| Fawcett, Fauchier Partners: lock-ups exist partly because of demand from institutional investors |
OK, Permal Twenty years ago people who bought hedge funds wanted to achieve 20% a year. In time, 15% became the new 20%, and three or four years ago 12% became the new 15%. Now it's 8% to 10%. So let's start by asking about the return expectations of investors starting a hedge fund investment programme today. CF, Fauchier Partners If you take the HFR Fund of Funds Index as a proxy for the industry, and look at its returns over Libor, returns have been declining. However volatility has declined as well. So the rolling Sharpe ratio of the HFR Fund of Funds Index was at its highest ever, taking the 12 months to the end of 2003. Alpha appears to be declining but if you had leveraged the HFR Fund of Funds Index over the past 36 months, your returns would have been similar to historical levels and with similar volatility. Also, you must ask: "What type or quality of alpha?" The headline nominal numbers are coming down, but depending on whether you measure over Libor or as a Sharpe ratio you get a very different picture.
ED, Credit Suisse There have been so many new hedge fund start-ups and so much money pouring into hedge funds recently that the dispersion of returns between the good-quality managers and the average managers has never been so pronounced – even within the same hedge fund style or strategy. I don't think alpha is declining per se: there are still very good quality hedge fund managers out there that are able to generate alpha consistently, it's just becoming more tricky to identify those managers. My job, which is sourcing those high-quality managers, has become more challenging. So, in brief, the race isn't over but it will become more important than ever to make sure you are betting on the right horses.
GI, Albourne Partners Yes, we shouldn't lose sight of the fact that hedge funds are not a homogenous group. For aggressive equity-oriented managers, 8% to 10% would be at the lower end of their expectations. For some arbitrage strategies, 8% would feel like an outsize positive return. So one of the issues the industry faces is an investor base comprising both those who require high returns – high-net-worth individuals whose focus is mainly on the absolute magnitude of return – and Libor-plus institutional investors who care more about correlation, volatility and so on. At present those two investor groups are investing in the same structures and in future that may have to change because their requirements are very different.
JW, Hermes As a pension fund, if we could get 8% to 10% pretty much guaranteed year in/year out, it would be fantastic. We have been in an environment in which returns have been low and for me therefore the question is, "Are we moving out of that environment?"
RHo, Barclays Capital Exactly. Right now, volatility, credit risk and liquidity premia are all at their cyclical lows. At the same time, a lot of money has gone into hedge funds. Both factors have pushed down returns and will continue to do so. The big question is how hedge fund managers will adapt to this new environment.
CF, Fauchier Partners Taking that point and also the fact that different investors want different things, I think we'll see more managers offering different types of risk off the same portfolio. Maverick have done it, for example. Then you ask where the manager has his own money. High-net-worth investors may prefer newer managers able to make money opportunistically from the latest inefficiencies without having to worry about volatility or Sharpe ratios.
DE, SG CIB I agree 100%. With the exponential growth in hedge fund assets of late and the corresponding diversification of their investor base, what you see is a wide spectrum of returns, matching a wide spectrum of expectations and investor type. You still get very high annual historical returns from some managers but you have to muster the associated risks and high volatility. CTA's are a good example.
Choosing fund structures
OK, Permal So how should investors go about choosing a hedge fund investment strategy? What are the options and their pros and cons?
RH, Mercer Clearly the fund-of-funds structure is one of the easier options – easier certainly than looking for single-strategy funds. And the fund-of-funds approach also allows institutions to include some of the most cutting-edge strategies without taking undue risk because they can access them in a diversified way.
CF, Fauchier Partners Despite most people's assumptions, there's no evidence that large funds have underperformed. As markets become tougher the theory that small is beautiful has been turned on its head. The large funds are better resourced, have huge clout with the investment banks, get better treatment and better service, and are less afraid of drawdowns and so do not become overly risk-averse in tough conditions. The private-equity groups are complaining that the big hedge funds can outgun them on recruiting talent, and they can certainly outgun the investment banks. So if you believe this is a talent-driven exercise, then perhaps size is an advantage.
