Why absolute returns rule
In a bear market, investment managers pursuing relative returns strategies can offer their clients both good news and bad. The bad news is that they have lost money. The good news is that they have not lost as much money as everyone else.
Managers implementing absolute return strategies, however, can offer clients only good news: they have not lost money.
Absolute return strategies, in theory, enable managers to make money whatever the direction of the market – upward, downward or sideways. They are therefore increasingly attractive to pension funds and other institutional investors disenchanted by the relative returns they received in the three years of the equity bear market between 2000 and 2003.
In the UK, pension funds advised by Watson Wyatt’s investment consulting business awarded twice as many alternative investment mandates to fund managers last year than they did in 2003. Most of the money went to hedge funds or funds of hedge funds. Of the total £1.75bn (e2.5bn) of alternative investment mandates, £1bn went to hedge funds, £400m to property and £350m to private equity.
Nick Watts, European head of investment consulting at Watson Wyatt, says the main impetus has come from the need to repair pension fund balance sheets. “The imperative to generate returns to reduce deficits has strengthened, with the result that many funds have moved some of their assets away from benchmark-sensitive instruments to make meaningful allocations to absolute return products, notably to funds of hedge funds.”
There is a spectrum of absolute return strategies from which to choose – from long-only through derivative-based products to hedge funds. Danny 1ll, who co-heads the Global Investment Strategies group at Goldman Sachs Asset Management (GSAM), says that pension funds have chosen broadly three strategies from this spectrum: hedge funds (including funds of fund structures), structured products and active alpha management.
“There are pension funds which have allocated a relatively small allocation to alternative strategies such as hedge funds and fund of hedge funds, private equity, commodities and currency. Then there are funds that have put in place structures that use swap and other derivatives to protect against changes in interest rates.
“Finally, there is a small number of clients who have sought to take out the market risk in their portfolio by hedging their equity risk. They’re focused on active alpha portfolios where returns are being driven by active management skills rather than by traditional market risk.”
T ruell says GSAM aims to cover these three approaches with customised products and services.
“We have a developed fund of hedge funds capability and also manage a number of direct hedge funds. For some clients we manage portfolios based against a liabilities benchmark rather than a traditional index benchmark. And we provide an active alpha approach where the constraints have been largely removed from the managers to try to create returns that clients require to meet their liabilities.”
Other asset managers slice the absolute return strategies cake differently. Vincent Chailley, head of international fixed income management at Credit Agricole Asset Management, suggests there are essentially two main categories of absolute returns strategies – leveraged and non-leveraged.
Non-leveraged absolute return strategies describe strategies where managers are given considerable investment flexibility to achieve targeted returns, often with no benchmark. They include, for example, portfolios that comply with UCITS III regulations.
Credit Suisse Asset Management, for example, has launched a ‘target return’ fund that invests solely in fixed income assets, including cash. These include core issues from traditional borrowers such as government issuers and more specialist securities such as emerging market debt, central European debt, convertibles and high yield.
“By taking full advantage of an expanding range of investment opportunities within fixed income, investors have the potential for a significant pick-up in yield during any given point of a market cycle,” says Jana Benesova Tuma senior fixed income portfolio manager at CSAM.
The attraction of funds like this is the freedom they give to managers to move between or within asset classes. “With non-leveraged absolute return portfolios basically the idea is to say you’ve got the same rules as the bond manager and the equity manager but you can buy anything you want. If you don’t believe markets are going to perform you stay in cash. If you like equities you buy 100% equities, and if you like bonds you buy 100% bonds,” says Chailley. “Basically they are of interest to an investor who doesn’t want to do his own asset allocation. For these investors the non-leveraged absolute returns solution is an all-in-one solution.”
Leveraged absolute return strategies include, by definition, hedge funds, says Chailley. “When a portfolio starts to be leveraged it falls into the hedge fund category. The difference is really the performance it gives you. Leverage gives you more room to look for opportunities in markets. You can go short in a market, implement arbitrages, and play one country against another. You have got many more sources of performance.”
