Lack of Transparency Traduced

One of the most commonly repeated fallacies about the hedge fund business is that it lacks transparency. I think the opposite: in many ways hedge funds provide much better information flows than long-only managers. Hedge funds cannot be easily sold, but are more often bought, and may only be bought by experienced and provenly-monied investors. So if someone is a qualified investor they can be in receipt of a plethora of information on a potential investment in a hedge fund.

The information flow is different at different stages, and is provided in several ways. In order to subscribe to a hedge fund investors are sent an offering memorandum or prospectus. They are usually sent a presentation document of some length, and most investors in hedge funds get to meet the manager of the Fund. He can answer their specific questions directly. When a potential investor decides that they are seriously interested in a hedge fund they will ask for a further set of information flows – portfolio snapshots and transaction lists to analyse, and the potential investor will ask for a completed due diligence questionnaire. The standardised due diligence questionnaires go into detail on the management company, business structure, ownership and resources of the investment advisor to the fund. The investment processes and risk management procedures are disclosed. The due diligence questionnaire can run to 40 pages once completed. Prior experiences and track records of the principals will be made available to a serious potential investor.

Once a potential investor subscribes and has capital in a hedge fund they receive other information to keep them abreast of developments in their fund. Typically hedge fund managers send out a monthly written communication (or "letter") to investors and potential investors. The letters - usually sent between 3 and 10 business days after month-end – contain a lot more analysis of activity and the portfolio than a long-only manager would provide. The letters from a hedge fund typically contain a breakdown of the portfolio by sector and geography and sometimes macro factor exposure. The largest sector and individual position exposures are disclosed. The use of cash and effect of current hedging is often given, and the liquidity of the portfolio is sometimes reflected in days-to-liquidate information. The portfolio risk is often described in exposure and VaR terms. Often the letters contain some P&L attribution and risk concentration information.

In addition to the letters, managers sometimes grant elective access to the portfolios they run via either the websites of their prime brokers and/or a third party risk measurement/attribution service like Measurerisk, or Riskmetrics. For investors that mimic a fund through a managed account, a further level of disclosure is available - the portfolio activity and exposures are then visible real-time. Portfolio managers of hedge funds now arrange conference calls for their investors, and podcasts and video links to keep their investors informed on a current basis and facilitate some interaction with the manager whilst not consuming too much of his or her time.

Contrast all the above with what an investor in an OEIC/UCITS receives for information flows – reports twice a year, months out of date, and with a low level of information and little analysis of either activity or the current investments/portfolio. The portfolio manager is extremely unlikely to be available to talk to a potential investor in an OEIC/UCITS, and the investor might find it difficult to get hold of a marketing person to quiz, nevermind the key decision-maker.

So qualified investors in hedge funds that display serious intention do not have issues of transparency with hedge funds. Only those who do not need access and legally cannot have access are excluded.

There are now dozens of funds that could be characterised as a half-way house between a hedge fund and a mutual fund or OEIC – absolute return funds. Major investment houses have started these funds to make available to retail investors some of the hedge fund investment strategies. The providers are hopeful they can offer products with the advantages of hedge funds in terms of scope of investment powers (wider than a long-only fund), but without some of the disadvantages of hedge funds (poorly regulated offshore domiciles, high fees and restrictive redemption terms).

I am disappointed that the onshore investment industry has not taken some lessons in communication from hedge funds: absolute return funds are producing manager letters, but they contain only pale shadows of the information shown in a hedge fund manager letter. Polar Capital is a quoted manager of long-only and hedge fund products, and has been running the UK Absolute Return Fund for 17 months. The monthly letter contains only monthly performance numbers and a graph of the same, plus six paragraphs of text – half looking backwards and half looking forwards. That I completely agree with the manager's outlook (given below) does not detract from the point that it exemplifies - investors in hedge funds get better transparency than investors in other forms of pooled investment.

