Wednesday, February 01, 2012
Aren’t hedge funds supposed to hedge? In 2011, as managers swerved in sync with the stock market’s wild swings, one might have wondered if hedging is a lost art. Maybe it is, as managers in many strategies — from equities and market neutral to event-driven and multistrategy — grappled with the thorny issue in a year of heightened volatility.
The performance of hedge funds since 2008 illustrates the problem: They failed to capture much of the upside in 2009 and then did worse than the markets on the downside last year.
That’s not the way it’s supposed to work. It’s okay for hedge funds to gain less than the market when it’s rising — after all, they are hedging — but when the market goes down, they should lose less. Theoretically, the alpha masters should be able to prosper during times of wildly fluctuating markets.
If these were the hedge fund rules, they have been broken now. While the S&P 500 was flat for the year, the median AR Composite Index fell 0.47 percent. Last year, when managers tried to hedge, it was often too little, too late: They reduced exposure, then the markets reversed and they missed the run-up, creating what’s been dubbed the whipsaw effect. In 2009, in contrast, the S&P 500 gained 23.5 percent, and the median gain for the AR Composite was 14.83 percent.
Even star managers have acknowledged the difficulty of hedging these days. At his annual investor meeting in late 2010 and in Las Vegas last spring, John Paulson warned that he would not be using certain hedging techniques because they had become too expensive. Paulson increased his hedges later in the year, but it was too late: Paulson’s Advantage fund was down 36 percent in 2011, while his Advantage Plus sank 51 percent.
Paulson’s losses were among the heftiest, but other event-driven managers were also hit hard. Typically long, some resort to shorting indexes to hedge even though they don’t have overall market risk. But event-driven managers tend to invest in riskier names, and these fall the most when the market goes through one of its gut-wrenching nosedives. That might be one reason the AR Event-Driven Index was down more than 5 percent for the year — the worst performance of any AR index by some 100 basis points.
Some managers short indexes instead of individual stock names because of the unlimited downside potential of short positions. Shorting individual stocks has also gotten more costly, in part because prime brokers are having trouble locating the stocks to borrow. It seems that since the fracas following the Lehman Brothers bankruptcy, pension funds and insurance companies have become wary of lending their securities.
Options, whose prices are a function of time, interest rates and market volatility, are another way to hedge individual names; their cost is limited to the premium. But despite low interest rates last year, puts were extraordinarily expensive because of market volatility.
Those who have figured out how to short individual names prospered in 2011. One such manager is Mason Capital Management, which gained about 5 percent, in part by shorting credit spreads, property developers and solar energy companies, according to investors.
Elliott Management was another savvy hedger last year, netting 4.2 percent in its onshore fund, much of it due to gains on hedging. Through the third quarter, Elliott reported that its portfolio volatility protection earned the fund 3.9 percent gross of fees and expenses. Some of the hedges employed were sovereign credit protection strategies, single-name high-yield shorts, gold call options and some rates trades.
A subset of event driven, risk arbitrage was also tough to hedge last year, and the much-anticipated flurry of deals just didn’t happen. When News Corp.’s bid for BSkyB fell through last summer in the wake of the investigation into the Murdochian method of news gathering — illegal phone hacking — the arbitrageurs who bet on it lost a bundle. Among them were Perry Capital and Taconic Capital Advisors. Perry’s offshore fund fell 7.57 percent for the year, while Taconic’s offshore event-driven fund ended down 2.7 percent.
Perhaps just as important, funds like Taconic also paid up for expensive tail hedges, designed to kick in if the market falls substantially in any single day. In a year when Armageddon seemed right around the corner, given the shaky status of the euro, the downgrade of U.S. debt, the Arab Spring and the Occupy movement, these hedges gained currency — and became quite pricey. Employing them inside a regular hedge fund ate into returns last year.
