Alternatives to Alternatives

Key risk factors

Hamlin Lovell, CFA, CAIA, FRM
Originally published in the March 2010 issue

The losses incurred by most hedge fund strategies (bar macro, managed futures and short bias) in 2008 inspired investors to search for new sources of diversification. The extent of the risk asset rally in 2009 overshadowed ‘alternatives to alternatives’ – such as electricity trading and insurance linked securities. However, many of these strategies offer the most sustainable diversification benefits as they are inherently uncorrelated with conventional asset classes – not just historically statistically uncorrelated. The pedestrian performance of such strategies in 2009 shows that they weren’t lifted by the liquidity explosion. Paridoxically, this may increase the faith some investors have in them even though their correlation with conventional asset classes will vary with how they are structured and executed.

Risk factors
Many alternative strategies involve unique risk factors and risk premiums that are not immediately apparent and also require very different types of research and due diligence. For example, sub-strategies under a particular strategy umbrella may have completely unrelated risk drivers. This article highlights a selection of some more unusual risks, but is not exhaustive, while exploring some broad investment themes.

Electricity trading: gap risk exists
Commodity volatility is inversely related to storability. So natural gas prices gyrate more wildly than oil, and perishable coffee and cocoa prices make bigger moves than warehouse-happy copper. Since electricity, once produced, cannot be stored, it is the most volatile commodity. In particular discrete price action or gaps are the rule rather than the exception for electricity trading – so there may be an extra risk premium for heightened volatility.

The equivalent of the 1987 stock-market crash hit Europe’s electricity markets in April 2006. The culprit was EU ETS quotas far ahead of expectations, and more important, well in excess of actual emissions. Carbon emission rights are often one component of the price of coal- and oil-generated electricity. So, capricious politicians, regulators and bureaucrats can be a special risk factor. Sizing positions in proportion to the volatility kept losses below 5% for most managers in April 2006.

The prevalence of hydro-generation in the $100 billion a year Nordpool electricity market (Norway, Sweden, Denmark and Finland) makes rainfall the main supply factor, with temperatures determining the demand side. Hence 2010’s coldest Scandinavian January since 1987 has contributed to price spikes. Some managers may have an edge at weather, rainfall and precipitation forecasting, from data access, methodology or experience. Modeling producer behavior can also be important, as producers, like forest owners, have the option of holding back capacity – unless rivers and reservoirs have run dry.


Carbon trading: markets and politics
Carbon could become the world’s biggest commodity market, and most electricity traders will launch carbon funds, if they haven’t already. Once emission regimes are fixed, carbon prices are linked to industrial production. The wild card factor arises when regulatory regimes are reviewed and reset, as in the EU ETS example. Within a month of that announcement carbon emission prices had plunged by two thirds, twice as fast as the electricity price drop. Flexible expiry dates for emission rights have reduced volatility since then, but mooted price floors (which might be introduced and later removed ) and imminent auctions for EU emission rights are uncertainties on the horizon. Cuts to solar subsidies in Spain and Germany show that green politics is not sacrosanct when governments are in debt.

The shadow or “grey” US emissions market anticipates a formal cap and trade market, but some fear this could be delayed or derailed by the Democrats’ loss of a filibuster-proof Senate majority after the result in the Massachusetts special election. It shows black swans can fly into the political arena that impacts on the carbon market as well as financial markets generally. The fungibility of emission rights between multiple exchanges and countries can create arbitrage opportunities, and may also be vulnerable to regulatory limits. Fraudsters have recently misappropriated EU carbon permits, suggesting that security procedures need to be improved in this nascent market.


Catastrophe bonds
Historically these had the same counterparty and credit issues as other asset backed securities: wrapper downgrades, failures and collateral impairments. Some funds may still have legacy positions guaranteed by a Lehman vehicle, and with dicey collateral. Going forward recent issues are more of a pure play on catastrophe risk, with treasury backing and other safeguards.

Indemnity bonds compensating insurers for incurred losses carry higher yields, partly as it takes longer to establish individual insurer losses – but also due to the perceived informational advantage of insurers vis a vis investors. Bonds making payouts relative to overall industry losses, modeled losses, or parameters such as wind speeds, carry lower yields because they provide definitive loss figures much faster, and because insurers are left with the basis risk versus their individual losses.

Opinions differ on whether the global warming phenomenon increases the risk of the types, and magnitudes, of catastrophes that can trigger payouts. Some managers claim superior loss prediction modeling skills, based on access to proprietary data or models, often obtained from affiliated or parent entities. Most managers buy and hold but some go short too.

Insurance linked securities
The new Solvency Two EU regulations might accelerate the securitization of insurance risks, to shift risks off balance sheets if insurers don’t raise capital. Only a single digit percentage of the insurance and reinsurance markets is now securitized. Most general insurance linked securities have a fixed life of between three months and 3 years; potentially much more distant longevity related risks are discussed separately. If held to maturity, losses materialise only from insured events occurring. So investors look for a spread of uncorrelated perils. Car insurance claims, for instance, normally fall in recessions as people drive less far and less often, but fire claims increase as struggling business people commit arson against their own properties to make claims.