 

Outlook

We remain cautious over the near term outlook for global equity markets. The recent reporting season on the whole was better than expected, largely the result of both cost cutting and strong cash generation. Revenue growth remains subdued but largely stable. However, as we said last month, it’s better to travel than to arrive; the internal dynamics of the market are not encouraging and whilst sentiment indicators are far from extreme, we expect the market to drift lower over the coming weeks, which should provide a better entry point into stocks with less market risk attached. As we near the end of the year, who would have thought that global equity markets would have performed so strongly? Many investors who are sitting on decent profits, (and with November the last liquid month for trading) will want to avoid risking these profits and are likely to be nervous holders of risk assets going into year end. On balance, we therefore expect a period of heightened volatility with risks skewed to the downside. As they said in one of the Godfather movies, it’s time to ‘go to the mattresses’, meaning time for war. A battle between the bears and the bulls is likely to persist for a while, with plenty of ammunition for both sides of the argument.

The Fund is currently modestly net short on both a dollar and delta adjusted basis and is exhibiting an inverse correlation with the market. When we feel the risks to the downside have either materialised or passed, we will be quick to take up our exposure levels in order to capture the value we believe is inherent within our long book.

Philip Hardy, Polar Capital, 5th November 2009

Two-Way Battle Continues Between Buyers and Sellers

The Greenwich Alternative Investments Macro Sentiment Indicators are based on the outlook of hedge fund managers employing a macro view and who manage, in aggregate, in excess of $30 billion in assets. The purpose of the indicators is to reveal how these managers believe the S&P 500, the U.S. Dollar and the U.S. Treasury 10-year Note will perform over the current month. There is an interesting trend in the results over the last three monthly surveys.

Greenwich Alternative Investments Market Sentiment Indicators
for U.S. Equities (S&P 500)





The survey is released on the 2nd of the month and this month shows that those who use a macro view to run their hedge funds are in one camp or the other – nobody is neutral. The neutrals have tended to become more bullish, and a minority of those that were formerly neutral have become bearish.

There have been two distinct phases in the rally to date. The first phase (March to end May then a month of consolidation) had a much steeper ascent than the second phase (early July to mid October). These have been two phases of a liquidity-fuelled rally from a massively oversold bear market low. The later stages of phase two were accompanies by some recovery in the real economy - 3Q GDP was up after all. Classically the real economy will continue to draw money from financial assets – the liquidity push and then cushion will be defused over time.

The breadth and volume in equity markets reflect this gradual withdrawal of liquidity – there is less buying power evident now, and selling has more of an impact on prices. The declining momentum is picked up in the lower peaks of the (14-day) RSI on the top of the S&P chart below.

I am grateful to Bernie Schaeffer for pointing out that the 80-day moving average has been significant to this market this year. Having touched it in July the S&P 500 has flirted with it at the turn of this month. The upside this month to minor new highs has caught some market-watchers: chartist Greg Troccoli wrote this week “I didn’t see this type of strength coming. The bigger picture at this juncture is quite interesting. The resiliency of this market is admirable, however, as can be viewed in the chart the major portion of a possible head and shoulder top has already formed. The right shoulder is coming together at this time- only time will tell if in fact this topping formation will come to fruition. Note that the right shoulder is usually higher than the left- which is taking place now.”

A head and shoulders is a reversal pattern that takes place over a period measured in weeks or months. For my part I see a distribution taking place – less buying power accompanying the market going up this month – the volume has noticeably dropped as the markets climbed from the 80-day MAV. If a head and shoulders does emerge, many participants and commentators will be on it. The measured target for a H&S on the S&P is the 950 area – exactly where the first phase started to consolidate from in the first half of June, and a good support level.

Whilst we see which camp becomes dominant on a multi-month basis, the waning buying power at work suggests that the bears will soon dominate, but there is not a clear sign that the bulls are out of it yet. So we could see a minor new high on the S&P shortly. That would be an untrustworthy further rally given what has unfolded over the last month.