It’s a little bit of the damned if you do, damned if you don’t. But hedge funds will have to do better this year to keep their reputations, if not their assets, intact. AR
Wednesday, February 01, 2012
By Ben Nickoll
The U.S. high-yield bond and loan markets were on a tear in 2011 — until the euro zone debt crisis and fears of global contagion hammered investor confidence. New issues fell off a cliff, declining from $182 billion in the first half of the year to just $59 billion in the second half (through November). Yields hit 10.2 percent in the fourth quarter, a level that typically signifies recession.
But the news isn’t all bad. While investors remain cautious, we are starting to see tentative signs of a recovery in the high-yield asset class — and I believe a much stronger rally is still to come. In my view, the recent sell-off has created a buying opportunity.
Yields are attractive compared with both U.S. Treasuries and investment-grade bonds. During recent market volatility, credit spreads for companies rated below investment grade increased by more than 250 basis points to about 750 basis points, pushing yields out to 8.8 percent. At the same time, ten-year U.S. Treasury rates rallied from 3.1 percent to 2 percent and five-year U.S. Treasuries rallied from 1.7 percent to below 1 percent. As a result, the credit spread of high-yield bonds (with an average duration of 4.5 years) was more than 7.5 times the yield on five-year U.S. Treasuries — a level never seen before.
This dramatic movement in the spread of high-yield bonds and loans over U.S. Treasuries signifies that investors are demanding a greater premium to compensate for the increased credit risk of noninvestment-grade debt. However, this widening spread is simply not justified by the fundamentals. The balance sheets and cash flows of companies rated below investment grade are stronger and more robust than they have been for years.
For starters, current aggregate financial leverage is not high for many high-yield borrowers, now running at or slightly below the long-term average of 3.6 times. Interest rate coverage is 3.7 times, up from the long-term average of 3.2 times. In addition, investors in search of yield may provide increased price support for this asset class.
High-yield credit also looks attractive compared to equities. High-yield debt is a hybrid asset class falling between fixed income and equity that has the advantage of offering gains while also potentially providing a certain level of downside protection due to promised interest and principal payments. In my opinion, the current slow-growth macroeconomic environment should favor high yield over equities. For example, from 1990 to the present, there are nine instances of low-growth quarters in the U.S. (real GDP growth of less than 1 percent), and high yield outperformed equity in six of the nine instances by an average of 2.2 percentage points.
Yet investors continue to focus on the so-called wall of maturities and the risk this poses for high-yield debt. However, North American high-yield borrowers have actively addressed this refinancing risk. At the end of 2008, the aggregate volume of high-yield bonds and leveraged loans maturing between 2012 and 2014 amounted to $710 billion, but by November 2011 this number had been reduced by more than half, to $285 billion. Given that the 15-year average monthly U.S. high-yield bond new issuance volume runs $9 billion, I am confident there is sufficient time and capacity to absorb these refinancings in the coming years.
High-yield debt is equally vulnerable to interest rate increases, but the effect from a total return perspective is less severe than for investment grade, since the credit part makes up a larger proportion of total returns. In September 2008, when Lehman Brothers disclosed its bankruptcy, the monetary base in the U.S. increased by a staggering 3 percent per month, on average, mainly due to quantitative easing programs designed to stimulate the economy. However, this growth in money supply is not yet fully reflected in consumer price inflation. Inflationary pressures should flare up quickly once liquidity leaks into the broader system, and with the ten-year U.S. Treasury rate about 2.0 percent and annual CPI at 3.5 percent, the U.S. could enter another period of negative real interest rates.
A combination of company-specific attractive fundamentals, the macroeconomic environment and a lack of alternatives makes North American high-yield credit an interesting asset class. Cash-rich corporate balance sheets with low leverage and modest refinancing needs in the coming years indicate low default rates in the near term. A low-growth environment in the medium term naturally should put fixed-income investments at an advantage over equities. Altogether, I believe investors can earn more competitive returns in high-yield credit. AR
Ben Nickoll is a principal officer and portfolio manager at GLG Ore Hill, a credit-focused,event-driven hedge fund and structured product manager based in New York.
