When other investors are acting irrationally, losing their nerve, or throwing in the towel, opportunistic managers will be there, ready to capitalise on the short-sightedness of others. Of course, nimble, flexible and aggressively opportunistic managers can generate outsized returns in ‘normal’ market environments too, but the extreme movements witnessed recently are providing them with a particularly rich opportunity set.
Defining what constitutes a compelling opportunistic investment is difficult. In the broadest terms, it’s an unusually rare investment prospect coupled with a distinctly compelling risk/reward asymmetry. However, opportunistic hedge fund managers are perhaps best defined by the characteristics that they commonly exhibit: discretion, contrarianism, directionality, ‘lumpy’ returns and flexibility. Examples of such managers can be found most frequently in equity long/short, event-driven and short term trading strategies, but notexclusively so.
But how do we assess whether a manager has genuine dexterity in spotting opportunities, and if he is likely be able to repeat that success over time? The obvious place to begin is in the analysis of his track record. We would expect opportunistic managers to have produced high, uncorrelated returns across a wide range of market environments. Investors should look carefully at historic exposure and attribution reports, and previous newsletters to see where past returns were generated, what rationale drove the manager’s thinking at the time, and whether their investment thesis proved correct (or they just got lucky). Did returns derive from a broad array of situations, or from a common theme? If the latter, did the manager find the most compelling opportunities in that theme?
At Eddington, we invest in many different types of opportunistic manager. For the purposes of this article we shall pool these into two categories, loosely described as ‘single-theme’ and ‘multi-theme’ funds:
‘Multi-theme’ managers are those who capitalise on a large number of situations, often across a diverse set of industries, asset classes, and geographies. They possesses an astute ability to read markets, identifying and exploiting market themes and capitalising on grossly mis-priced securities (regardless of type or jurisdiction) ahead of the pack. Managers of this calibre are regular high alpha generators – bona fide ‘idea machines’ that would compliment any portfolio. They have a long shelf life and (barring uncontrolled asset growth) are capable of generating outstanding, uncorrelated returns for many years.
‘Single-theme’ funds are often created as separate, stand-alone vehicles by existing opportunistic managers who may have spotted a truly outstanding investment opportunity. Their conviction is so strong, and the risk/reward asymmetry so favourable, that it justifies deploying a large proportion (in some cases 100% of capital), to a single trade idea. We have successfully identified several such themes. The sub-prime credit trade in early 2007, for example – that went on to deliver one of the largest annual returns in hedge fund history. At the time, it was a contrarian view, but offered massive asymmetry between potential profit and loss. The manager had substantial pedigree in his particular niche, had quietly and thoroughly researched the segment and built up an impressive team of individuals to help manage the portfolio. The return potential of the fund was huge and several catalysts existed for the thesis to be realised. While concentration risks can be higher in these types of fund, the fact that the maximum downside was known at the point of entry made this investment proposition very compelling.
The distinction between singe-theme and multi-theme is not always clear. For example, many multi-theme opportunistic managers have maintained a high exposure to natural resource stocks in recent years. This does not necessarily make them single theme managers, if they have genuinely chosen this exposure from a broad range of potential investments. Of course each theme will tend to last a finite time, so single theme funds are typically of short to-medium term interest, which can create problems if a manager has built a team around that opportunity. Whilst this is obviously a positive in the short to medium term, it could potentially result in a future bias against pursuing superior themes.
Flexibility is the core skill of an opportunistic manager; he will have very broad investment experience and exhibit skill in analysing and interpreting a wide range of situations, across many asset classes and geographical regions. The manager should be willing to invest meaningful proportions of his portfolio in situations where he has high conviction and, where relevant, to trade around positions aggressively in order to maximise returns.
Liquidity can also be an issue for investors in opportunistic funds.In general, a fund’s liquidity terms should match those of the underlying portfolio. However, when dealing with opportunistic hedge funds it is important to remember that judging their liquidity terms against their current portfolio composition could be misleading. Instead, they must be judged against the fund’s broader mandate, and the likely portfolio composition over time. In addition, investors must ask themselves whether the returns on offer, and the risks being taken, are high enough to justify the redemption terms being imposed, relative to other funds.
Opportunistic managers are generally more return-focused and do not sacrifice long-term returns in favour of lower volatility. But they also tend to be uncorrelated to the wider market throughout the economic cycle, due to the esoteric and diverse (but not necessarily diversified) nature of their investments. Skilled opportunistic managers offer a unique insight into the market and can be a huge source of alpha for funds of funds willing to accept higher volatility. We are a firm believer in the value they add to our portfolios and are always on the lookout for opportunistic managers with a proven edge, especially because these ‘interesting times’ may be here to stay.
Glenn Baggley is Chief Executive Officer of Eddington Capital Management. He began his financial career with Bita Plus Consultants where he led a team of computer programmers and research professionals in the development of risk control, optimisation and portfolio management software.
Alexander Ahari is Fund Manager of Eddington Capital Management. He began his career in 1999 with a portfolio administration role at the private client broker, Gerrard. He joined Attica Asset Management in 2001 as a Fund Manager’s Assistant, working closely with Glenn Baggley. He joined Eddington as a Hedge Fund Analyst in 2003.
Eddington Capital Management Limited is a joint venture between its management team and Caledonia Investments plc a London listed investment trust linked to the wealth of the Cayzer family.