Looking around the global hedge fund industry in 2010 there are a number of topical issues that are worthing looking at. Why, for example, has stock picking alpha been so poor in equity long-short strategies? What about the rise in “tail hedge” products that promise to protect investors against a future financial crisis? And why have large managers sucked up the majority of the money flowing into hedge funds?
Like many investors, we believed that the case for stock-picking alpha was good going into 2010. We had been through a period of high momentum down, and then up, and it seemed logical that we would see more differentiation based on fundamentals. The changing global economic environment had also created new winners and losers.
Until August 2010, the average long-short manager was still down for the year, although the strong September has now moved the average slightly positive. Alpha proved elusive. The core of the problem seems to be the high correlation between stocks, both within sectors and between different sectors. Even when a theme has driven stocks such as the” Asian Consumer” it has been rather indiscriminate. Part can be attributed to the inability of the market to shake off macro concerns, part to the increasing role of exchange-traded funds (ETFs) and index-related flows and part the increasing domination of volumes by high-frequency trading.
The key issue is whether there has been any lasting change: has the alpha in long-short strategies been permanently impaired, or can we expect some form of normalisation? The managers themselves believe that as correlation drops they typically have a period of higher alpha. The correlation did seem to peak in August and some believe we have past the worst. The managers have also been hedging themselves more with ETFs and futures and once confidence returns they will move more shorts to single stocks. This can lead to a virtuous cycle in returning to fundamentals.
Investors seem to be relaxed so far. The most common view is while the short-term alpha is uncertain, there is no reason to worry about the long-term. A significant group thinks that this makes it a very attractive time to enter the strategy. Only a few worry that alpha may be in permanent decline.
“Tail hedge” products
We are seeing a number of funds launch “tail hedge” products. These are meant to provide very significant gains in the event of a future financial crisis. They don’t pretend to hedge a more normal market correction, and they will ultimately lose most of their value over a given period if a crisis does not materialise. Clearly they are attempts to replicate the success of the credit-default swaps (CDS) on sub-prime mortgages.
The products have an insurance or option nature. Most will be “long volatility”, paying a premium for the potential of a windfall. However, they will have an expected future loss in most cases. In that sense they are “negative alpha”. Option sellers don’t logically sell options at implied volatilities lower that the actual volatility of the underlying market.
The more out-of-the-money the option is, or remote the event, the higher the spread between implied and actual volatility. However, periodically a market becomes so mispriced that conventional logic makes no sense in valuing an option. This is often true in the case of illogical buyers creating bubbles. This was the case with subprime due to a combination of declining lending standards and an erroneous assumption on correlation.
The funds will be looking for trades that have at least a five-to-ten times payout should the event happen. Most trades will use some form of put option, interest rate cap or CDS. They are also likely to have some period over which the premium will erode should the event not happen.
The key is to find the right event. Many are looking at the longer maturities of the developed world’s government bond markets. Yields are low due to zero short-term rates, potential deflationary fears, perceived flight to quality and buying programmes related to quantitative easing.
However the credit worthiness of the governments is deteriorating; continued quantitative easing may ultimately lead to inflation. None of this is reflected in the price.
A few such products have a Japan focus - the country’s government debt is around 200% of GDP yet government bond yields are minimal. To date these bonds have been financed domestically by postal savings, banks and pension funds. Some now worry that the pension industry is soon to be a net redeemer. In general, Japan’s saving rate is falling. These views are often expressed in heavily out-of-the-money yen put options or interest-rate caps. Many people have got this trade wrong for the last ten years, though it now seems to be having a resurgence as many argue the catalysts are now nearer term.
There are certain challenges running such products in a typical hedge fund structure and investors are reluctant to pay standard hedge fund fees for such a product. There are also challenges commingling assets and allowing redemptions and subscriptions. Heavily out-of-the-money options will typically have very high bid-offer spreads.
Establishing actual dealing prices can be difficult.
To achieve any meaningful hedge on a portfolio basis is not likely to be cheap. The alternative is to include more investment in hedge fund strategies they typically have negative correlation in a crisis. These would be global macro and systematic trend-following strategies.
Big managers dominate
It is not uncommon now to find that 80% to 90% of the inflows in a quarter are going to managers with in excess of $5bn AUM. Many of these larger managers are now restricting future inflows as they reach the capacity limit of their strategy. At the other extreme many managers have struggled maintaining sufficient AUM and many are giving up. This environment has also made it challenging for new managers to get started.
This is due to the continued institutionalisation of the hedge fund investors. A lot of growth is coming from large pension funds and sovereign wealth funds. Many are investing direct in single managers or even if they use funds of funds it is via a segregated mandate which tends to have fewer managers than a commingled fund. The size of many of these investors also forces them to focus on larger managers.
Conversely retail flows have not recovered so well. They were the main source of assets for fund-of-fund industry especially in Europe. Funds of funds have typically been the earlier investors for small- and mid-size managers. Managers who can tap the European UCIT structure may get some benefit from the growth of these flows but it will be at the cost of offering shorter liquidity terms.
Part of this institutionalisation would seem to be permanent. Most of the pension industry globally seems to still be increasing allocations to hedge funds. While the risk reward of hedge funds remains attractive and bond yields remain so low, this is likely to continue. However, this trend will tend to benefit managers with at least $1bn. The challenge for other managers is to get to this size.
The market may develop a few different ways. We are already seeing larger managers trying to attract talent from managers that lack critical mass, so they can continue to scale their business. We may see more platforms get set up where a manager is part of a larger enterprise rather than independent. We will probably see parts of the fund-of-fund industry focus more in seeding managers and developing emerging manager programmes. It seems now that a higher calibre of manager now accepts that they will need a seed deal to achieve critical mass.
At some point there will need to be more of a trickle down of capital as opportunities to invest in the larger managers are constrained by capacity. However, the barrier to entry has been raised to be part of the next group of managers to benefit.