This is an industry poised for further growth next year driven by allocations from the pensions, insurance and endowments sectors, as they seek out absolute returns. Here at CQS we have built the infrastructure, processes and team to take advantage of this likely inflow, as we view ourselves as alpha generators.
One of the key developments next year will be continued institutionalisation. We're now seeing family offices and an increasing number of consultants bringing institutional-grade criteria to their selection process. There used to be a high degree of qualitative judgement exercised in the selection of a hedge fund, but now there is a more quantitative approach with detailed analysis of risk structure, disaster recovery, the nitty gritty. At CQS our mantra since inception has been that we are paid to take investment risk, rather than operational risk. The continuous investment we have been making in infrastructure, processes and risk management is now being seen as a necessity. Byway of example, 160 people now work at CQS, 60 at the front end, plus 100 in the middle and back offices, legal and in compliance. Infrastructure, legal support, risk management, stress tests, and long tail risks tests: firms are looking to make 20-30 different reports. It's all far more than VaR these days. Hedge funds are becoming expensive things to run. You can probably operate an effective stock-picking fund without much infrastructure, but you will need a complex structure if you want to be cutting edge.
This coming year is also likely to see more convergence between hedge funds and the private equity and long-only worlds, as firms seek to deploy capital. We will see the long-only industry looking more carefully at hedge fund-style fee structures, and we will see more emphasis on absolute returns and alpha rather than investment style.
Firms may also diversify into other asset classes, but they will need to be cautious, ensuring they have the right infrastructure and that investors in funds feel confident that they are benefiting. At CQS, we have to have adjacency within what we do and an environment that fosters a collegiate and partnership approach is critical – namely eschewing compartmentalisation.
While it remains difficult to predict which strategy will be the winner next year, convertible arbitrage is looking like a good prospect, although, there's already a lot of money chasing alpha in that space. However, we continue to believe that credit offers good opportunities.
Next year will also see a continuation of the trend towards permanent capital vehicles on a number of different levels, such as this years' trend of hedge fund management firms floating on the market as well as firms floating individual funds. This will put them on a more even keel compared with the more institutional hedge fund players. For example, CQS has recently embarked on the listing of a closed-end fund.We will also see firms innovating in the area of capital structure.
On the regulatory front, it has been interesting to see that the SEC has retreated somewhat from its position at the beginning of 2006, whilst the FSA continues to invest substantial resources in monitoring, and seeking feed-back, from hedge fund management firms.
Tim Haywood, Chief Investment Officer, Julius Baer Investments Ltd
This has been a tricky year to be managing fixed income portfolios. Yield curves have flattened further than markets foresaw last year, hinting at a global recession which central bankers do not foresee, credit has behaved better than expected whilst other risk assets have exhibited far greater relative volatility. Ex |apan, government bond yields are closer to an easing cycle than we were 12 months ago. This is good news for long-only investors, were it not for expectations of interest rates already built in; consequently the better opportunities may appear in FX. That said, expecting the Chinese Renminbi to appreciate faster than the rate implied by its forward rates will likely disappoint once more.
The global interest rate trend is not entirely obvious however: as a result, volatility of bond markets could rise. Also appealing is the notable difference between individual bond markets. If the Bank of |apan continues to hike rates, local investors may switch more capital from the domestic market to bond markets expecting monetary easing. The emerging markets will – as ever – be exciting, with Ql budgets and elections providing focus points, within the context of ongoing real currency appreciation and interest rate convergence. Long Latin interest rates, hedged to EMEA FX risk and linked with Asian EM equity risk would be a neat combination.
Credit has sown the seeds of its own destruction – the more corporate bonds rally, the less they can rally going forward, as bonds will track to par on redemption date absent defaults, which, whilst unlikely, are more probable in a decelerating 2007. A long corporate bond stance can be seen as having a short volatility bias – at a level which is not inspiring given the corporate event twin risks of both LBO and increasing payment stress. Momentum chasers buying the best performing asset class of 2006 will, I reckon, make a grave mistake chasing credit in 2007; better, in fixed income, to buy the sector that has underperformed.