Wednesday, January 25, 2012
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Tim Ng |
Due to the market uncertainties that abound in Europe and Asia, along with the political impasse seen in the U.S. and social unrest in the Middle East, the global economic outlook is mixed.
On the positive side, global monetary conditions will likely ease in order to foster economic growth. The European Central Bank, Bank of England, and various emerging market central banks are likely to make use of their printing presses. The Eurozone is expected to be in recession going into 2012, with moderate growth expected in the years ahead. Business and consumer confidence is weak in Europe as expected due to the financial market stresses. As such, capital formation remains weak as well as private consumption.
U.S. growth should come in around 2.5% as real consumer spending has increased. There should be continued increases in manufacturing output and improvement in employment as witnessed by the recent decline in jobless claims.
When looking at China and emerging Asian countries, we do not foresee a hard landing, but a soft one with GDP growth in China slowing from 9.1% in 2011 to 8.1% in 2012. The continued growth in Chinese domestic consumption and easing monetary and fiscal policies should help GDP growth remain on a positive trajectory. Emerging Asian country growth remains positive in India, Malaysia, Thailand, and Philippines, bolstered by resilient domestic demand.
Despite those positive signs, hedge fund returns in 2012 will be reflective of a mixed market environment. Risk aversion still characterized markets early in the year, but we expect a divergence of global growth later in 2012. Strong growth in emerging and developing markets will combine with recession in Europe and slow growth in the U.S. and Japan. As such, we believe asset valuations in 2012 may be driven more by fundamental than macro factors, but we expect market volatility to remain higher than normal with the potential for downside drafts. Another theme is the investor search for yield as short rates continue to be negative in real terms.
So, which are the hedge fund strategies to pick? First, we like market neutral long/short equity investing as we expect greater divergence and lower correlation of stock prices in 2012. And for stocks, we also like managers that invest in emerging markets. They performed poorly due to capital flight in 2011, leaving such the markets with low valuations. Combined with monetary policies to foster growth, emerging market stock prices should recover. Emerging market debt is also attractive based on higher yields, stronger credit worthiness and the values of emerging market currencies versus those of developed countries.
For developed markets, investing in high-yield corporate bonds is a good alternative as sovereign debt is priced to perfection, and money market alternatives are providing negative real yields. Default rates continue to remain low and corporate balance sheets are strong and still retain a great deal of cash on hand.
After a difficult year, global macro managers should recover as themes in currencies, commodities (energy and metals), and interest rates should have greater visibility in 2012, providing good trading opportunities.
We also like options-based strategies. They can both enhance yield via the sale of covered call options or the combined use of short call and long put spreads to hedge downside equity market risk while offsetting a portion of the downside protection cost. In addition, we favor strategies that are long volatility as it will spike dramatically in a market downturn. The firm is also in favor of strategies that can take advantage of widening sovereign debt and credit spreads, either in the form of CDS or straight short debt positions.
And which hedge funds strategies should be avoided? Strategies that will be out of favor include long-biased long/short equity, as we foresee equities markets will be subject to bouts of volatility and thus downside risk. Merger arbitrage is also risky as deal spreads are subject to not only idiosyncratic but also market risk, and we believe the present overhang of global economic and political uncertainty will cause so-called CEO paralysis and the number of deals that will transpire will leave a lot to be desired. Also, distressed debt could be confronted with tail winds as any de-risking phase will cause bouts of illiquidity and cause spreads to widen.
Clearbrook has been working with its clients to incorporate hedge funds in order to decrease the amount of equity beta or volatility (or both) in their portfolios. In addition, we are looking at hedge funds to provide yield alternatives to traditional fixed income investments due to their low to negative real yields, as well as the eventual duration and interest rate risk that will come.
Timothy Ng is a managing director at investment consultant Clearbrook Investment Consulting
See also: 2012 Investor Outlook: Huge disparities, no shift to small funds
Friday, December 09, 2011
By Nathan Anderson
If you’ve ever hired a consultant to help choose your investments, chances are you did a lousy job vetting them. More than 74 percent of North American institutions use the services of consultants, yet to this day no institutional investors have truly satisfied their fiduciary duty with respect to consultant selection. Institutions do not perform thorough due diligence on consultants before they hire them and then fail to measure their performance afterward, leading these investors to make poor allocation decisions as a result.
