Hedge Funds: Bottom-up on the up
The structure of investment markets seems to have changed significantly since the end of 2011. Since then, there has been a definite trend of falling correlation of the price action of individual equity securities, as indicated by such measures as the CBOE S&P500 Implied Correlation index. After peaking over 0.90, it is now flirting with correlations of just 0.50 again.
“We’ve seen correlations moving away from 1.0, and that means that attention has to start moving away from politics and towards individual situations,” suggests Morten Spenner, CEO at International Asset Management. “That’s part of what we’d call the ‘post-crisis clean-up.’”
So much for correlation within risky assets. Look at the all-important correlations between risky and ‘risk-free’ core government bonds and you see the antithesis. Here, the correlation between changes in the price of 10-year US Treasuries and changes in the S&P500 index has been rising since about the same time – some 6-7 months, at least, before bond yields bottomed-out in mid-2012. (Figure 1 shows correlation between the equity index and the bond yield, inverted). The trend appears to have really taken off as 2012 passed into 2013, perhaps in response to ECB President Mario Draghi’s promise on 26 July 2012 that the ECB was ready to do “whatever it takes” to preserve the euro, which may have set the floor under both safe-haven yields and developed-market equities. This year, Federal Reserve Chairman Ben Bernanke’s hints that the quantitative easing programme might be tapered added to the upward pressure on rates without seriously damaging the equity bull market.
This dramatic change in the underlying environment has led to differing impacts across hedge fund strategies.
“Hedge funds exploit dispersion – the result of which we would call alpha – or they exploit volatility – the result of which is market timing,” says Nicolas Rousselet, head of hedge funds at Unigestion. “Before 2007, there was always one of the two opportunities available. But the post-2008 volatility, especially in credit, was short-lived: the central banks intervened and the volatility was compressed. In the past, when volatility went down, dispersion went up. But because of the dominance of these top-down drivers of risk, everything moved as one – dispersion collapsed alongside volatility, for the same reasons.”
The only good news for hedge funds since the crisis, Rousselet continues, is that this regime ended in 2012, as dispersion coming back to equity markets. What changed? Rousselet points to both “whatever it takes” and the related appearance of ‘QE Infinity’ – the practice of central bank purchases of a set amount of assets in the open market every month until some measure of economic recovery had reached a set level.
“We moved from a world of QE1, 2, 3 to a world of ‘QE Eternity’,” he explains. “The market got used to QE and was now faced with a situation where it felt, rightly or wrongly, it knew what was going to be happening from the top-down level for a long time into the future. That meant that no-one was interested in views on QE anymore, so attention focused back on fundamentals. At the same time, banks continue to reduce their activity: we can see that in lending, in market-making, but also we expect to them to reduce their analysts’ activity on the sell-side, providing much less coverage of the market, which should also be beneficial for stockpickers who are able to do that work for themselves. For the first time in a long while, long/short managers are making money in both their long and short books, and that’s where we think the best opportunities are today, with managers focused on the micro, the fundamentals, stockpicking.”
Christopher Fawcett, senior investment officer at Permal Group, whose funds of funds tend to be biased towards top-down and macro strategies than the average, agrees that the new environment “hasn’t been helpful for trend-following managers such as CTAs”. He adds: “It has been good for long/short equity managers and is potentially beneficial for distressed and macro managers, particularly if they include emerging markets where there has been a fair amount of movement.”
Recent numbers from hedge fund research firm HFR tell the broader story. The top-down strategists that make up the HFRI Macro index are currently the only group in negative territory for 2013. The Systematic Diversified sub-strategy – HFR’s term for CTAs, broadly-speaking – has certainly been the worst place to be but, pace Fawcett, macro as a whole has found conditions tough. By contrast, strategies that depend particularly on bottom-up analysis – and on markets recognising companies’ bottom-up fundamentals – are faring well. The Distressed/Restructuring index is having an excellent year; but perhaps even more impressive are the returns to the normally low-volatility, low-return strategies included in Event Driven and Equity Market Neutral.
Given that there is a long way that intra-equity correlations could fall, and a long way that bond yields could rise, should investors dig in for a continuation of this pattern of returns?
“At the moment, we prefer discretionary macro to CTAs in this environment, as well as those managers whose skills lie in single stock or credit selection,” Fawcett concedes. “But, this can all change very quickly. Macro managers did well on Japan earlier this year, so macro is not finished as a style.”