RHo, Barclays Capital And when you're trading complex strategies, you are dealing with more complex instruments and that requires more complex risk management systems and support staff and services. That argues for scaling. I think going forward you'll see some of the larger funds doing well by having the resources to adapt to the changing environment. The smaller specialists can also perform well but might have difficulty hanging on to their special expertise as markets evolve. Also, from time to time, there will be markets that offer potentially good returns – like energy – but the risks cannot be analyzed easily or indeed be hedgeable. Again, smaller funds might not be able to enter these markets easily.
GI, Albourne Partners The environment has counted against the smaller firms too. For the areas that are attractive – multi-strategy firms, capital structure arbitrage, credit arbitrage – you have to have scale: you can't be a small multi-strategist. If you're going to be trading credit default swaps you need to be writing big tickets, you need to have lawyers on the staff.
JW, Hermes Also we pension funds are less worried about investment risk than business risk. Trustees, rightly or wrongly, are happier with big, established funds of funds or big hedge funds.
DE, SG CIB It seems there is an agreement that big is beautiful right now in the hedge fund space. It certainly makes the life of institutional investors easier as the hedge fund will have more support staff and better infrastructure. But I still think that a major driver for the industry is the ability for new talents to emerge quickly; it may be challenging for those big hedge fund firms to foster such talents. So I think it is very healthy that smaller hedge funds can still enter any strategy and compete neck and neck with the more established mega-funds.
ED, Credit Suisse I don't think we can generalize that bigger is better. Some fund-of-hedge-fund managers simply lost it the day they were swamped with inflows and couldn't allocate the money properly, hence performance erosion. For single-manager hedge funds, there are niche strategies, which are not scaleable (especially in Asia).
Trend: longer lock-ups
| Ho, Barclays Capital: leverage is acceptable as long as it is applied at an appropriate level |
GI, Albourne Partners One key trend is that more and more of the large managers are locking investors up for longer periods and offering less advantageous terms. CF, Fauchier Partners It's a trend but I think a good one. The manager feels more secure about his asset base and can take more risks – both investment risk and liquidity risk. Now, whether the returns will be sufficiently higher to justify the illiquidity of the fund is a difficult question. That's a choice for individual investors.
ED, Credit Suisse As far as private investors are concerned, they will not accept a longer lock-up unless the underlying strategy requires one.
RH, Mercer Our view is that the liquidity of the fund – our ability to trade in and out of it – should reflect the actual underlying liquidity of the instruments that the manager is trading. That said, the liquidity terms should be such that they don't constrain the manager from managing money in the way they want. But I think some of the terms being touted around now, particularly those that appear to be in response to a loophole in the regulations, are unfair to investors. They don't reflect the underlying liquidity and are nothing to do with the way the money is being managed.
JW, Hermes And there are other very good reasons you might want to get out of a fund. You might find that the manager who had 100% of his net wealth in a fund on day one, six months later has 50% or none of his net wealth invested. And I think you've got a right to get out at that point because what you've bought is no longer what they're offering. So although traditionally as institutional investors we don't mind being tied into investments for quite some time, we don't want to be tied into investments for the wrong reasons.
RHo, Barclays Capital A hedge fund manager has near absolute discretion on what to do with the fund. After an investor has invested in a fund, he or she only has one option to exercise, and that is when to redeem. So in the absence of any good reason why there should be a long lock-up – say poor liquidity of the underlying – I think the liquidity of the fund should match the liquidity of the underlying investments. Having said that, market forces will have the final say.
CF, Fauchier Partners Interestingly it's partly due to institutional investor demand that lock-ups exist like this. I heard one pension fund say they've actually encouraged managers to put in an exit penalty, because they reckon they'll be slower to move than most people.
