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

Hedge Fund Returns Are Path Dependent - As 2011 Illustrates

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

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

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

Dear Investor,

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

We now had a period of seven consecutive negative months with the fund being down 22% for the year. The main reasons for the negative performance are:

1) We use mostly fundamental factors when selecting our stocks from a global universe of over 6000 stocks. Fundamentals haven’t been driving markets in the past seven months. Macro-economic factors were driving markets and correlations have been at an all time high.

2) We use a trend following methodology that adjust factor weightings each period for what worked well in a certain past period (dynamic) before. This didn’t work well in the past seven months due to volatility spikes and trend reversals.

3) We use a hedging methodology whereby we are either 0% or 50% net exposed mostly based on aggregate earnings revisions number and some price performance related techniques. This hasn’t added value in the past seven months.

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

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

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

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

Kind regards,
The QAM Team

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

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

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



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

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.

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?



   

Hedge Fund Returns for 2011

A poll was conducted on this website recently asking this question:

"In 2010 the year was rescued in performance terms by the huge injection of QE2. So the outcome was a reasonable year. Is there a Second Act to rescue this year? What do you think hedge fund returns will be for the whole of 2011?"

Most respondents were still looking for positive returns from hedge funds in 2011 - only one-in-six who took part in the poll were looking for flat or negative returns for the year. 

Nearly three quarters of the votes were cast for either +2% or +5% returns, and only 8% of participants were looking for 7% or better returns for 2011 from hedge funds.  If the outcome was in the range suggested investors in hedge funds would probably be satisfied, with a couple of conditions. To give credibility to 5% returns from hedge funds, equity markets would have to be flat (or down on the year), and inflation would have to moderate between now and year end. How plausible are those conditions?

The Grind Continues for Many Hedge Fund Managers

Whilst there is a constituency within the hedge fund industry which have obtained the Hollywood version of the trappings of success in the financial sector - the cars, the ranches, and the (part-owned) private jet - there is also a very long tail of funds which have not been in performance fee nirvana for some years.

Barton Biggs gave a very good  insight into the under-reported downside of running a hedge fund business in his book Hedgehogging. He told the story of an acquaintance who had put in a good year for performance, so collected a handsome performance fee for his added value. But as the manager's style of investment wasn't suited for subsequent market conditions, the following years were rough. The fund manager had to attend all his usual company meetings, read copious amounts of material, track stock market shifts, talk to his investors and put his ego on the line by selecting stocks. He had to put in long hours running his own small business as well as being a full-time professional investor - dealing with accountants, lawyers, budgets, planning, and hitting deadlines for regulatory filings and statutory reporting. All this while not making big money - in fact the big money of the fat year was ploughed back into the business for the subsequent lean years.

There are many challenges running a small business. In the hedge fund segment, in which the spoils go to the victors of the war of performance, not the least of the challenges is to retain (smart, professional, and mobile)  staff  who have no prospect of a bonus for some time. When the average hedge fund fell 19% in 2008 that presented the challenge of returning 23.4% to get back to the NAV of the start of that year. For most hedge funds that is two good years of returns. So staff could only get paid a meaningful bonus at the end of year three - that is, get paid at the start of year four! Hence staff defections from the hedge fund losers of 2008 was a theme of 2009 and into 2010.

The business school tenet for running a business like managing hedge funds is to build your expenses to be in line with your regular revenue, i.e. on the management fees. The performance fee is often characterised as the gravy in the meal, but if the base diet is thin gruel then gravy is not what a diner wants as a supplement.

And small gleanings are what have been available to many managers. It was reported here in a recent article that around half of Europe's largest hedge fund manager groups had not gathered more assets in the middle six months of last year - so the base revenues of the businesses were not expanding. However, by the end of September last year only 5% of the assets of the largest managers in Europe were not qualified to pay performance fees because of the high water mark feature. So by extension, with a further five months of positive hedge fund returns, most of the world's large hedge fund groups are now accruing performance fees. The well known names who run these businesses will be able to buy a larger house in the Hamptons if they choose. The more socially sensitive of them will be able to fund another urban academy in a deprived neighbourhood.

However, there are many dedicated hedge fund managers who will not be in a position to fund such largesse, or even take a house in Vail for the season. Eurekhedge reports that fully 42% of hedge funds are still below their end 2008 NAV at the end of February.

