Unhedged Commentary

Wednesday, May 11, 2016

Unhedged Commentary: The $3 Trillion Question


By Mark Anson and Ryan Driscoll

The growth of the hedge fund industry over the past decade has been tremendous, with more and more institutional and retail investors allocating capital to investment strategies that fall outside the boundaries of traditional stock and bond funds. The hedge fund industry, which has gone from managing approximately $240 billion in 2000 to $3.2 trillion at the end of 2015, has grown by 19 percent annually, on average. It is only natural to question whether there is sufficient capacity for this amount of capital to be absorbed and productively invested in these alternative-investment strategies.

Perhaps it is worthwhile to take a step back and observe what propelled the hedge fund growth story. Partly, it was the advent of so-called endowment-style investing. A key principle of endowment investing is to expand the efficient frontier of portfolio construction into alternative assets, where investment strategies are less constrained and have the opportunity to add excess returns while providing additional portfolio diversification. The growth of hedge fund assets parallels the popularity of other alternative-asset classes, such as private equity and real assets.

Another reason for hedge fund growth traces back to the popping of the tech bubble. Once the fantasy of technology stocks taking over the world faded and a global recession ensued, equity markets around the world experienced double-digit declines for three straight years, from 2000 to 2002.

During this time period hedge funds lived up to their name: Many hedged their portfolios and generated positive returns. The Barclay Hedge Fund Index recorded gains of 12.2 percent, 6.8 percent and 1.4 percent during 2000, 2001, and 2002, respectively. Not only did hedge funds produce positive returns during this time, they did so while taking less risk than that generated by the equity markets.

More accurately, using Sharpe ratios, we found that hedge funds far outperformed the global equity markets during 2000–’02. We use risk-adjusted returns because investors often overlook the fact that hedge funds generate their returns with a much more risk-controlled process than the broad financial markets. Specifically, from 2000 through 2002 hedge funds produced large, positive Sharpe ratios compared with the negative returns generated by the stock market. This performance helped to fuel the demand for hedge funds as an important component of a diversified portfolio.

However, since the Great Recession hedge funds have not outperformed the stock market. Again using Sharpe ratios, we found that the risk-adjusted returns of hedge funds are on par with those of the S&P 500 index. This might lead investors to conclude that the hedge fund industry has become capacity-­constrained.

The recent performance of hedge funds has ratcheted up the debate about whether these funds deserve their fees. With such a long growth trajectory for hedge fund assets, it would not be surprising to discover that exposure to beta has crept up in hedge fund portfolios over the years.

Over time, as any active manager accumulates assets, it will become capacity-constrained in its alpha generation; it simply cannot put as much capital to work in its active strategy. As a result, more of an active manager’s portfolio may have to be put to work through beta trades —investments that accumulate more market exposure than genuine alpha.

Surprisingly, this does not seem to be the case with hedge funds. We reviewed several hedge fund strategies, and we did not observe any marketable increase in beta exposure over the past 15 years. Although the amount of beta exposure does fluctuate, there has been no discernable uptick since 2000. This provides some comfort that the hedge fund industry is not capacity-constrained.

So where does this leave us? Unfortunately, we are unable to resolve the dispute over whether hedge funds add sufficient value for the fees they charge. On the one hand, it appears that hedge fund managers are not capacity-­constrained — the amount of beta in their portfolios has not crept upward over time. On the other hand, the risk-adjusted performance of hedge funds since the Great Recession does not seem to warrant the standard 2 percent management fee and 20 percent performance fee structure that managers frequently demand. This means that the hedge fund industry is best approached with a discerning eye to select those managers who have a competitive edge. Alpha exists, but can it be captured in both a cost-effective and a risk-efficient manner? The debate continues. a

Mark Anson is chief investment officer and Ryan Driscoll is director of trading at Wilton, Connecticut–based Commonfund.

