Unhedged Commentary

Thursday, July 17, 2014

Unhedged Commentary: Japan’s Commitment Issues

   
   Jason Mitchell co-manages the GLG Global Equities Fund

By Jason Mitchell

Japan’s great experiment in Abenomics remains as divided now as a year and a half ago, when Shinzo Abe won re-election. Gains in the Topix have been impressive but less so when adjusted for the weaker Yen. And while central bank measures have supported U.S. and European recoveries, Japan by comparison still struggles with how to get the reflation narrative right. That structural reforms, the third arrow of Abenomics, have lost momentum hasn’t helped.

But while tax, labour, and regulatory reforms all suffer from high expectations, corporate governance reform remains comparatively modest. Thus far, progress has been measured by improved board representation, a rise in Western-style activism and a reset in governance norms like the recently-passed Stewardship Code.

But there’s a larger effort underway that treats corporate governance and capital efficiency as interdependent. The Nikkei 400, which weighs return on equity, profitability and governance, marks the latest move with its effects already apparent. Reacting to its exclusion from the index, Amada announced plans for a 100 percent payout ratio over the next two years to make its ROE more competitive.

In April, the Ministry of Economy, Trade and Industry published the ITO Review of Competitiveness and Incentive for Sustainable Growth, addressing capital efficiency and governance as an interlinked problem. Better governance, the logic goes, leads to improved capital allocation.

The emphasis on ROE isn’t surprising. Declining corporate profitability, excess capacity and low reinvestment form the productivity gap that Abenomic reflation means to close. Persistent deflation removed pressure on managements to put corporate balance sheets to work, leaving almost half of Topix companies at the end of 2013 sitting on net cash positions, up from 35 percent a decade ago.

How can investors play this? Attempts to correlate governance criteria and share performance have yielded mixed results at best, particularly in the case of Japan, where studies even show companies with lower governance scores outperforming higher-scoring companies. The same applies for returns where high-ROE companies have historically underperformed the Topix. Companies with rising ROEs fare better, but the relative outperformance applies only to the top quintile.

Another way to test the ITO Review’s recommendations is to view companies’ capital efficiency targets as a commitment signal. Like the electoral pledges that politicians make, companies are similarly constrained — and incentivized to fulfil — their commitments to investors. Should they miss these targets, they lose market credibility. While most companies already publish sales, operating profit and net income forecasts, few issue returns guidance. In fact, we found only 86 companies that commit to ROE or return on assets (ROA) targets.

What do companies who formally commit to capital efficiency targets reveal? Considering the persistent, equal-weighted outperformance of the group relative to the Topix over the past 10 years, there are several messages.

First, the market appears to reward companies that formally commit to return targets with higher relative valuations. With the group’s earnings growth lagging the Topix, outperformance owed itself entirely to a higher valuation rating on a price-to-earnings and price-to-book basis. The group went from trading at a valuation discount to the Topix to ultimately a premium over the 10 year period.

Second, this signal modulates across different market regimes, lagging during Koizumi’s 2006 reform agenda, the 2009 global economic recovery and the start of Abe’s term in 2013. It’s consistent with the idea that higher quality companies underperform during reflationary periods, when markets are less discriminating.

Third, the commitment to a financial return target appears to matter more than the target itself. Companies that issue unambitious targets — defined as a 100 basis points or less improvement relative to their long term average — outperformed both the Topix and the companies that issue ambitious targets.

Finally, leadership appears to drive broader adoption in sectors. Companies like Ajinomoto, Komatsu and Mitsubishi Heavy all led by example, establishing return targets later adopted by peers. These often outlined transformational change to the capital structure. Like Amada, these say more about better asset allocation than any underlying change to business.

Japan’s challenges are already well defined: an aging demographic, energy dependence, geopolitical pressure from China, weak corporate governance, a deflation-conditioned national psyche and unprecedented monetary expansion. With the Bank of Japan priming a 2 percent inflation target, investors will likely demand greater accountability for a company’s capital structure. Correlations between share outperformance and companies committing to return targets should prompt greater attention to those signalling their seriousness about re-evaluating their capital structure.

In short, conflating capital efficiency and corporate governance carries significant advantages for Japan. It reinforces the integrity of Abenomic reform and positions Japan for further rerating. On a price to book value basis, Japan’s 9 percent ROE implies a 7.5 percent equity risk premium, well above that of the US and Europe at 4 to 5 percent. If Japan improves its ROE to Europe’s level, its risk premium should narrow, providing substantial further market upside.

