Do Hedge Funds Benefit from the Increased Interest Rate Environment?

Macroeconomic regime change improves opportunity set for hedge funds

_{MARCUS STORR, HEAD OF ALTERNATIVE INVESTMENTS, FERI}

Global hedge fund assets have tripled from USD 1.5 trillion during and after the Great Financial Crisis to USD 4.5 trillion in 2023. This growth has come from both positive performance and net inflows as hedge fund managers attract more assets, mainly from institutional investors such as pension funds, insurance companies, foundations, endowments and family offices.

The traditional long only 60/40 equity/bond portfolio saw its worst performance in a generation in 2022. And in 2023 bond and equity markets are still grappling with the twin threats of inflation and recession amid rising interest rates. Most fixed income categories appear to be heading for their third consecutive year of negative returns.

Some hedge fund strategies can however benefit from higher interest rates, inflation and volatility.

Interest rates

In fact, FERI’s regression analysis on the HFRX Global Hedge Fund Index (Flagship Funds) shows that average 12-month performance has been higher at 5.16% under rising rate environments than the 3.81% seen under falling rate environments. This has been true across the four broad strategy groups: the Equity Hedge Fund Index, the Event Driven Index, the Relative Value Index and the Macro/CTA Index.

There are some logical and simple explanations. For instance, market neutral equity strategies benefit from higher interest rates since they earn interest on short sale proceeds. And merger arbitrage strategies also show returns proportional to interest rates plus a risk premium on top.

Inflation

Hedge funds also demonstrate their skill under inflationary climates. When inflation was below 2% hedge fund absolute performance lagged the S&P 500 Total Return Index for US large cap equities, whereas under inflation above 4% hedge funds considerably outperform the Index, and when inflation has been between 2% and 4% hedge funds have matched S&P 500 performance.

In terms of risk-adjusted returns, hedge funds have outperformed most under high inflation.

Alpha opportunity

A more volatile macro climate can contribute towards greater stock dispersion and improve the opportunity set for stock pickers. Hedge funds’ alpha generation has been increasing since 2020, according to Goldman Sachs Asset Management’s statistical analysis of the Albourne Hedge Fund Index.

Arbitrage strategies, which are partly based on single security alpha, have also been outperforming.

Scouring the globe for talent

Competition for talent remains fierce as multi-strategy funds attract inflows, and there is also considerable investor competition for the best hedge funds.

FERI invests with managers across all five continents, and the FERI teams make regular trips to meet managers and carry out due diligence on a worldwide basis.

In North America, managers could be based in the tristate area of New York, New Jersey and Connecticut, but can also come from Charlottesville and Atlanta in the South; Chicago in the Mid-West; San Francisco and Los Angeles on the West Coast and Toronto, north of the border in Canada. In South America, they might be found in Rio de Janeiro and Sao Paolo in Brazil, or Buenos Aires in Argentina. In Europe, managers can be drawn from London or Cambridge in the UK, Dublin, Paris, Zurich, Vienna, Amsterdam, The Hague, Oslo or Stockholm, as well as Dubai. In Africa there is even a manager from Johannesburg in South Africa. In Asia, managers can come from Singapore, Hong Kong, Shanghai and Tokyo.

The 2023 FERI Hedge Fund Investor Day was however highly unusual in that all managers presenting came from London.

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Finding Sustainable Return Sources with Carbon Emissions?

Risk premia, alpha and carbon reduction

_{MICHAEL AZLEN, FOUNDER AND CEO, CARBON CAP MANAGEMENT LLP (CCM), LONDON}

Why climate change matters

Michael Azlen’s career started in proprietary trading before building two asset management businesses, one of which was sold to a Swiss public company. He has become passionate about climate change and has been teaching as a guest lecturer on the graduate degree program at London Business School for the past 18 years.

“I am an empiricist, and my views are based on data and high-quality peer reviewed academic research. The data and research has convinced me that climate change is actually worse than many people are aware of and that it is anthropogenic – caused by humans – and specifically caused by burning fossil fuels. This burning increases the atmospheric concentration of carbon dioxide causing an increase in global surface temperatures,” says Azlen. This view matches the IPCC Sixth Assessment Report of August 2023.