GI, Albourne Partners Investors will accept lock-ups because they are a form of protection for them against the fund getting taken down by short-term events or market moves. They prevent the investor being taken out at the bottom. On the other hand, lock-ups can give investors a real problem because in the current difficult environment, when they might want to have tactical flexibility, a significant chunk of their strategy is fixed for two years. One answer to that is to give big chunks of your money to the multi-strategists.
DE, SG CIB Lock-ups should not encourage hedge fund managers to grow complacent. Generally speaking, the liquidity of a fund should match the liquidity – or lack of liquidity – of its underlying positions. Contrary to traditional belief, reduced liquidity can actually be an aggravating factor for a fund as it sometimes magnifies investors' herd mentality.
Trend: Private equity
OK, Permal There is a link between longer lock-ups and the move by hedge funds into private equity. What do you think about that trend?
GI, Albourne Partners I'm not sure it is a good idea. These are radically different disciplines. Hedge funds investing in public equity are making a financial evaluation, whereas private equity is often about operational and business management issues. Some of the big multi-strategists may have the resources to bring the right people in but if they're trying to push the listed team into doing private-equity transactions, I see that as potentially a recipe for disaster.
CF, Fauchier Partners But hedge funds as a group have had control of companies via distressed debt, and they've run the whole process with the sale of the assets and so on. Here they just want to get control via the equity. There is a distinction in that most private equity funds want 100% ownership of the business and its cash flow, so they can leverage it. Hedge funds want to own a strategic stake and they have an advantage over the private-equity groups, in that they understand the whole capital structure of existing business, rather than looking at it post releveraging. With that strategic stake they can force change – look at Deutsche Börse – and the rewards can be very high.
RHo, Barclays Capital Investors have to be very careful here. Hedge funds and private equity are very different types of investment and anyone with specific liquidity or mark-to-market requirements will find private equity unsuitable. As for the actual investment management, I am not sure that the skill sets required are that similar.
JW, Hermes The private-equity teams love the fee structure of hedge funds and the hedge fund teams love the lock-up of the private equities. So the motivations are clear. But we've already got a significant asset allocation to private equity and we don't want to find our hedge fund portfolio is actually drifting into it as well.
RH, Mercer But they will. Is trading unlisted equities and distressed debt private equity? I think we get unnecessarily hung up on definitions of "this is a hedge fund", "this is private equity".
RHo, Barclays Capital At the end of the day it's the investor who must decide.
Trend: multi-strategy funds
OK, Permal A clear trend is the rise of the multi-strategy funds. Why is that and how do they fit into a conventional asset allocation strategy?
JW, Hermes They fulfil a specific need. For us, if an opportunity in, say, convertible arbitrage or merger arbitrage arose, we would not be quick enough to take advantage. Having a multi-strategy manager means we can. So it makes sense for part of your portfolio.
ED, Credit Suisse Yes. Effectively they can make tactical asset allocation decisions more quickly than we can and so can give us access to strategies we would otherwise miss. In addition, it is one way of getting exposure to a strategy that we would not want to invest in directly – convertible bond arbitrage, for example – because the timing can be extremely tricky.
DE, SG CIB One of their biggest advantages is their ability to share common risk management techniques and very efficiently allocate capital from one strategy to the other. But as a leverage and structured products provider, it is sometimes difficult to understand such reallocation processes and thus adequately price the risks. As a result our models are still giving the advantage to an allocation to a diversified portfolio of hedge funds rather than to one multi-strategy fund.
CF, Fauchier Partners One thing to be careful of in multi-strategy funds is that they often started out by being highly talented in one strategy and then branched out into other sectors. So you need to be sure you're not buying a Jack of all trades and master of none. A mediocre multi-strat fund will be beaten by the specialists and the better multi-strats.
RH, Mercer There is also the fee aspect: you get some of the benefits of a fund of funds but don't pay the additional fund-of-funds fees.
RHo, Barclays Capital A well-diversified and well-run fund of funds will potentially offer much greater diversification than a multi-strategy fund. Also, although multi-strategy funds have separate teams running different strategies, there is often a house philosophy or a house view that is reflected across all the different portfolios, thus creating potential systemic risk.