Prior to maturity mark to market risks can arise from higher insurance or reinsurance rates re-pricing bonds downwards to match the yields offered by new issues. This works both ways: in 2007 reinsurance was the only risk premium I noticed tightening, so some ILS showed capital appreciation on top of coupon income. Historically major natural catastrophes have been the key influence on the insurance cycle, where premiums harden after a big event depletes the supply of insurance capital (the September 2001 attacks had the same effect).

Longevity instruments
Here it is important to distinguish between life premium finance, life or viatical settlements, and longevity swaps. Each is exposed to different risks. For life settlements, credit risk means the insurer’s claims paying ability rather than its credit rating, because policyholders sit at the top of the capital structure (and anyway are covered by compensation schemes in most places). So policyholders could be made whole even if an insurer failure wipes out creditors.

Lending against, or investing in, the pure life insurance element of somebody else’s life policy is illegal in many countries including most provinces of Canada. Everywhere, policies can be invalidated due to medical and other frauds, suicide, murder by policy beneficiaries, or if insurers can prove no bona fide insurable interest ever existed. Allocators should feel comfortable that recent legal precedents will be a good guide to future judgments. As US judges are elected, politics matters, and many Americans need to monetise life policies to meet medical bills that would otherwise bankrupt them. Some therefore believe that life settlements are legally more durable in the US than in countries with free healthcare.

Quite apart from jurisdictional due diligence, managers of such funds need to ensure, and monitor, that policyholders’ net worth at least matches the policy value. Whilst life settlements are intended to provide the exit route for life premium finance, the latter strategy can rapidly morph into the former if secondary or securitised markets evaporate, or if policyholders exercise any options to put policies back to lenders. Buyers of life settlements are long mortality and short longevity, like sellers of annuities. Accessing medical reports and longevity forecasts are important risk gauges, with some funds insisting that all of their policyholders be aged 75-plus and have at least two of the key killers: diabetes, heart disease or cancer. The natural buyers for life settlements should theoretically be life insurers seeking to hedge a surfeit of life assurance against annuity risk, and for many years a buoyant market existed for policies past the contestability threshold.

The growing longevity swap market may now offer insurers (and pension funds) another way to hedge longevity exposures. One investment fund is already active in this space. The intricacies of individual policies and jurisdictions are replaced by potentially very long dated counterparty risk from the seller of the swap, which will usually be a larger bank, insurer or reinsurer. The distant nature of liabilities should theoretically make the valuation of such swaps super sensitive to credit spreads of the swap seller; witness the plummeting prices of XXX ILS in the US.

Asset based lending
Any lending strategy can become private equity if the debt is swapped for the borrowing company (or if securitization or secondary markets dry up). This can be true even of the most apparently liquid strategies discounting short dated invoices and receivables, if theborrowers’ customers customers turn out to be of sufficiently low credit quality – many such borrowers are unrated credits. Hence some funds in this area have become correlated with credit markets since 2008. The difficulties of perfecting liens in some countries lead managers to lend via an offshore special purpose vehicle, ideally holding collateral in escrow. Onshore collateral can be tricky to foreclose – even if the SPV is offshore. Some investors assign field agents to verify inventories in warehouses in addition to following the usual desk based due diligence, such as corroborating invoices, to try and avoid a repeat of recent frauds. The centralized US register of liens makes it easier to check for prior liens.
Offshore investors seldom invest directly into US based ABL funds, for tax reasons. To reduce the chances of being deemed liable for US taxes, offshore entities tend to lend to an onshore vehicle that originates the loans, or may only participate in loans after a certain ‘seasoning’ period, or both. While President Obama has other offshore tax breaks in his crosshairs, it remains to be seen how long this one will last (although it is not exploitable by US citizens).

Usury laws capping interest rates in most US states are designed to protect ordinary consumers, so there may be exemptions for larger loans, corporate loans or even whole industries (film finance in California). Some managers disguise interest as various fees – investors should investigate whether these loopholes are watertight.

Film finance
Film finance spans a wide spectrum of risk appetites with tax credit discounting at the top and equity finance at the bottom. So long as investors are sure that film producers can prove they have spent the required amounts in the relevant territory, lending against tax credits is similar to discounting other government receivables, with creditors such as the Government of New Zealand and the State of New York. However, some investors do worry about the parlous state of US municipal finances given reports of California paying people in IOUs.

Other forms of film finance have completely different risk profiles. Pre-sale lending against distribution rights in one or more territories is not directly exposed to box office receipts – although a flop in one territory might discourage distributors elsewhere from buying a picture. Post-sale lending is a case of discounting receivables subject to distributors’ credit risk.

The most risky part of film finance is the equity, since many films lose money and even those that eventually turn a profit may only do so after ancillary revenue windows kick-in through TV broadcasts or DVD revenue years later. However, this is one factor that moves in the opposite direction of the economic cycle: cinema audiences rose in 2009 just as they did in the 1930s.