“Carbon dioxide in the atmosphere is like a duvet wrapping around our planet, blocking infrared radiation from being released and thereby trapping heat around the planet. The last 8 years have been the hottest ever on record and 2023 was the hottest year on record,” points out Azlen. The Paris Agreement on carbon emissions was struck in 2015 but global emissions have reached new records every year since, except for 2020, when they dropped 7% as the world economy shut down due to Covid. New temperature records were broken in 2021 and 2022 and were surpassed again in 2023.

“In terms of economic costs alone, it is cheaper to reduce emissions than to deal with their impacts and in terms of human costs, the least developed and poorest countries will be the hardest hit by the changing climate and yet have the least resources and resilience to deal with climate consequences,” he explains. This means that much of the equatorial region of the planet will become unsuitable for human habitation as it will become too hot and too dry in the coming decades affecting crop yields and increasing water scarcity. The UN has said that it is possible for this to create up to 500 million “climate refugees” who will flee these areas causing increased levels of global immigration that could trigger political instability,” explains Azlen.

The research behind carbon cap

After reviewing more than 200 peer-reviewed papers on climate change, Azlen enrolled in the “Economics and Governance of Climate Change” program at the London School of Economics (LSE), where he learned about “cap and trade” carbon markets as a policy tool designed to cap and lower emissions. Emissions Trading Systems (ETS) such as the EU ETS have been one of the most successful environmental policies: the EU ETS launched in 2005 and has reduced the annual run-rate of emissions in Europe by 1 billion tonnes/year. In a world with total global emissions of 36 billion tonnes, this is impressive and has spurred other countries including China, India, Brazil, Japan and multiple others to launch their own ETS.

Azlen also became curious about the properties of carbon as a liquid investment asset class. In 2018, regulated carbon markets were trading about $10 billion per month and yet he found no research on this liquid alternative asset class. Azlen hired Glen Gostlow, a PhD student from the LSE, and together they collected data on multiple carbon markets and produced the first comprehensive research paper on carbon as an asset class, “The Carbon Risk Premium”, published in the Journal of Alternative Investments in 2022. The proprietary data set in the paper provides the foundation for the investment strategy that culminated with the launch of the World Carbon Fund (WCF) in 2020. After completing the research, Azlen then hired a world class team with experience in climate policy, carbon pricing, power sector analysis, quantitative trading and portfolio management. The Fund was launched in February 2020 and now has almost 4 years of track record and has reached $300 million in size with a total net return to investors of +106% since inception to October 2023, annualizing at over 22%.

Fund objectives: consistent absolute returns and a direct impact on climate change

In this context, an “all weather” performance objective could be an unfortunate pun, so it is better to say that it has an objective to generate positive returns over all rolling 12-month periods, regardless of the performance in the carbon market.

Its resilience was demonstrated in 2022, when the four main carbon markets dropped by an average of -3.3%, while the Fund was up +9.2%, and again in 2023 to October when the four main carbon markets declined an average of -6.1%%, while the Fund was up +11.5%.

The return profile exhibits a very low correlation to commodities, equities and hedge funds. The strategy may also offer more subtle diversification benefits: portfolios of equities and credit, as well as some emerging market sovereign debt, may contain hidden carbon price risk in the form of implicit short carbon exposure that could become an increasingly expensive liability. In this context, long exposure to carbon via the WCF could potentially mitigate some of these risks.

Regulated carbon markets vs voluntary carbon markets

The WCF strategy only holds exchange traded carbon futures, options, physical carbon certificates and cash, and is only focused on the regulated compliance markets. Its universe has grown from 3 to 5 carbon markets and may soon add new markets as they launch. CCM believes that additional markets will add to the fund capacity and provide excellent alpha generation opportunities.

The fund is not involved in the voluntary markets and Azlen argues that “Voluntary carbon markets have little to no regulation, potentially unlimited supply, a disparate range of standards and methodologies, are illiquid and due to the lack of regulatory oversight they are vulnerable to moral hazard since most of the participants are paid for the quantity of tonnes issued in each project. Unfortunately, there have been several cases of significant over-crediting resulting in financial losses and scandals. The voluntary market is also very small and illiquid with only about USD 1 billion traded in 2022 against approximately USD 1 trillion traded across the compliance capital markets”.