Wednesday, March 16, 2016

Unhedged Commentary: Giving European Credit its Due

   Stuart Fiertz

With continued market volatility in early 2016, the collapse in oil prices, shocking acts of terrorism and waves of migrants seeking refuge from war, at Cheyne we believe Europe deserves more credit - literally. The anticipation of a flood of credit opportunities in the euro zone has existed for several years but proved fleeting. However, we think the time is ripe for compelling and scalable opportunities in alternative credit within Europe because of the combination of well-meaning but poorly designed regulatory reforms and the fact that efforts to address the looming need to shrink the banking system have only just begun.

To profit from the recent dislocation and increase allocations to Europe, investors will need to accept that we have reached the level of political and economic distress necessary to trigger effective policy responses. We think we have: European Central Bank president Mario Draghi has dusted off the quantitative easing playbook, U.K. Prime Minister David Cameron appears to be getting closer to securing sufficient concessions from the European Union to neutralize the risk of Brexit, and the EU is building fences on its external borders to stem the flow of migrants.

The global financial crisis highlighted that the European banking system was far too large relative to the size of the European economy. This means that European banks remain overly reliant on wholesale funding and are too big to either be left to fail or bailed out again. Regulators have recognized this and responded with measures to force banks to shrink their balance sheets, including increased capital requirements and explicit leverage limits.

Alternative credit has the opportunity to offset the withdrawal of liquidity that will result from shrinking European bank balance sheets. Consider that the total assets of U.S. banks are some $14 trillion, whereas the assets of European banks total $41 trillion although the underlying economies are approximately the same size.

The transition toward alternative credit is now being supported by the EU, which has gone from vilifying nonbank sources of credit to actively promoting them. Furthermore, the European distressed-­corporate-credit cycle is shifting toward opportunity. Postcrisis, many investors thought there was going to be a fire sale of European corporate loans. This flood of sales didn't occur, as European banks proved more willing to sell real estate assets than corporate loans. One of the motivations was political pressure to safeguard jobs and avoid putting companies into the hands of private equity, which would look to rationalize operations. Another factor was the surprising growth in the European high-yield market, which allowed the orderly refinancing of most of the largest and most leveraged companies.

It is also evident that European banks were not in a position to absorb the hit to their capital that would have been necessary to mark the corporate loans down to their clearing level. While still undercapitalized, European banks are today in a much improved position to sell down their corporate exposure, which will now begin to increase the supply of distressed corporate opportunities.

In the wake of the crisis, the impact that unemployment rates had on forcing real estate borrowers into receivership was muted. Banks were therefore in a much better position to sharply reduce their risk appetite for real estate loans as the crisis unfolded.

The most attractive opportunities can be found where the new regulatory capital regimes are most punitive and where the local regulator has a particularly negative bias. Bank loans to fund new construction, for example, are more readily available than loans for refurbishment. The opportunity to make this type of loan is underlined by the fact that the availability of credit in European real estate has been severely constrained since as far back as 2007, leaving a generous supply of assets in need of capital expenditures. What's more, there are an estimated €745 billion ($826 billion) of loans that will need to be refinanced over the next three years. It is estimated that European banks still need to work out some €333 billion of noncore real estate loans.

The total of nonperforming corporate loans that are likely to be sold by European banks now dwarfs the remaining noncore real estate on bank balance sheets. It is an indication of how far attitudes toward alternative credit have changed that the Italian government recently chose to securitize €350 billion of nonperforming corporate loans rather than sell them outright. a

Stuart Fiertz is president of London-­based Cheyne Capital Management (UK) and chair of the Alternative Credit Council of AIMA. This article is based on his findings from a recently published white paper.

Friday, January 08, 2016

Unhedged Commentary: Trust Is the Hidden Alpha in Hedge Fund Sales Coverage

By Dean Curnutt

   Dean Curnutt, Macro Risk Advisors

When it comes to asset management firms, studies have shown that how well their investments perform contributes only marginally to how much money they raise. In a previous Unhedged Commentary piece, it was reported that the correlation between investment flows and performance was between just 0.4 and 0.24 percent. What matters instead is a combination of client education, manager trust and an effective investor relations effort. Perhaps the old adage that money chases returns needs an update.

