Taking a Top-Down View

Talking CTAs and equity market-neutral with Commonfund

SIMON KERR
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Commonfund is an unusual investing institution. Reflecting its historical association with academia, it has been more open-minded than most investors in its approach and decision-making. Commonfund has been an early adopter and a thought-leader in investing. At the time it first used hedge fund strategies the vast majority of capital in hedge funds came from wealthy individuals. That was 1982. That makes Commonfund amongst the longest-tenured investing institutions in hedge funds. To find out what use the Connecticut-based asset manager makes of alternatives today, The Hedge Fund Journal spoke to the CEO of the Commonfund Hedge Fund Strategies Group, Nick De Monico.

The team working with Nick De Monico largely consists of two components: the five managing directors (each with an investment speciality) that oversee the portfolios of hedge funds, and the six-person quantitative research team. The quant team is dedicated to the hedge fund strategies group of Commonfund. They develop the models used in the portfolio construction and risk analysis of the portfolios of the hedge funds that Commonfund is invested in. (There is also a separate risk team for the overall Commonfund group.) The managing directors are specialists and will spend most of their time on one investment strategy, making them the go-to person for that strategy. However, they also work across several portfolios. For that reason, De Monico prefers that they possess a significant degree of knowledge across several strategies. Therefore, while each MD specializes in one of the major risk buckets, they also double team andback one another up. To give a few examples, there is one person who is the specialist on CTA and global macro. That staffer is also the back-up on credit strategies. Two, and sometimes three of the MDs cover hedged equity and equity market-neutral. At least two of the managing directors will work on event driven and multi-strategy funds.

De Monico outlines the philosophical structure of the hedge fund investment process at Commonfund: “Most of the levers we pull are very top-down, so we’re not considering the merits of an individual stock or credit exposure. We select a strategy first, then examine opportunity sets within that strategy such as regions or sectors, and then we look for the best managers we can find to express that tactical view. The manager selection part is very important.”

Commonfund staff members are keen to put hedge fund investment strategies into a broader context – the strategies don’t freely float, but are a function of what is going on in the broader economies and financial markets. Commonfund takes the view that hedge funds are not a separate asset class. Rather, they represent a style of unconstrained investing within broader asset classes, and as such may share some of the underlying risks of those asset classes. De Monico recalls reading last summer that 81% of the world’s equity markets were at that point supported by zero-interest-rate policies. “It means that if you (as an investor in hedge funds) don’t follow central bank policy you are at a huge disadvantage,” he comments.

“Valuation and liquidity are two factors that can have great influence on the underlying asset classes that comprise various hedge fund strategies, like hedged equity or distressed investing. Valuations were favourable in both debt and equity from 2009 through 2013, and liquidity supplied by the central banks was ample. But now, debt and equity valuations in most regions are no longer cheap and liquidity is in flux, particularly if the Federal Reserve begins raising rates later in the year. At the end of the day, your analysis of valuations and liquidity should impact your view on opportunities and risks, and which hedge strategies you favour.”

He cites 2014 as an example of a policy-driven year: “You had a minor correction and a fairly significant growth to value rotation in stocks in March-April, following remarks by Janet Yellen that the end of QE would be “of the order of six months.” The market problems in September arose because the ECB asset purchase programme announced by Mario Draghi was recognized as insufficient (in view of his statements that the (European) economy was weaker than was previously thought). Almost immediately after that ECB meeting there was a near 10% correction in equity markets. In sum, the central banks are still the primary drivers of the markets.

“I think these policy gyrations made things much more difficult for a number of managers,” concedes De Monico. “That’s why we have recently favoured managers with more moderate beta exposures. They are able to ride out these fluctuations and still maintain their high-conviction positions.” A senior investor in hedge funds has great access. “You can talk to some of the smartest people in each asset class. Through that, a careful listener can get some of the best information on the planet when it comes to financial matters. If you have enough folks with enough touches to people doing that kind of investing, and if you are thoughtful about how you organise the information you receive, then I think it really does give you an informational advantage,” he maintains.

De Monico continues, “Although I enjoy talking to all of them, in particular I like talking to managers who operate across asset classes, and those that have to pay attention to flows. Global macro would be an example of those. They may not always be right, but they give you lots of the factors you should be looking at as investors with a wide range of choices.”