Compliance markets in contrast are highly regulated, large, liquid, transparent and crucially, they have a cap on the amount of carbon permits issued which declines each year. The largest emitters (usually above 25,000 tonnes a year) must participate in the market and they are audited on their emissions annually by the government. This strict regulation via monitoring, reporting and verification (MRV), as well as penalties, means that these markets normally achieve 99+% compliance amongst their participants. For instance, in 2022, in the EU ETS, approximately 1.4 billion permits were supplied to the market. At the end of the year the emissions of the entities were audited, and these entities must submit to the government the number of permits equal to their emissions. The government confirms that the companies have complied and then cancels all those permits. In the following year, a lower number of permits is issued and this supply reduction along with the auditing and cancellation occurs year on year.

In 2023, 2024 and beyond, the quantity of permits issued will continue to decline at a rate of 4.3% per year to ensure that CO2 emissions within Europe must also decline. This creates scarcity value rather like bitcoin, only the formula is determined by politics rather than mathematics.

Internalising costs and incentivizing reductions

The government controls the supply of permits (quantity of emissions) while allowing the free market to determine the price. In the EU ETS, the carbon market trades a value of approximately Euro 2 billion daily, so it is a very liquid market. The objective is for the compliance entities to internalize the carbon price to incentivize companies with the lowest abatement costs, to reduce their emissions. “Company boards look at market prices and internalize the costs in a process of liquidity and price discovery that compares the external and internal prices. The companies with internal costs of abatement below the carbon price will have an incentive to reduce emissions. If carbon prices exceed internal abatement costs, they have an incentive to cut carbon emissions by investing in energy efficiency and low carbon solutions,” explains Azlen. The driver of the decision to cut internal emissions by these companies is simply the profit objective since they will only choose to cut their emissions if their internal cost is less than the price of the carbon permit.

This market-based system has delivered concrete results. The EU ETS, launched in 2005, where the annual run-rate of emissions in Europe has declined from 4.2 billion tonnes/year in 2004 to 3.2 billion tonnes in 2022¹. This reduction of 1 billion tonnes/per year is significant in the context of global emissions at 37 Gt/year and refers to total European emissions, but emissions from the entities actually covered by the ETS have declined by 775 million tonnes/year which is a 37% reduction.² While there are many factors that can affect emissions, academic research has confirmed that the EU ETS was the principal driver of the emissions reductions while at the same time having no impact on economic growth.³

Marginal abatement costs vary between industries such as steel, cement, power generation and transport, and they also vary within those industries according to the types of behavioural or technological change required, such as shifts from road to rail or carbon capture and storage (CCS), which is currently a relatively high-cost solution.

Policy risk premium

Unlike other commodities, Azlen’s research paper makes the case for carbon having a policy risk premium. There are different opinions about what level of carbon price is consistent with The Paris Agreement, ranging from USD 75/tonne to USD 150/tonne by 2030. The average target price using a range of estimates is USD 120 per tonne by 2030 to align with The Paris Agreement goals. If carbon prices rose to this level by the year 2030, this would create a “buy and hold” annual risk premium of approximately 7% per year. “This is attractive but can only be captured if you hold the physical carbon permits since the futures market, while very liquid, is in a state of contango meaning that you would lose a significant amount of return through the roll premium by holding the futures. Holding physical carbon can only be done by registering with the governments and this can be expensive and time consuming. The fund has physical carbon accounts with all the 5 governments that it trades in,” explains Azlen.

Reasons for a carbon risk premium

The premium is partly to cover policy and regulatory risk, though this may be reduced through reforms. CCM judges that a recurrence of the 2008 EU ETS carbon price collapse – of about 70% peak to trough – is unlikely, due to a much stronger focus by politicians on addressing climate change combined with new policy features: the EU Market Stability Reserve which reduces supply, strict limits on fungibility of offsets, and regulations forcing the largest emitters, power generators, to buy allowances at auction.

Carbon markets are a pro-cyclical asset class and therefore have some GDP sensitivity, as seen when the market dipped in March 2020, but not nearly as much as in 2008, and it recovered by year end 2020.

Another reason for the risk premium is technology: “A breakthrough in cheaper ways to remove carbon emissions could be tremendous for humanity and the planet, but would not be good for carbon markets,” acknowledges Azlen, and CCM is planning to launch a separate strategy which would be exposed to carbon removal technologies.

Long exposure and tactical rebalancing between carbon markets

Since being long carbon is seen as aligning with policy makers who also want a higher price to stimulate lower levels of emissions, the WCF has committed to always have at least a 10% net long exposure.