Ultimately, credit -which has behaved so well in 2006 – looks unattractive for 2007. Corporate bond yields seem too low relative to earnings yields. As underlying interest rates are unlikely to spike higher, it is left to corporate bond spreads to widen if yields are to rise. In order to widen the gap to equities, then earnings must fall (unlikely) or equity prices rise (valuations are broadly fair in the large cap growth stocks). Consequently, I am predicting a modest equity rally in 2007, although I realise this will have to follow the good year that equities have had in 2006.
Combining the equity and credit calls leads to a rosy outlook for convertibles, exchangeables or other equity-linked debt -that are credit-hedged, and, from about Valentines Day on, up to fully equity-hedging too. This is an unashamedly 'long vol' trade, but with expensive corporate debt, easing growth, breaking FX ranges and looming policy errors, 2007 should reward such positioning in a way that 2006 did not.
Stephen Zimmerman, Chairman, NewSmith Asset Management
I feel the hedge fund industry's prospects are better than some pundits imagine. Hedge funds are cash vehicles. In strong markets people sometimes forget they are also about protecting capital, yet this should be uppermost in investment managers' minds. The ability to provide absolute returns in a low inflationary environment means that they are a type of asset which investors should want, and hence prospects for next year for the hedge fund industry look reasonably good.
After 2006 I'm cautiously optimistic about returns: we're seeing a period of benign growth at the moment, and I'm not anticipating that will change in the short term. Short term interest rates could still go up a bit further but central bankers have performed an important function in the last year by putting interest rates higher predominantly because of their fears that there is too much leverage in the system. In my view their action has already taken some of the heat out of the markets. Also we should not underestimate the effect of the strong Euro and Pound Sterling in helping to reduce inflationary pressures, but the big question will be what happens to the dollar next year. I feel we are not far short of a turning point here. It looks remarkably weak at the moment, and is hard to forecast. I think it has to be a buy right now however.
Looking at the world situation, there's obviously been a major shift in the administration in the US. A Democratic majority of Congress in both houses is not a bad scenario, as it means a balancing act for the remainder of the Bush administration. It will also be interesting to see whether Treasury Secretary Paulson will have any influence in his negotiations with the Chinese. There are also some noises about simplifying the US regulatory system – for example Sarbanes Oxley – prompted by concerns that perhaps the US is losing its attraction as a financial centre, although I don't see it myself.
In 2007 I expect to see a continuation of the high level of M&A activity we've seen this year. Private equity deals are likely to continue which when added to share buybacks is likely to see more funds drained from the equity market. I am too old not to worry about unexpected recessions but given the technological advances which have allowed firms to exercise greater controls over their global inventories we may be lucky this time and escape with a mild slowdown.
Chinese and Indian growth looks reasonably robust, and with other locomotives driving the global economy I don't see why markets can't make some progress. We certainly feel that we can find companies in which we want to invest. As for Christmas wishes, I'd like there to be some resolution of geopolitical issues facing the world – it would be a huge plus for markets if any of the major conflicts were resolved
As for NewSmith, we have completed the initial design of our business and we are hoping to build on the strategies we already have in place. We hope to continue to build out our platform, and expand our business in Europe, Asia and North America. We're excited about our business; we've got a great team of people, and look forward with optimism to 2007.
Philippe Richard, Secretary General, IOSCO [International Organisation of Securities Commissions]
lOSCO's Technical Committee is about to release a report on the regulatory environment for hedge funds. In a nutshell, we have been polling our members to provide a comparative picture of market regulation for these vehicles. We noted that there was no formal legal definition of the word hedge fund, and that most hedge fund advisers themselves are being regulated. Some jurisdictions have also reported a trend towards the retailisation of hedge funds.
