Turbulent times widen opportunities for some strategies

Originally published in the June 2008 issue

After a tough first quarter, most hedge fund strategies staged a recovery from April onwards. Managers were helped by the perception of abating uncertainty on financial markets and price re-convergence after market dislocations. In fact, the consensus is poised as if the Bear Stearns bail out marked the low point of financials-related stress.

We tend to believe that this spring’s upward move is simply a consolidation and not a lasting recovery. If markets are ready to trade on fundamentals, they should also acknowledge that the consequences of the financial breakdown still have to trickle through to the real economy. The US consumer is facing more than headwinds. The labourmarket is deteriorating and high inflation and negative home/equity price trends are constraining purchasing.

More significantly, it has to be recognised that the consumer will not be able to draw on the credit lines that, in the previous financing regime, were readily offered by financial institutions. After hitting financial markets, the deleveraging process should now work its way through to household balance sheets, a much longer and more tedious process. In our view, the severity of this financial quake has the potential to transform what initially could have been a short and soft landing for the US economy into a much longer and more widespread correction.

Not only has the monetary policy transmission mechanism broken down, but the financial crisis is acting as a magnifying glass, exacerbating the links between housing and economic activity.

As long as the US housing market crisis continues to disrupt global credit markets, risky assets will be negatively impacted. Slowing global output growth, higher commodity input prices, and a new exchange rate regime with a permanently weaker US dollar could drag major world equity markets further down as current earnings growth expectations are not sustainable.

In such a context, we are confident that alternative investments will allow simultaneous performance enhancement and volatility reduction, driven by a favourable market structure. Correlation among asset classes retreated from peak levels reached earlier this year, while equity return dispersion stabilised at high levels. The opportunity set for alternatives as an asset class has thus, in our view, massively widened.

For the time being, we feel comfortable with a defensive stance. Directional equity beta exposure is not worth the risk, as de-correlated sources of returns are to be found in other segments. Obviously, we are in a new volatility regime that should benefit all trading oriented strategies.

For instance, pure volatility-oriented funds can thrive in such an environment. All arbitrage and relative value strategies that offer market neutral performance should also be among the main beneficiaries. Now that the deleveraging tide has left cleaner shores, liquidity issues are less pregnant and opportunities are to be found as market dislocations have created opportunities, in particular in some credit/MBS segments.

One of the main beneficiaries of the new financing/volatitlity regime

The recent lacklustre performance by convertibles managers has not led us to believe that the strategy is broken. Convertibles have sold off as supply came to the market. As market participants craved liquidity at the start of the year, both older bonds and newly issued ones were sold to meet margin calls. Even as realised volatility and listed option volatility rose, convert volatility fell. We believe the cheapness of convert volatility will eventually reverse itself. Managers who focus on gamma trading will ultimately benefit in this space. Convertibles issuance remained remarkably steady given the market situation. This contrasts with that of the high-yield market (potentially a close substitute to convertible financing), which has not recovered yet. In the long-run, this supply of paper should provide some jet fuel for convert managers who can delta hedge the bonds issued at very attractive prices. Additionally, much of the issuance is in the financials space, which we expect to have sustained volatility.

Trends are strong, and we like managers who can capture them

Given the higher level of volatility in the marketplace as compared to a year ago, many CTAs have reduced their exposure and margin to equity. Nonetheless, they continue to provide exposure to markets besides equities, which is attractive given our belief that we will not get paid enough for beta risk. Moreover, extreme intra-day ranges are a major characteristic of the current trading environment.

Our proprietary models indicate that this market choppiness benefits short-term CTAs. Models that, by definition, shift exposure on an intra-day basis, can make the most of the volatility in the market place. As for long term CTAs, they did benefit from the strong and persisting trends in several market segments (bonds, currencies, and commodities). Current ‘low visibility’ markets are, however, characterised by violent turning points, a feature that can disrupt longer term models. Risk adjusted returns are thus less compelling than those of shorter term models.

Time to begin taking advantage of opportunities in specific segments

Ever since last summer, we have seen various analyses and heard from market participants that there were outstanding opportunities in the fixed income arbitrage space. And indeed, every month, opportunities became more and more attractive, it seemed. True, the housing market remains difficult, and liquidity in credit markets remains less than ideal, but market dislocations have gone very far, so that many assets are pricing a much less complacent scenario than equities. The strategy has suffered from sufficient forced selling, and we feel comfortable stepping into it cautiously. Still, we believe the mark-to-market risk is real, and we would not recommend this move to investors who expect a quick resolution with no drawdowns.

Humans, not models

Cyclical turning points breed uncertainty, offering opportunities to global macro managers. In the segment, we tend to strongly prefer discretionary managers to model-driven, systematic ones. Transparency of the Lyxor platform shows that discretionary mangers tend to have more relative value plays in equities against each other (ie. long equity indexes in one region and short indexes in another region). As for systematic managers, their models are currently telling them that equities are cheap on a valuation basis. They are thus net long equities across the globe, adding a strong positive equity beta to portfolios.

Deal and mark-to-market risk remain high

Even if the M&A cycle is far beyond its sell-by date, there have been quite a number of strategic deals by firms with cash on their balance sheets. Aside from the brief moment of optimism last October as markets rallied and spreads fell, deal spreads trended upward from mid-summer 2007 until the beginning of this year. They have stabilised at historically high levels over the past couple of months and are attractive enough to justify allocation to the pure risk arb managers.

As for special situation funds, they are structurally long, so that their portfolio performance is correlated with equity returns. The differentiating factor among managers here is the hedging method used. As for distressed, our belief that the macro situation still has more room to unwind is likely to lead to volatility in this space that keeps us away from it for now.

Astute hedging and stockpicking skills are key

High dispersion among sectors/styles/geographical zones, but also in individual stocks return offer strong opportunities to managers.

However, directional risk is still very present in the segment. Most managers have increased exposure in the wake of the bear market rally that followed the Bear Stearns bailout. This can leave them vulnerable to a new wave of equity market drawdown, as equities should price in the impact of the financial regime change on the real economy. Hedging and stockpicking skills will be a clear differentiating factor of returns.

Lyxor Asset Management

Created in 1998, Lyxor AM currently manages EUR 72.5 billion. A wholly-owned subsidiary of Société Générale Group, belonging to the Corporate and Investment Banking arm of the group, the asset management company specialises in three businesses: Alternative Investments (€25.4 billion); Structured Management (€10.9 billion) and Index Tracking (€27.3 billion).