The core strategy generates returns from a mix of the aforementioned risk premiums, and tactically varying asset allocation between the growing range of carbon markets traded including going both long and short at the single market level.

“The tactical asset allocation is determined by a multi-factor model that incorporates technical signals, fundamental analysis of supply and demand and market policy and sentiment outlook. Two thirds of the model are very systematic and quantitative and based on statistical significance for factors that are proven drivers of carbon prices. One third is more qualitative, based on sentiment, macro and upcoming legislation,” explains Azlen.

2022 witnessed WCF’s adroit tactical trading: “Upon Russia’s invasion of Ukraine, WCF immediately held an investment committee meeting, cut exposure across all five carbon markets, and purchased put option protection in the EUA carbon market. The market then dropped 25% in 7 days and the WCF was insulated against much of this decline. The war brought a huge spike in energy prices and the spike in gas prices meant that coal burn by power companies was more profitable resulting in more emissions. This resulted in a bullish outlook, the WCF bought back into the market and the EUA carbon price rallied 18% by the end of the month,” says Azlen.

Alpha and hedgers

If risk premia differentiate carbon from other commodities, hedging behavior can open up opportunities for alpha generation in common with other commodities. The majority of EU ETS trading volume of EUR 1-3 billion per day, or EUR 40 billion per month, is estimated to be end users, who are mainly hedgers. “Utility hedgers are some of the biggest end users, trading very volatile hedge books. WCF aims to profit from this, but we expect that less knowledgeable traders would struggle trading the highly volatile market which has long run volatility of 50%,” says Azlen.

This hedging activity feeds into WCF’s shorter term arbitrage strategies, which extract alpha from arbitrage and relative value trades. These include intraday liquidity provision and mean reversion strategies with a multi-hour timeframe, as well as relative value trades within or between markets over multi-day periods, and multi-week carry trades based on contango in the term structure.

Cancelling carbon and SFDR 9

WCF devotes 20% of its performance fee to purchasing and cancelling carbon allowances, which helps it to meet the criteria for classification as an article 9 fund of the EU Sustainable Finance Disclosure Regime (SFDR).

“We do this in a meaningful and impactful way, contributing a significant portion of our gross revenue to create a real impact on reducing emissions.” Paying USD 80 per tonne to buy and cancel compliance carbon credits has much more veracity than paying as little as USD 5 per tonne for some voluntary schemes,” says Azlen. “This impact has not always been an important driver for some investors, but it was very important for a recent Swiss institutional investor who has taken USD 100 million of capacity in the Fund and was very focused on the quality of its impact,” he adds.

The fund has crystalized performance fees for three years and used EU compliance carbon markets for cancellation in the first two years and the UK market for the third year.

Incidentally, this concept is attracting interest from other institutional investors, who have asked CCM to guide them through the process of registering and cancelling permits themselves as several of them are concerned about the reputational risk of participating in the voluntary carbon markets.

Capacity and new markets

In 2023 WCF assets have more than doubled to USD 300 million in an Irish QIAIF, and the strategy may soft close at USD 500-600 million. “The EU is currently by far the most liquid market, and we therefore need to be cognizant of the reduced liquidity in the other four carbon markets when thinking about capacity,” says Azlen.

Capacity is however a moving target as new carbon markets are launching around the world, which could expand capacity. However, not all of them are suitable; the sixth market that WCF considered adding was the State of Washington, but there is not currently enough liquidity, so CCM is monitoring it and will only look to add this market when liquidity is sufficient.

Already 13 ETS are in force globally, with 6 more scheduled and 12 under consideration.

“China, the world’s biggest emitter, has launched an emissions market that is already three times larger than Europe’s, even though it is currently only based on the power sector, emitting 4.5 billion tonnes of emissions versus 1.4 billion in Europe. China’s market will grow as steel, cement and chemicals are added to the scheme,” says Azlen.

China and the South Korean carbon market have not yet opened to international investors. Brazil, India and Japan, all big emitters, will soon be launching their own compliance markets and these will be sizeable. In contrast, the California market and US RGGI markets, capped at 300 million and 100 million tonnes respectively, are much smaller than Europe at 1.4 billion.

“Having already grown from USD 10 billion to USD 70 billion per month, values traded could reach USD 200-300 billion per month within 3-5 years and overtake oil as the most liquid global commodity within 5-10 years,” predicts Azlen.