Stocks over Bonds for 2011

Just over a year ago I featured as my Chart of the Day the mutual fund flows for U.S. bond funds and equity funds. At that point I summarised the attitudes of retail investors as "keep me out of Wall Street, I want the return of my cash, and I can only trust Uncle Sam with my money at the moment, thank you." The updated chart (Fig 1 below) shows that 2010 had more of the same, that is, huge inflows to bond funds and net outflows from equity mutual funds.

                                  Fig 1. Monthly Net New Cash Flows to U.S. Mutual Funds by Asset Class

As at the previous point of review (December 2009) the logical case now is very strong for a preference for equities over bonds based on valuation. Looking at the P/E ratio of American shares in isolation the case is not particularly convincing as Figure 2 shows. The S&P 500 trades at 13.6x forward four quarter earnings – this level is neither cheap nor dear in an absolute sense. But the context is very constructive: inflation is low at the consumer level; interest rates, whether real or absolute, are low and will remain so for some time; and earnings growth may be a positive surprise in 2011 as expectations are low.

                                    Fig 2. P/E Ratio of U.S. Stocks based on 12m Forward Estimates

The earnings surprise at the market level could come because expectations are low and the American corporate sector is well set in several regards. First the operating leverage is good after staying lean and mean, and hiring has only recently begun. Secondly the level of the Dollar makes the U.S. internationally competitive (and exports accounted for 1.1 percentage points of the 3.2% increase in real GDP in 2010). Thirdly, and this will be very important this year, unlike the consumer and the government, the corporate sector has a good balance sheet in aggregate. I place an emphasis on the balance sheet because there is good scope for capital spending as well as hiring, and, most importantly for investor psychology, conditions are good for a lot more mergers and acquisition activity this year.

However, even if the earnings growth for 2011 only turns out to be in line with the current consensus, a strong case can be made for a preference for stocks over bonds on the basis of relative valuation. This is illustrated in Figure 3.

                                                      Fig 3. Yield Comparison for Stocks v Bonds 
                                               (Earnings Yield on S&P500 v Real Yield on 10 Year Treasuries)

The widening gap between the real yield on the highest quality bonds and the earnings yield on American blue-chip stocks (the inversion of the P/E ratio) reflects the neglect by investors of stocks relative to bonds. The risk premium for stocks now is higher than it has been for more than 80% of the last decade, and at nearly 3.9% is 1.6% higher than the average over the last 10 years. The logical case is very strong - on the basis of valuation investors should switch out of bonds and into stocks.

On the basis of investor psychology investors won't switch. The aversion of the man in the street to anything to do with Wall Street will continue. ETFs have continued to grow whilst equity mutual funds remain out of favour suggesting that Americans don't want to give money to stock-selecting money managers. Individual investors are dis-engaged with markets to an extent rarely seen before. In short, America has fallen out of love with stocks.

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.
 

Cevian Capital II Ranks High on 2010 Returns

Europe's largest activist fund, the €3.5bn Cevian Capital II, has had a(nother) banner year – up over 34% in 2010, after a return of 35.7 percent in 2009. This puts the Fund very close to the top of the ranking for hedge funds of any style, ahead of almost any other equity hedge fund, and given that most of the other top-ranking funds are a fraction of the size of Cevian II it again confirms the quality of the management. Without doubt founders Christer Gardell and Lars Förberg are amongst the most impressive managers of capital I have met. So I thought I would share some thoughts from Lars Förberg that were elucidated during a session in October last year under the auspices of The Greenwich Roundtable.



First here's a bit of background on the firm and what it does, and the talk should illustrate the principles outlined.

Cevian Capital was founded in 2002 by with the launch of Cevian Capital I, a fund dedicated to activist investments in the Nordic region, and in which Carl Icahn was a significant investor. In 2006 Cevian raised its second fund, Cevian Capital II which had a remit to invest in companies in Northern Europe. To put the wider remit into practice Lars Förberg moved to Zurich, whilst Gardell remained in Stockholm.

Cevian Capital's version of active ownership creates value by (i) acquiring substantial ownership positions in undervalued public companies and (ii) realizing their long term value potential through change. Cevian generally invests in companies overlooked or misunderstood by the market and in many instances out of favor with investors. Cevian targets investments where there is a meaningful opportunity to enhance the long term value by improving corporate governance, operational performance, corporate strategy and structure.

