Making the risks more manageable
Hedge funds are attracting great interest from institutional investors in the present climate, largely because of the attractive risk-return profile and the relatively low correlation between hedge funds and equities and bonds.
Hedge funds only run the risks that they ‘want’ to run – which means that investors can effectively do the same by choosing one or more specific hedge funds. As a result, alternative products such as hedge funds in general can be a valuable addition to an investment portfolio. This can significantly improve the return for a given risk or, conversely, significantly reduce the risk for a given return.
Risk is often defined as the deviation of the yield of an investment portfolio from the long-term trend: the standard deviation. A distinction can be drawn here between the market or systematic risk and company-specific or non-systematic risk. Company risks can broadly be divided into five categories: credit risk, market risk, liquidity risk, operational risk and legal risk. In practice, however, we also encounter these risks at the level of the market.
Developments such as globalisation, the blurring of boundaries between the different financial markets, the increasing marketability of previously non-marketable debt, the increased complexity of financial instruments and the consolidation taking place in various markets and sectors of industry have created a need for good risk management
Hedge fund fall into three categories based on their strategies: funds focused on relative value; funds focusing on special situations, or funds with an opportunistic strategy (see table 1):
q Relative value. Here the manager seeks to take advantage of relative price differences in the financial markets. One possibility is convertible arbitrage. Convertible arbitrage funds seek to derive ‘advantage’ from the often ‘too cheap’ call option component of a regular convertible.
A second possibility is fixed income arbitrage. Here the manager seeks to take advantage of small inadequacies in pricing and inefficiencies on the fixed-income markets and their derivatives. Wide use is made of futures here.
A third possibility is the equity market neutral fund. This type of hedge fund takes advantage of the existence or occurrence of temporary ‘blips’ in the relative pricing of related equities and derived instruments.
q Special situations. The event-driven hedge fund manager seeks to draw advantage from ‘unusual’ events in the existence of a company, such as a takeover, merger, liquidation or a spin-off, by using his skill to determine the most probable outcome of the event. The manager therefore concentrates on the event itself, while the market risk is hedged.
Hedge funds in this category may focus on distressed securities, or securities of companies which are in serious financial difficulties. US companies covered by Regulation D and which thus have a low credit rating can still be an interesting investment proposition because the attractive valuation of convertibles adequately offsets the higher risk profile. The hedge fund does not therefore participate directly in the share capital of the company, but in a convertible which is usually offered to a limited group of investors.
Other hedge funds in this category may concentrate on merger arbitrage. In the event of a merger, these hedge funds take opposing positions in the acquiring company (sale of shares and/or derivatives) and the company to be acquired (buying of shares and/or derivatives), assuming the merger goes ahead. The same system may be applied to a restructuring or an acquisition.
q Opportunistic strategy. These are hedge funds with a specific vision of the future. Global macro hedge funds use a top-down approach to take advantage of specific and anticipated macroeconomic, interest rate or currency movements by buying and selling equities and bonds and through the use of commodity derivatives and currencies. The emphasis is on the ‘big picture’ and involves wide use of futures, options and currencies.
Short selling or long only strategies aim to derive benefit from leverage by selling or buying – possibly using borrowed funds – securities based on a positive or negative view of the future with regard to a company or market. In contrast to the top-down approach of global macro funds, these funds adopt a bottom-up approach.
Mortgage-backed hedge funds focus on securities mortgage portfolios to benefit from the ‘hidden’ value which is there to be taken from the increased marketability.
The most widely used form of hedge fund is the long/short equity fund. This type of manager therefore buys equities which he expects to outperform the market. At the same time he sells equities from which he expects an underperformance relative to the market. The ultimate objective is to reduce the market-sensitivity or ‘beta’ of the portfolio by having an exposure of less than 1% to the market, whilst at the same time seeking to achieve a high ‘alpha’, the added value contributed by the skills of the manager.
How do hedge funds as a whole perform compared with equities and bonds? The end of the bull market on the main equity markets coincided with the quest for a ‘good’ absolute or relative performance. Research shows that hedge funds are generally an attractive addition to an investment portfolio consisting solely of bonds and equities. Table 2 confirms this. The low correlation, especially with bonds, improves the chances of a better risk/return profile through the addition of hedge funds.
Hedging using convertibles is increasingly dominating activity on the convertible markets in the US and Europe. Hedge funds that focus on convertible arbitrage account for approximately 70% of turnover on the specific convertible markets. In addition, roughly 40% of the outstanding loans worldwide are in the hands of these hedge funds. The ‘proprietary desks’ of investment banks are also active in this market. However, given the risks and the size of the borrowed amounts involved, these activities are placed in separate legal entities which operate separately from the banking institution.
A convertible consists of a normal bond and a call option. The ultimate objective of convertible arbitrage is to reap the rewards which are lying there to be picked, as it were, in the form of the difference between the actual and theoretical value or under valuation of the call option portion of a convertible. An important factor in this regard is the convex (gamma) curve of the theoretically determined value of the convertible, being the sum of the bond and call option value.
The best-known form of hedging is delta or risk-neutral hedging. The change in the price of the convertible relative to the price of the underlying equity is defined as the ‘delta’ Several conditions have to be met in order to achieve a successful delta hedge. Good marketability of both the convertible and the underlying equity is the first prerequisite because otherwise it is not possible to take full advantage of the available ‘profit’. The ability to borrow on the underlying equity is a second condition if the institutional investor already holds the shares and wishes to use borrowing to release money to purchase a ‘protective’ convertible.
In the convertible market the average liquidity and the opportunities for borrowing on the underlying equities, has improved since 1998. This is good for hedge funds operating in this field, as the net returns achieved between 1998 and 2001 show. The global convertible market is expected to grow from around $475bn (e537bn) to $1,200bn–1,500bn in 2010. Against this background, and in the light of the increasing size of individual loans, it is likely that the volume of convertible arbitrage will grow further.
More convertible loans are being given an official rating on issue, while the Association of Convertible Bond Managers recently set an example with respect to potential prospectus risks. This means that efforts are also being made via other channels – the official bodies which issue credit ratings and the managers of convertible portfolios – to make the various risks more ‘manageable’.
Jacques Grubben is head of institutional asset management research at Insinger de Beaufort in Amsterdam