a refreshed palate for risk assumption.

This is not what Moore Capital did. Instead the positions were maintained, risk levels were unaltered and in effect, a confidence was expressed in the original conception of how they were going to make money for the regime prevailing in markets. After the worst single monthly loss experienced in 20 years it was a very tough call to make, because a continuation of the markets moving against the positions taken would be debilitating psychologically for the traders, and investors would be calling in by 'phone for comfort to a much greater degree than in the previous month.

Of course it helps that Moore Capital has a 20-year record of delivering big returns to clients. On average, the fund has returned more than 19 per cent annually. But even such a stellar long-term return profile can be challenged by a YTD figure running at minus 7 per cent when other funds have positive returns.  It is to Louis Bacon's credit that he stayed firm enough of his convictions to hold on to positions and bounce back to the extent he has. Tough call, successful call.


Addition of 28th January 2011: Peer Group Fund Returns for 2010

China Investment Corporation…the next winner is…York Capital

China Investment Corporation (CIC), the Chinese sovereign wealth fund, currently manages $332bn andlast year invested $58bn. It  has been on accelerated path in learning about investing in hedge funds for the last three years. A source close to the CIC suggests that they are about to make their next commitment to a specific hedge fund.

The story of China Investment Corporation’s interest in alternatives can be traced back to the purchase of a USD 3 billion stake in alternative investment company Blackstone during its IPO in mid-2007. A predecessor entity to the then unformed CIC negotiated a non-voting stake with a four year lock-up. On day one of public trading this looked like a master stroke as Blackrock stock soared to $45 from the $31 (top-of-the-range) issue price. However that level has never been seen since and post-Credit Crunch the BX stock traded down to $4 and is now at just over $9.

The second leg of the advisory platform for CIC’s hedge fund program was the purchase of an interest in Morgan Stanley late in 2007. The Chinese SWF bought $5.6 billion of Morgan Stanley convertible securities with a conversion price of $48 to $57 in 2007. This was a 10% stake at the time. The CIC’s stake in MS was then diluted when, in October 2008, a major stake in the investment bank was bought by Mitsubishi UFJ. In the middle of last year CIC spent $1.2bn buying 44.7m shares of common stock in the bulge bracket investment firm to take its interest back to 9.86%.

So the CIC had two natural partners in looking to expand its investments beyond fixed interest and other additional assets. The intention from the off was to invest as much as $6bn within a year to hedge funds. The first step for CIC in investing in hedge funds was taken in July 2009 when allocations were made to the fund of hedge fund units of Blackrock and Morgan Stanley. Blackrock received an allocation of $500m to put into a portfolio of hedge funds, and Morgan Stanley some $200m.


Co-Opted Specialist Knowledge

At this point, at the start of the second half of 2009, the China Investment Corporation was utilising a knowledgeable special adviser to the chief investment officer of CIC. Felix Chee, the special advisor, had been responsible for an allocation of $1bn to hedge funds when he was working at the endowment of the University of Toronto. But this was several leagues different. The intention then and now is to build a core exposure to hedge funds for CIC with two elements – holdings in large, experienced single manager hedge funds and exposure to hedge funds via a small number of funds of hedge funds.

So having described the first funds of hedge funds exposures, what about the single manager exposures? Special advisor Chee has stated that CIC were to going to give capital to the best managers across a spectrum of investment strategies. The representatives of the Chinese SWF certainly started at the top: they invited Jim Simons of Renaissance Technologies to go to China to see if he was prepared to sell a chunk of his firm. He was not, and given his subsequent announcement that Simons will retire this year, it was only to be expected that the first single manager allocations went elsewhere. The first allocations came at the end of the 3Q last year and went to a natural extension of the fixed income investments already in place within the CIC, probably allowing some comfort that the strategies being used were ones that could be readily understood.

Unsurprisingly, the first two allocations of capital went to large, successful hedge fund management companies. The largest mandate to date has gone to a very large firm - Oaktree Capital Management is a Los Angeles based shop that manages US$76 billion in fixed-income strategies including distressed debt and high yield. The CIC has given Oaktree a $1bn mandate.

Oaktree espouses a clear investment philosophy based on six elements: the primacy of risk control (priority of preventing losses); an emphasis on consistent returns in the medium term to deliver a high batting average in the long term; Oaktree only invests in inefficient markets which may give a return to the manager’s skill and effort; specialisation of each investment portfolio is the surest route to the return targets; the investment process is entirely bottom up; the firm keep portfolios fully invested whenever attractively priced assets can be bought and do not time markets.

The second single manager hedge fund mandate granted by the China Investment Corporation was awarded at the end of last September to London’s Capula Investment Management. Reflecting the dynamism of the industry, Capula was set up only in 2005, and sold a chunk of the equity in the management company to the Petershill Fund (run by Goldman Sachs) in 2008. At the time of the capital allocation from CIC Capula ran between $3 ½ and 4 bn mostly in fixed income arbitrage. Capula presently advises on $4.6bn of assets. The returns of the main fund, Capula Global Relative Value Fund are very impressive – average annual returns of 13.3% with 88% of months positive. The volatility of the return series is only just under 3.5% and there has been no correlation to traded equity markets.


In-House Specialist Knowledge

After the first single manager hedge fund investments in the third quarter of 2009, the next significant development in the hedge fund activities of CIC came at the end of the year when there was an appointment to run the hedge fund investments on a permanent basis. Bill Lu, was born and educated in China, but received his post graduate education in the United States, and went on to manage the relationships in China of Paul Tudor Jones’ Tudor Investments. His background as a portfolio manager at Tudor, and experience at both end of the Sino-American axis make his credentials clear.