Several years ago I did a survey asking hedge fund clients what made a salesperson’s coverage good or bad. Many responses cited market knowledge or product expertise as important. But there was a striking focus on consistency and trustworthiness as characteristics of the valuable salesperson. At its core, the success of a buy-side–sell-side coverage relationship hinges on that unspoken yet all too important presence of trust.

As trading technology improves, the costs of execution continue to decline. For example, the average commission rate in the listed options space for voice brokers has fallen by 11 percent over the past five years, according to financial market research and advisory firm Tabb Group. On the fixed-income side, the advent of TRACE (Trade Reporting and Compliance Engine) by Finra as well as the migration to swap execution facilities increases price transparency and serves to reduce the spread that dealers can extract through client flow. This greater transparency has caused the after-tax return on equity to fall for flow businesses from 20 percent to 7 percent following the financial crisis of 2008, according to global consulting firm McKinsey & Co.

With these profitability headwinds in mind, where can brokers improve their flow businesses? With markets increasingly complex, providing higher-quality research seems an obvious place to allocate resources. While differentiated research matters, the mass forwarding of original work is an unfortunate reality in the investment business, greatly reducing the returns on content.

A less obvious but higher return investment in strengthening a flow business is in building more trust with clients. In the words of motivational speaker Zig Ziglar: “If people like you, they will listen to you. But if they trust you, they will do business with you.” If investing is all about finding performance edge, trust can be looked at as providing alpha of the very best kind: It has high payoff, requires no capital, is completely uncorrelated to the market, lasts indefinitely and has significant barriers to entry. As with other kinds of alpha, however, trust is difficult to earn.

From a client coverage standpoint, building trust first requires a salesperson to accept the reality that a client’s inner circle of advisers is typically established over years. In this way, the broker-dealer firm’s incentive system must also embrace the long game of trust building so as to provide the salesperson with considerable runway for this process.

My survey work suggests that when clients cite “trust” in why they deal with a particular salesperson or firm, they perceive a strong sense of business alignment in the coverage relationship. Absent is any view of hidden agenda in which the broker-dealer’s objectives may be counter to the investment results sought by the client. In light of the LIBOR and foreign exchange market manipulation scandals, it is easy to see the skepticism that many clients feel about their counterparty dealings. As a result, a sell-side firm must make transparency a top priority when transacting with clients.

A second component of trust is a sense of familiarity and rapport. “Am I being listened to?” is an unconscious question a client repeatedly asks when evaluating the relationship. In the hedge fund universe, clients tend to be bucketed into easily consumable categories such as long-short, macro, credit, etc. However, no two clients are the same, and the effective salesperson must excel at asking the right questions and listening intently to the road map the client provides on how optimal coverage can be achieved. The thoughtful salesperson knows what is important to the client, effectively screening the delivery of information based on a careful assessment of its relevance.

Lastly, clients equate trust with broad business advocacy. When the alpha of the coverage relationship is at its apex, the client views the salesperson not just in light of superior market intelligence and transaction execution, but as a partner in business development. In the ultracompetitive world of investment management, funds are not just hunting for the next great trade idea. Rather, they aim for constant platform improvement, searching for better technology solutions, looking at expansion into new strategies and always seeking the strongest professionals to join their teams. The salesperson who has truly earned the client’s trust becomes a meaningful element in this ongoing business development process.

In an environment where margins are experiencing secular decline, it is easy to be bearish on the sales and trading business. Commission rates are compressing as electronic trading increases and it is difficult to be compensated for research. While these headwinds are real, clients are clamoring for sales coverage that delivers not just expert market insight but that is fully aligned on business objectives. By making the achievement of client trust a primary focus, a desk can powerfully differentiate its efforts from the competition.

Dean Curnutt is CEO of Macro Risk Advisors, an equity derivatives strategy and execution firm that specializes in translating proprietary market intelligence into actionable trade ideas for institutional clients. The New York-­based firm is a registered broker/dealer with the FINRA.

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