Jason Mitchell co-manages the GLG Global Equities Fund and oversees GLG’s sustainability investment strategies.

*Unless stated otherwise all market data is from Bloomberg.

Wednesday, June 25, 2014

Unhedged Commentary: How to Unmask the Mystery of Alpha

   
   Tilak Lal, K2 Advisors
Humans have a long history of assigning supernatural or metaphysical explanations to things and events they do not understand. Theologians in the early 19th century coined the phrase “god of the gaps” to describe this tendency. Long before the advent of plate tectonics and microbiology, for example, physical phenomena such as earthquakes and plagues were readily chalked up to divine intervention — the gods were simply angry again. A 2008 article in the Economist magazine conceptualized investment alpha in the same way. While the article did not suggest alpha is the result of any sort of metaphysical or deified intervention, it did imply that what is often defined as alpha may merely be beta residing in the so-called gaps. In other words, until it is clearly defined and measured, the true nature of alpha remains somewhat mysterious and elusive, and often it may be misrepresented.

Because of its subjective, relative and sometimes ambiguous nature, alpha is somewhat difficult to quantify. From a purely qualitative standpoint, investors understand it as the value that an active portfolio manager adds to or subtracts from a fund’s return, depending upon his or her skill as an investment manager. Quite simply, alpha is the portion of a portfolio’s return that is the result of factors other than the portfolio’s exposure to the market.

To conceptualize alpha allegorically, imagine the market as a radio station. Listeners to the station are market investors, the songs played represent broad market performance, and the volume at which songs are played represents investor beta — or sensitivity — to the songs. The songs are easily received, clearly delivered and carried on a strong signal. When the songs are good, the listeners have the option of turning up the volume on their radios (increasing beta) to appreciate the strength of the music signal even more. Of course, this decision bears risk, as the radio station will regularly change the music — often without warning — to songs that are quite offensive to the ears. At these times, despite the desire to listen to music at very high volumes (let’s say our investors are teenagers), listeners are compelled to turn down their radios to minimize the strength of the signal. They simply cannot stand the noise.

Now imagine that in addition to the clear songs the market broadcasts on the strong signal, there are other less obvious, less clear and more difficult to discern notes and melodies delivered on weaker frequencies alongside the primary songs. To less discerning listeners these peripheral signals are typically interpreted as simply noise, but to a diligent and specially trained ear — one with high-end audio equipment that is perhaps especially sensitive to tangential and weaker signals — this noise may form a song of its own. This is the market’s alpha song, the peripheral noise that accompanies the strong market signal. This signal is difficult to hear, but when it is discovered, listeners have the option of listening to music they enjoy, even though the song the broad market is playing may be a bad one. In this way the noise is transformed into beautiful music, or alpha, and investors may capture positive returns with limited risk.

Given this understanding, it follows that in order to be able to identify alpha, one must first be able to identify and measure both the market where the alpha is expected to reside and the beta (or sensitivity) the investor has to that market. To identify and measure a given hedge fund’s alpha it is necessary to be able to identify and measure its beta profile first. We must know beta to understand alpha, and in the case of hedge funds this can be a difficult task as they do not measure themselves against traditional market benchmarks such as the S&P 500 index.

So, to identify a hedge fund’s beta profile we must have insight and transparency into the manager’s trading strategy and the securities in which they invest, so that we may be able to understand and measure their systematic risk exposures.

In this way a passive alternative benchmark can be established, often one that is customized based on a given fund’s strategy specialization. A composite of a biotechnology and health care exchange-traded fund, for example, could be built to serve as a baseline for a manager’s systematic exposures. We need to comprehend a fund’s strategy to observe its alpha. What is the manager’s specialization, and in what types of securities does he or she search for opportunities?

Measuring and monitoring hedge fund alpha is a variable exercise contingent upon each individual manager’s investment program and the securities in which the manager invests. To accomplish this, one needs transparency, because you cannot measure what you cannot see . . . and alpha is no exception.

Tilak Lal is the chief risk officer of K2 Advisors, which provides integrated hedge fund product solutions to institutional and high-net-worth investors across the globe. K2 is part of Franklin Templeton Investments, a global asset management firm.

