Opalesque Roundtable

A panel discuss a range of topics

Originally published in the October 2009 issue

The 2009 Opalesque UK roundtable, sponsored by Newedge Prime Brokerage Group, took place in London on 8th September. Hedge fund managers and other experts from within the industry shared their views on topics ranging from the outlook for the industry and the opportunities for funds and investors to the implications of potential new legislation in Europe and the potential for a hedge fund exodus from the UK to Switzerland.

The following is an abridged transcript of some of the key issues discussed by the panel and chaired by Opalesque’s Matthias Knab.

Roundtable participants

AW: Anthony Ward, Co-Founder of Armajaro and non-executive Chairman of Armajaro Trading Limited
AK: Aref Karim, Founder, Quality Capital Management
DS: Douglas Shaw, Managing Director Proprietary Alpha Strategies, BlackRock
DC: Duncan Crawford, Head of Capital Introductions, Prime Brokerage Group, Newedge Group
ER: Emmanuel Roman, Co-Chief Executive Officer, GLG Partners
GW: Giles White, Partner and CIO, MaxCap Partners
LS: Lawrence Staden, Founder, GLC
MG: Max Gottschalk, Senior Managing Director, Gottex
OD: Oliver Dobbs, CIO of Portfolio Management, CQS

What are the opportunities hedge funds and their investors are focusing on right now?

AK: 2009 has been a challenging year thus far mainly because of a lack of directional volatility in the markets. There is always a bit of time required for switching regimes in most systematic strategies. Position changes tend to lag a bit, particularly if you are shifting directions in markets that have moved in a direction strongly. So far, 2009 has been tricky.

Where are we going from here? Currently, our positions seem to be favouring a recovery play, in the sense we are long equity markets and long fixed-income where we have been for a considerable period of time. We were long short-term interest rates, of course. But we swiftly arrived into a zero rate environment with all the quantitative easing, so there was no further opportunity to make money there.

Convexity turned dull in most of the interest rate positions causing our models to reduce positions aggressively but the commodity play (short dollar, long commodities) became interesting once again. Metals have been very good for us, sugar has been great – we have been able to participate relatively well in most of the moves in the very recent months. We do not know at this point whether this recovery morphs into a W-shape. However, the advantage with a systematic strategy is that we do not have to particularly worry about what environment we are in, so long as there are some directional moves.

OD: It is difficult to have a strong view on the world economic environment we are in or the macro moves in the market place, other than that we are generally taking a somewhat conservative approach. We have, however, seen a lot of corporations looking for new capital and prepared to offer much better terms than has been the case for many, many years. This makes it very interesting and we think it is a great time for investment. We also have much less competition. A lot of the competition has left the market, not only some of our brethren in the hedge fund community, but also from the sell side where a lot of our competition has traditionally came from – namely proprietary trading desks – and they seem to be much less focused on this area. In addition, financing terms have dramatically improved over the last six-to-nine months, and that is encouraging to see. From a valuation perspective, and with the trend of new products that come from corporates, wherever the market goes in the next few months, we see a lot of opportunity.

ER: Let us go back for a moment into 2008: the months of September, October and November were the worst markets in terms of pure liquidation that I have experienced in 25 years. I cannot stress enough how brutal the moves were and how much pain there was in the market; essentially every single bank and every single money manager was selling at the same time. Needless to say, those months had the worst returns in terms of risk adjusted return, with the possible exception of CTA (commodity trading adviser) and macro, which actually turned out tohave the right bet on.

Vice versa, you have witnessed so far this year the best returns on a risk-adjusted basis for all the strategies. think we have seen a situation that we really haven’t witnessed before, with the possible exception of the LTCM crisis in 1998. Back then you had significant abnormal negative returns over the last couple of months of the year and really tremendous returns for the first six months of 1999. There were heavy redemptions and, obviously, part of this bounce has been missed by investors who basically got very, very scared that there would be no banking system at the end of 2008 and therefore got into cash. This, by the way, also explains why we believe the market is going to drift higher for the next few months, simply because there is a lot of cash lying around. Some people are not invested, and when rates are somewhere between a quarter of a percent and half a percent, risky assets all of a sudden look better than earning nothing.

MG: A key trend developing in our industry is the increased demand for managed accounts. Many hedge fund investors who were commingled with other investors and experienced restricted liquidity on their investments last year, as managers imposed gates, suspensions and side pockets, are now seeking greater transparency, control and liquidity via the use of managed accounts. We are, for example, seeking to have in excess of 25% of our portfolio in managed accounts by next year. In order to achieve our objective, we have created our own managed account platform.

A meaningful number of very large institutions and fund of hedge fund groups are also in the process of moving their hedge fund investments into managed accounts. Some are doing it by themselves; however, the majority is looking at outsourcing such functions. As we have developed our own managed account platform, we are currently having number discussions with these groups of investors.