New markets do not only increase strategy capacity but also provide portfolio diversification since correlations between different carbon markets are low. In addition, CCM have found that new markets are often solid sources of alpha across its range of trading strategies.

Some carbon markets may, however, merge. Switzerland has linked its market to the adjacent European market and Quebec has joined forces with California, which is 5,000 kilometres away and not contiguous. Washington State now wants to link up with the California/Quebec market. Azlen expects to see more regional linking of markets over the next 5-7 years, and eventually perhaps one global price within 15-20 years.

New carbon removal fund seeks cornerstone

To complement the WCF strategy, CCM plans to launch a new carbon removal fund, supporting technologies that aim to remove billions of tonnes of emissions. CCM is already tracking 1,000 companies that are removing carbon in various ways, including direct air capture and biochar. Some of the strategies liquify the carbon and inject it deep underground for permanent long-term storage. “The plan is to build a portfolio of 15-20 companies, and to profit from dynamic arbitrage. Carbon removal costs, currently USD 500 per tonne, are descending a steep curve. As they converge towards compliance carbon prices, there will be potential to hedge and to do relative value trades. It is possible to buy these credits at a significant discount if you are willing to prepay now and take delivery risk. CCM believes that the EU ETS will accept carbon removal credits as being fungible within 3-5 years,” says Azlen.

Profiting from lower carbon removal costs could also act as a sort of hedge for one of the risk premia underlying the long biased WCF carbon strategy, so the two strategies may turn out to be complementary.

A cornerstone investor is being sought for the new strategy and interested parties should get in touch with CCM.

Re-Emerging Markets 

Idiosyncratic alpha from country cycles and restructurings

_{ANTOINE ESTIER, FOUNDER AND CIO, AMIA CAPITAL LLP, LONDON}

Antoine Estier has been living and breathing emerging markets since 1997, including seven years in Asia during the Asian Financial crisis, and has worked on the buy side since 2008. He was Head of emerging markets trading at UBS, which bought Pactual in Brazil in 2006, before leaving to form BTG in 2008.

Optimal asset size in emerging markets 

In 2009 BTG launched an emerging markets macro fund which reached peak assets of USD 9.2 billion. This was a very substantial operation, with 75 portfolio managers across 5 locations covering several asset classes. 

In June 2017 Estier, along with the 3 co-founders, launched discretionary global macro fund manager Amia Capital, which has a capacity of circa USD 2 billion and current assets of USD 1.1 billion, made up of largely institutional investors and personal capital from the team. The close-knit Amia team is comprised of 24 people, of which 13 are in portfolio management and risk, and 11 in support. They have an average of 20 years’ experience each and two thirds of them have worked together for at least 10 years, in some cases longer, between UBS and BTG. 

Deep specialist expertise

The strategy trades emerging markets and developed markets, mainly rates and credit but also currencies, and can trade equities. Estier insists that, “Emerging markets tourists will lose money; you have to be a specialist, and nobody can follow 70 countries”. Amia therefore follows a multi-PM model, employing specialists in asset classes, such as emerging markets sovereign credit, emerging markets corporate credit, emerging markets rates, developed markets rates and developed markets credit, many of whom are country specialists. Estier himself has a team of three and other strategies are covered by between one and three PMs, all of whom are paid based largely on performance; there is no application of pass-through fees.

The investment professionals are multicultural, including Albanian, Brazilian, French, German and South African nationalities, “But nationality per se is not the key criterion – competence and experience matter more,” says Estier “although diversity of backgrounds clearly helps, especially in Emerging Markets”.

Investor apathy creates opportunity

Estier observes investor apathy around emerging markets, which have submerged so far below investor consciousness that they might more accurately be dubbed as potentially “re-emerging” markets. He believes that, “even if we don’t see inflows from international investors, we will see intra EM flows; China has USD 900 billion of savings looking for a home and which are less likely to continue to be invested in developed countries. Even in the largest emerging market, China, foreign ownership is quite low”.

There are not many emerging markets hedge funds left. There is also much less retail interest in emerging markets: the emerging markets share of ETFs and mutual funds’ bond holdings has dropped from 30% to 10% between 2006 and 2023, according to research from J.P. Morgan. 

Overall, emerging markets is under-owned by both institutional and retail investors, and this may help to explain why there is plenty of potential for surprises. “Only 20% of Polish government debt is now owned by foreigners and in September 2023, Poland shocked investors with a 75-basis point rate cut, much more than the 25 expected by the market,” says Estier, who finds that there are less players in emerging markets, but those remaining active are important. 