Cevian manages a concentrated portfolio of 8-12 companies at a time, with significant ownership positions in a limited number of publicly listed companies and is typically one of the largest shareholders in its portfolio companies. Consequently, Cevian maintains a strong commitment to oversight of each of its investments.

The investment process of Cevian is in two stages. Prior to investing, Cevian commits considerable time and resources to evaluating and analyzing prospective investments. All investment decisions rely on a well established and rigorous proprietary due diligence process, including comprehensive financial, commercial, operational and legal analysis. In the second stage Cevian looks to work constructively together with the management and board of directors of its portfolio companies, aiming to increase the company's long term competitiveness and create value for all shareholders. Cevian frequently participates on boards and nomination committees of its portfolio companies.

Lars Förberg

Three Questions for Lars Förberg

Question One: Is Europe Falling Apart?

To the first question, is Europe falling apart, the answer is clearly no. Sure, there are immense macroeconomic issues in many parts of Europe, notably in the south, what many people call Club Med or the pigs. That is Portugal, Italy, Greece, and Spain. These countries are over-levered. They have big deficits. They're not easy to run politically.

Having said that, the most difficult countries -- Greece, Portugal and Ireland -- only account for 6 percent of GDP of Europe. If you add Spain to that, you go 10 percentage points higher. This is still a small part of Europe, and it's not big enough to bring the more healthy northern and central Europe down. And what is interesting is that fiscal and labour market reform of almost unprecedented scope in the problem countries is going roughly according to plan.

Question Two: Can Europe Compete?

On the second question, can Europe compete -- a common view is that Europe is ridden by Euro-sclerosis, an inability to grow and compete based on regional labour markets, militant unions, punitive taxes, and generous social security. In some countries this is true. But when I look at our home market, Scandinavia, and German speaking Europe, i.e., Norway, Sweden, Finland, Denmark, Germany, Switzerland, Austria, you see a different picture. Look, for instance, at the statistics over which countries are the most competitive in the world, and I'm now using the World Economic Forum's global competitiveness statistics. You'll find Switzerland number one, Sweden number two, Germany number five, Finland number seven. As in parenthesis, U.S. is in the middle of these being ranked at number four.

Also interestingly, these numbers go hand in hand, leaving the U.S. aside, with where you will find the most fiscal sound countries. These northern European countries, I imagine, have limited budget deficits, if at all. And a country like Sweden, as an example, has been running budget surpluses for almost every year since the mid-nineties. Another characteristic of these countries is that they all have a strong industrial base geared towards exporting and being the home of a number of successful global companies with strong market positions, excellent product and services, and wide ranging distribution capabilities. These companies benefit from the global economic growth driven by emerging markets, and they have shown an ability to adapt to the changing market environment. I will come back to these companies a bit later.

So, the somewhat short answer to the second question, is Europe competitive, is two-fold -- a strong competitive northern Europe and a somewhat weaker south. One thing I'd like to add here, though, is that when you look at most of the countries that are now successful and most competitive, they went through major reform to get there. Germany did that in the early 2000s after the reunification of the problems that that led to in Germany. Scandinavia did that in the mid-nineties following the financial crisis in a number of Scandinavian countries. These reforms, many times orchestrated by the social democratic governments, led to labour productivity growth way above peers, many times at the level of 5 percent year after year.

Many of these same measures are now being undertaken in the currently weak countries - the fiscally problematic countries in southern Europe. This is being forced by the financial crisis. Examples of these efforts are major deregulations of labour markets, fiscal savings of up to 10 percent of budgets, restructurings of the pension systems, and VAT hikes of 5 percentage points. It's difficult to tell, but in a rosy scenario, these changes can lead to pretty benign environments in southern Europe and have attractive effects in the medium term. But that's something I wouldn't bank on, though, because the political situation is difficult and will continue to be difficult and uncertain over a couple of years, in my estimation. But what should be noted is that the financial crisis is used as a tool to move through structure reforms that are well needed in many parts of Europe, especially in the labour market.
 

Question Three: Attractive Opportunities?

So, on to the third question -- where do we see the most attractive investment opportunities in Europe right now? Well, we are an activist fund operating primarily in northern Europe, buying into equities, so I will back up the earlier comments by what we're doing. What we think are the most attractive investment opportunities right now are the companies I mentioned before -- the equities of the globally oriented companies out of Scandinavia and Germany.