Managed accounts are certainly a topic of discussion right now which has been gathering a lot of momentum. We won mandates this year because of our platform and a number of investors who are seeking to gain or increase their exposure to hedge funds that way in order to achieve greater transparency and control over their investments. We believe that the industry will move much more aggressively into the managed account model as its benefits are better understood. Linked to this development is that many large hedge fund allocators have found that their risk management tools were unsuitable to truly understand the risk they were exposed to. Although many hedge funds provide their investors with some level of transparency, it was often not sufficient to allow investors to understand their risks. Investors are increasingly seeking tools and services to enable them to better understand the risks in their alternative portfolios.

To finish on market opportunities, we see today the best opportunities in the credit space; distressed, direct lending, mortgage backed securities, asset backed securities, and to a certain extent convertible bonds offer some of the best risk adjusted returns. We believe that with the lack of capital in the US lending market today, spreads on newly originated loans can be in access of 900 basis points over Libor for a period of up to five years. A well constructed portfolio of these loans should give investors a great return and a fantastic hedge against inflation.

GW: When I look at 2009, we have really seen the abatement of those types of systemic risks against which the only real defence is making sure to use as little leverage as possible, and be as much in cash and short-dated sovereign as one can. Generally, we are cautious by nature and intend to achieve positive returns across relatively short time periods.

At this time, innovation is for us to adopt our asset allocation to where we think the deck is stacked best in our favor in terms of the risk and reward. We look at a lot of products that single managers and others in the market offer. There are a lot of interesting things going on; however some of those are transient opportunities being launched as funds simply at the bottom of the V and which follow a relatively obvious and unimaginative approach.

On the other side of the spectrum, you see a structural move towards managed accounts and a more open and transparent method of management on behalf of hedge fund managers. These issues are likely a long-term development, particularly in an environment where regulators and the powers in the market seem to prefer such an approach as opposed to vehicles where managers can do whatever they want without any sort of reporting requirements to anyone other than the shareholders. Whether that’s good or bad I couldn’t pass judgment, but I believe that is the direction a lot of investors’ regulatory authorities would like the industry to go. We are cautiously optimistic about the current opportunities. We are not massively directional. There is always something trying to destroy the world, it’s just a question of making sure that you manage the downside so that nothing can give you a serious injury whilst retaining as much optionality to the upside as possible.

LS: Generally, this is a good environment for all strategies. There is less competition as we have said, and this usually means more alpha. There is less competition in the markets because the banks have been constrained in what they can do and because the amount of money any of us has under management has come down – I wouldn’t think that anybody at this roundtable has actually got more money now than they started off with last year. Statistical arbitrage is one of the strategies we deploy – essentially providing liquidity to European equity markets – where the opportunity stands out to a certain extent. When the markets’ liquidity dries up, you get paid rather more for providing liquidity as opposed to the times when 101 statistical arbitrage funds were queuing up to do the same trade. As a result, this strategy is serving us well at the moment, and I think it will probably carry on working until at some point sufficient liquidity floods back into the market.

The other thing I want to highlight relates to CTAs. CTAs have had a rough time so far this year and as a result most CTAs have been down. I think that going forward, CTAs – even the old fashioned trend-following CTA products – are going to do okay. Generally, mean reversion makes things difficult for a trend-following CTA. A lot of mean reversion movements are caused by proprietary traders who get in, push things up, then push stuff down again as they get stopped-out later… With fewer proprietary traders active at banks, it means there should be less of those rapid mean reversions. Now, so far this year that hasn’t worked, but I would say over the next few years most trend-following CTAs will make more money than they would have done if the banking collapse had not happened.

DC: I’d like to come back briefly to managed accounts. Aside from investors having direct ownership of the assets traded, the demand for liquidity is driving many of the developments here. Investors were hurt badly by being gated last year, thus a major driver of the interest in managed accounts is the demand for liquidity. A key issue with effective use of managed accounts, however, is the liquidity of the instruments traded in the program. Strategies such as managed futures, many macro funds and liquid equity long/short funds lend themselves very well to the use of managed accounts. Strategies which are engaged in trading instruments with relatively poor underlying liquidity can cause major issues for the fund manager.

The other development we observe is the growing interest in UCITS III, which I’m sure everyone at this roundtable has looked at. There are relatively few funds available currently, about 50 as I understand. There are, however, certainly many in the pipeline.

With personal income taxes reaching 50%, who will be migrating to Switzerland? And what then are the implications of the coming EU regulation on alternative investments?

We are seeing certainly a number of hedge funds now strongly considering moving to Switzerland. It certainly is a growing percentage of managers. Some London based firms have already made their move to Switzerland or other jurisdictions, and I would believe more firms will do so in the coming years. You have to keep in mind that a few years back these firms were probably not considering moving…

It is clear that the European governments are taking rapid steps to implement some directives around the hedge fund industry. I have read the EU directive and have found it vague on a number of points, but we will get far more clarity as to what will be imposed upon our industry. The greatest concern at the moment lays around the various sales restrictions that will be imposed on non-EU investment managers.However, I do expect them to be modified before they directive gets passed. In my opinion, in the long run regulation will probably help our industry in providing increased comfort for investors wishing to invest in alternative funds.

