Hedge Fund Investing

Originally published in the October/November 2011 issue

When ABN Amro and Opalesque asked Permal to speak about the ‘new’ rules of hedge fund investing, I spent a lot of time thinking about it and came to the conclusion that the overall basic rules themselves had not changed. It is about finding talented managers around the world who can deliver superior risk adjusted returns, but how we search has clearly changed.

So today, what I want to highlight are three changes in the industry that have significantly impacted how we search and invest in hedge funds and then I want to touch on three of the biggest mistakes I think institutional investors make in hedge fund investing.

There was clearly a sea-change in the relationship between economies and markets going into the 2008 financial crisis, which has only been reinforced in subsequent years. The interconnectivity of global dynamics has come to the fore. Perhaps Fed Chairman Bernanke ignored the concept of interconnectivity in late 2007 when he uttered the now famous quote that sub-prime was “contained”.

Certainly recent market action has shown very strong linkage among different elements. When the Fed engages in QE and prints money, for example, it causes inflation in emerging markets. Or when mass protests in Egypt cause the price of oil to rise, US gas prices hit $4.00 a gallon and reduces growth. Or when Japan has as an earthquake and disrupts the global supply chain leading to bottlenecks and further inflation. Or when a Mediterranean country of just 11 million threatens to destabilize the entire world by defaulting on its debt. Clearly, the inter-connectivity of national economies is now higher than ever, as shown by 10-year correlations to world GDP.

Not surprisingly, equity markets around the world have reflected the same levels of high correlation. While this trend was slowly rising, 2008 accelerated this process and a somewhat coordinated global response to the crisis has only reinforced this behaviour. Even hedge fund strategies are demonstrating elevated levels of correlation to global equity markets.

Responding to change
So the first change, whether it is because of globalization or the speed information moves, is that gaining diversification in a portfolio of hedge funds is becoming much harder to achieve because of rising correlations. One of the ways we have responded to this phenomenon is by employing more macro strategies, either systematic or discretionary across our portfolios. Discretionary and systematic macro strategies demonstrate the lowest correlations to both equity markets and other hedge fund strategies; so adding more macro continues to make sense considering how the world is currently dominated by macro economic and political headlines.

The second change can be attributed to Madoff. It used to be that the only way to access a hedge fund manager was through investing in his comingled fund, with all the non-market risks that entailed. But with the Madoff scandal, managers understood why hedge fund investors wanted not only transparency and independent administration, but also custody of their own assets through separate accounts.

A year or two ago, we asked one of the major prime brokers if they were inundated with a back log of paperwork from investors trying to open separate accounts with various managers. To our surprise, they weren’t. The reason was that when investors understood the work and resources that go into setting up a separate account – opening multiple prime brokerage and custody arrangements, negotiating investment management or ISDA arrangements – they realised they were not equipped to do so and opted for the co-mingled fund.

Many separate accounts
Fortunately for Permal, we have a big infrastructure that has allowed us to develop a tremendous platform with approximately 86 separate accounts. In addition to having custody of the assets, there are three big benefits:

• The first benefit is transparency. At any point in time, not just at month end, we are able to look into a manager’s portfolio to better understand their positioning, exposures and risks and adjust our portfolios accordingly.
• Second, the separate account platform allows for more dynamic asset allocation, particularly when we want to add or reduce a manager or an exposure intra-month. This is something that you cannot do in a comingled fund. A very good example happened recently in Japan. When the Nikkei was down 20% in the first half of March, we believed that this was oversold, so we deployed capital from many of our portfolios into four of our Japanese separate accounts which in turn generated returns of 8-16% during the last two weeks of March. Again, this option was not available in a comingled vehicle.
• Lastly, one area where our separate accounts differ from other platforms is in our use of customization. Instead of using a manager’s flagship strategy, we ask the manager to do something unique for us. In fact, about 50% of our separate accounts have been customized in some fashion.