Valuation and liquidity are two factors that can have great influence on the asset classes that define various hedge strategies (hedged equity and distressed, for example). De Monico notes that central banks are the ultimate arbiters of liquidity, and so their actions have great influence on prices in the debt and equity markets. According to De Monico, the critical question to ask is, “What will benefit from this (environment)?” He says, “We are still paying close attention to central bank policy. At the beginning of 2015 the specific question we had was what was the European Central Bank going to do? Are they going to pursue sovereign QE? If so, to what extent? And if they do, what will the ramifications be for various areas of the markets?”

He observes that that money is flowing back into the European equity markets – the DAX is up double-digits. “So our take is that (at the moment) you still have to pay close attention to what the ECB and other central banks are doing.”

Equity market-neutral
At some investing institutions equity market-neutral hedge funds help produce absolute returns with low volatility. Commonfund has long invested in funds in this strategy. De Monico considers that equity market-neutral has been amongst the most successful allocations in fulfilling their portfolio role. In part this is because of the type of market-neutral managers that Commonfund allocates to. The quant shock of July-August 2007 pointed out the risks of crowding in positions amongst stat-arb-type market-neutral funds. Rather, Commonfund prefers close-to-neutral managers that have a fundamental basis to selecting securities, and that have holding periods longer than a high-frequency trader. Commonfund also allocates to sector specialists and managers with a broad market mandate in equity market-neutral.

“We do have some managers that are exactly market-neutral, but most of our equity market-neutral managers are close to M-N,” he explains. “Typically they can have plus or minus 20% beta-adjusted net market exposure. This enables us to work with non-quant equity market-neutral managers. Many have teams of sector specialists, which means that the research effort can go a lot deeper into the stocks, and the managers can knowingly take a little net sector, net stock or net market risk. This scope at the net level means the managers avoid being forced to take short positions they may not want or have low conviction about.” The rationale of investing in equity market-neutral has been vindicated by the outcomes.

De Monico says that he has found in the past that there was an increase in M&A activity and spin-offs in the later stages of the economic cycle. “There is a limit to corporate margins through organic growth,” he expands. “They are often mean-reverting, and margins have been high in the last three to four years. In the later stages of the economic cycle corporate management look for other ways to maintain their earnings and margins. They look at acquisitions as another way of maintaining top-line growth and, ultimately, that of the bottom line.”

Accordingly, we may be in the seventh innings economically, and quite a long way into a bull market in equities. Although De Monico acknowledges there may be conditions prevalent to sustain equities for even longer, there is evidence to suggest that this is a mature economic cycle and stock market in the United States. So there is a lot of corporate activity. There is expected to be a record number of spin-offs this year, and the level of deal flow is back to where it was in 2007. This is a fertile background for event driven strategies.

De Monico also liked that the spreads in merger arbitrage deals widened after the Shire/AbbVie deal broke last year in October. Some event driven managers had dry powder they could put to work then on unlevered spreads. He has a strong preference at the moment for event driven managers that put an end date on their investments. For these managers, with a fixed date in mind for each holding, they effectively structure investments of “shorter duration”. “Event driven managers in the late stages of a cycle generally do not plan to hold positions in perpetuity,” he said.

The role of CTAs/global macro
“We view CTAs as an option on momentum in the portfolio,” expounds De Monico. “We believe that markets trend, so having an element of the portfolio in CTAs and/or global macro is consistent with that belief. There will be periods in markets where it is not easy to pick up on trends, but sooner or later there will be an environment which is more favourable for trend following. There may be a time when two or three major trends develop in markets. If you look at the dollar, high-yield bonds, volatility and the MSCI, our work shows cross-asset-class correlations falling over the last two years. In addition, in the last six months of 2014 volatility rose from a low of near 10% in equities. This pick-up in volatility during the second half of the year coincided with a major correction in the oil and commodity markets. This is exactly when many CTAs began to outperform other investment strategies. We look for CTAs to catch on to price trends, and we are agnostic as to the direction of these trends. It’s what has made CTAs such an effective long-term diversification tool.”