Thursday, June 19, 2014

Unhedged Commentary: Don’t Get Complacent Over SEC’s Insider Trading Losses

   
   DLA Piper's Nicolas Morgan and Megan Vesely

This year has dealt a streak of high-profile insider trading losses to the Securities and Exchange Commission. In the first half of 2014, defendants prevailed against the SEC in six insider trading cases, including, most recently, SEC v. Obus and SEC v. Moshayedi. In these cases, courts and juries rejected the SEC’s sweeping interpretations of conduct that constitutes insider trading, suggesting that circumstantial evidence and the SEC’s aggressive legal theories may not be enough to establish a violation of the securities laws. Notwithstanding these recent defeats — or perhaps because of them — individuals and firms in the financial industry should take note that the SEC shows no signs of abating its practice of investigating and charging insider trading beyond what is supported by the law or the facts of particular cases. Accordingly, while corporate insiders and outsiders may now have some guidance for defending against the SEC’s enduring insider trading crusade, they nonetheless remain vulnerable to the SEC’s regulatory overreach.

Insider trading based on tips generally involves the misappropriation of material nonpublic information by an individual who then trades securities based on that information. To prevail on a claim for insider trading, the government must prove that the insider tippers were entrusted with the duty to protect confidential information, which they breached by disclosing to their tippee, who knew of their duty and still used (or in some jurisdictions merely possessed) the information to trade a security or further tip the information for his or her benefit. Finally, the government must prove that the insider tippers benefited in some way from their disclosure.

The SEC has repeatedly adopted the widest possible interpretation of these elements, particularly with regard to the existence of a duty by the tipper and the receiver’s use of the confidential information. Recently, courts have rejected the SEC’s expansive legal theories and its efforts to rely on circumstantial evidence in proving its cases.

On May 30, 2014, 13 years after the purported improper trading, a New York federal court jury cleared Nelson Obus, Peter Black and Thomas Strickland of securities fraud charges in one of the SEC’s oldest insider trading cases. The SEC alleged that Obus, a hedge fund manager, traded on confidential information regarding the acquisition of SunSource, a solar company, in 2001. In a somewhat protracted procedural history, one of the primary issues in the case was whether Strickland — an analyst for his employer, a potential lender in the SunSource acquisition — breached a duty to his employer in allegedly sharing confidential information about the transaction with his college friend Black, who passed the information to his employer, Obus. Deliberating for one day, the jury rejected the agency’s claims that the defendants traded on inside information.

Seven days after the Obus verdict, a California federal jury again found against the SEC and in favor of defendant Manouchehr Moshayedi, co-founder of a computer storage device company. The SEC alleged that Moshayedi sold 4.5 million of his company’s shares in a secondary offering after learning that a major customer would not renew its $120 million supply chain contract and was cutting demand for the company’s flagship product. Moshayedi, who made $260 million in the sale, refused to cancel the offering despite the negative customer news and attempted to hide the information related to the canceled contract and orders through a side deal with the customer, according to the SEC. Again, after just one day of deliberations, the jury rejected the agency’s claim that Moshayedi traded on undisclosed confidential information.

Obus and Moshayedi are just the most recent examples of courts rejecting the SEC’s attempts to prove insider trading through circumstantial evidence. Earlier this year, in SEC v. Schvacho, an Atlanta federal court found that the SEC’s demonstration of a pattern of conversations between defendant Ladislav (Larry) Schvacho and his friend, then-CEO of Comsys, and Schvacho’s trading in Comsys, was not sufficient to establish that Schvacho used confidential information in selling shares of Comsys, an employment services company.

Similarly, in SEC v. Yang, an Illinois federal jury rejected the SEC’s arguments that defendant Siming Yang’s alleged timely trades in the stock of a Chinese meat and food processing plant and his alleged access to a presentation created by an unnamed source demonstrated that Yang used material nonpublic information in connection with his trading.

Perhaps the most pointed example of the confusion about a corporate insider’s obligations is found in SEC v. Steffes. In Steffes, the SEC alleged that the defendants, employees of the Florida East Coast Railway who learned about a pending acquisition of their company through on-the-job observations, committed securities fraud when they traded securities in the company and passed on their observations to family members who also traded based on that information. As in Yang, the jury declined to adopt the SEC’s broad view of the law that defendants’ workplace observations constituted material nonpublic information or that defendants breached their duty to their employer by observing public activity at their workplace.

Under somewhat different circumstances, in SEC v. Life Partners Holdings, Inc., a Texas federal jury found that the SEC failed to prove that the CEO and CFO of Life Partners, a company operating in the secondary market for life insurance, engaged in insider trading when they failed to disclose that the company was purportedly overvalued by the market and the media.