When Amaranth Advisors blew up over bad energy bets, consultants were rightly fired for having recommended more than $200 million in allocations to the fund. Pension funds made strong public statements condemning their advisers for those recommendations, yet were silent regarding their own failures in hiring those advisers in the first place.
A phrase heard commonly in the industry is “no one ever got fired for hiring (insert brand-name consultant here).” Consultants are too often hired for their ability to be high-quality scapegoats rather than for any ability to outperform their peers.
Misaligned motives lead investors to hire consultants based on such factors as name-brand recognition, assets under advisement and breadth of services. None of these criteria replaces due diligence. Compensation structures do not reflect the importance of hiring the right consultant. If the consultant has influence over one-quarter of the portfolio, a quarter of the compensation of those who hired him should be tied to his performance.
Asset managers also need to do better due diligence on their consultants. The typical due diligence review rarely looks past basic presentation materials, references and disclosure statements. But an environment that lacks thorough due diligence enables conflicts of interest.
In 2009, Consulting Services Group, a consultant with $21.5 billion in assets under advisement, was investigated by the U.S. Department of Labor. The department released the results of the investigation, stating that CSG and one of their principals received “undisclosed and unauthorized compensation.” (The firm later settled after agreeing to additional reforms and disclosures.) In 2005, the San Diego City Employees’ Retirement System sued Callan Associates over poor performance stemming from alleged pay-to-play conflicts. At the time, Callan had $2.5 trillion of assets under advisement, making it one of the industry’s largest players. (Callan eventually settled the allegations without admitting wrongdoing.)
The procedure for identifying ethical top-performing consultants should resemble the process consultants use to select fund managers. A detailed review of audited financial statements and operational procedures, background checks on key employees and site visits should be part of a comprehensive vetting process to root out fraud and abuse before it affects performance.
Investors have been almost completely absent at tracking another crucial component of due diligence: past performance. There ought to be metrics to know which of the 1,700-plus existing consultants and pension advisers excel at such distinct skills as asset allocation, private equity advisory or emerging hedge fund manager selection. Consultants with discretionary authority should be required to report their returns according to the same standards they require of their underlying fund managers. Performance of the most highly recommended funds in each asset class should be publicly reported to allow for peer comparisons.
Pension funds face catastrophic unfunded balances in excess of $1 trillion, while endowments and foundations are missing their performance targets by wide margins. Markets break when capital is concentrated.
With more than $7.2 trillion in assets split across the largest ten consultants, one wonders how much cross-exposure to subprime debt losses in the financial meltdown of 2008 might have been avoided if each institution did not employ the same circle of consultants, who in turn made the same allocation and manager recommendations.
To be clear, consultants perform very important services. The shortcomings of the consultant industry today are a reflection of the investors who hire them. Institutional investors must learn to treat consultants as an extension, not an abdication, of their responsibility. The consultant industry will respond to the needs of its consumers, but investors must demand a higher standard first. AR
Nathan Anderson, CFA, CAIA, is principal, alternative fund investments, at Washington, D.C., consultancy Blue Heron Capital, and CEO of ClaritySpring, a software firm focused on hedge fund transparency services.
Monday, December 05, 2011
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Paul Tudor Jones
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Robin Hood founder and board member, Paul Tudor Jones II, closed the charity foundation's 22nd annual Heroes awards breakfast on November 10 with this speech:I have had trouble sleeping this year. My sleeplessness is due to my worry over the increased social ills that beset this country. One of the reactions to these ills is the Occupy Wall Street movement. And while I disagree with their message, and I’m not even sure they know what they want, I am extraordinarily sympathetic to what caused them to be there. And that is the growing poverty that afflicts this nation. 47 million Americans on food stamps can only lead to social instability.
