The disruption in the credit market in 2008 has opened up opportunities for investors, although these have been somewhat reduced after recent market rallies. After a substantial repricing of credit markets in 2008, largely due to technical factors such as the shortage of liquidity and rising fund costs, and forced selling in a dislocated market, spreads are now back at levels seen prior to the collapse of Lehman Brothers last September.
Attractive valuations, combined with the deleveraging that is well underway, the large-scale policy actions, and some surprisingly positive economic news since February 2009, have led to increased investor appetite for risk. This has driven money back into credit, absorbing substantial global bond issuance in 2009: year-to-date non-financial issuance is greater than in 2008 as a whole in both euros and sterling, with €175 billion of European investment-grade corporate bonds issued for the first five months of 2009 according to Lipper FMI. Credit funds raised €11 billion in the first five months of the year, compared with just €4 billion in 2008.
Nevertheless, downside risk persists. There is a growing concern that the rally may run out of steam and that spread levels just reflect fair value. The combination of tighter spreads, consensus long positions, rising concern over yields, a still-illiquid market subject to headline risk, and, of course, profit taking, could lead to a correction by the end of the year.
Fundamentally, we are still in a weak macro economic environment, so that valuations – especially relative to government bonds – may now adequately reflect expected losses. There is also no doubt that the worst is still to come with regard to defaults: 12-month lagging default rates are rising from their 2008 lows and already topping the highs of the previous default cycle (see Fig. 1).
All of this may challenge risk appetite, leading to increased volatility and technical pressures. During the past two years, markets have been driven by technical factors, but fundamental influences are now catching up as defaults materialise and markets normalise. Investors and managers now have to balance perceived low but volatile valuations with a deteriorating macro-economic environment. This presents a historic opportunity for fund managers to differentiate themselves through fundamental credit selection, relative value analysis and trading.
The features of the surviving and new credit hedge funds
All types of credit hedge funds (with a few well-known exceptions that exhibited a strong short bias) suffered in 2008. In this environment, it is also important to identify and steer clear of so-called “zombie” credit managers, with impaired platforms that are in a run-off mode. The extent of this adverse impact depended on their exposure to the most affected asset classes, the nature and stability of investor base investors and the level of leverage and quality of funding. Credit managers are now rebuilding their credit franchise, adapting leverage, fund structures, investment and risk management and infrastructure.
Given the current high levels of spreads, persistent volatility and bank’s increased cost of funding, credit hedge funds are expected to remain modestly leveraged, (i.e. around 1.25 or 1.5 times, maximum). This level of leverage is deemed sufficient to either exploit arbitrage opportunities or lock-in yield. In terms of structures, new funds are likely to have a longer, private equity type of lock-up, which is more appropriate for the illiquid credit asset class.
Investment strategies are expected to focus on absolute return strategies where fundamental influences will matter most, away from the bull-market beta style drift. As a result, strategies are expected to be polarised between credit dispersion (long/short credit arbitrage or capital structure arbitrage) and recovery (distressed). Long/short strategies exploit opportunities resulting from the mispricing of assets and other market anomalies, which are all the more available as arbitrage trades are now less crowded. In addition, in a high volatility environment, small capital commitments are sufficient to obtain targeted returns despite large cash balances in most funds. Long-only hedge fund strategies are expected to increasingly focus on distressed situations, as these investment opportunities become more available. There is a risk that managers may develop this strategy opportunistically without the required expertise or resources to work out multiple distressed credits, exposing the fund to a risk of selling into illiquid markets. Managing distressed portfolio requires significant specialised resources, which smaller hedge funds may not be able to commit.
The crisis has revealed that credit is not the commoditised asset class that it was generally regarded as during the bull market. On the contrary, credit management is a resource-intensive business, and Fitch believes the industry is heading towards the institutionalisation of the credit platform with either a core focus on one sub-asset class or multi-capabilities around deep resources and robust infrastructure. Meanwhile, there is an increasing emergence of opportunistic, boutique-type niche players, built around a core investment capability and strong value proposition for investors.
Fund of hedge funds management: the worst 12 months in history
The last 12 months have been the worst period in the history of the hedge fund industry. The major cause of the industry’s problems was its inability to face unprecedented liquidity pressure. No one had anticipated the evaporation of liquidity on the asset side and the sheer size and timing of redemption requests on the liability side. This revealed the mismatch in the hedge fund industry between liquidity of underlying strategies and the liquidity terms and investor requirements on the liability side.
Other factors included ever-greater exposure to beta, albeit lower than during the previous equity bear markets of 1969 and 1974. Leverage has been greater, though has remained lower than in 1998 when it damaged hedge funds amid a flight to quality.
Loss of investor confidence, as hedge funds have underperformed their absolute return expectations, has been a key factor. The resulting massive redemptions, combined with absolute underperformance, led to a contraction in the fund of hedge funds industry by approximately 40% from its peak in Q208 and a negative performance of 21% in 2008. However, relative to the market, hedge funds and funds of hedge funds did not do so badly.
In 2008, they lost 21% on average, a return which is twice as good as that produced by equities in the same period.
Performance and assets under management have bottomed out
Today, it seems that the situation is clearing up for funds of hedge funds after strong performance year to date and redemption pressure bottoming up. After a stabilisation in the first quarter, the second quarter has shown impressive performance figures for hedge funds in general. Year to date, performances are strong, especially as compared with traditional equities (see Fig. 2).