Unlike non-leveraged absolute return strategies, leveraged absolute return strategies represent a new asset class that will sit happily alongside existing asset classes, he says. “It has to be considered as a separate asset class because it’s non-correlated to traditional asset classes. The bets and the positions are different from those you have in a traditional portfolio.”
Yet pension funds may be put off by hedge funds’ use of leveraging. The US Federal Reserve’s rescue of Long-Term Capital Management (LTCM) in 1998 alerted institutional investors to the level of leveraging hedge funds used to produce their absolute returns. LTCM had only $4.8bn (e4.7bn) in equity, yet it borrowed more than $125bn from banks and securities firms and entered into derivatives contracts worth more than $1trn.
Since then average levels of leveraged have halved to safer levels. “There is no link between leverage and risk, unless the leverage is huge – say above 20,” says Chailley. “In the
0 to 20 leverage range, a portfolio that has a leverage of 15 is not necessarily more risky than a portfolio that has a leverage of one. If you buy Argentinean bonds or South East Asia equities with a leverage of one you could end up with a volatility of 20% to 30%. If you buy only government bonds with a leverage of 15 the risk might be around 10%.”
Yet investors are still wary. Jack Schwager, senior managing partner of the Fortune Group, a fund of hedge funds manager, recalls Mark Twain’s observation that the cat who sits on a hot stove will never sit on a hot stove again – or a cold one. “Investors have got the same message about leverage.
“Leverage alone tells you nothing about risk. You have to also look at what is being leveraged, the underlying investment. A prospective investor will ask me as a fund of funds manager ‘how much leverage is there in your portfolio?’ That is a question that makes absolutely no sense. Leverage means something different in different investment strategies.”
A nother misconception, says Schwager, is that funds of hedge funds produce lower returns than single hedge funds, principally because they charge higher fees. “Single funds indexes are a few per cent higher than for the fund of funds. It depends which index you use, but this year it is around 7% to 8% for single funds and 5% for fund of funds.
“The common assumption is that this is because of double fees. That is certainly part of the answer, because in fund of funds you add a layer of fees. But the real explanation is that there are a tremendous number of biases in hedge fund indexes, and those biases are far more prevalent in single fund indexes than fund of fund indexes. Single fund indexes are heavily over-stated. That is the cause of the difference. In fund of funds the skill added more than pays for the double fees.”
Fund of hedge funds are still seen as the natural point of entry into leveraged absolute return strategise, and now represent a third of the assets invested in the hedge fund industry.
However, the rationale for this may have changed. Jean Keller, chief executive officer of Alternative Asset Advisors (3A) a fund of hedge fund manager that manages more than e1.2bn in alternative investments, says fund of hedge funds are no long perceived as a back door in to single hedge funds which are closed to direct investment, but as platform for delivering steady returns and lower volatility: “Fund of hedge funds have become mainstream as the demand has grown for absolute return strategies. This has led to an institutionalisation of the fund of hedge funds process. Whereas 20 years ago the typical process of a fund of hedge funds was simply to get an investor into the Tudor Jones or Soros funds, there is now a far greater need for analytical work, due diligence and a style allocation process.
“At the same time, pension funds, as interest rates have come down and they’ve been put under pressure in terms of their funding, are looking towards more asymmetric absolute return strategies. They are looking for something that will provide stable returns to their portfolio, but also will fit into their diversification process.”
The strong demand from investors for absolute return strategies has posed a number of questions about capacity. Is the hedge fund industry capable of meeting the demand? Are the best funds now closed to investors? Have pension funds left investment in hedge funds too late?
One of the characteristics of hedge funds – as with traditional funds – is that performance falls off as size increases. Currently, a large number of funds of hedge funds are closing their doors to investors simply because they are attracting too much money. Hedge fund assets are now estimated to total over $1trn. Some analysts suggest the industry is now seeing a substantial compression in returns as it absorbs these assets.