At Robin Hood we’ve operated under the notion that with a helping hand—be it in the form of better education, job training, or temporary shelter and food—our neighbors in need could and would gain entry into the economic mainstream. We’ve become adept at pushing just the right levers to help hundreds of thousands of disadvantaged people get on their own two feet and under their own power cross that bridge to the economic Promised Land. For almost two decades now, our efforts have provided me with sense of hope, but for the first time since 1987, I am dispirited. Today that Promised Land is frozen and barren. “Sorry,” says the sign, “There are no jobs here.”
Poverty is an enemy that comes in many forms. But the worst form of poverty facing America today is the poverty of opportunity. Ironically, it was this poverty of opportunity that drove so many of our ancestors to flee their homelands for America. The promise of opportunity was so important that it became the first founding principle in the Declaration of Independence—“All men are created equal” and implicit in that is a promise of equal opportunity. But go tell that to the 20,000 New York City children -- children mind you -- who will sleep in a homeless shelter tonight in this fair city. Where is their opportunity?
America’s relatively short history overflows with remarkable acts of charity over the years that have helped define us as a nation; whether it was the poorest of the poor who operated the Underground Railroad in the Civil War; or the wealthiest as personified by Andrew Carnegie in the 1900s who famously said, “A man who dies rich dies disgraced;” or those who operate and support the 42,000 charities in New York City today. Helping our neighbors through acts of selflessness and kindness is more American than apple pie. It is who we are as a people and sets us apart from the rest of the world. It is our defining grace.
So here we are, faced with our biggest economic crisis since the Great Depression. But instead of coming together, the lack of trust in our leaders and among our citizens is at a fever pitch: Some liberals accuse the rich of being corrupt and greedy. Some conservatives accuse the disadvantaged of being lazy and entitled. I know both the rich and the poor pretty well and I can tell you first hand that neither statement is true and both are grounded in ignorance. What is clear is that the government is struggling to find a way out, and that’s going to take longer than any of us would like. And we have yet to even experience the consequences of closing the 9% budget deficit the U.S. currently runs. Which leaves us with two choices: We can sit on the sidelines and wait for the government; or, we can step in ourselves and do our part to help our neighbors in need when they need it most.
You know, I’m not one to tell you what you should do to help a neighbor get back on their feet, but I will tell you what I plan to do. I’m going to care more than I’ve ever cared. I’m going dig deeper and give more time, money, and know-how than I’ve ever given. It doesn’t make any difference whether you are rich or poor but I believe you have to give and give according to your means.
I’m very proud to say that my friend Ray Dalio feels the same way. A few weeks ago, Ray and his wife, Barbara, made a $10 million challenge grant to Robin Hood which was matched by Robin Hood’s Board of Directors to create a matching grant fund in this time of extreme need. Thanks to the Dalio’s extraordinary generosity, every dollar given to Robin Hood before the end of this year will be matched up to $20 million. That’s going to create a tremendous amount of opportunity for thousands of New Yorkers in the coming years.
It’s going to take a great many of us, working together, to improve the current political and social environment. Today we are faced with a threat that in my mind is as great as 9/11. Fighting that war was simpler as there was an identifiable enemy who we sought out and defeated. Now, we are in a similar amount of pain but we can’t see the enemy, so we start blaming each other.
One of America’s greatest conservative thinkers, Thomas Jefferson, put it this way in the Declaration of Independence 235 years ago, “With a firm reliance on the protection of Divine Providence, we mutually pledge to each other our Lives, our Fortunes, and our sacred Honor.” Our founding fathers stated it is un-American not to care about people in need. We have to take the 1% and the 99% and remember that together we are 100%.
I’ve had too many sleepless nights lately. Those of us in the financial community know that when you have too big a position in a stock and are confronted with sleepless nights, you have to sell down to the sleeping point. For me, I have to give down to the sleeping point. So as the poet Robert Frost so beautifully said,
“… I have promises to keep,
And miles to go before I sleep,
And miles to go before I sleep.”
I hope we all do.
See also: Ray Dalio makes a $10 million challenge grant to Robin Hood