The distribution referred to in these posts could be a trading range market for a while. It doesn’t have to be a dramatic fall to the bear market lows. After this year’s gains a visit to 950 on the S&P would be neat technically. But the consolidation of the gains could be a longer lasting sideways band – say 150 points trading up and down on the S&P lasting 6 months. There is more than one way to consolidate a rise, even a major liquidity-fuelled one.

A HF Joke - Allocators of Capital and Marketers

A group of hedge fund allocators and feeder fund marketers are all travelling by train to Lausanne for the same conference. The allocators of capital make a big deal out of making sure they each have their tickets, but the marketers report that they just had one of their number buy a ticket, and the rest would do without, which the allocators of course thought was just braggadocio. Before long, the conductor comes down the aisle, collecting tickets, and all the marketers of feeder funds get up and crowd into the toilet. After the conductor collects all the rest of the passengers' tickets, he knocks on the WC door, demanding, "Ticket!" The marketers slip their one ticket out the door, which the conductor takes and stamps and hands back before going on his way.

One the return trip, the allocators of capital to hedge funds are all a-grin, and they proclaim that they've just got one ticket between the lot of them. But now the marketers say they haven't any tickets at all. The allocators mumble amongst themselves words to the effect of, "Marketers, what are they like!" Then the conductor starts down the aisle, and all of the allocators crowd into the toilet. And one of the feeder fund marketers goes the the WC door, knocks, and demands, "Ticket!"

Galleon Edge Illegal, But Information Flows to Hedge Funds Can Be Important

The information that hedge fund groups use is a topic that comes into and out of focus. Recently it has been in the spotlight because of the Galleon-related indictments, but it has been a live issue as far back as Ivan Boesky's advanced receipt of deal-flow information in the mid 1980's. Over the years the buy-side has decreased its reliance on traditional sell-side research, partly because of Regulation FD. Also the reliance has been downplayed to put marketing emphasis on the prowess of in-house efforts in research - it is widely marketed as a differentiating factor in asset management pitches. These concepts apply even more so to the hedge fund business.

To a great extent, and particularly in America, hedge fund managers are paid their large fees to be experts in a particular area. As America is home to so many hedge funds and has a deep and broad range of stocks and industries it is natural that there are hedge funds that specialise in particular fields such as healthcare and energy. Investors pay their managers to be the best informed participants in their sector.

This concept applied in different ways to two of the dominant firms of the early to mid 1990s. Michael Steinhardt in his pomp was well known to have the highest commission bill and commission rate on the Street. His thinking was that if he paid the highest rate he would be first call from an analyst or block trader. Given the turnover in his funds and assets under management it is easy to see how he became the biggest client of the brokerage community. And it worked – he was the first call for the sell-side. Steinhardt both traded and invested. So he liked to be in the flow of trading in a stock, and he knew where the axe was in any particular stock. There are many modern era equivalents – if you are a trader-style hedge fund manager you have to have a feel for the flows, and have finely-tuned antennae for the change of ownership in stocks and sectors. This is said to be how some hedge fund operations have grown within the context of institutional investment firms. The transaction flow information from the dealing desks (monitoring institutional and hedge fund flows) feeds the information requirements of the faster-moving hedge fund managers under the same roof.

Steinhardt was an investor as well as a trader. Although he was known for calling the turn in bonds in 1983, he was essentially an analytical investor rather than a macro manager. His background was as an equity analyst, but his trading around long term positions left the impression on the Street that he was what we would think of today as an SAC-style trader. He was not (only or just). Something similar has happened to the perception of what Julian Robertson's Tiger was about. Yes the firm engaged in macro trading, but the core activity was relative value investing within sectors (and in the mature period, markets). The ultimate arbiter was Robertson, but there were analysts dedicated to sectors. Analysts had to defend their views on the sector they covered, and the analysts were expected have profound knowledge of their sectors. In the later stages analysts ran portfolios in their sectors, and so gained the experience that would set them up to become the Tiger cubs that grew out of the firm. But the core competency was depth of knowledge of a sector.