The above cases indicate that despite setbacks, the agency has been undeterred in bringing cases based on nebulous, push-the-envelope legal theories and circumstantial evidence. In this regard, the SEC is undoubtedly intending to exploit the Department of Justice’s recent successes against defendants for insider trading and is watching closely as certain criminal insider trading actions are heard on appeal. In the meantime, anyone who receives material nonpublic information about a public company and transacts in the securities of that company remains vulnerable to the SEC’s ever-expanding definition of what constitutes insider trading. The fact that a judge or jury may decide years later that the SEC’s interpretation of the law or facts was wrong provides little comfort.

Nicolas Morgan and Megan Vesely are attorneys at the law firm DLA Piper.

Wednesday, May 28, 2014

Unhedged Commentary: Ignore AIFMD at Your Own Peril

   
   INDOS Financial founder Bill Prew

By Bill Prew

For the large number of U.S. managers marketing their hedge funds in Europe, the game will change dramatically on July 22, 2014. That’s the day Europe’s new raft of hedge fund regulations embodied in the Alternative Investment Fund Managers Directive comes into force.

Change isn’t necessarily a bad thing. For U.S. managers interested in raising money in Europe, embracing AIFMD could be well rewarded. Still, it’s going to be painful, particularly for U.S. firms seeking first-mover status and thus having to work through the largely untested additional compliance obligations imposed by AIFMD. But there will be rewards.

First, AIFMD managers will gain a competitive advantage in being able to access the increasingly active pool of wealthy European investors — and maintain existing access to those investors — while managers who choose to stay away from Europe will lose that access. Second, firms will be able to manage the very real compliance and business risk to their business that will result from noncompliance with the marketing rules. In short, attempting to stay in the game post-July without AIFMD compliance is at worst not an option and at best a potentially short-sighted and costly plan.

The AIFMD actually came into force on July 22, 2013, but Europe-based managers had a full year to complete their compliance. U.S. and other non-EU managers that do not manage EU funds or market non-EU funds in the EU are outside the scope of AIFMD. But for the large number of U.S. managers that do manage or market such funds, the AIFMD imposes a number of additional investor and regulatory disclosure and reporting obligations, including the European equivalent of form PF regulatory reporting.

It’s not all stick and no carrot. Another potential benefit of the AIFMD is the introduction of a pan-European marketing passport. This gain is not available to U.S. managers at the moment, being limited to EU funds managed by authorized EU managers. However, it is anticipated that the passport should become available to compliant U.S. firms in a year or two.

In the intervening period, as has been the case to date, the principal route for non-EU managers to market to European investors is via national private placement regimes — country-by-country rules that govern the marketing of funds to professional investors.

Some U.S. managers may reasonably believe that this increasingly complex European regulatory regime should be consigned to the “too hard” basket. But the good news is that even for them, the door won’t completely close. An alternative to marketing is to seek to rely on reverse solicitation. That means U.S. managers can accept capital from European investors who approach the manager directly, as long as the manager does not take any initiative when it comes to marketing the fund, whether directly or via a third party.

Many U.S. managers appear to be planning to avoid having to deal with AIFMD by relying on reverse solicitation. But this tactic comes with compliance and business risk. AIFMD has raised marketing up the regulatory radar, and countries are tightening their private placement regimes and marketing rules. This increased regulatory focus could result in unlawful marketing activity being brought to the attention of a manager’s home regulator by a local EU regulator. In some EU countries unlawful marketing will constitute a criminal offense. There could be an increased risk of investors bringing private claims for mis-selling.

In Europe the prevailing view is that many U.S. managers are adopting a wait-and-see approach to the AIFMD. There are also suggestions that U.S. managers will shun Europe as a result of the directive. Some argue, speciously, that European investor interest in alternative funds remains diminished. On the other hand, there have also been reports that European investors, looking for access to specialist providers and asset classes, are concerned and frustrated that the AIFMD is reducing choice and access to U.S. managers.

Over recent weeks we have seen a noticeable increase in the number of managers working through the new requirements with a view to complying. The AIFMD itself does not provide a transitional period for non-EU managers, but many countries, notably Finland, Germany, Luxembourg, the Netherlands, Sweden and the UK, have extended the transitional year for U.S. and other non-EU managers, although in some cases only where a fund had been marketed prior to the July deadline.

Going forward, non-EU managers will, depending on the country, either need to register or seek authorization from the local regulator in order to market via private placement in the country. There’s time and effort involved in this process. Non-EU fund managers need to start the process now in order to avoid disruption to their business and their marketing.

Bill Prew is the founder of INDOS Financial, the first AIFMD Depositary business to be authorized by the UK Financial Conduct Authority. Previously, he served as chief operating officer of Moore Capital Management spin-out James Caird Asset Management and European chief financial officer of Barclays Global Investors.