To cope with the periods when CTAs are not performing Commonfund does two things: vary the allocation and change the mix between CTAs and macro. During the period 2006-2009, the diversifying strategies were wholly in CTAs. In the post-credit crunch period allocations to diversifying strategies were reduced to 10% of the hedge fund portfolio, and the mix was changed to 60/40, with 60% in trend-followers and 40% in discretionary macro managers. “We have found that discretionary managers are much better at catching sharp reversals in markets, and in policy-driven periods markets can quickly turn on a policy change,” explains De Monico. At the moment the mix is that 60/40 split with a bias to trend-followers. This is an example of setting the investment policy to the investment strategies that would do best for a particular macroeconomic environment. It may be related that De Monico notes that a number of systematic macro managers have become better at catching reversals in the last year or year and a half.

Within the trend-following managers Commonfund likes to maintain a mix of styles. “We have longer-term managers, medium-term managers and managers that have a bias to faster signals,” says De Monico. “We have also been deliberate in utilizing managers from different geographic locations, in order to find managers who may represent different schools of thought. Ahead of time it is very difficult to forecast which style is going to perform best, so we use a mixture.”

“The systematic investment approaches we view as in an arms race. They compete on the number of research scientists they employ”, he explains. “But there are other criteria which are important too. We think it is important how the portfolios of managed futures are constructed, and the risk management is a key differentiator.” De Monico notes that some of themanaged futures firms are trying to become systematic multi-strategy shops. “They are adding things like systematic approaches to event driven. But the reason we invest with them is their trend-following capabilities. It may be that we can invest in the non-trend-following strategies they develop if they are good at them – we don’t rule that out. But that is not the reason why we have been tracking them.”

Facilitating a top-down view
De Monico explains how investment policy is set in the Hedge Fund Group at Commonfund: “We try to take a top-down view of what strategies are going to have a tail-wind in the period ahead. Obviously, we believe that you are better off having a tail-wind in an asset class or trading style than a head-wind. We will look at the asset classes on a valuation and liquidity basis, and we take those things into account in setting our investment policy for the following year.”

In order to do this De Monico times his visits to the managers that Commonfund employs. The staff of Commonfund typically has between 750 and 1,000 face-to-face meetings with hedge fund managers a year. Those figures include the 60 managers that Commonfund invests in, the 300 funds that the asset manager actively tracks, and the new names coming into the top of the hopper for the first time. Each November De Monico will schedule meetings with the hedge fund managers with which they have capital. The Commonfund Hedge Fund Strategies Group will visit each manager with whom they are invested at least once a year, often followed by a second on-site visit that is timed specifically to inform the intelligence gathering for year-ahead prognostications. The manager visits are part of a three-month effort to gather inputs, analyse, think, conclude and afterwards communicate. A visible outcome from this intelligence gathering is the 12-page Commonfund Hedge Fund Strategies Group Outlook, this year titled, “Fully Invested, But Fully Hedged”. The outlook document is available to clients, and covers factors important to strategy allocation as well as giving an outlook per major strategy group. To illustrate the factors, here is an extract on dispersion:

“There are several factors that give us cause to be optimistic about active management in 2015, namely, volatility and its close cousin, dispersion. Dispersion is one of the important factors in deter-mining the environment and opportunity set for active management. Dispersion measures the difference in returns between the best and worst performing securities in a given asset class – for active managers, the more dispersion the better… There are a number of theories as to why dispersion last year was minimal, none of them conclusive. What is well established is that while volatility and dispersion are not synonymous, they are related, such that dispersion tends to be higher when volatility is higher.”

Dispersion and historic volatility are amongst the factors brought into the mix in assessing the prospects for hedge equity strategies, on which De Monico is guardedly optimistic. He finds it difficult to allocate more capital to European-focused managers at the moment because of geopolitical concerns with Russia, as well as the consequences of the election of a new Greek government, and the economic sclerosis in the Eurozone, illustrating top-down thinking. However, Commonfund is part-way through the process of selecting a Pan-Asian equity hedge manager. Part of the rationale is that dispersion has been a lot higher in Asian markets in the last year than elsewhere, but also because Japanese equities are the cheapest in developed markets (and Japan has QE and a policy of public purchasing of equities), and the People’s Bank of China is easing. Further, regional equity hedge managers claim to have less competition in Asian markets than elsewhere.