Rousselet at Unigestion is sceptical. “None of this generation of macro and currency traders seem to have adjusted to the post-2008 world, where politics drive everything,” he says. “When was the last time that central banks did anything that was genuinely unpredictable? It was 1994. The models that the new crop of managers have become used to exploiting simply aren’t valid any longer.”
Ray Nolte, the CIO of SkyBridge Capital, similarly points out that his firm has a zero weighting in macro because it finds that, whilst one might imagine that the environment should be teeming with opportunities to trade interest rates, currencies and shifts in yield curves, it is finding that macro managers have been unable to generate profits.
“A big driver can be attributed to the fact that markets are being skewed – or even manipulated – by central bank policy,” he says. “It is very difficult to trade markets where you have a global QE programme going on. How much have central banks driven rates beyond the point where any models will have any predictability?”
Instead, Nolte sees the new environment as fundamentally favouring the more bottom-up, and especially event-driven, equity-biased strategies.
“A big move we made earlier that is working well was towards catalyst-focussed approaches in the event driven space, both recognising and expecting a healthy equity environment,” he says. “Having been absent long/short equities for several years, we have begun moving into long-biased fundamental equity managers that are very focused on individual stock selection. The US market is at fair value, but you can start to differentiate outperforming companies.”
While fund of funds firm Cube Capital does not divide the hedge fund world up into top-down and bottom-up strategists, but rather thinks of its portfolio in terms of investment and trading themes, its current themes certainly play into the assumption that conditions are best-suited to bottom-up approaches.
Recognisably top-down themes are limited to one that exploits demographics and growth, primarily executed via long-only funds in frontier markets, and another that is about playing yield-curve normalisation, executed with macro strategies but also convexity products like mortgages. More important have been its themes of regulatory change – which was played through managers exploiting fundamental mispricing in structured credit, the spike in longer-term volatility that occurred in the wake of investment banks shutting propriety trading desks in response to the ‘Volcker Rule’, and the opportunities presented by banks seeking to improve their balance sheets by issuing hybrid paper and equity, and replacing their TARP allocations.
These are all dependent upon bottom-up analysis of fundamental mispricing of risk, and sure enough, Cube Capital’s biggest theme is focused on ‘de-synchronisation’ and stock dispersion, which it exploits through equity market neutral strategies.
“That became crystallised at the end of last year,” says Scott Gibb, a partner at Cube Capital. “We focus on low net exposure sector specialists that are taking advantage of stock dispersion which suits a low-rate, low-growth environment. As things move towards normal, quite a lot companies will not survive and others will do very well. There is a lot of creative destruction, for instance in sectors like media where entire revenue models are changing.”
Credit strategies have performed well, as Fawcett explains, but the view that investment grade presents interest rate risk and high yield is trading at, or above par, leaving scant chance of appreciation dominates.
This has led investors to consider the distressed-debt area for high value opportunities in credit. Interestingly, performance has been impressive even though there have been few bankruptcies since 2008.
“What you are seeing is opportunities arising from the consolidation of the banking industry,” Fawcett explains, echoing some of Cube Capital’s themes. “In the US, medium-sized companies are finding it difficult to get financing, and European banks have been off-loading loan books – these are not liquid, so only suitable for certain hedge funds. We are talking about distressed sellers, not distressed borrowers. The more regulatory pressure the banks have been under to tidy things up, the greater the need to sell. Interestingly, the bank that has been able to rebuild its reserves can afford to sell the loans and take the loss whereas a weaker bank may not be able to afford to do that.”
All of this may be useful if hedge funds are being used purely to generate attractive returns, and allocators want to time their balance to or entry in and out of strategies. But if a hedge fund portfolio is being used to strategically complement the rest of the portfolio, are these insights relevant?
Toby Goodworth, head of risk management at the investment consultant Bfinance and ex-head of risk at the fund of funds firm Key Asset Management, says that while there are plenty of good stockpickers among long-biased long/short equity managers, these do not offer much diversification against a core portfolio exposure to equity markets.
“Credit long/short is a bottom-up strategy that is diversifying so can make sense,” he says. “But if you are a pension fund with enough equity and bond exposures, you may prefer something like CTAs, so investors are still allocating to top-down strategies as much as they have always.”