Managers have to have an edge. It is requirement that they are able to answer well the standard question "what is it that makes you unique?" Further, the question had better be answered with reference to repeatable elements. The question becomes "what are you going to be able to continue doing that will give you a persistent edge in your trading/investing in future?" In this regard, it is much less satisfactory to investors to infer that the manager is going to do the same as other people running hedge funds, but do the same things better to deliver superior returns. If the manager happens to be better at using the same information flows as others – better at interpretation or quicker at understanding –that is not as sound a commercial response as declaring possession of an information edge, an unusual source of data. It could well be that money management is the key skill in driving the returns of hedge fund manager. Money management is the change of position size at the stock, sector and market levels. Indeed I have worked closely with a manager who had little edge in information flow, or even in understanding of companies through analysis, but had such good money management and risk understanding that he is an above-median hedge fund manager largely through that ability alone. But money management would not sell as well as a marketing point as an information edge. Rather, investors in hedge funds express strong biases towards managers with information or understanding edges in relation to company fundamentals.

Very often investors will state explicitly that they only invest in fundamentally driven hedge funds. A good example of the latter is the DB Equilibria Japan Fund run by James Pulsford at Deutsche Bank. Using the HOLT system, the approach of Pulsford's team rank return-potential based on RoE, cashflow and other fundamental metrics. Because they match long and short positions in pairs and stay market-neutral they can make good absolute returns using an investing time-frame (multi-month holding period). The DB Equilibria Japan Fund made money last year and this year for its investors. Somehow this sort of investment process is superior in the minds of investors to a manager that uses non-fundamental information to select stocks, or manage the position size.

In my mind the institutionalisation of the hedge fund industry is a factor in this behavioural bias towards fundamentally-driven strategies. They are much more easily explicable, even though there is increasing attention paid to behavioural aspects of finance and investing. And this bias to fundamental styles of investing reinforces the need to demonstrate an information edge. For a manager just using sell-side research it is difficult to claim that they have an edge. Interpretation is not sufficient. So other initiatives have to be taken to have an edge and demonstrate it to potential investors.

The first is the employment of analysts. As hedge fund groups have grown, like the rest of the buy-side they have added analysts. In truth, for investor perception, fundamental analysts have to be added to a small hedge fund operation before any other capability in the firm. Say you are going to add an analyst and you get a nod of the head at an investor meeting. Say you are going to add a marketer to a small hedge fund firm before adding an analyst and the manager would be thought the less of. Not that analysts at hedge fund groups don't add a lot of value in some cases - analysts at hedge funds can be award-winning in their understanding of companies they follow – like Charles Evans Lombe at Egerton Capital in capital goods companies, or Robert Donald at GLG building materials, who both gained plaudits in the Extel survey this year.

The second initiative that hedge fund groups have taken that help them demonstrate an information edge is in procuring (primary) research. Leading hedge funds now deploy a wide range of industry experts on an out-sourced basis via consultancies and specialist research houses. It is not uncommon for large US hedge fund groups to retain political consultancies in Washington to get a handle on the probabilities of regulatory change in various industries. Healthcare specialist funds might tap into firms that understand the workings of the FDA, or can interpret clinical trial data to commercial effect.

Leading hedge fund groups have enough capacity in research spending to commission their own research – footfall at malls or in particular chains of shops, interviews on the street with shoppers on particular brands, counting of cars at import terminals, or monitoring iron-ore ship-loads at Australian ports. Sometimes managers at different hedge fund management groups get together to fund such primary research. Student interns are sometimes brought in to carry out bespoke research projects.

A third initiative taken by hedge funds to obtain a demonstrable information edge is the use of expert network providers like Vista, Coleman, and Guidepoint Global. There were seven such firms just over ten years ago, and there are at least 24 operating today. The largest is Gerson Lehrman which is the only expert network company with a global network. It is instructive that Gerson Lehrman was founded (in 1998) by Mark Gerson and Thomas Lehrman who had spent the prior two years at hedge fund Tiger Management.