Thursday, May 15, 2014

Unhedged Commentary: The Time is Right for Intermediate Credit

   
   Marinus Capital Advisors Senior strategist Sam Derosa-Farag
By Sam Derosa-Farag

After a 30-year trend of declining interest rates, the Federal Reserve is seeking to use the economic recovery as a chance to continue the so-called new normal of zero-bound interest rates. Many observers believe the central bank’s actions as the U.S. economy begins to bounce back will be generally unfavorable for fixed-income investors and less damaging to holders of equities.

However, this view may be shortsighted. Recent economic growth, while disappointingly weak, owes much to easy monetary conditions. But the flood of capital has distorted asset class returns and upended traditional relative value behavior. In short, generous global liquidity policies and demographic trends have reshaped the return expectations of traditional asset classes and changed the outlook of future expected behavior.

The consequences of this new paradigm are already challenging traditional schools of thought on asset allocation and modern portfolio theory. In the 1980s and 1990s the investment risk curve generally sloped upward, with risk and return profiles of core asset classes correlating positively. In the past 14 years, a combination of persistently low interest rates, changing demographics, regulatory reform and macroeconomic conditions have bent the investment risk curve into a negatively convex one. At the low end of the return spectrum are three-month Treasury bills and the S&P 500, both underperforming on an historical basis. Both low-risk three-month Treasury bills and the higher-risk S&P 500 have underperformed the markets on a historical basis. These underperformance patterns appear to have already become entrenched and should be expected to hold for the foreseeable future. However, credit instruments such as high-yield corporate bonds and commercial mortgage-backed securities lean closer to the optimal point on the risk-return curve. In addition, these instruments offer diversification from standard rate and equity risks. This new risk-reward curve has greatly influenced relative asset class returns since 2000, and many investors have failed to distinguish its effects from the turbulence and distortion of two market crashes. The causes of this investing sea change include, among other things, slower economic growth driven by demographics, deleveraging, central bank policies and the resulting high liquidity, and a shift away from equities and toward shorter liabilities in both retail and pension investing. In light of these drivers, and upon examining historical returns in rate environments ranging from deflationary to stable to inflationary, outside of a narrow equilibrium, intermediate credit risk tends to do better than either rates or equities.
 


To explain the outperformance, one must look at the development of the credit asset class over the past 15 years. Credit has become less sensitive to interest rate movement and more of a proxy for equity behavior. There has also been a divergence between lower-risk and higher-risk credit, with lower-risk acting as a proxy for interest rates and higher-risk for equity. In addition, since 2000 there have been lower incidences of default, thanks in part to activist central banks’ indirect support of capital markets and an increasing corporate appetite for debt in the capital structure. Credit risk premiums have also widened. As such, the same demographics that are slowing economic activity will also require investors to focus on shorter-duration hybrid assets that blend both equity and rate exposure.

Unlike rates and equities, whose return streams are well-defined, credit offers a diverse set of more event-specific performance drivers — from corporate and consumer profitability to housing prices and defaults to legal events such as bankruptcies and settlements. Having exposure to these idiosyncratic risks can be very useful in an unsettled environment such as the present one. Thus credit remains a high-dispersion proposition with significant outperformance opportunities and segments of the market that are not exposed to the current flood of liquidity. Investors who consider assets with more drivers such as intermediate credit can therefore help in diversifying a more classical portfolio. Credit produces close to coupon returns under lower economic activity rates and offers differentiated and uncorrelated risk factors.

 

With these attributes about credit in mind, it is important to consider where credit will reside on the risk-reward curve in the future. Keep in mind that double-digit returns based on an upward-sloping risk curve are very regime sensitive, and portfolios built with those parameters have performed well only in benign scenarios. In fact, a 60-40 equity-bond portfolio would have produced strong returns in only four of the past 11 decades in the U.S. The average return for each of the four decades would be 11.3 percent, versus 0.7 percent for the other seven, according to Deutsche Bank and Yale University economics professor Robert Shiller’s database. Not surprisingly, those decades were the 1920s, 1950s, 1980s and 1990s, eras known for breakneck economic growth. Current conditions tell us that kind of growth is not likely in the near or even mid-term. Investors should adjust their portfolios accordingly.

Sam Derosa-Farag is a senior strategist at Marinus Capital Advisors, a $400 million asset manager that provides commingled and customized credit portfolios for institutional investors. This article is based on his findings from a recently published white paper.

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