OD: Although we have had a presence in Geneva since 2004, I don’t see us moving to Switzerland. I agree that there are concerns about taxation and regulations. But something else comes into play here that I call the Wimbledon effect. London attracts the best people to one of the best tournaments. Businesses come to London because they have the best courts, the best talent, the best infrastructure, and a great championship.

Now if the government starts altering that significantly – so suddenly there are worse schools for all our children, there are worse telephone lines, the infrastructure is significantly degraded and things like that – you could get to a migratory situation. However it seems to me it will be many years before the infrastructure at some of the other parts of Europe with possibly better taxation and regulatory environments will be able to compete more broadly.

On the directive, I think the recently appointed Rapporteur, John Paul Gauzes and the other people working on it are going to have to consider what they want to achieve. This process originally started with the assumption that maybe hedge funds were responsible for this systematic failure that led to the market upheaval in 2008. I would suggest that by now, almost everyone has moved away from that thinking. In fact, highly respected individuals like de la Rossiere and Lord Turner have also come to this conclusion. We are hopeful that sensible regulation is eventually passed that will make Europe an even more attractive destination for a growth industry.

AK: In our case, we are location-agnostic – we could be anywhere, as long as we have good communication facilities and access to our computers and systems we need. This is a great advantage for systematic managers that we can be pretty much located anywhere. London is a great location in terms of its reputation as a premier world financial centre, its advantages in terms of the time zone, the political stability of the UK etc. It has all the right ingredients, which is why the financial markets have such a long history here.

It would be very unfortunate if we were being pushed out by unnecessarily high tax burden. At the end of the day, we have to look after our own interests and our investor interests, and if these are better served by having to make a move, we will have no choice. But we will try and resist this to the extent possible. Speaking for myself and my team, certainly London is a great place, and this is where we want to be. We have no plans of moving.

LS: I suppose it’s a cynical thing to say, but you aren’t going to get too many hedge funds relocating to Switzerland when they are below their high watermark, so they have to work that one out first. But even when you get there, most people’s assets under management are lessthan they were two years ago. That means moving to avoid 50% tax on a smaller amount, when you were not prepared to move before to avoid 40% on a larger amount. I don’t think the argument that floods of hedge funds will decamp is hugely persuasive. What I am saying here refers to this year, of course, and things might change in the future.

DS: At BlackRock, we do worry that the EU directive would oblige EU investors to hire EU managers of EU-domiciled funds which are lucky enough to find one of four EU credit institutions which act as prime brokers – our host Newedge is one of those – and hiring EU auditors, EU fund administrators – you see what I am getting at. We fear that such a policy risks generating an inward looking, potentially atrophied fund management landscape, to the detriment of everyone.

Professional investors in the EU can currently choose from the best fund managers the world has to offer. They may live or die by their own decisions. With this directive, they may end up in a position where their choices are greatly restricted to EU based managers of EU based funds. This is a fundamental change for them, and not one that I believe is in our clients’ interests.

MG: Do you actually think the directive will go through in its current form?

DS: Yes, absolutely. The directive is here, it is not going to go away. It is a 57-article directive, and there are a thousand proposed amendments to it. The directive may be amended, and its final form is still not clear, but the substance will be unchanged. It’s coming, you can’t wish it away, because it won’t go away, but you can attempt to modify it in some way.

AW: I think we in Britain, in particular, make the mistake of thinking that the Europeans come with these mad ideas and they will go away. Just look at the euro – who would have foreseen what has happened to the euro, and it’s the world’s great currency now. We can deny it, a single currency doesn’t make any sense in economics, but they just don’t care. These politicians form this huge block, and if they say it, they do it. And for the time being it sort of defies sometimes economics but, it seems to work.

DC: I am not sure we will see quite the draconian changes in regulations as were laid out in the original draft. AIMA (The Alternative Investment Management Association) is working extremely hard on trying to make it a sensible directive. And just this morning it was on the wire that eight Dutch pension funds with combined assets of $450 billion euros have sent a letter complaining about the directive. I would think they will be taken relatively seriously.

GW: I don’t think that one would see any type of negative correlation between the stupidity of an idea and its likelihood of being implemented. There are many cases on both sides of the Atlantic where things that seem absurd at any other moment in time get passed quickly into law and remain stubbornly in force. I agree that regulation is coming. There will be changes between the regulation being adopted and their implementation by member states and there will be a few years of uncertain interpretation before litigation finally settles things one way or another. But it seems to me that the direction from which the winds blow is pretty plain.

The only saving grace is that the hedge fund industry at its best is highly motivated and intelligent, and is therefore as well-positioned as it can be to find ways to make the implementation bearable from an investor’s point of view. Having reread the regulations in the last couple of days, they clearly are not grounded in the idea that individuals and individual investors bear responsibility for what they do with their money. This comes back to one of the lessons that you can take away from 2008: ultimately, you have to make the effort to understand and be comfortable with what you are investing in. That is not ultimately an obligation that you can properly put on anybody else.

Reprinted with permission from Opalesque: 20 roundtables have been published so far. These can be accessed at http://www.opalesque.com/index.php?act=archiveRT