Of course, many hedge fund managers talk to their companies directly to produce an understanding of the companies in their universe, which can be an edge. Meetings with senior executives can be limited as sources of information, given what the executives feel able to disclose in Western countries. A common tactic to get some useful information from a company meeting is to talk and ask about competitors. It is often seen that investors pair up in company meetings – one staffer to ask the prepared questions and one to observe the body language and reactions of the executives. One manager I know seeks better operational level information by using extensive contacts at the level of divisional heads in the companies in his universe.

If you think about it, investors in distressed securities and activist investors try hard to put themselves in the position of being privileged investors. Distressed managers position themselves to be on the creditor committees which help decide how company financial reorganisations unfold. Activists seek Board representation. Being on the committee/Board puts them in a position of being better informed investors about the securities and companies to which they have exposure.

So a manager has information that he thinks is not priced into the market, even if he thinks several other investors know it too (the efficient market hypothesis being recognised as dead at this point). The information edge then has to be appropriately expressed in the fund's portfolio. This is where conviction and positive reinforcement should come in, but that is a whole other topic and would take us on to the dynamics of position sizing and portfolio construction – topics addressed in my consultancy but not here today.

Going back to when I was an investor in hedge funds at a fund of funds outfit, I used to ask managers of hedge funds in Europe about their information flows. I would only ask the managers in private meetings as this was not a topic for discussion in open forums like a Cap Into event. I don't recall a manager ever saying to me directly in this time (2001-2) that they had special or unique sources of information about stocks or companies. Finding out what the inputs to their process are is part of understanding how a manager operates. What sources they tap (and how frequently) is part of what helps you as an investor understand where the manager is on the spectrums: wholly fundamental through to wholly technical; long holding period investor through to short holding period trader; and where the manager is positioned in breadth versus depth in their universe.

So in conclusion, all hedge fund managers are required by investors to have an edge. Although the edge may theoretically be of different sorts (such as ability to forecast volatility or correlations, or time markets), often investors expect a hedge fund manager to have an information edge in some way. There is a significant bias amongst investors that the investment process of managers should be fundamentally driven, and this reinforces the desire amongst investors for an information edge to be part of the offering. In the pursuit of such an edge managers of hedge funds have made and continue to take significant initiatives to obtain for themselves proprietary information. Deep research and expertise justifies the (externally perceived) steep hedge fund fees. The trends are for hedge funds to devote more resources to acquiring the elusive information edge. Galleon allegedly did it the wrong way, but the information edge is worth persuing with most managers in the due diligence process.

DO YOU AGREE? DO YOU HAVE A COMMENT?

The Posting A difference between long only and hedge has a comment on it.

Do you agree with Doug of London, or was he just talking his own book?

A difference between long only and hedge - Schroders for example

At a series of presentations by senior Schroders executives recently one of the differences between long-only and hedge fund management came through forcibly. Gary Clarke, Head of European Equities, gave a good pitch about how well they had done in the last couple of years. And indeed the Schroders ISF European Equity Alpha Fund is first quartile amongst the European equity funds domiciled in Luxembourg universe, according to Micropal.

The Fund is ahead of the index by about 10% in the last year or so. So Schroders have done a very good job on the European equity side versus the competition by weighting the sectors appropriately in the last couple of years.Gary Clarke said such good differential performance was achieved whilst “of course, we were fully invested.”

That was the shock statement to me. I’ve been in the hedge fund world for so long that that casual conditionality thrown out by a long-only manager that he is structurally fully-invested came as an icy blast of wind in my face. The fund balance sheets are Long 100 Short 0.

At this point it seemed a very artificial, not to say limiting structure. Of course, there are advantages in staying long-only. My old boss at Clerical Medical, Robert Walther, whom I admired enormously, used to say that portfolio managers couldn’t time markets. In his mind they were better off concentrating on picking sector and stocks and letting him allocate between asset classes and geographies. Given his talents he was probably right in that case. Schroders are following a pattern set in the 1980’s and which I had thought, in my naivety, had disappeared ten years ago.