For example:
• We have had managers run their flagship program but with increased leverage.
• We have asked managers to run more concentrated portfolios.
• And our favourite is when we see a short-lived, but very specific opportunity that a manager sees as well.

Alpha evaporates
One of the things we have noticed over the years is that alpha evaporates quickly. This goes back to the point about the world being more correlated. The separate account platform allows us to react to this phenomenon in one of two ways.

The first is through re-engineering the separate account to where we and the manager see the greatest opportunities and potential for alpha generation. Recently, a US-focused credit manager pointed out a dislocation in European corporate credits which had inverted the yield curves of some specific company credits, despite the fact that the shorter-dated securities were identical to their longer-dated counterparts in terms of seniority in the capital structure. In other words, there was a higher return being offered for the lower risk security. We quickly modified our separate account agreement with the manager to allow him to capture this anomaly; something his comingled vehicle would not permit him to do. In a separate account there is no bureaucratic process, or conflicting interests with other investors. This allows us to quickly re-engineer a separate account to take advantage of such opportunities.

The second way that we seek to deal with evaporating alpha is by partially reducing exposure or even eliminating the manager. We are not complacent with managers in the separate account platform and we hold all of our managers to the same standards. Even more encouraging is the diversity of strategies that we are employing. Historically, the easiest strategies in which to launch separate accounts were equity strategies but now we have a nice balance between equity, macro and fixed income.

Two last points about separate accounts. First is that they offer guaranteed liquidity. The problems experiencedin 2008 with gating, side pockets and suspensions don’t arise with a separate account. Second, separate accounts frequently allow for better terms, especially on fees, and thus benefit our investors. The second change, thanks to Madoff, is that most managers accept separate accounts. We are adding about two new separate accounts every month. Our platform is now sufficiently robust that we have convinced some very high-profile existing managers to accommodate separate accounts. But it takes resources and infrastructure to do so.

That brings up the third change, and here Paul Volcker deserves thanks. The diaspora from eliminating prop trading is enormous. At one time we’d see two or three managers a week. Now we see that many every day. Deep resources are needed to research these managers as is a deep network to undertake the due diligence. Quite a few prop traders were very successful for no other reason than they had a front row seat to significant fund flows. Determining which managers have the insight and ability to be successful without that helping hand is a difficult but critical component.

Mistakes analyzing funds
Market dynamics have forced us to be more aggressive in searching for specialized ways to construct portfolios. But that doesn’t mean that long-standing principles should be ditched. In this regard, thre are three common mistakes made in analyzing hedge funds.

• The first mistake is looking in the rear view mirror, that is, extrapolating future performance from prior returns.
• Confusing alpha and beta. Is a manager’s performance skill based or just being in the right place at the right time?
• Mistaking low volatility for low risk. Simple risk/return analysis is sorely lacking as a measure of potential losses.

The idea of following the crowd is not exclusive to traditional investing. Hedge fund investors follow the same herd-like mentality, where the concern of ‘missing out’ overwhelms concern that the best part of the return stream is gone.

An example of too much reliance on past performance and less consideration of forward looking factors such as changes in a manager’s organization or style drift is Peleton. Originally a discretionary macro manager with a solid pedigree from both Goldman Sachs and J.P. Morgan, the fund began to morph over time, devoting more and more of its risk budget to asset backed securities. Key employees abandoned ship over the shift in investment style, which was highly profitable, but at odds with the firm’s original intent. While our investors originally questioned our decision to exit, especially as the fund’s returns turned parabolic as the mortgage crisis began to unfold, those questions stopped abruptly in early 2008 as a levered bet on the spread between sub-prime and Alt-A went horribly wrong, and essentially wiped out investors.

Common mistakes
So mistake #1 that investors make is relying too much on past performance. Mistake # 2 that investors make is confusing alpha and beta. Is a manager’s performance attributable to skill or just being in the right place at the right time? Now some can argue that alpha is choosing the right beta to have in one’s portfolio and we heartily agree. But understanding what’s beta and what’s alpha is critical.

