|| 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
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
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
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.