Hedge Funds: Rehabilitated
Since assets under management crashed during the financial crisis the hedge fund industry has experienced a phoenix-like revival in fortunes. But Joseph Mariathasan finds that it is far from back to business as usual
Some hedge funds had a torrid time of the 2007-08 financial crash, driven by investors' realisation that they were not participating in an absolute return asset class after all, that their money could be ‘gated' for months, and the epic fraud perpetrated by Bernard Madoff.
That is the opinion of Charles Baillie, co-head of alternative investments and global portfolio solutions at Goldman Sachs Asset Management. "Seven out of the 10 largest hedge fund of funds were exposed to Madoff, or other hedge funds that wound down in a similar manner," he says.
Despite all that, hedge fund assets are now around $1.7trn, not far from their previous peak of $1.9trn, and Baillie reckons that three quarters of hedge funds are at or around their high water marks again. The recovery has been swift. But the industry has also changed substantially. "The hedge fund industry has matured and moved from the rampant growth phase that we saw in 2006-2007," says Joe McDonnell, head of diversified alternatives at Morgan Stanley Alternative Investment Partners. "The interest has moved from the private client world to the institutional space - which presents its own challenges for hedge fund businesses."
The hedge fund world is supposed to be about skill and the persistence of outperformance - qualities that have always been difficult to pin down in the long-only world. But as David Kabiller, founding principal of AQR Kabiller observes: "Skills are antithetical to scale. There has been a paradigm shift from an asset class with $50bn under management to one approaching $2trn."
Where once skill was expressed in markets in the most liquid instruments, scale has led to moves towards less liquid and more directional strategies. Furthermore, fund of fund managers coping with such large inflows and the fact that many of the best strategies are long closed to new business, are forced to invest more into non-capacity constrained strategies like long/short equity, resulting in skewed portfolios.
But it does not have to be this way. Lisa Fridman, head of European research at PAAMCO, says that while most new flows have gone to the largest and more well established players, "it has been very exciting to see new launches in Europe after a subdued emerging manager activity period in 2009, and we expect to see more as banks have to divest their proprietary trading desks".
The flipside of the shrinking prop desks is that the hedge fund world might face even less liquidity for many of its strategies.
Classifying hedge fund opportunities can be done in a variety of ways reflecting the asset classes being utilised, the instruments traded, and the levels of liquidity available for the strategy. The Dow Jones Credit Suisse Hedge Fund indices (formerly known as the Credit Suisse/Tremont Hedge Fund indices) divides the universe into nine sectors: convertible arbitrage, dedicated short bias, emerging markets, equity market neutral, event driven, fixed income arbitrage, global macro, long/short equity, managed futures and multi-strategy. The most liquid would include equity hedged (encompassing equity market neutral and long/short equity), managed futures, global macro and low-geared relative value. The more illiquid end of the spectrum includes event-driven relative value strategies such as distressed debt and convertible arbitrage.
The split among these strategies varies tremendously between different funds of funds. John Angell, COO of Man Group's fund of fund business, says that its offering is skewed towards equity hedged, global macro and low-geared relative value, while smaller weightings are applied to event-driven strategies and managed futures. By contrast, Omar Kodmani, CIO of Permal, says that its portfolio focuses on the broad liquid strategies - which for the firm encompasses macro, fixed income and equity-related strategies.
"This has been our hallmark since we started more than 30 years ago and these are strategies that work through time, unlike others that work only in limited market environments," he explains.
When it comes to tailor-made strategies rather than the off-the-shelf funds, the ratio of demand for liquid versus less liquid strategies is 90-95% in favour of liquid, says Angell. This is not surprising as one of the biggest consequences of the crash was that investors found themselves ‘gated', because funds facing redemption notices had to sell their most liquid assets no matter the price.
The credit crash dislocations will take years to stabilise, which should provide immense opportunities for hedge funds. Global macro strategies have historically done well in the years after major market dislocations, with their ability to exploit the asset price distortions, central bank actions and exchange rate readjustments that generally follow such events.