While overall hedge funds have outperformed equities (as of May 2009, the 12-month return of the HFRI Fund of Funds Composite index is -15.7% versus -36.4% for the MSCI World Index), there is a significant variation, depending on the strategies employed. Convertible bond arbitrage and long/short equity strategies are pointing upwards, thanks to a favourable market context, better credit conditions and the perception that asset levels were hit too strongly. However, systematic macro traders still suffer from the unclear medium-term outlook for commodities, currencies and interest rates.
Efforts in 2008 to manage liquidity, de-leverage portfolios and to reduce directional market orientation are starting to pay off. Funds of hedge funds are clearly back on the upside, though often lagging single hedge funds. There are several factors which explain this: a lower flexibility in re-allocation to the best performing strategies, the reduction of beta exposure, legacy investments, and of course continued redemption pressures in the first quarter of this year.
Performance is expected to vary significantly between managers. The trend of divergence in returns, as exemplified by the increasing difference between the top and bottom decile performers, shows that the market has divided into two branches. Fitch expects the gap to widen as there will be clear winners and losers in a more differentiated market.
Assets under management in funds of hedge funds contracted by approximately 40% from the peak in the second quarter of last year, dropping to US$818 billion, according to HFN. This compares with a reduction of 45% to US$1.6 billion for the direct hedge fund industry. Some 80% of redemptions came from private investors and their intermediaries. More institutional-orientated pension funds are redeeming less violently, but many of these are re-evaluating their commitment to hedge funds.
Investors are slowly showing signs of a renewal in risk appetite. Yet, cash levels of funds of hedge funds and institutional portfolios remain high, awaiting a clear sign for reinvesting the hedge fund asset class. Looking forward, Fitch expects that “hot money” – principally from private investors – will return, although there is a clear trend towards the institutionalisation of the hedge fund investor base. The pace of asset reduction is slowing, as are redemptions on a dollar basis. Given that flows are correlated with return, it is expected that outflows are likely to reverse when there is more evidence that returns have improved.
The proportion of hedge fund assets under management that are held by funds of hedge funds has remained stable through the crisis at around 45%. This would indicate that funds of hedge funds will continue to be the primary distribution channel for hedge funds.
Funds of hedge funds adapt their operating and business model
Fitch has identified three main areas of development: liquidity, investment processes and operations.
Funds of hedge funds are strengthening liquidity risk management through systematic stress testing and seeking better alignment of liquidity terms with underlying strategies and investors’ requirements in new funds. We are seeing the re-categorisation of underlying hedge fund strategies by liquidity and risk exposure in line with investors revisiting hedge fund allocation processes.
With regard to investment processes, hedge funds are back to their absolute return roots, in sharp contrast with the previous (pre-crisis) period where inflows led hedge funds to drift from their absolute return objectives and take ever greater beta exposure. Substantial risk capacity has been removed and the trades are much less crowded, so hedge funds should be able to exploit arbitrage or trading opportunities, even if lower leverage may constrain return on equity. In general we are seeing refinements of the manager due-diligence and monitoring process (checks and balances, review of sub-advisors, autocorrelation etc.) and stronger top-down processes.
Risk control is likely to gain prominence which will involve rebuilding operations and investing in infrastructure and risk technology. Connectivity with third parties is being reviewed, which we would expect to lead to more diversification of counterparty and prime broker exposure, and reliance on more non-conflicted top tier service providers for a growing range of administrative activities that will demonstrate robust and segregated controls.
The future landscape of the fund of hedge funds industry
Fitch expects to see a large degree of attrition within the industry, as well as some consolidation. Some managers will be unable to survive the loss in assets under management, and as such will disappear. Also at risk are those that are unable to position themselves within an increased polarisation between niche medium-sized firms concentrating on one source of alpha or value proposition (thematic fund of hedge fund players) and global providers of alternative investment solutions offering multiple expertise and programmes. The classic model of providing broad and somewhat undifferentiated access to the hedge fund asset class is unlikely to be viable in the foreseeable future.
The product range is being rationalised and more aligned with investors’ requirements: increased liquidity, risk and investment horizon drive investor’s allocation to hedge funds, and we are seeing increasing polarisation between funds of hedge funds focusing on liquid strategies (both directional and non-directional) and opportunistic funds of hedge funds focusing on illiquid strategies. We are also seeing further development of managed account platforms, which are perceived as offering increasedtransparency and liquidity.
Investors are imposing new standards in what is now effectively an investors’ market. We would therefore expect to see more transparent reporting requirements, enhanced corporate/fund governance and control frameworks, lower fees and customised solutions and advisory.
Despite the massive manager attrition and product range rationalisation that is currently in progress, Fitch believes the fund of hedge funds industry will ultimately survive. It is expected that investors will continue to rely on outsourced expertise for hedge fund manager sourcing, manager due diligence and on-going monitoring and appropriate portfolio construction and diversification. However, the need clearly remains to address the primary business and product offering businesses challenges, such as the alignment of liquidity alignment and increased transparency.
ABOUT THE AUTHOR
Manuel Arrive is a Senior Director in Fitch Ratings’ fund and asset manager rating team, having previously worked for six years at AXA Investment Managers. He began his career at Banque Paribas. Manuel graduated from ESSEC Graduate School of Management in 1997 and is a CFA charter holder and a member of UK Sip.