Credit: Where credit is due
Joseph Mariathasan finds there is more to credit hedge funds than an inflated fee structure
Adopting an absolute return approach to credit invesment seems almost a no-
brainer when government bond yields have been depressed by central banks. But beating a cash objective with credit instruments spans an enormous range of strategies that encompass traditional managers as well as hedge funds – and everything in between.
Allocations to credit by multi-strategy funds and launches of new credit funds in the hedge fund space are testament to the perceived opportunity.
After increasing its exposures, multi-strategy fund of hedge funds SkyBridge Capital currently holds only 3% in long/short equity compared with nearly 40% in event-driven credit and approaching 30% in credit-sensitive mortgage securities, according to managing partner Ray Nolte. Stenham Asset Management, after 25 years managing funds of funds, has just launched a pure credit strategy.
Flows of investment into traditional long-only managers have been huge as well, but this has been driven by retail flows into index-benchmarked products. Should such flows reverse on the back of rate rises, spreads could widen sharply as well, which might provide opportunities for those managers with the capability to dynamically short credit.
Those traditional managers who are pursuing absolute-return strategies can approach the problem in different ways, but they all involve hedging out interest rate risk and targeting a cash benchmark (usually three-month LIBOR). Pioneer Investments, for example, runs both benchmark-oriented and absolute-return strategies, based on the same process.
“We take directional views using credit indices and also long/short positions on single names using CDS and do pair trades, taking advantage of credit views we have from the research team,” says Garrett Walsh, head of credit research in Europe. “Our fee structure is not that of a hedge fund.”
ECM also runs an absolute-return strategy, but, again, it would not see itself as a hedge fund.
“We are not tied to benchmarks and are completely unconstrained, and our absolute return fund is a long/short credit fund,” explains senior portfolio manager Derek Hynes.
“But it is significantly different from other absolute return hedge funds in the marketplace that derive a significant proportion of their returns from views on FX and rates. We are purely credit focused.”
ECM also runs what it calls a total-return portfolio, which is long-only: while it can hedge positions, it cannot run naked short positions.
From these examples, it might appear that what differentiates the hedge fund from the traditional world is simply the fee structure. But Nolte says there is more to it than that.
The liquidity profile of the underlying assets in the two worlds can be very different, he observes. The hedge-fund world tends to trade non-exchange-traded instruments, which explains why they often offer only monthly or quarterly liquidity or even longer lock-ups. (Stenham’s recently launched credit fund of funds has quarterly liquidity with 95 days’ notice and has a 25% gate).
Absolute return credit hedge funds often aspire to far higher returns, too, even after fees. The return expectation for SkyBridge’s fund of funds’ credit positions would be 10-15% against a long-only manager expecting 5-6%. Stenham targets 8-12% annualised returns, according to senior research analyst Tim Beck.
They pursue these returns through strategies that are distinct from those followed by even the absolute or target-return oriented traditional managers. Nolte identifies three main families. Relative value strategies trade between the risks of different companies, sectors or markets, or even between different parts of the same company’s capital structure or different points on its yield curve; they are nearly always duration-neutral and often credit-beta neutral, too. Event-driven strategies encompass most of the purely credit-related opportunities and would include most of the standard long/short credit funds. And the third category, macro, focuses on directional risk that might be credit-related but could also encompass FX, rates or other risks. Hedge funds are also moving into other areas left open by the reduction in bank lending.
Stenham’s new credit fund covers the full spectrum of these hedge fund credit strategies, encompassing long/short credit, structured credit and distressed debt. The long/short credit managers are focused on the high-yield market, looking to benefit from the asymmetry of being short credit, but others exploit strategies and use instruments that are not generally available to traditional managers. Structured credit exposure is gained by investing in funds with 50-70% exposure to opportunities in securities such as non-agency RMBS and CMBS, CDOs and other ABS.
“These are very complex and the least homogenous securities,” says Beck. “They don’t have a beta to the sub-prime market but require analysis of the dynamics of individual cashflows, so there is plenty of scope to generate alpha.
Distressed debt funds focus on opportunities like those arising from 2008 liquidations. “The underlying risks in this are very different from broad credit market risks,” explains Beck.
These strategies bear more resemblance to what goes on at private equity firms, commercial banks and the proprietary trading desks in investment banks – and indeed, Beck at Stenham sees these traders as the biggest competitors to hedge funds rather than absolute-return long-only managers. Of course, the reduction in ‘prop’ trading by those banks has therefore increased the opportunities for credit hedge funds (and indeed led to the creation of new ones as prop traders leave their jobs on Wall Street).
Hedge funds and long-only managers may both be targeting absolute returns, but investors need to weigh up the benefits of the hedge fund approaches against their higher fees – and those strategies are not just more costly versions of what they can buy at the traditional credit and bond houses.