The small size of emerging markets and low foreign participation can also mean that a modest change in flows leads to rapid price changes in either direction. Dispersion is wide: in the first 9 months of 2023, total returns within the EMBI bond universe ranged from minus 46.5% in Turkey to plus 43.8% in Chile. This clearly opens many opportunities, but Amia sizes positions carefully to allow for volatility and keeps a close eye on recall risk when shorting.

A time for alpha not beta

Estier judges that now is the time for alpha not beta. There have been defaults in Sri Lanka and in Africa, e.g. in Ghana and Zambia, and there may be more in Latin America. Every continent has countries with inflation out of control – including Turkey in Europe and Argentina in South America. “The headline spread and yield on emerging markets may seem superficially attractive, but after stripping out several “toxic” names, the adjusted spread is quite tight,” Estier points out. Excluding Russia, local emerging markets rates offered a spread only around 2.3% over US Treasuries in September 2023. And corporate credit spreads in emerging markets minus developed markets have even turned slightly negative at the BB rating, as of September 2023, per J.P. Morgan research. 

The Amia strategy has long and short positions and incorporates dynamic hedging.

Idiosyncratic opportunities 

Amia finds opportunities in some less well trafficked markets. The emerging markets rates cycles can be different from developed markets, for instance Brazil and South Africa have already started cutting rates in 2023. There are also unique country-specific stories, such as restructuring of debt in sub-Saharan African countries, and elections in countries such as Argentina.

Amia’s biggest two winning trades in 2023 so far have included short exposure to Turkey and long exposure to Brazil. “Neither trade was easy, and timing needed to be impeccable in both cases,” recalls Estier. 

The Turkey trade was expressed via short positions in three markets: rates; currencies; and credit. This was based on classic macroeconomic analysis highlighting an 8% current account deficit, inflation above 50%, and an unsustainable currency peg. The timing was also informed by analysis of technical and CTA positioning.

The Brazil trade was receiving local rates. It has profited as Brazil’s monetary tightening, which reduced inflation and then allowed the Brazilian central bank to cut rates. As with Turkey, implementation of the trade was also partly based on technical positioning.

Amia carefully monitors volatility-adjusted carry, and times its entries and exits partly by using liquidity provided by CTAs.

Amia has now taken some profits in its core Brazil long holding and redeployed capital into South Africa, where specialist local knowledge is important. “Local pension funds are maxed out on foreign assets, which supports local markets. A panic around alleged shipments of arms to Russia provided a good entry point,” says Estier.

South Africa is one example where dialogue with emerging markets policymakers proves to be important. “We have established an open dialogue where we can ask questions directly to the central bank,” reveals Estier. “South Africa’s central bank is well funded, with a strong balance sheet that does not have to be transferred to the Treasury, in contrast to the Swiss central bank policy,” he adds.

Restructurings

Defaults are creating an opportunity set for distressed debt in emerging markets. Estier and his team have extensive experience of restructurings, having sat on various restructuring steering committees, including most recently Zambia’s sovereign debt. This multi-year process started with a bondholder committee being formed in summer of 2020, before the Eurobond defaulted in November 2020. National elections were held in August 2021, and the country began engaging with bondholders in October 2021 before an official creditor committee (OCC) was formed in July 2022. The IMF published its Debt Sustainability Analysis in September 2022, followed by a Staff Level Agreement on the first review of the program in April 2023, and a provisional agreement on OCC debt relief in June 2023. Amia has taken a view on a range of factors: probable recovery values, present value discounts, upside contingent instruments, the IMF programme and market technicals. The negotiations with the government are now in the final stages, with the target to resolve the debt impasse by the end of the year, which will set the country well for the road of recovery and provide value to all those investors that have stuck with it over this difficult period.

Amia team members have also previously sat on Ukraine’s creditor committee, where they helped to design the GDP warrants, which pay out based on a formula. “Careful selection of these exotic instruments is needed by the investor; some other GDP warrants were badly designed,” points out Estier.

Outlook

Estier finds that investors can pay too much attention to the largest emerging market, China, given its huge external surplus, excess savings, FX reserves and construction sector with new starts less than half the peak. He is conscious that geopolitics could change how China recycles excess savings, and it could also be affected by trends such as nearshoring and the green transition. Though Estier is less bearish than consensus on China because he believes property problems are factored into pricing, he retains some short exposure, partly as a hedge against Taiwan tensions.