For quite a few years into their hedge fund management expansion Gartmore used to run hedge funds which followed the template of Alphagen Capella. So the funds had a limited net exposure to markets – this makes the return stream driven off alpha much more than market beta. With this structure the hedge fund managers don't have to have a distinctive talent to time markets. Amongst Gartmore’s hedge funds that have been successful recently are hedge funds that utilised a wider band of net exposures, including running net short last year. Gartmore has moved on.

It struck me listening to Schroders presentations that they have some good equity selection alpha. They could at least run limited net hedge funds to start with. Schroders have a fine fund of hedge funds operation in NewFinance. They have a credit hedge fund that is in its ninth year and manages $106m. Schroders recently announced that they are launching a regulated, transparently operated platform for UCITS III funds designed to give investors easier access to hedge fund expertise. The first Fund available on the platform is exposure to European hedge fund pioneer John Armitage’s Egerton. Egerton Capital has a good performance record, however Schroders as a business would be much better off developing its own single manager hedge fund products.


p.s. If you want help in doing this, Alan Brown (Schroders CIO), give me a call – that is the kind of project my consultancy Enhance Consulting gets involved in.

S&P at resistance, Volume fallen on rise

Yesterday the S&P500 traded up by nearly 2%, completing a four-day up sequence from the intra-day lower low of Monday. On the New York Stock Exchange 2501 issues advanced and 541 issues declined for a ratio of over 4.6 to 1. Advancing to declining volume was better than the ratio of issues A/D at 6 to 1. Overall volume has fallen through this week as the market has risen – not a good sign. Falling volume on rising prices in the first half of October at the exchange/index level provided a good set up for the top formed in the second half of the month.

The S&P index is now in a resistance zone, and after four up-days and being a Friday, which has a tendency to be a reversal day (profit taking ahead of the weekend) expect a dull day at best today. Beyond today we are still in distribution mode – trading down on bigger volume and up on lesser volume. The 10 and 50 day moving averages should cross today (a dead cross as opposed to a golden cross). Investors can come back to the market in January and not have missed any major upside in prices – this is highly likely. That is not to say that that equity markets have to go down a lot. The liquidity cushion is still under financial assets, so markets can consolidate the huge gains from the March lows by moving sideways, hence the distribution rather than collapse to lower levels.

Tactically today is as a week ago – a good day for lightening longs, adding to shorts and overwriting call options. Beyond a day tactics should be focussed on selling into strength when the index gets into resistance levels.

Gathering Assets Still Difficult for Hedge Funds (New and Old)

I spoke to the CEO of a London-based hedge fund group today. He said that his experience was that money was coming back into his hedge funds slowly. His funds outperformed two-thirds of the industry last year and this. "The whole process (of investing) takes a lot longer than it used to," he said.

It is natural, given Madoff (and maybe K1) that due diligence prior to commitment of any capital will take longer than it did previously. The due diligence will be more diligent, and there may be second checks, and references are much more likely to be taken up now.

The situation for hedge fund managers looking for seed capital is much more difficult than it was. There remains a shortage of entrepreneurial spirit in combination with ready capital from seeders. A survey by Acceleration Capital Group* estimates that from the stated intentions of seeding groups there is 44% less seed capital available in the second half of 2009 than there was in the first half of the year. The survey also shows that there are less seeders around by number than there were. As in the first half of the year, the strategy preferred by most seeders is distressed investing.

*available at http://www.scribd.com/doc/22022800/Hedge-Fund-Seed-Capital-Report-For-Q3-Q4-2009

Equity Market Distribution to Continue

Last week I wrote a piece headed “Interim Top on S&P Signalled on Close on Wednesday”. Market activity since could be characterised as topping action. Over the week the market broke to the downside the 20-day moving average on the indices (a MAV watched by traders), and traded back beneath the previous month’s highs. In four of the last five sessions the markets closed near their lows of the day. This is a change from how the markets traded earlier in October. Over the whole of October volume has gone up in the latter part of the month (as markets traded down) compared to the earlier part of the month. Not a healthy sign for bulls. Wednesday was a short-term selling climax for stocks as volume of selling expanded. So the market was ready for a reversal day, and got one yesterday.

