Separating style drift from thoughtful hedging

February 14, 2012  


"If handled incorrectly, non-equity hedges can lead to more trouble than they’re worth."

 
   Scot Norden

By Scot Norden

If you're an investor in hedge funds you're probably familiar with the following situation. One of your managers has begun to invest outside of his original mandate, and you're forced to ask yourself: is this a sign of thoughtful evolution or style drift? At the end of the day, some might complain that the only way to know for sure is by whether or not it works. But it's possible to determine the difference ahead of time if you ask the right questions.

In recent years, we've noticed an increase in non-equity exposure in the portfolios of long/short equity managers, including positions in credit hedges, currencies, and commodity options and futures. Traditionally, these securities would not find their way into the portfolios of fundamental stock pickers, as their inclusion would lead to some eyebrow-raising on the part of skeptical investors. However, we view this as a positive development, not an indication of style drift. To us, it is evidence that long/short equity managers are trying to be more thoughtful about how they express their investment insights and how they shape the risk profiles of their portfolios.

For example, imagine a manager owns shares in businesses which derive a heavy component of sales from overseas and he worries about the underlying currency exposure. Or perhaps a manager recognizes that an increase in sovereign funding costs will have a knock-on impact on equities to which he's exposed in that country. In each case, it's completely reasonable that the manager may look to hedge some or all of that risk, and would naturally look outside equity securities to do so. If done thoughtfully, the manager can use these tools to better isolate the risk in the trade to only that risk he truly wants and understands. That's a positive evolution in the manager's process, not style drift.

That said, if handled incorrectly non-equity hedges can lead to more trouble than they're worth. The primary point is that the manager has an effective implementation process. Some key questions we ask ourselves when evaluating that process are:

Is it really a hedge? It's important to distinguish between positions that truly offset an embedded portfolio risk from those that actually add risk to the portfolio. We're less likely to be comfortable in cases where our long/short equity manager is seeking to express a macro view, or where there is a large degree of basis between the hedge and the underlying risk he's seeking to neutralize.

Is it a risk worth hedging? Some managers seem anxious to hedge just about every risk they can identify, which can drive down returns and drive up portfolio complexity. Instead, we believe managers should just focus on protecting investors from outcomes they can't live with.

How does the manager think about the cost? The manager should consider the cost of hedging in relation to the overall expected return of his portfolio and should be disciplined in comparing that cost with other hedging options including the use of cash.

Does the manager have a plan for how to trade the hedge over time? It's important to understand what the manager will do with the hedge as conditions change, particularly if they become profitable. More often than not we'd hope to see the manager start to monetize a portion of the exposure, since otherwise it may begin to have an outsized impact on returns. Regardless, the manager should have a credible plan in place and stick to it.

Does the manager understand the impact of crowding? As more similar-minded investors look to use non-equity securities as hedges, the risk increases that these positions may react to events differently from the past. Importantly, the more basis there is between the hedge and the risk the manager is trying to offset, the more this worry is exacerbated. It's therefore essential the manager has a thoughtful implementation process in place to research and analyze these positions.

So is increased use of non-equity hedges by long/short managers evolution or style drift? We think it's the former and view it as a positive development that managers are more aware of, and willing to use, the risk reduction options available to them. But investors need to ask the right questions to be certain their managers are evolving successfully. After all, evolution doesn't turn out equally well for everyone: just ask a Zeuglodon, if you can find one.

Scot Norden is a managing director and senior research analyst for J.P. Morgan Alternative Asset Management where he is responsible for investment analysis, research, and due diligence with a focus in long/short equity, event driven and short selling strategies. He is also a member of the JPMAAM Investment Committee and the Portfolio Management Group.

Disclaimer
Views and opinions expressed are those of J.P. Morgan Alternative Asset Management, are based on the current market environment and may be changed without notice. These views and opinions may not be suitable for all investors.






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