Hedge Funds Positioning to Benefit from Euro Banks Spitting out Assets

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

Waiting to turn trash into treasure

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

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

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

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

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

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

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

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

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

Comment from Simon Kerr

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

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

Graphic 1 - European Leveraged Loan & High-Yield Bond 

New-Issue Volume

 

source:S&P LCD

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

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

Graphic2 - Default Rates for European Leveraged Loans

source: S&P LCD

That recent change has been a small negative is picked up by data for companies that are seeking to renegotiate their borrowings with their lenders. Graphic 3 shows a low level of restructurings and renegotiations, but against a background of some economic growth in Europe. 

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

source: S&P LCD

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

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

 source:Fitch

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

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

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

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

Addendum
6th December 2011:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Macro Managers Coming Through at Last

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

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

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

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

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

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

Additional:

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

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.

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

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

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

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

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

Top Level: Administrative

The top level of management in most organizations is the ultimate authority. Administrative level managers can give authority to other managers in the organization, delegating to, or directly promoting, other managers. The top level of management consists of board of directors, top officers in the company, and directors in the company. Some of the functions of those at the top level of management include:

• Setting out the goals, benchmarks and big picture for the organization.
• Prepares policies for the organization, and sets forth consequences for their violation.
• Promotes and appoints others to fulfill various roles in the company.
• Coordinates activities for the whole organization, making sure that different departments are working in tandem to reach the organization’s goals.
• Usually in charge of making public statements on behalf of the organization, as well as making appearances so that the community is aware of what the company is doing.
• Directs broad changes in company direction.
• Shows accountability to shareholders and other stakeholders in the company.
• Ultimately responsible for the success or failure of the organization and its enterprises.

Those in the top level of management are often well-compensated for their efforts, due to the fact that, in theory, they have great responsibilities. It can be difficult to make it to the top level of management, since those positions are often scarce, and the competition for them is fierce. However, with hard work, good ideas, competence, and an ability to network, it is possible to reach the top level of management.

 

Middle Level: Executory

Depending on the size of the company or organization, middle management can be bigger or smaller. In some of the smaller organizations, the functions of the middle level and lower level of management are combined. However, in larger organizations, middle level management often requires additional divisions into senior and junior levels.

At this level, managers are in charge of branches or departments. Their job is to come up with sub-plans that contribute to the success of the company when meeting its goals. Middle managers are often involved in making sure that the steps to achieving the larger aims of the company are carried out. Some of the other duties that those at the executory level of management might be required to carry out include:

• Training lower management, and training employees.
• Coming up with incentives for employees and lower level managers.
• Coordinating projects within the departments and branches.
• Evaluating employee and lower manager performance.
• At more senior positions in middle management, sometimes it is necessary to interact with the public, or issue statements.
• Report to members of the top level of management. This might include in-person reports, or written reports and memos.
• Enforce policies handed down from top management, and sometimes discipline lower level managers, or employees.

The owners of hedge fund businesses carry out all the tasks of Top Level Management as given above. However, it is quite usual for the largest shareholders of a hedge fund business to be carrying out the main activity of the company, that of carrying out research and making investment decisions. That is, the principals of a hedge fund management company carry out the Executory Level activity as well as fulfill the roles of those in the Administrative Level. Even where there is a separate CEO in a hedge fund, the CIO whose name is over the door is highly likely to be involved in decision-making related to how the business is run as well as how the investments are run.

Switching Modes

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

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

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

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

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

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

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

Hedge Fund Credit & Risk

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

 

 

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.

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

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

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

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

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


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

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?



   

What are Hedge Fund Managers made of?

What are HEDGE FUND MANAGERS made of?

     40% Work Rate
     15% Ambition
     15% Talent
     12% Hubris
     10% Entrepreneurialism
       8% Reactiveness



What are FUNDS OF HEDGE FUND MANAGERS made of?

     35% Process
     20% Marketing
     20% Database and library
     15% Understanding
       5% Structure
       3% Risk measurement
       2% Promises


Add your own version and responses using the comments function below.

The Hedge Fund Job Interview

I know the readership of this website includes partners in hedge fund management companies, but it has also attracted some people who are both relatively new to hedge funds and some looking to get into the hedge fund industry. So this article should work for both constituencies.

I came across some interview questions used by Lex Van Dam, who may be widely known for the tv programme "Million Dollar Trader", but who now runs his own small hedge fund company called Hampstead Capital. He was formerly a trader at Goldman Sachs and GLG Partners. Lex has been described as tough or brusque. When I have dealt with him he has been direct and commercial but polite. The directness of the questions are what an interviewee at a hedge fund may face because the people who run them often are strict over use of their time, as is Lex himself. The questions are biased towards hiring a trader for a hedge fund.  

a) To assess energy, drive, initiative
1.Why are you here?
2. How did you prepare for this interview?
3. What was on the front page of the FT today?
 
b) To assess personal growth and performance over time
4. Tell me about your job?
5. What could make you fail here?
 
c) To assess past accomplishments
6. What was the biggest success you had over the last 12 months?
7. What is the most pressure you have ever been under?
 
d) To assess problem solving skills
8 Is your intelligence above average? What percentage of people have above average intelligence?
9. Does the quality of your decision making improve under pressure?
10. How many buses are there in London?
11. What is 32*32? How confident are you about that answer?
12. How many degrees between the hands on the clock at 3.15?

e) To assess overall talent, technical competency and potential
13. What makes you a good trader?
14. What is the most money you have ever lost?
 
f) To assess management and organizational ability
15. If I gave you £100,000 what would you do with it?
16. What is the most difficult decision you ever had to make?

g) To assess team leadership and the ability to motivate others
17. Do you react better to compliments or criticism?
18. How do you deal with authority when you perceive them to be wrong?

h) To assess character - values, commitment, goals
19. What would you wear to the office?
20. How are you with money? Are you a big spender? Are you in debt?
21. Would you screw someone over to get ahead?

i) To assess personality and cultural fit
22. How do you measure success in your life?
23. Why should we hire you and not someone else?
24. If things go wrong do you tend to blame other people or take responsibility yourself?
25. How do you think the interview went? If you were me would you hire you?

Please feel free to add some questions of your own using the comments button below. The questions given here were disseminated on E-Financial News.