Hedge Funds: A true alternative

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Bainbridge Partners exploits the fact that some hedge fund strategies simply diversify better than others, finds Martin Steward

Most in the financial world would prefer to forget the second half of 2008. For Bainbridge Partners, the $1bn (€0.7bn) fund of hedge funds founded in New York in 2002 and now based in London, it brought long-awaited vindication.

To the end of September 2011, Bainbridge's eight-year old flagship, Aperio Master Alpha Strategy, achieved an annualised return of 4.4% with volatility of 3.56% and a maximum peak-to-trough drawdown of just 3.95%. Over the same period the HFRI Fund of Funds Composite index annualised 3.18% with volatility of 5.96%. But its maximum drawdown was 22.2%. Of course, it was that horrifying fourth quarter of 2008, when Aperio not only preserved capital but grew it by 1.85% (while the fund of hedge funds universe slumped by 10%), that made all the difference.

In the fund's first full year, 2004, it lost 0.18% when the broad hedge fund universe (as represented by the HFRXGL investable index) made about 2.7%; in 2005-07 it generated fine absolute returns, but underperformed the hedge fund universe by several percentage points. During the good times, Aperio made for a rather plain Jane among the hedge fund world's more ostentatious beauties.

"Our managers are liquidity-takers, so we were paying the liquidity premium to the others," explains Aperio founder and managing partner Antoine Haddad. "They are long-volatility, using ‘divergence' strategies, and faced significant headwinds in this period where volatility collapsed back towards its historical lows. And our fund is beta-neutral, while the average fund of funds has a beta of about 0.3, so that cost us about 3%, too. It's unfair for investors to pay 1.5/10 on top of 2/20 for that beta which Vanguard or any other ETF provider can deliver for less than 15bps, but it's still difficult to sell this strategy in benign markets. How long could we have survived delivering 1-2% less than our fund of fund peers, if 2008 hadn't come along?"

The long-vol, trading-oriented strategies preferred by Aperio are where Haddad feels at home.

He started out as a Kansas grains trader for Louis Dreyfus before joining the managed futures specialists Millburn Ridgefield Corporation and Quest Partners. It was a small part of Quest's fund of funds division that Haddad spun-out in 2002, as the firm decided to focus on its core business, that was to become Bainbridge Partners.

The profile of the fund Haddad wanted to build had become deeply unfashionable. Up until the late 1990s the hedge fund universe was dominated by directional traders - the classic CTAs and macro funds - but as it ‘institutionalised' in the early 2000s it changed to meet demand for ‘equity-like returns with bond-like volatility', provided by more and more long-biased long/short equity funds and the ‘convergence', short-vol strategies that make up the arbitrage universe (all intermediated by ‘low-volatility' diversified fund of funds).

Luckily, it was precisely this drift that gave Bainbridge its first gig, from a French bank that had $10m to allocate to part of its portfolio of funds of funds. "Most of what they were putting in that basket had similar characteristics," Haddad recalls. "They were all about collecting market premia - the convergence premium, the illiquidity premium and the equity premium - so I suggested that we design something diametrically opposed - long volatility, beta neutral, with no exploitation of the illiquidity premium."

Aperio was the result, together with its (perhaps disappointing) steady returns until 2008, and (extremely gratifying) steady returns in 2008. It should not be surprising that it came into its own again through Q3 2011 - finishing up 2.15% while the broad hedge fund universe (in its fourth-worst quarter ever) gave up 6.45%.

A cursory look at Aperio's style allocation demonstrates how different it is from today's hedge fund universe. Analysis by HFR suggests that universe is split roughly evenly by assets into relative value, macro, long/short equity and event-driven strategies. While defining hedge fund styles is as much an art as a science, it is fair to say that Aperio runs close to that benchmark for long/short equity and relative value, but has a massive underweight to event-driven (0.5% of assets) and a massive overweight to macro and directional strategies (43%).

That goes some way to explain the relatively low correlation Aperio exhibits with the HFR Fund of Funds index (0.58). "Once you filter out for the illiquid, long-beta and short-vol characteristics, you're left with very few hedge funds that fit the bill," Haddad explains. "Out of 10,000 hedge funds, perhaps 300-500 have the characteristics we look for. Diversification is good, but over-diversification can make you look like the index, diluting the efforts of underlying managers to generate alpha."

But, as Haddad says, diversification is good, and perhaps the most notable aspect of Aperio is that it delivers its long-vol payoff in tumultuous markets from a foundation of diversified risk that limits the insurance premiums it pays out in benign ones. A glance at the fund's strategy allocation confirms, for example, that pure options-based volatility trading is negligible, at 2.35%.

"Most volatility strategies are short-vol," Haddad notes. "Our portfolio has a strong long-gamma bias [that is, it behaves non-linearly, like an option], but we don't simply buy out-of-the-money options - we get it from strategies whose returns resemble the long-option payoff, mean-divergence strategies like medium-term trend-following CTAs, for example."