Amia’s broad outlook as of September 2023 was for emerging markets CPI (excluding China and Turkey) to come down due to output gaps, base effects and food disinflation. In certain countries, such as Mexico and South Africa, the probable disinflation may not yet be reflected in pricing. 

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Opportunities in Global M&A

Merger and event alpha from small and mid-sized companies and countries, and complexity

_{FELIX LO, PORTFOLIO MANAGER, TRIUM CAPITAL LLP, LONDON}

Felix Lo, born in Hong Kong and educated in the US, has spent 17 years trading merger arbitrage and event driven strategies, partly under Tom Sandell, who pioneered international merger arbitrage in the 1980s. Lo later founded a hedge fund called Granite Fund Advisors in Hong Kong and worked at the LMR and Millennium Management multi-strategy platforms. He estimates that at least half of the capital trading merger arbitrage now resides in the giant multi strategy funds and observes that, “the capital invested there is necessarily more short-term, and when things go wrong, many of them are forced to trade the same way, even when the final deal outcome may still be positive. We have the luxury of being able to be more focused on final deal outcomes”.

In 2021 Lo joined Trium Capital, which provides incubation, seeding and acceleration capital, as well as broad operational, regulatory and distribution support. He works with British Cypriot Neo Tsangarides, who has been a colleague since 2018. Canadian Max Wang rounds out the team, which trades merger arbitrage globally. Data plays an important role in the strategy and the team gathers a significant amount of proprietary data, but Lo does not expect AI to fully replace human merger arbitrage traders, “the key risk in merger arbitrage is regulatory risk, which will always be evolving and is never fully reflected in just the data”.

The Trium Khartes strategy runs a well-diversified book of 60-80 positions, with core positions sized at 6-10% and a maximum of 20%. The fund has met its low double-digit return target, greatly outperformed the broader merger arbitrage indices, and has also performed very well during negative months for equity markets.

Geared to rising interest rates 

Merger arbitrage offers a spread over the risk-free rate and returns from the strategy quickly reflect increases in short-term interest rates, while deal risk does not increase significantly. “Rising interest rates have not historically led to increased deal breaks, in part because most deals close within 6 months and interest rates generally do not rise quickly enough to scupper deals,” says Lo. 

Small and mid-sized countries and companies 

He also finds that small and mid-cap deals, defined as market caps between USD 1 and USD 8 billion, have historically had higher completion rates but are generally priced more inefficiently, with less sell-side coverage, allowing more alpha to be generated.

Investors can pick up additional risk premiums (and alpha) in more ‘esoteric’ markets, which could include smaller developed countries such as Norway and Sweden. “In these markets, written and unwritten rules can be very different, and it pays to have local contacts and experience,” says Lo. 

“The Nordic countries or the German-speaking countries, for example, are often lumped together due to their similar regulatory frameworks. On the ground, however, the jurisdictions can be very different,” says Lo. In these jurisdictions, it can also be more difficult to build up enough experience to be able to get a high level of conviction in more complex situations. For example, he recently traded a hostile deal in Finland, where there has only been two hostile deals in over five years.  He has less exposure to the more crowded UK and US markets. Overall, the strategy can invest as much as 90% outside the US but does insist on a strong legal and regulatory framework. As a result, the types of risk in the book can be very diverse, so long as there is sufficient return to justify its inclusion. For example, deals with Chinese risk can be selectively traded: “China risk is a material risk but is often a bit of a “black box”, though we find that the market often overprices this risk,” argues Lo.

Extra returns from complexity, deal structures 

“Complexity, such as cross border deals, unorthodox deal structures, consideration mixes, and embedded options, can provide higher risk premiums and sometimes free optionality, either upfront or later on,” says Lo.

Reasons for breaks

Regulatory risk premia have been heightened since 2022 and there have been more examples of regulators attempting blocking deals such as Microsoft’s bid for Activision. Whether successful or not, more regulatory intervention creates more volatility and opportunity for active traders to extract alpha. 

Competition or national security policies can scupper deals, as can legal and litigation factors such as breach of contract in relation to a Material Adverse Change (MAC) clause, which might be triggered by product problems, financial or liquidity issues. Buyers may also attempt to walk away from deals where a changing market environment might lead to buyers’ remorse. 