Lu is responsible for CIC’s investments in hedge funds and investments in securities which reflect hedge fund exposures in public markets. It is thought that after a couple of quarters bedding in, the first of Bill Lu’s major decisions is about to become publicly visible as the next single manager hedge fund mandate from CIC is made known.

The market scuttlebutt suggests that CIC will allocate capital to New York’s York Capital, an organisation running nearly $14bn in event driven strategies. James Dinan’s firm is known for using a catalyst-driven, fundamental value approach, which it applies to US, European and Asian developed market securities, including taking credit risk. Whilst the size of the allocation has not been confirmed, an allocation of $500bn would be proportionate to the other hedge fund investments of China Investment Corporation.



Two Additions from AR Magazine: 1) York Capital Ranked Number One Among Top 50 by Investors 
2)York explains May losses

RANKED Number 1 in 2010
AR Magazine carries out an annual poll in which investors score hedge funds by various criteria. In 2010 York Capital Management came top, moving up from 10th place last year. Here is what the citation says:

"York Capital, with $11.35 billion, edged $50.9 billion Bridgewater Associates out of the lead, scoring 52.63 points out of a possible 60 and jumping nine notches from its tenth-place ranking in last year's survey. "I think the world of York's founder [Jamie Dinan] in terms of his ability and his integrity, and needless to say, I am impressed with his performance," says Richard Galanti, chief financial officer of Costco, who has been an investor in York since its inception. Adds another institutional investor in the firm: "They were very bearish at the end of '08, but then they were very adaptable when they realized that things had changed in '09... when they realized equities weren't going to be as bad as they thought, they were able to make that adjustment and to make something off of it, which is very admirable."


Investors say their main concern now with hedge fund generally is performance, as evidenced by alpha generation jumping into second place of the six factors that investors took into consideration when scoring the top 50 firms in the AR Billion Dollar Club for the report card. York, which did not restrict redemptions during 2008—which investors appear to remember—also ranked high in transparency and liquidity, two of the other six factors. Investors rated firms on alignment of interests, alpha generation, independent oversight, infrastructure, transparency and liquidity terms, scoring firms in each of those categories on a scale from 1 to 10, for the possible total of 60.

MAY LOSSES
York Capital Management’s investments in General Motors, Alcon and Xerox contributed to the York Select Fund’s negative May performance, according to a recent investor letter. The $1.2 billion fund’s private equity position in Chrysler, meanwhile, produced positive returns. York Select, a concentrated event-driven strategy, dropped 5.70% in May, but remains up 1.23% for the year.


"In May, the equity and credit markets dramatically shifted their focus from corporate earnings growth to the unfolding European fiscal crisis and the potential impact on the global recovery,” read the letter. “These macro economic concerns triggered significant market selling and investor de-risking activities overshadowing positive company-specific developments.”

York manages $13.8 billion firmwide. Chief investment officer Daniel Schwartz and partner Michael Weinberger co-manage York Select in New York.

York Select is a more concentrated version of the firm’s flagship $4.3 billion multistrategy and diversified event-driven fund, York Capital Management, which fell 4.9% in May leaving it up 3 basis points for the year. In 2009, York Select gained 82.59%, following a loss of 44.91% in 2008. Most of the Select fund’s investors are wealthy individuals and family offices. The fund is not open to institutions given its concentrated positions and high volatility.

In May, the majority of the York Select fund was heavily invested in financials (37.5% of the portfolio), materials (28%), and healthcare (14.6%).

York Select’s position in General Motors contributed to a month in the red. “Our bonds in General Motors produced losses on concerns about the sustainability of the economic recovery following the events in Europe,” the letter read.

Another losing position was the fund’s investment in eye-care company Alcon. In January, Nestlé agreed to sell its remaining interest of 156,076,263 shares of Alcon to healthcare company Novartis. But the remaining shares of Alcon have declined recently due to Novartis’ shares trading poorly and the Swiss Franc’s fall against the U.S. dollar, the letter said. York believes that Novartis will need to increase its offer in order to encourage the minority Alcon shareholders to tender their shares, given that Novartis’ offer to Nestlé is higher than the stock consideration offered to Alcon shareholders.

York’s stake in European polyethylene-maker Lyondell Chemical Company also dipped due to the general market weakness in European equities. Prior gains in Xerox likewise evaporated in the May maelstrom.
Positive positions came from the Select fund’s private equity investment in Chrysler. “After the U.S. government stake was bought out, [it] resulted in increased investor interest."

York remains concerned about the European sovereign debt situation and its effect on the global economy. “We are focused on identifying the compelling opportunities that market dislocations often offer our strategies."

All of York's funds were negative in May; The $3.4 billion York Credit Opportunities Fund dropped 4.80%; the $260 million York Global Value Partners fund fell 6.20%; the $2.3 billion York European Opportunities Fund fell 2%; the $420 million York European Focus Fund was down 3.50%; the $210 million York Asian Opportunities Fund dropped 5.70% and the York Total Return fund, the firm’s fund of funds that invests across all of its funds, was down 4.60%.

Most of York’s funds remain positive for the year. The Credit fund was up 4.48%, Global Value was up 65 basis points, European was up 5.18%, European Focus was up 3.67%, and Total Return was up 2.39%. The only fund in the red for the year is the Asian fund, with a loss of 1.07%.