There have been some instances of fraud this year, but the prevalence varies from one jurisdiction to another. Possible future projects may include the development of principles around valuation issues, and I would expect IOSCO to be publishing a fact-finding report on this in the near future.
One of our standing committees is already looking at clarity of valuation, the issue of independence, as well as consistency and methodology. lOSCO's work on valuation is yet to be completed, but this issue could be raised during the organisation's next Annual General Meeting in early April in Mumbai, India.
IOSCO has developed aclose relationship with the hedge fund industry, and is working with experts in the field to develop a set of principles which will hopefully outline acceptable practices for the valuation of instruments being used by hedge funds.
Assets invested in hedge funds are growing fast, so effective valuation is critical. It affects the calculation of the NAV, deferments reporting, fees paid, and the risk profile of individual hedge funds. It can be difficult because of the nature of the investment strategies being pursued. In addition you have human error coming into play: it is easy to see how the portfolio valuation potentially could be manipulated, and international regulators have an interest in ensuring that investors are not being treated unfairly.
Another issue we are studying at the moment is conflict of interest: we want to be able to describe the need for good separation of functions. It is one of the challenges facing the hedge funds industry at the moment, as the manager is often the best – and only – person able to provide an accurate valuation. For instance, one of the principles we may try to develop is the principle of independence.
Going forwards IOSCO will look at the issue of using methods – making sure financial instruments are valued using established policies and procedures, the use of methodologies and their consistent applications. However, there has to remain a degree of adequate flexibility.
Ultimately, this is a global issue we're trying to address. The purpose is not to add a new layer of regulation: we're looking to describe good and common practices. The selection of pricing sources is also an important matter. It should be independent and not directly influenced by the manager.
Bill Maldonado, Head of Alternative Investments, Halbis Capital Management
I think hybrid products will take firmer root next year – these are product which are somewhere between hedge funds and long-only investment. There's been a lot of talk about these products for the last couple of years. Customers are becoming much smarter at differentiating between alpha and beta, and would like to obtain their beta very cheaply, from specialist suppliers. It is not a trend that goes in one direction, but rather something that is cyclical. It will be an important evolutionary step for the industry. I suspect we'll see both traditional managers and hedge fund managers launching these, probably to continental Europe where there might be more acceptance. Going forward 5-10 years, in terms of AUM, they could represent a significant chunk.
In terms of markets this year, we've seen a lot of managers struggling with market conditions, particularly fundamentally-driven managers. Some two-thirds will have had a really tough year, beginning in May, and that's unusual. Valuations in some cases are very stretched, and some types of stocks – best represented by assets stocks or utilities – are in a strange situation. Private equity buyers are paying much higher multiples than in the public market, yet institutional investors are shifting money into private equity because they think some public equities are trading at high multiples. This activity has taken some stocks, like the Spanish construction sector for example, to very high multiples, where we have to do discounted cashflows over generations in order to justify valuations.
This has made life hard for a lot of managers, particularly on the short side. The general level of corporate activity is also very high. There seems to be a high degree of financial engineering going on in some transactions. One could characterise this as something of a bubble, yet perversely it involves a group of stocks many managers would have thought of as a safe haven in difficult times. Next year we may see an unwinding of this bubble, we may see one of these deals falter, we may see people begin to price risk again into these stocks. If that does happen, that could also be a key feature of markets next year, which will impact all market participants. We've had a couple of years of high issuance of sub-investment grade bonds, at record levels, and the default rate has so far been incredibly low.
Below investment grade, at 5-10 years, the default rate should be phenomenally high, at 60-80% historically. We're going to end up in a situation where a lot of these bonds are going to fail at some point, yet in September alone there were no corporate bankruptcies declared amongst US listed companies. If economic conditions change, next year could be a vintage year for distressed debt players. This is an interesting skill set – it's not something that's easy to move into. If there is suddenly a big surge in supply, returns will be high, and will remain high for some time.