Litigation funding
Absent an appeals process, lending against final settlements or awards can be seen as just taking on the credit risk of the party asked to pay out, which will often be an insurer. Clearly pre-settlement or pre-award finance is much more risky since a case may be lost. Even so several litigation funding funds have sprung up in the UK and US and are doing well. It is simplest when there is a clear cut no-win no fee arrangement. In cases where litigators can become liable for fees for lost cases, insurance against this comes into play.

Trade finance
“Self liquidating” is the standard sales catchphrase for such funds, and can be accurate in some situations such as where client turnover is high enough. But trade finance often seems to be a relationship business, where at least the principal element of debt is rolled over from one period to the next without any cash changing hands. Sometimes the interest also accrues as a Payment In Kind. Some funds only find out if borrowers can pay when funds themselves
receive redemption requests. One fund is now comprised entirely of unlisted interests inemerging market commodity producers.

Just as invoices need to be checked for onshore factoring, forfeiting or lending against cargoes involves verifying documents such as bills of ladling that prove goods were loaded onto ships. Fraudsters are adept at forging these documents, so the authentication process is crucial. Even the largest trade finance funds have sometimes suffered from fraud. Counterparty concentration is a common feature of trade finance hedge funds. In contrast one large Dutch pension fund prefers to hyper-diversify the idiosyncratic risk by taking the mezzanine tranche of a structured trade credit vehicle exposed to 1,500 different credits. That way they pick up the trade finance risk premium without the odd fraud wiping out a year or more of returns.

Dealing with “axis of evil” states such as Iran, North Korea, and Cuba is one way to enhance returns in this strategy, so long as you are not seeking US investors who could be prosecuted for financing trade with these countries. In addition, recent fines levied on major international banks dealing with those countries suggest that anyone with a formal presence in the US could face penalties.

Freight derivatives
Whilst overall freight rates correlate to the economic cycle, spreads between types of ships and routes can be an uncorrelated source of return, as can calendar spreads. Some funds trade only derivatives, many of which have now migrated to exchanges to mitigate counterparty risks.

Shipping and commodity trading
Whilst commodities always have intrinsic value that keeps their price above zero, some types of shipping rates in 2008 were reported to have touched zero because it was cheaper to keep a ship moving than moored. This illustrates the fixed costs of owning or leasing a ship. Derivatives avoid the very different risks of physically chartering ships, which include documentation uncertainty, insurance and piracy.
The paperwork to charter a ship can run into hundreds of pages and elaborates arcane issues such as the definition of public holidays in some countries, and how this influences any compensation for delays – yet these issues can still be the subject of disputes. Shippers may also have to make insurance claims for damaged cargoes, and piracy, which can also in itself cause delays.

Where commodities such as sugar are sold “free on board” the shipper must cover shipping costs, so may be short of freight rates if these cannot be pre-fixed. In contrast, CIF commodities such as cocoa include the costs of freight and insurance. Freight delays, damage to goods, and delays and uncertainties over insurance claims are examples of the hands on risks involved in this strategy.

The obvious trade in 2009 was to buy front dated oil, store it in tankers, and sell it forward for a far higher price to take advantage of the steeply contango-ed curve. Such apparently inexplicable arbitrages are seen in other commodities. The reason why they can persist is the barriers to entry entailed in putting on cash and carry trades. Storage capacity must be sourced, quality specifications measured and monitored, freight logistics coordinated to synchronize delivery into the short future, and specialist insurance purchased against mishaps at each stage. This may be why the only managers I know doing this have many years of experience at some of the largest commodity houses.

Intellectual property
Patents normally last for 20 years, and music, film and book copyrights for 70 years after the death of the author or artiste. Monitoring rock star rehab visits might help to gauge the life of music royalties, which are fixed by governments for mechanical recordings. Of course in the short term mortalities generate publicity that temporarily increases sales of the deceased’s music. In contrast an advertising campaign can have a transformational impact on the value of a royalty stream, with royalties sometimes running into the millions. Similarly patent and trademarkroyalty rates can be calculated via various methods including cost, comparables and income.

The efficiency and incentivization of royalty collection agents can vary widely, so the selection decision here can be every bit as important as the choice of servicers for mortgage backed securities. And there is nearly always scope to increase compliance even in developed countries, let alone in some emerging markets where collection rates are believed to be less than 10% of those in the US or Europe. The advent of payment for internet music downloads, and penalties for the erstwhile pirates, also improve the outlook for music royalties.

Risk factors in alternatives to alternatives are sometimes more binary, and analagous to exotic options such as knock outs, one touches, and barriers. If a catastrophe, adverse tax, legal, political or regulatory judgment could at a stroke reduce returns 30% or more, these strategies have fat tails that are not amenable to mean variance optimization. They also may not suitable for modeling with continuous distributions, so discrete distributions may be useful. Yet the worst moments for these alternatives are not likely to coincide with, or be caused by, financial catastrophes.

It seems that innovation is allowing more asset classes to be investible, giving investors potential to select from an ever expanding menu of exotic risk factors and risk premia. But investors need to keep an open mind about broadening the horizons of their research repertoire to deepen their understanding of new types of risk. Since many of these strategies are not generating commissions, stock lending fees or other fees, they may not be on the menu of choices offered by the capital introduction teams of prime brokers. They can however be sourced via specialist networks and consultants.