The last mistake that we see hedge fund investors make time and time again is mistaking low volatility for low risk. I thought the world had become more attune to this mistake after Long Term Capital Management, which delivered annualized returns of just over 40% with volatility of a fraction of that for a period of just over four years before finally blowing up in spectacular fashion. Perhaps the world has yet to truly learn this lesson.

Using more detailed statistical analysis, you can actually observe what appear to be seemingly low risk strategies demonstrating high levels of skew and kurtosis. In simple terms, the returns are not normally distributed and display significant downside deviation.

While statistics explain why we may limit the amount of arbitrage exposure in our portfolios, we are cognizant that the markets will at times present opportunities which favour these types of strategies. Our approach tries to find other methods of extracting performance which shift the risk/return profile more in our favour. While the crisis in 2008 drove down M&A activity, it became apparent that cheaper valuations and corporate cash were driving a new wave of mergers as we entered the second half of 2010.

Skewed return profiles
The problem with merger arbitrage, however, was the same problem observed with convertible arbitrage, namely that the return profile was skewed to the downside. If we use a scatter pattern to observe the excess returns generated in M&A deals, we can clearly see that the upside in announced deals is constrained, while the downside is significant. In fact, the payoff profile looks identical to that of a short put position, where return is capped by the premium received but the losses can be multiples of the expected gains.

With interest rates essentially pegged at zero, the premium on announced deals has been even more compressed, further minimizing expected returns, while deal breaks remain fairly common, as witnessed by the recent disintegration of the BSkyB deal or the justice department’s objections to AT&T’s merger with T-Mobile. Rather than shun the sector, Permal’s managers devised new ways to capture the increase in deal flow. By focusing on potential targets rather than announced deals, managers were able to purchase cheap optionality through credit default swaps on companies which were attractive targets. In this example, a manager bought five year CDS on Sara Lee for around 30 basis points. When a potential LBO was announced, the CDS rallied significantly on the assumption that Sara Lee’s once-pristine balance sheet would be levered to complete the deal. A second bidder for the company emerged, seeking to apply even more leverage to the company to purchase it at a higher multiple. This pushed the CDS even wider and the manager was able to unwind the position at almost 300 basis points, offering a much more attractive risk/return profile than traditional risk arb.

As markets have become more correlated and alpha more quickly morphs into beta, we are forced to be more dynamic in our own approach to investing. Our portfolios do not remain static in terms of the managers themselves or the strategies in which we invest. In our fixed-income focused fund, allocations to credit-related strategies declined as spreads grew tighter in the run up to 2008 and then grew substantially when we felt the market had priced in an “end of the world” scenario.

Quick reaction to jolts
Earlier I mentioned our increased allocation to macro and managed futures strategies. With the interconnectivity of markets and the effects of contagion, it seems to us that markets and economies may be more susceptible to shocks in this kind of environment. It makes sense to us to be overweight strategies and managers that can react more quickly to these potential jolts. We can only hope that troubles in Euroland are more contained than those witnessed in sub-prime in 2007.

The world has clearly changed in the last few years. Markets and economies are more correlated. It has altered the way we must view both managers and their investments, requiring new tools to construct a portfolio. Some long-held beliefs still remain true, however, and thoughtful analysis is still required to avoid holding an investment for too long or investing for the wrong reasons.

Transparency and flexibility have become paramount to hedge fund investing and this is a trend that will persist regardless of market conditions. Hedge fund investing has become a decidedly dynamic activity and is destined to remain that way.

Tim Schuler is the Investment Strategist for Permal Group. He has two decades of professional investment experience, including 15 years of direct hedge fund investing. This is an edited version of a presentation Schuler gave at a recent ABN Amro investment conference and does not necessarily reflect the views of Permal or any of its affiliates.