Hedge fund investments can be viewed by some investors as an asset class in themselves, or alternatively as an investment strategy used as a style of investing in securities. De Monico says that Commonfund is in the latter camp. That said, their investors use hedge funds in several ways. Some use them as an adjunct or complement to a traditional long-only fixed income or equity portfolio – treating their hedge fund investments as a way of enhancing the long-only allocations. “We also have investors that take a more general approach,” he says. “They tend to make a capital commitment, looking for low correlation to the traditional asset classes along with lower volatility and the potential for diversified sources of alpha. Those clients might look to take exposure to a multi-strategy fund of hedge funds product.”

The most recent customised mandate for Commonfund’s Hedge Fund Strategies Group was in alternative fixed income. “With 30-year Treasuries yielding 2.5% and high-yield corporates yielding 6.5%, investors are not being compensated for taking that duration/credit risk,” says De Monico. “If we can build something that theoretically has a similar risk profile but higher return potential, or offers the same return level but with a lower level of risk, then that obviously will have appeal. I think that more money will flow into hedge funds as they are increasingly used as an adjunct to traditional fixed income and equity investments. Potentially, money flowing in from long-only investors represents a very large pool of money.” He concludes that a lot of investors are increasingly viewing hedge funds as a way to enhance existing portfolios. Around half of Commonfund’s hedge fund assets are in separately managed accounts. A lot of those allocations are for the purposes of alpha generation, and for lowering the volatility as well as correlation of the underlying portfolio to markets.

What differentiates Commonfund
Nick De Monico says that going to work at Commonfund was a great move for him for a number of reasons. “The investment staff includes fixed income people, the long-only equity group, the commodity trading group, and then the hedge funds all on one floor. In addition we have a private capital team in the same building. So there is a chance to work with a group of investment professionals across the asset classes, and the flow of information is good.” The second reason is the emphasis at Commonfund on investments. He notes that “in some forms of asset management business the top of the agenda seems to be asset gathering. The primary focus at Commonfund is very much on the investment return. And as someone who ran trading desks for 20 years, it was part of me, and so it was critical that I work somewhere with that focus on investments.”

A distinguishing feature of Commonfund, according to the CEO, is the emphasis there on educational services to the client base. “It has always been part of the Commonfund DNA to have an educational bent to what we do,” he says. “The Commonfund Institute regularly sponsors seminars and educational events for clients. We also run the Commonfund Forum, our investor meeting, once a year over three or four days. We get experts in from different parts of the (asset management) industry; and we get people in from the political sphere to give insights into where government policy is going.” He continues, “I also like that you can be very innovative at the Commonfund. The people I work for here will let you run with an idea – so it is a very creative place at which to spend your time.”

But most of all, De Monico gets real enjoyment out of implementing the top-down views. “You can have a conversation with really intelligent people across the asset classes, both inside and outside Commonfund. It is what has kept me at this for over a decade as much as anything else. I have the chance to talk to people across a wide range of markets and strategies, which is a great opportunity to learn. It never gets boring – these are interesting people to talk to who are at the top of their game.”

Nick De Monico
Nick De Monico is responsible for investment and business leadership for the Commonfund hedge fund portfolios, including funds and separate accounts in directional and relative value strategies. Prior to that, De Monico served as deputy CIO and head of hedge fund strategies. Prior to joining Commonfund in 2002, he was managing director and portfolio manager for Citigroup Alternative Investments, where he was on the management team responsible for $2 billion in hedge fund investments for eight diversified multi-strategy and single-strategy funds.

From 1991-2001, he was managing director and senior portfolio manager for CDC Investment Management Corp., a subsidiary of CDC IXIS North America, where he managed mortgage hedge positions and relative value trading strategies for eight mortgage-backed securities funds with approximately $2 billion in assets. De Monico also built and managed the CDC Global Relative Value Fund, and was the executive vice president supervising proprietary trading and treasury for CDC Capital. From 1983-1991, De Monico was a senior proprietary trader in the fixed income arbitrage groups at Merrill Lynch and Chemical Bank (now J.P. Morgan Chase). He began his trading career as a fixed income arbitrage trader at Kidder, Peabody & Co. De Monico earned his MBA in Finance and Marketing from the Columbia University Graduate School of Business and a BA in Political Science from Columbia College.