Marcel Herbst, head of business development at fund of hedge funds manager Harcourt Investment Consulting in Zurich, says the growth of assets makes it more important to be selective when selecting funds and strategies: “It is a huge challenge, not only to figure out which strategies are impacted by the growth of assets but also to find the hedge funds which are not yet impacted by these assets.”
Herbst says investing in anything that is available will eventually reduce performance. “There are very big economies of scale in funds of hedge funds and that, in turn, sometimes forces you to over-diversify and invest in hedge funds that are too big, simply because they are open for investment. That will negatively impact our own performance, so it is an absolute necessity to resist that.”
The rise in demand for absolute return strategies has led to high expectations of what they can deliver. Absolute return products are often seen as the circle squared, the ultimate free lunch. This is dangerous, says Rossen Djounov, managing director institutional at fund of hedge fund manager Forsyth Partners.
“The market place has developed and everyone is trying to get in. That’s great in diversifying the client base and introducing more liquidity. But it brings people into the industry that have a somewhat limited understanding of what the asset class is about. It’s not a panacea. It’s not a money market fund that only goes up. Yes, managers target absolute returns but in doing so they take some directional risks.
‘So although investors get positive returns on the one hand with somewhat lower volatility, on the other hand they are sacrificing liquidity and some transparency,” says Djounov.
There may also be misconceptions about diversification, a key selling point for pension funds thinking of buying into absolute return strategies. “Diversification doesn’t operate in the way it does in traditional portfolios. In hedge funds the capital asset pricing model does not apply. Concepts like value and growth work even less. The whole concept of the market is allowing managers to have complete flexibility to trade as they see fit their particular asset class.
“In theory, diversification means diversifying across different strategies. But in reality we argue that it’s not really the strategies you buy, but the way the managers trade these strategies that brings real investment diversification,” says Djounov.
For pension funds, the attraction of fund of hedge funds is the diversification they provide. Yet the cost of this diversification is some loss of returns. Yet Randall Dillard, partner of Liongate Capital Management, which launched a multi-strategy fund of hedge funds last year specifically aimed at institutions, says this is a cost pension funds are prepared to pay.
“You give up return for diversifying investments by managers and by style but we felt that was what our investors would want, and I believe that’s what pension funds and endowments would need.”
Diversification is the only way to achieve the low volatility that pension fund trustees and boards want, he says. “In the case of hedge funds pension funds would like to see volatility in a range of 6% and probably no more than 8% and they’re willing to give up some of the top end of return to achieve that control.
“You couldn’t have that low volatility if you didn’t maintain diversity over time. Therefore, the fund of funds and the diversification is the right first step for a pension fund and the best way to control volatility relative to return. “
Yet the bottom line of an absolute returns strategy is its ability to make money, whatever direction the market moves. This has proved difficult for hedge funds in the past 12 months, says Dillard. “Hedge fund managers need some direction and some volatility to make money. The market has to move, and it has to move in a direction they can call. If the market goes into the doldrums they find it very hard to make money. We had to ask what type of managers do you invest in where there is low volatility and limited market direction?”
The solution for Liongate was to move away from traditional strategies towards small segments of the market that had been overlooked.
“Within each segment you can make money in a sub-strategy. Typical of those are certain kinds of carry-trades and credit risks, and a number of idiosyncratic opportunities within each strategy that would still make money notwithstanding those market circumstances,” says Dillard.
The lesson seems to be that there are always opportunities for making money in absolute return strategies if you know where to look for them.
Richard Tarvin, head of research at the Fortune Group, is bullish. “Opportunities are very dynamic at the sub-strategy level and are changing all the time. Outside returns can still be achieved by focusing on the sub-strategies.”
The way the asset weighting of the different hedge fund strategies has changed over the past 15 years suggests that there is less consensus than ever about where these opportunities lie. In 1990 about 70% of all hedge fund investments were in global macro strategies. Last year, the figure was only 10%.
Perhaps the real challenge today is not the capacity of absolute return strategies to absorb assets but the ability of the hedge fund industry to generate new ideas.