GI, Albourne Partners Yes – and one of the few things that most multi-strategists don't do is macro trading. I wonder whether that's because generally there is one dominant person at the centre who feels that they should be the one to trade on a macro basis but can't do that and run the business at the same time.
CF, Fauchier Partners Macro can dominate the whole P&L in a way that the funds may not like – it doesn't sit well with other strategies.
GI, Albourne Partners The other area you tend not to see is fixed-income arbitrage, and again I think that's simply because the leverage numbers make the whole fund look risky. And there is a team management issue: multi-strategy funds are very aggressive about cutting positions in unfavourable sectors – which means taking capital away from managers. Given how easy it is for those managers to leave and set up a fund of their own, you need to make sure you're investing with a multi-strat who can retain its key people.
OK, Permal Eleonore, when you look at funds for clients, is multi-strategy one of your favourites?
ED, Credit Suisse Yes. Some of them have been quite good at spotting where opportunities are – energy trading in the last couple of years, distressed debt in Europe – with the convergence towards a more unified bankruptcy code and new supply of distressed loans – and some of them have gone back into risk arb recently.
Trend: leverage
OK, Permal We've moved from principal protection to leverage. How is this trend going to play out?
RHo, Barclays Capital Leverage is acceptable as long as it's applied at an appropriate level. Earlier, Christopher pointed out that you can leverage a diversified basket of funds and earn a high Sharpe ratio. As the market develops and more opportunities for diversification of specific risks become available, the case for appropriate leverage becomes stronger.
ED, Credit Suisse I think you have to be careful. A lot of private clients were disappointed with performance last year and this year as well, and they've turned to leveraged funds of funds. A few leveraged fund-of-hedge-funds managers that I have come across are invested with more than 130 hedge funds, have done absolutely zero due diligence on the underlying managers, provide no minimum transparency and add 3.5 to 5 times leverage on top of the underlying fund's leverage. Then comes April to May 2004 and they lose more than 10% in just one month!
RHo, Barclays Capital Yes, you have to be careful but, most of all, as I said, you have to match the amount of leverage with the risk profile of the underlying and the investor's risk tolerance.
GI, Albourne Partners Leverage is an extra cost that you must take into account. And it can cause systemic problems by forcing people to sell what they can rather than what they want to.
CF, Fauchier Partners We're not keen on leverage for a variety or reasons, and we actually had to resist a number of investors last year wanting us to leverage. First, it's more efficient for the underlying hedge funds to leverage. So we would much rather put together a portfolio of slightly more aggressive funds than leverage up the whole edifice. We've also had a number of managers who have got us to certify that the money we're investing is not, to our knowledge, leveraged money.
RHo, Barclays Capital I think we may be blurring two types of leverage. The general concept of leverage has a sound financial basis as part of efficient portfolio management and construction. Leverage for purely speculative use is often inappropriate.
CF, Fauchier Partners The problem is that you can end up creating a product that is not your first choice for the investor, because of the requirements of the lender.
RHo, Barclays Capital But as you said earlier, leverage, when applied appropriately, potentially offers an efficient investment for investors.
CF, Fauchier Partners I don't deny it, and a lot of people have looked at the numbers and thought this makes perfect sense. But we would rather have the individual hedge funds making those decisions individually.
RHo, Barclays Capital Hedge fund managers manage investment according to their investment objectives. Investors should be able to manage their portfolio of investment according to their own risk aversion, of which redemption is one option, with leverage and protection being the other parameters.
CF, Fauchier Partners I think this gets us back to the concept that a lot of these managers would be well advised to offer classes of shares with different levels of leverage – and some do. Maverick was one of the first.
JW, Hermes And it's systemic risk – not a risk that's diversified within the portfolio, that's the worry.
RH, Mercer I haven't come across any client that has gone into a leveraged fund of funds. A few have considered it and decided they'd rather not do it.