You can still buy these companies as they are for double digit cash on cash yields, and get companies with excellent products, strong market positions, and full exposure to the emerging markets. Prices vary, though, and I don't believe there's going to be an over the line bull market, but I believe that with selective stock picking there are immense opportunities. I'll give you a couple of examples that we have put on into our concentrated portfolio of ten companies.

One example is the German crane manufacturer, Demag Cranes AG, in which we bought more than 10 percent of the share capital over the spring. Demag is the global leader in its field and has the largest installed base of industrial cranes globally. This is important because that means a great opportunity for stable earnings servicing this installed base. The company was undervalued because of its late cyclical nature, but also because there were some question marks over its strategic -- future strategic direction. Therefore, we could buy the company only paying for the service business which is 35 percent of the business, and getting 65 percent of the business - the equipment business - for free.

Another way to see it is that we bought the company paying an enterprise value equivalent to 50 percent of sales. This is for a company that we think will make 10 percent EBIT margin on a sustainable basis.

Another example is Panalpina World Transport, one of the global leaders in freight forwarding, which is based in Switzerland. This company we could buy early this year for a price reflecting the difficult conditions of the logistics industry during the slump. If the company comes back to its normalized earnings level, it will mean a doubling on our initial investment. If we manage to close the company's underperformance to its peers, which is our job as an activist, it will be a 3x investment.

On top of having these sound companies with attractive valuations, I think Europe has offered and continues to offer great opportunities for restructurings. Many companies have been unexposed to active ownership due to a legacy of passive shareholdings, unengaged board members, and value destroying cross share holdings. I believe there is a tremendous value potential in the existing unwieldy corporate structures, operational inefficiencies, underutilized balance sheets, and entrenched boards and management teams that are not pressured to perform. And in most parts of Europe, the corporate governance framework is there to unlock these inefficiencies. The restructuring opportunities, the low valuations, are coupled with one of the greatest opportunities that is not in the share prices today, and that will soon come to fruition, which is restructuring in terms of M&A.

If you are on the right side of M&A, there is tremendous opportunity to make great returns. And I point to a few factors that is driving this. One, corporate restructuring has been absent over the last two years. We all know why. So, there is a pent up demand and appetite. Two, the debt financing is there, both for industrial companies and private equity firms, and corporate cash is at all time highs. Three, the ability to make these M&A decisions is back in the boardroom: markets have stabilized; there's better visibility, and you don't have to focus on your short term crisis anymore. If you as a CEO had brought a big acquisition to your board a year ago, you would have gotten no traction. Now it's a totally different story.

When this M&A boom will happen is difficult to know. It's going to happen. Will it be three years ... three months from now, six months from now, or within a year, I can't say, but it's going to happen.

So, I think these three factors in terms of low valuations, restructurings, and the M&A opportunity, have created some very attractive opportunities in Europe from our vantage point in what we think, at least in northern Europe, is going to be a relatively benign macroeconomic environment.



Q&A


Q1. To marry what you're seeing in terms of micro opportunities with the macro, I was wondering, have you come across situations in your portfolio where macroeconomic or regulatory risk that one of these companies, say the crane company, in the tough economic environment, dwarfed what you saw as the micro economic opportunity. So what you thought was a great value turned out not to be because of macroeconomic risks?

A. (Lars Förberg): You're saying with a macroeconomic environment is it too tough for these companies? Well, when we buy companies that are cyclical, like at Demag, the crane manufacturer, yes, it was a cyclical company. But we would not buy it if we had to rely on a macroeconomic upturn. I think this is the attractive thing. We could buy it paying only for the servicing business. That servicing business is really something, and this was in a slump. So, this servicing business is typically something when you're a core manufacturer or, which Demag sells to, you need these things to function.

It's almost like an elevator business. So, we could buy into this company only paying for this business which is very stable. An elevator business has to go there. You know, it has to run. But we've got the equipment business - 65 percent of the business for free - so we're covered on the downside because we're not paying for the macroeconomic upside, but we're getting that if it comes. I think it's going to come, but it doesn't need to come for it to be an okay investment. If the macroeconomic environment swings up, which it's doing, it's going to be an excellent investment. So, that's the way we think about it.