Many commentators have been calling the end to the commodities boom, but whether the directional boom in commodities is over or not, the level of activity and money going into commodities remains very high, and is unlikely to diminish in the foreseeable future. Pension funds are unlikely to sell out of commodities very quickly. That creates a lot of opportunity in commodity markets.
Thomas Delia Casa and Mark Rechsteiner, RMF
The world economy is expected to slow moderately in 2007, primarily due to a soft patch in the US.
Earnings are set to show only moderate growth. This appears to be priced into the markets already, as they did not react adversely when companies lowered their guidance for next year. A moderate slowdown in profit growth can be seen as favourable, as it prevents the economy from overheating, and reins in investor confidence.
Equity market valuations do not look stretched, and the asset class looks relatively attractive when compared to bonds. Taking a 10-year valuation average for the US and European equity markets – excluding the 2000 multiples – the markets would still have some 10% upside based on current ratios.
Emerging markets, particularly in Asia, also offer good opportunities. In |apan, small and mid cap stocks have corrected heavily in 2006, and now offer opportunities again. Strong swings in money flows, however, could put a lid on performance and equity markets thus require a cautious approach. As a result, we see potential for further gains by equities but with increasing downside risk. Thus, the outlook for equity hedged strategies remains favourable.
Bond markets currently price in a more pronounced downturn as long-term yields in the US remain stubbornly below short-term yields. Fixed income arbitrageurs will struggle to identify fresh opportunities in this environment. We expect better performance from convertible bond arbitrageurs as volatility is the cheapest asset class. We think that convertible bond arbitrage is a smart way to gain exposure to cheap implied volatility with the option to make money and pay premiums by actively trading the gamma.
Hedge funds generally prefer high volatility and strong directional moves, so the current low volatility environment is a constraint on most strategies. In particular, arbitrage strategies are set to remain challenging as long as volatility is low. For example, credit arbitrage has been restricted by the lack of movement in credit spreads, which remain about as tight as it gets. However, this can change quickly and idiosyncratic credit dislocations caused by corporate events, such as M&A and LBO situations, are expected to create attractive opportunities. Record low default rates make it difficult for classic distressed securities players to generate above average returns. Supply has been insufficient for some time due to the fundamentally sound economic environment, which has been particularly tough for passive funds. We think that the active funds will fare better and continue to outperform the passive managers. However, in event driven, we prefer special situations over distressed securities.
Corporate deal flow remains very high, with M&A activity continuing at a strong pace on both sides of the Atlantic. In recent months, the merger wave even intensified. In just one day, 20 November 2006, 35 transactions worth $75bn were announced globally. This reflects strong corporate balance sheets as many firms have focused on cutting costs and reducing debt over the past few years, and are now looking outward to boost growth. Special situation managers should continue to find ample opportunities as corporate cash levels are still high, and private equity firms, which globally collected $l72bn YTD, still seek appropriate targets.
Ewen Cameron-Watt, Head of the Strategic Investment Group (EMEA), BlackRock Merrill Lynch
Interest rates and inflation remain under control and while we are likely to see an increase in volatility, we still see equities as a better investment than bonds. Two new themes that are likely to emerge this year are the increasing importance of agricultural produce -so-called 'soft commodities', as demand for biofuel increases, while the Asian comsumer looks set to take up the slack from the US consumer. Also, cash financed M&A activity has now surpassed the peak of 2000, and with the record sums raised by private equity funds, this is also likely to be a major driver of the financial markets in 2007.
The US economy, the primary driver of global growth, looks set for a soft landing. While the US housing slowdown has been underway for six months, consumer spending has remained robust. Furthermore, we see positive surprises in other major global economies, including Asia and parts of Europe, where any slowdown is expected to be moderate.