Deal break risk can be managed with appropriate position sizing and dynamic downside estimates. The Khartes team also utilize a proprietary risk factor model that takes advantage of nearly 15 years of curated data on underfollowed, international and complex deals. Historically, Lo has had much lower deal break rates than merger arbitrage as a whole.

The team will also occasionally short merger deals at different stages during the deal timeline.

Case study: multiple global regulatory approvals

Uncertainties around cross border regulatory approvals are one reason for wider spreads. A June 2023 bid by French cooperative InVivo for United Malt Group of Australia traded below the offer price of USD 5 for some months, because multiple approvals were required: regulatory approvals in Canada, UK and US, as well as shareholder and foreign direct investment approval in Australia. The main competition concern was in the UK, which had made headlines around that time for blocking Microsoft’s acquisition of Activision, leading to skepticism about the regulatory approval. The team conducted extensive research in the UK, which combined with Lo’s experience in each of these jurisdictions, allowed the team to profit when the deal successfully closed quicker than expected.

Case study: Canadian approvals

One deal in Canada announced in March 2021, Rogers Communications’ bid for Shaw Communications, illustrates the windy path some deals can take: the deal took nearly two years to close. “Initially, the Canadian Radio-television and Telecommunications Commission (CRTC) approved the deal after multiple hearings. Then, Canada’s Competition Bureau sued to block the deal at the Competition Tribunal, leading to a temporary pullback. The stock recovered briefly when the parties offered to make divestments, only for the stock to pullback again when that remedy was rejected. After months of pleadings and hearings, the Competition Tribunal ultimately refused to block the merger, but the Competition Bureau appealed the decision. The deal eventually closed after the appeals court rejected the appeal, but not before another 3-month wait for the Minister of Innovation, Science and Industry to give his final approval,” explains Lo, who traded the spread multiple ways to capitalize on the volatility over this period.

Portfolio turnover and liquidity

While complex deals can have long timeframes, deal duration is generally shorter as most deals close within 3-6 months. In addition, Trium Khartes’ portfolio turnover of 8-10x is higher than implied by average deal completion because the strategy will actively trade around deal milestones. Liquidity mismatch is mitigated by matching the fund liquidity of 90 days to the underlying deal completion timeframes. Liquidity is generally not a major concern for the strategy since it is invested in liquid equities. When deals complete, investors exit the trade when they receive the merger consideration.

Tail risk sensitivity, perceptions and hedging 

He also likes the low beta nature of the strategy since deal risk is primarily driven by regulatory action, which is usually uncorrelated to wider equity markets. The strategy has additionally been resilient during recessions as deal completion rates typically remain high.

Merger arbitrage is perceived by some to be like selling puts, or “picking up pennies in front of a steamroller”. Behavioral finance can provide insights into some inefficiencies in the merger arbitrage space. “On average, merger deals have a 95% probability of closing, but humans are bad at looking at very large and very small numbers. There is an observed human bias against low return, but high probability events. Specialists can exploit this because a small increase in closing rate can actually generate significant alpha: an increase in completion rate from 95% to 96% can increase the realized strategy premium by over 30%.” explains Lo. 

Perceived deal break risk can become grossly overstated during crises. The return stream is generally uncorrelated, but a typical beta of 0.1 spiked up as high as 0.6 or 0.8 during the Covid crisis of 2020 or the GFC of 2008. This usually provides a good buying opportunity. “In 2008, markets were discounting a 40% deal break probability, but within three months this implied probability of deals closing had recovered to nearly 90%,” says Lo.

Optimising short-term tail risk protection

During those periods, there is a huge but ephemeral mispricing of risk. “Though most deals do close, even during crises such as 2008 and 2020, we still like to have some degree of short-term tail risk protection to mitigate volatility. Long-term tail risk protection is very expensive but shorter term put protection strategies can be much cheaper and can be used to create convexity that matches the volatility,” says Lo. 

Small cap sweet spot

Deal volumes in 2023, measured by financial value of all deals, fell over 20% as companies shied away from making large bets in an uncertain environment. However, the number of deals was only down about 5%, which means that there were a larger number of smaller deals, which played perfectly into Lo’s focus areas. There continues to be many reasons for consolidation, as supply chain issues, labour shortages, and inflationary pressures all combine to create significant headwinds for corporates and acquisitions are often a quick way for management teams to solve their problems.