"The last few years have seen an explosion of activity in the credit markets," says Stewart, Director of Mellon Global Investments, who has been the driving force behind the evolution of Mellon's international fund of hedge funds capability since he and MacDonald joined from Liberty Ermitage in 2000. "Structural change, developments in credit derivatives, increased market liquidity and investor appetite for yield have all contributed to this activity. Hedge funds have been key participants in these markets and due to their flexible investment mandate can take advantage of opportunities not available to traditional credit investors."
Mellon reckons it is now possible to create a diversified fund of hedge funds composed of credit specialists. The fund is intended to give investors access to the opportunities in these rapidly developing markets without being dependent on the direction of interest rates, or the direction of credit markets.
Over the long term a 'long only' investment in high yield bonds has provided investors with an attractive risk/return profile. However, returns are cyclical, and there have been extended periods of indifferent performance, for example between 1998 and 2002. By implementing an alternative strategy with the flexibility to invest long and short of the market, Mellon argues it is possible for its strategy-specific fund of hedge funds to achieve an attractive return, while avoiding the cyclicality of a traditional approach.
Mellon is a fairly conservative funds house: its launches in the fund of hedge funds sphere have been few and far between, and are driven by the convictions of the managers that a real opportunity exists within a specific strategy space. In this case, it is believed that structural inefficiencies exist across a range of credit related strategies with leveraged loans, long/ short credit, and distressed offering the most attractive risk/return characteristics. The plan is to conduct active allocation at both strategy and manager level throughout the credit cycle to ensure the allocations are focused on the most attractive opportunities.
"Everything we do is driven by a top-down strategic view," Stewart says. "Our decisionmaking process tends to be on a different cycle from many of our competitors. Our portfolios shift over time as we find new ideas."
Mellon is also very discerning once it comes to picking new managers. Although Stewart and MacDonald conduct around 300 manager visits per year, they are currently invested with less than 30. The new fund, which has $20m under management right now, of which $10m is Mellon seed capital, has only nine managers currently in the portfolio, although it is hoped that this will expand to 15-20 as more capacity is required.
"Between 15 and 20 managers is more than enough for diversification purposes," says Stewart. "We've got nine in the credit fund, but that's a very specialist product. We like to build up a working relationship with our managers. We need to show our investors every decision that we make. We've met every manager in our portfolio, which is not the case with some of the bigger [fund of funds] managers out there."
Mellon has developed its proprietary AdvantHedge research system to evaluate thefundamental, technical, and sentiment factors driving each strategy. For example, in a period of rising defaults or increasing interest rates, the fund will adopt a defensive posture by increasing the short exposure and focusing the long investments in senior secured loans. When conditions are favourable for credit, the fund will take a more directional stance and have greater exposure to distressed.
Strategy analysis is used to evaluate the drivers behind each hedge fund strategy in order to inform the funds' asset allocations, based on expectations of future risk and return. "Find a strategy which you're comfortable with, and you can make money," says MacDonald. Right now, based on its April 2006 strategy meeting, the Mellon team is bullish on credit and special situations.
Close monitoring of peer groups categorised by strategy ensures that investment ideas can be prioritised and tracked efficiently. The strengths and weaknesses of each fund Mellon follows are identified via a rating methodology that considers in excess of 300 factors.
Taking special situations as an example, which Stewart defines as any type of corporate event, Mellon has seen corporate activity levels increasing dramatically in the past year. Private equity firms are fuelling leveraged buy-outs and management buy-outs, and shareholder activism has emerged as a powerful catalyst towards unlocking corporate value. Boards are now more responsive to the will of shareholders, driving large gains in share prices. Traditional merger arbitrage offers limited upside, but special situation trades have greater profit potential, Mellon reckons.
On a sub-strategy basis, Europe is moving from a culture of family or state controlled businesses in autonomous legal environments to a more unified and open financial and judicial system. There is also evidence of increasingly speculative industry and private equity deals, which have caused deal spread volatility, creating short term trading opportunities around merger transactions. "There are far fewer funds in Europe chasing these sort of opportunities than there are in the US," says Stewart.
Returning to the credit strategy, the Mellon team is currently impressed with the depth and diversity of credit instruments, which they think offer a vast array of investment opportunities. Rapid growth in credit markets coupled with increased liquidity, and the flexibility to short credit, has led to the development of new strategies. Increasing indexation and ratingsdriven portfolio management, have served to create structural inefficiencies. Experienced credit specialists are using hedge fund structures to capitalise on opportunities in corporate bond markets.