The rising price of commodities drove inflation in 2005-06. In the second half of 2006 commodity prices have come down, which has helped subdue inflation. In addition, we are not seeing the second round effects of inflation: wage increases, for example, remain moderate. Investors will continue to watch inflation carefully, but we will see some moderation in the factors affecting it. Interest rates have been low over the last four years. In the last 12 months global rates have risen, but have still not hit the restrictive levels seen in 2001. Instead, interest rates are in fact now normalising. We see a long period of flat or gently rising interest rates in 2007.
Earnings growth has rebounded since the earnings collapse of 2001. However, both investors and analysts now have much more realistic earnings expectations which are priced into the market. Earnings are expected to slow in 2007, but this is unlikely to have a negative impact on global stock-markets as unlike the Internet-driven stock market boom of 2000, investors no longer have unrealistic expectations. This means the market currently trades at a more normal level, and may even generate surprises as the best companies report stronger earnings.
Merger and acquisition activity has surpassed the levels seen in 2000. However, the fundamental difference is that now an increasing proportion of deals are funded by cash as opposed to the paper-driven M&A boom of 2000. Private equity has also raised record sums this year and will be on the lookout for deals in 2007 even in non-traditional private equity sectors such as utilities and aviation.
Equity volatility has been historically low, suggesting economic data has been benign. While the general outlook remains positive we have now reached a point in the economic cycle where the direction of inflation, interest rates, and growth are not certain. It is this uncertainty that will increase stock-market volatility. We are also likely to see stronger growth outside the US as the importance of the domestic investor base, particularly in Asia, comes to the fore. Currently, Asia still lags the G7 nations in terms of household consumption as a percentage of GDP, indicating that as the power of the Asian consumer grows, this gap will close.
Greater Asian consumer wealth is also positive news for the US dollar. The dollar is unlikely to collapse as there is still significant Asian capital looking for a home in US assets, as Asian domestic markets will continue to improve in 2007.
David Harding, CEO, Winton Capital Management
The hedge fund industry has been growing over the past year and I believe it will continue to grow. Despite all the negatives comments, such as mutterings that hedge funds do not really perform, there has been very rapid growth this year, a large part of which has been driven by institutional money. This must be for a reason – investors are often professionals, and they look very carefully at where they put their money. Institutional investors like the pension funds look for lower risk and therefore invest in lower return strategies. They need to make 7-8% in order to meet their liabilities and so they are going to seek strategies with lower risk and lower returns compared with the glory days of hedge funds. If they invest in a fund with 9% or 10% return and a volatility of 5% then they are happy. If you are looking for a good return and low risk, then putting all your money into a stock with 7-8% return with 100% volatility is not the wisest move. I think that the preponderance of new money will continue go to the top 10 firms going forwards. I see hedge funds as essentially entrepreneurial financial service businesses. In the last 20 years £20trn of wealth has been added to global assets. A lot of new companies have sprung up and they have sprung up in the world's busiest business which is money management. It just seems common sense.
I do think there will still be a large degree of turnover next year. Just because a company has been around for five years does not necessarily mean it is now permanent. This year we have seen several large hedge funds in the limelight for the wrong reasons. Amaranth and Vega both dropped out of the top 50 this year and there will be more failures, but they may be more relative. LTCM was a spectacular failure, Amaranth was a spectacular semi-failure as they did not lose all their investors' money, they only lost 60%, and Vega was a spectacular semi semi-failure as they raised the money and then did not perform in line with past performance figures on which basis the investments had been made. But there are bad apples in every barrel and there are hedge funds of different quality. I have shares in 150 British companies and over the last five years six or seven have gone bankrupt. However a lot have quadrupled or even sextupled. That is just the nature of shares. Some will lose 100% while others will triple in value.
I also think that there will be more IPO's. This year we saw Charlemagne, Ashmore and more recently Bluebay's floatation, and Fortress is considering it, which would make it the first in the US. It is interesting to note that the share prices of Ashmore and Bluebay have risen since their IPO's which shows that the market is very friendly to hedge funds becoming real companies and not just shady prop traders out to make a quick buck.