Yesterday the Dow jumped 200 points, and the S&P500 rose by over 2% on the “end of recession” GDP release. Did this make me change my view that the markets are topping? No, because of breadth and volume yesterday. Overall volume for the big up-day was in line with the previous 10 trading days, to be more bullish needed a volume expansion.

Then the breadth was not particularly constructive yesterday. What do I mean by that? Yesterday (Thursday) the volume of shares trading up was somewhat concentrated in the number of names participating to the upside. The NYSE is still the best exchange to look at for technical data for the broad market. On the NYSE yesterday advancing volume was 1.3bn shares compared to 150m shares declining, a ratio of over 8.5 to 1. However in looking at the number of issues: 2,504 issues advanced and 552 declined, a ratio of less than 1 in 5. So the reversal day was not fully in gear to the upside.

A good counter-trend reversal day is useful for tactical positioning. Yesterday near the close was a good time to be locking in some gains, trimming long positions and over-writing portfolios with short call options.

Podcast 1 - Hedge Fund M&A

Linked below is the first hedge fund podcast on this blog.

Today's subject is mergers and acquisitions amongst hedge fund management companies.
For a long time in the industry there has been a lot more talk than action. Because of events of the last two years in combination with new strategic thinking amongst the owner/managers of hedge fund businesses that will change in the period ahead.
Potential activity like a Gartmore IPO or a deal for Mesirow's alternatives business can be catalysts for a focus on hedge fund company M&A.

Podcast 28 October 2009

Clicking on the link above will open a new window with two choices available:
download the podcast or
play the podcast.

Today's podcast runs for just over 10 minutes.

CB Arbitrage - is it becoming Institutionally Uninvestable?

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

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

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


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

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

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

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

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

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

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

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



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

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

Interim Top on S&P Signalled on Close on Wednesday

On Wednesday there was a new high followed by a close at the low of the day on the S&P. This is a sign of an interim top. Sometimes there can be a weak minor new high after, but over the course of weeks we are going down on the basis of this one signal. Other signals are already in place on momentum, and valuation has been in a warning zone for a while (high but can go higher).

Yesterday's market action of up 1% net on the day, finishing just under the high of the day, did not negate the call of an interim top. Yesterday also had a lower opening than the previous day's close and the close (and intraday high) were some way below the previous day's high of the day.

Shallow/Narrow Profits Recovery for the HF Industry

Credit Suisse Tremont Index LLC yesterday released a new research piece, "Q3 2009 Hedge Fund Update: On the Road to Recovery". One of the points the report makes is that 26% of all hedge funds have “fully recovered” their losses from 2008, i.e., they have regained all losses to meet or surpass previous peak performance levels.

Last year around 30% of hedge funds made a positive absolute return. So given that, the proportion of hedge funds hitting their high water marks this year is still relatively low. This reinforces the point that last years winners are this years losers in the performance ranking stakes. Better profitability for hedge fund firms as a whole is still not here yet.

Last week HFR of Chicago released their take on the flows of 3Q 2009. They said that "Over two-thirds of all hedge funds experienced capital inflows in 3Q, accounting for over $38 billion in new assets; however, these gains were largely offset by over $37 billion in capital outflows from investor redemptions and liquidations, resulting in a net inflow of only $1.1 billion."

HFR continued that "In contrast to the first half of 2009, redemptions were concentrated in specific strategies. Hedge funds in the Relative Value Arbitrage and Event Driven space experienced a total net redemption of more than $5.7 billion during the period."

So while flows have gone from negative to positive for the industry, only in some strategies and only for some managers within them is decent profitability being attained.