In 2008 Permal increased exposures to macro and systematic strategies. This year it shifted towards discretionary macro strategies, believing such managers to be better suited to the uncertain environment. This includes plays on emerging market currencies and commodities, particularly agricultural commodities. "We still see upside there and we are still positive on metals, where the technical position is still favourable in terms of demand versus supply whilst there is an ongoing arbitrage between gold and gold mining shares," says Kodmani. "But the global economy is now in a fragile zone: we put the probability of a double-dip recession at 30% and as a result we have to be balanced, and at the margin favour fixed income and macro strategies over equity related ones."
Man Group is most positive on global macro strategies and describes a very similar outlook to Permal's. "The dislocations mean that there are plenty of opportunities out there," says Angell. "With emerging markets, for example, there are opportunities with currencies, interest rates and sovereign debt markets giving rise to curve-flattening trades and fixed income arbitrage. Including commodities in global macro introduces another range of opportunities."
At PAAMCO, Fridman notes that ‘risk-on/risk-off' has presented "a difficult environment through which to navigate directional funds", resulting in a more event driven-tilted portfolio. But its increasing bank loans exposure also illustrates how fund of fund players are well positioned to adapt their own portfolios to reflect the changing market environment and more short term, but still highly attractive, opportunities.
Distressed debt may well be a strategy with this kind of potential in the coming years.
Jason Mudrick, CEO of debt specialist Mudrick Capital Management points out that while defaults hit a high of 13% last year, most of the leveraged buyouts undertaken at the height of the private equity boom have not yet been restructured.
"The period from 2005-08 had the largest in number and value of leveraged buyouts in any three-year period in history, and at historically high leverage multiples averaging eight times EBITDA," he observes. "Then we saw the most severe contraction since the Great Depression. That should be the cause of many restructurings."
However, these have been delayed because as the debt was floating rate, near-zero interest rates and few covenants on the debt meant that companies have so far been able to avoid any technical defaults on the debt. As a result, there are likely to be two waves of defaults. The first has already occurred with companies that could not meet interest payments because the business environment changed; the next wave is still to come and is less correlated with the recession and more with debt maturity - much has to be refinanced over the next few years. Companies more than six times leveraged will face a problem as capital markets demand interest rates at double digit spreads over LIBOR, leading inevitably to restructurings.
Some investors are keen to make these top-down decisions themselves - not least because they are no longer sure that a multi-strategy fund of funds is the best vehicle for managing conflicting liquidity profiles. "What we have seen throughout our history is that our investors are becoming more sophisticated in alternatives," says Fridman. "Some are investing directly in the larger hedge funds, while using fund of funds for niche strategies and specific portfolios that can complement their direct allocations. At the beginning of 2009, we had requests for a credit focused fund of funds; more recently we are seeing demand for macro-oriented and event-driven exposure."
The Madoff fraud had a tremendous impact on pension funds investing in hedge funds. Most notably, it increased their ‘headline' exposure and placed more emphasis on rigorous approaches to monitoring operational, market, liquidity and reputational risks.
"Hedge fund investing has moved away from the more informal network of high net worth individuals, although that still exists, to the more rigorous institutional marketplace," says McDonnell.
Attracting investors requires more than the Madoff approach - opacity combined with an aura of cocktail-party exclusivity and access to strategies that may be on the margins of the acceptable. For institutional investors, the story of hedge fund investment now is of moving beyond simplistic exposures to an ‘asset class' through opaque multi-strategy products, towards more detailed understanding of underlying exposures and their effect on the portfolio as a whole. They also demand a level of due diligence that will ensure that the Madoff-type risks are a thing of the past. "We have a dedicated due diligence team of forensic accountants and we would never invest with anyone who we were not able to meet," explains Michael Dyer, fund of hedge funds portfolio specialist at Morgan Stanley Alternative Investment Partners. This is increasingly the standard demanded by institutional investors.
Will hedge funds will deliver on the promise of double-equity returns at half the volatility over the next decade? Their return to favour seems to suggest that many people believe this is the case. But it mightg be worth ensuring that the transparency and liquidity exists to be able to monitor the situation and bail out if the hopes turn out to be misplaced.