Q2. Have you thought about playing on the fixed income side at all - corporate fixed income?

A. You know, there isn't much corporate depth in that. I think if you have a credit fund in Europe you have a lot to do two years, and then you have nothing to do for five years. It was a great opportunity two years ago. Then there were many of the convertibles trading maybe at 35 percent of par - very attractive opportunities, companies that you know would survive maybe with equity infusion but they were not going to go dead. But I think that opportunity is gone from my perspective. I think the opportunity in (European) corporate bonds is not there now.

I think when you look at the macro there are a number of issues in terms of how Europe is going to grow, and I think a common view is that Europe is not going to grow that much. When I painted a pretty positive picture of Europe, I was not talking about the GDP growth numbers. I pointed to the Export-oriented companies that have global market positions. If we do something in the domestic oriented sector, which we do limited of but if we do, we only do situations where we can increase the profits of the company by, say, 50 or 100 percent by cost-cutting, typically, or by restructuring in terms of selling off non-core assets because I don't think you should expect in Europe domestic demand to drive growth.

The joker could be Germany, actually, which has been a laggard for many years in terms of domestic demand - consumption demand being very low for many years. But you have a situation in Germany where the unemployment is at its lowest for probably 20 years, and so there could be consumption growth coming in Germany, which would surprise the markets, I think. But it's not going to make a huge lot of difference if you go from 1 percent growth to 3 percent growth. You're not going to make much money from that, so in the domestic economy you have to find special situations.


Q3. There's been a concentration on bank debt in Europe, as opposed to corporate fixed income. So there's not enough in play in the distressed and high yield and corporate bond markets. Does that make it difficult for an activist to get purchase to force through labour reforms in target companies? Europe needs labour reform to make the economies more flexible. That's what the activists need isn't it, flexibility?

A. I think restructuring in Europe is much easier than generally perceived from a legal/cultural perspective. There are countries in Europe where the companies have already restructured. In Germany it used to be impossible to restructure a company ten years ago. It's completely different now. After the agenda 2010 laws that were passed by the social democratic government in the early 2000s, you can restructure in Germany.

And you have to remember that these companies, and many of the countries of Europe, are very dependent on exports. And the governments and the unions know that the companies have to be successful, otherwise it's going to be a problem in terms of employment. They're subject to global competition from China, from the U.S., from everywhere. And therefore many times you have a consensus among the stakeholders (the boards, shareholders, unions, and governments) in cutting costs.

In the countries where I operate (Germany, Sweden, Finland, Denmark, Norway) you have, by law, unions on the boards of companies. And you would think that's going to be problematic in terms of restructuring a company. It's actually the other way around because the unions understand that if we don't do anything to improve the company we're going to be out of business. They hate underperformance more than shareholders do or as much, I should say.

Now, southern Europe is a different thing ... if you look at Spain and Italy and so on. But I think we're seeing labour reform there, and in Portugal as well. And I think that that's the good thing, that the crisis is used to reform labour laws. I think in terms of Greece, we should recognize that it's not that relevant. We talk a lot about Greece, but it's like in a discussion about the U.S. talking 50 percent of the time about North Dakota. It's not that significant.


Q4. So can Europe split – into a fast-track Euro with a slower Euro for certain countries? There are countries that were thinking of leaving the EU, though there are a lot of logistical issues with that?

A. I think politically it's a no-starter. When Europe looked this spring at the budget problems in Greece it took some time for Germany to come around and help bail Greece out. That was a purely political calculation, and I think rightly so. What they did was to wait to endorse a bailout package until Greece had committed to more far reaching reforms. So, it was more a political process than anything else. I don't think a two-speed Euro is going to happen.

I should say, though, I personally voted as a Swedish citizen against the adoption of the Euro a few years ago. I'm a Euro skeptic - there are a lot of problems with it that we're seeing in a country like Greece where they should have a lower currency. But look at Estonia, for example, a country which was not with the Euro, but they were locked in terms of parity with the euro, and they made an internal devaluation by lowering the salaries of government employees by 25 percent an incredible process to adjust their economy to staying with the locked in currency rate with the Euro. They managed through that, and hopefully they will manage through that in Greece as well.


Appendix- Key terms of Cevian Capital II 

A full profile of Cevian Capital can be found at The Hedge Fund Journal