"This all adds up to a great buying opportunity for hedge funds, but there are relatively few hedge funds," says MacDonald. "Within three to five years we expect to see more funds of hedge funds specialising in credit. We're seeing higher liquidity in corporate bonds, and the ability to short has improved, for example through the cash or derivatives market. We've also seen phenomenal growth in the high yield market and the number of outstanding default swaps. There are also far more opportunities on the short side than there used to be."
Few funds can currently offer investors access across the broad credit spectrum within a single, actively managed investment vehicle, hence the case for encapsulating a broad range of credit strategies within a fund of funds portfolio.
Seasoned credit funds of funds, and there aren't that many around, have an unprecedented range of options open to them, as do their underlying managers. They can exploit the market on the basis of capital structure (e.g. loans, senior bonds, subordinate bonds), investment grade, trade types (e.g. capital structure arbitraged, hedged, relative value), and geography.
MacDonald says the team will be looking at the market across the entire range of capital structures. "We're looking at managers all the way from investment grade to distressed specialists," he says. "We're following managers across all types of bonds."
The geographic focus of the portfolio is primarily in the US and European corporate debt markets. It will be pursuing three distinct investment strategies initially: leveraged loans, long/short credit, and distressed debt. Going into May, the fund had 39% allocated to long/short credit, 30% in the leveraged loan market, and its distressed debt segment split into 19% long-biased and 11% hedged. The bulk of the geographical allocation (two thirds) is in the US, with 31% devoted to Europe, and 1% in Japan.
High yield investors enjoyed strong returns in 2003 and 2004 as credit spreads approached historically tight levels due to the combination of a strong economy, low interest rates, and a declining default rate. Last year was less rewarding, as interest rates rose, several high profile companies were downgraded (GM and Ford) and credit spreads moved within a tight range. With the default rate projected to rise in 2006, Mellon is expecting to see increased volatility in credit spreads, and greater differentiation between strong and weak credits. This environment could be challenging for traditional credit investors and the more flexible, active approach used by hedge funds could provide greater scope for generating superior risk-adjusted returns.
But despite the positive market scenario, there is by no means the proliferation of credit managers out there in the market that is seen in the long/short equity space. Mellon is currently following 83 funds, up from 63 in 2003, so there are more opportunities available, a trend Stewart expects to see continue. "Only 21 are pure credit however," he says. "In 2001 we were following only five dedicated credit managers. We're at the very early stages of this strategy."
Many of the new managers coming out of investment banks are very senior figures in the credit business, with 15 years or more experience under their belts. Stewart likens the story to European long/short equity in the mid-1990s: the real pioneers of credit funds are setting up their stalls now. In three to five years many of them will be hard-closed, he argues. He is adamant that as a fund of funds, he does not want to end up investing with the so-called 'second wave' of managers, who will be drawn out of the banks as the credit story matures, and it is seen that the pioneers have been successful.
"Credit was considered dull and boring," says MacDonald, "but now it has become more fashionable. Many managers setting up funds now were global heads within their respective banks. The barriers to entry in credit are higher too: managers have got to be totally sure of their strategy."
Another characteristic of Mellon's team is their insistence on track record from their underlying managers: the new credit managers they are talking to have to comply with the same rigorous due diligence process they have always applied to underlying funds: if you have not managed money through a crisis period, if you cannot demonstrate clearly how your fund will behave in a major credit crisis event, it is unlikely they will invest with you. "You have to be sure you're not a pioneer into something that has not been tried and tested in a crisis scenario." Stewart and MacDonald are also very aware that many convertible managers are widening their remits as opportunities in the bonds versus equities space dry up. "We're very good at identifying true credit specialists," MacDonald says.
In terms of capacity, Mellon is confident that it could put a billion dollars to work in the credit fund today, but the problem is that, if the market does well, capacity will be reduced as more second wave managers appear on the scene.
Mellon comes across as a very conservative house to be investing with. Its managers are not out create a global behemoth, and are very realistic in terms of the resources available to them, the optimal research coverage they can achieve. Launching a credit fund now is based on a sincere macro view: there is a genuine belief that now is a good time for a credit strategy to be launched. And this is no venture into dark corridors: the team has already been running a substantial credit component in its earlier funds, namely Special Situations and Special Situations 2. Now is simply the time for that strategy to grow up and get a room to itself.