But the portfolio is not weighed down by managed futures, either: 17.15% is enough to get sufficient bang for each buck (Haddad essentially sees them as tail-risk protection for an otherwise diversified pure-alpha portfolio, which is why Aperio favours medium-term trend followers to short-term traders that tend to bet on mean-reversion; Bainbridge offers a fund-of-CTAs for those who want to buy such protection for their own core portfolios).

This diversity can be seen at work through several key periods in Aperio's life. The collapse in volatility in post-dotcom 2004 resulted in a loss, but -0.18% was hardly fatal. Similarly, the return to lower, but still elevated levels of volatility during 2009 - which caused medium-term trend-following managed futures such a headache - threw up abundant opportunities for Aperio's long/short equity managers (who tend to be either market-neutral or more ‘macro' in style, with highly variable net exposures). Essentially, the source of returns shifted from managed futures in 2008 to long/short in 2009. "But that was not due to a change in our allocation, which is roughly static precisely because it is hard to time manager alpha," says Haddad. "It is reasonable, however, to diversify its sources; it really is possible to diversify among these directional strategies - between CTAs and long/short equity, between systematic and discretionary, between short-term traders and longer-term traders, and so on,"

By the same token, it is worth noting that the fund did not shoot the lights out in 2008; its return of 3.04% was perhaps 2.5% lower than it might have been had the high-conviction long/short equity traders in the portfolio not been nudging overall portfolio beta up to around 0.10 (positions that eventually came good through 2009). Q3 2011 looks very similar. In all three months, managed futures came out on top, but beneath that was quite a varied story: July benefited from a big contribution from a highly idiosyncratic European local power trading strategy; August benefited a long-vol options trader and a short-biased credit manager (unusual in a long/short credit universe which is very long-biased); and September had good returns from the power traders again, but also an emerging-markets macro fund. This last example is particularly striking, given that the worst performing sector in the fund over Q3 was emerging-markets macro, which suffered from the flight-from-risk sell-off in emerging currencies.

Haddad particularly likes the fact that, for any single year, two-thirds of Aperio's managers will be in positive territory and one-third flat or negative: "Even if you take out our top three managers in 2008, our return would have been close to 0%, and nowhere near the -22% of our peers," he says. "Likewise, in Q3 of this year the return sources have been very mixed, but always from managers outside the traditional long/short world, directional, looking to trade opportunities for a few weeks or months."

Those shorter time horizons are another key to the diversification Aperio can exploit.
In one respect it is accidental - because these funds trade frequently they cannot afford to get too big which, in turn, means that many of the mainstream funds of funds cannot get the capacity they need with them. More pointedly, the alphas of shorter-term traders are more robust and less correlated with one another than those of longer-term investment managers (the odds of having overlapping trades when taking long-term positions is simply higher).

"If your track record is based on three or four ideas per year, there is no reason it should be indicative of future performance," says Haddad. "That's a bigger leap of faith than going with someone who said they made money from 300 of 500 trades last year, and they intend to make another 500 trades this year."

The net result is portfolio-level volatility of 3.56%, despite the volatilities of individual funds often clocking in north of 10%. Not only does that volatility undercut the 5-6% delivered by most of the ‘low-risk' short-vol strategies out there; the fact that most of those strategies load up on longer-term exposures to the same factors - market beta, short-vol and the illiquidity premium, the factors that Aperio takes the other side of - results in very little portfolio-level diversification for mainstream multi-strategy funds of funds. Even with 20-25 of these strategies, they still deliver 5-6% volatility. And that is before we even consider the fat left tails in their return distributions, relative to the positive skew afforded by the directional strategies favoured by Aperio.

These characteristics - low volatility and robust diversification that is unlikely to collapse suddenly in a flight to safety and liquidity - make Aperio an excellent platform for leverage. Bainbridge's high net-worth and family-office clients take advantage of a leveraged version of the strategy which has volatility of about 8%. For pension fund and insurance clients, Haddad prefers to draw attention to Aperio's bond-like returns and volatility with zero duration.

Over its first eight years (which, remember, were not always ideal markets for its long-volatility, beta-neutral mandate), Aperio generated the same return as the Barclays Aggregate Bond index, with the same volatility, the same worst monthly loss and very similar maximum peak-to-trough drawdowns. But Aperio's beta against the index was just 0.10.

"The big fear among pension funds is that, first, there isn't enough yield in bonds to meet their obligations and, second, there is a lot of downside risk presented by a potential pick-up in inflation," says Haddad. "Why wouldn't somebody looking to reduce their duration risk choose to move to something like Aperio, and then move back into fixed income when rates have risen? From an asset-liability perspective, pensions may not worry because their long-term liabilities are matched with their long duration assets, but do they really want to see their asset portfolios take a big mark-to-market hit? They know inflation is coming; it seems complacent not to do anything and be tactical about it."

It is an interesting turnaround. We find ourselves back with the argument that hedge funds should be considered as a fixed income replacement - but this time the argument is based on the robust power of genuine alphas to diversify, rather than the power of the fat tails of risk premiums to deceive.

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