JW, Hermes From the pension fund point of view, I think trustees are quite nervous about explicit leveraging.
DE, SG CIB There are many forms of leverage, I should know because we provide them all: swaps, options, funds, managed accounts, notes, credit facilities, loans, you name it. As Chris mentioned earlier the key is to have a process centred on investors' choices. This business has changed a lot recently and if you have invested sufficient human and IT resources in your platform, as a provider you can now offer a lot of flexibility and customization. Leverage then becomes simply a tool that any fund-of-funds manager or investor can access effectively.
Trend: structured products
OK, Permal What else is new in the structured product world?
RHo, Barclays Capital We have seen substantial developments on the institutional side of the business. One is portable alpha strategy. Instead of investing in traditional assets, people are now looking at combining liability management – using inflation or fixed-income derivatives (primarily swaps) to match liabilities and an investment in hedge funds to provide funding for the swaps and alpha. The institutionalization of hedge funds is coming, and I think portable alpha is an important first significant step, in the sense that people are overcoming their nervousness about investing in hedge funds by using them not as an absolute return vehicle but as part of liability management. We are actually working with fund-of-funds managers to create generic fund vehicles with the embedded derivatives to achieve the investment objectives. The other aspect is that of direct liability management, where banks or insurance companies, due to funding or liquidity requirements, are having to extract coupon or income to finance their ongoing liabilities. There we are seeing a lot of development in packaging hedge funds into structured products to provide the dedicated cashflow.
JW, Hermes Yes. This combination of liability management and alpha is good. Clients don't want Libor plus 3%, they want index-linked gilts plus 3%.
RH, Mercer The big problem with absolute returns or cash-plus products is that when we do our modelling from an asset/liability perspective, even if you make quite optimistic assumptions about hedge funds, they get beaten down in the optimization. This is because they're cash plus, and the liability is all linked to long-dated bonds. Taking that alpha return and porting it onto a long-dated bond makes hedge funds a lot more attractive for institutions. And the mechanics of portable alpha are becoming a lot simpler. Big funds can do it directly themselves; for medium and smaller funds turnkey solutions are needed.
JW, Hermes Presumably that's going to take some time to do, because there's an element of explaining it all to the trustees.
RHo, Barclays Capital We've worked on a couple of dedicated funds with 15-year and 30-year target maturities. These vehicles would enter into long-dated inflation and interest rate swaps, and invest in fund-of-hedge-funds shares. The fund shares would act as collaterals for financing the initial and variation margins associated with the swaps.
DE, SG CIB Cross-assets and portable alpha are certainly the talk of the day. But what is striking also is the refinements in the pricing of the more traditional structured products, for guaranteed notes obviously but also on leveraged solutions. To give you a simple example, we are now offering investors to pay reduced leverage fees in periods of low performance. Although very complex to price and manage, this is a great feature for investors and managers alike.
Trend: investable indices
| Ingram, Albourne Partners: hedge fund indices have been successful and clearly fulfil a need |
OK, Permal Investable indices represent $25 billion or so in assets, there are a lot of them out there and they all seem to be growing. Are they a good investment in their own right? Are they a good benchmark against active funds of funds or other diversified approaches to hedge fund investment? JW, Hermes It's always interesting to have a benchmark even if it is absolute return. I think the concern from our point of view is that the investment indices are not trying to find the best managers, all they're trying to do is find a representative manager. The problem with that is that there's a huge dispersion and it's worth paying the money for someone to find the good managers.
GI, Albourne Partners I think anything that attempts to be reflective or represents some kind of additional type of investment opportunity has to be good. These indices have been successful, so they're clearly fulfilling a need. Conceptually you're trying to turn something that's always been viewed as alpha into a sort of beta product, and it's quite useful to be able to identify what is beta – and certainly some of the strategies, like merger arbitrage, feel like a commodity or index-like product, and therefore I think it's very natural that there are going to be some significant chunks of the hedge fund universe where these kind of indices are very appropriate.
DE, SG CIB I think investable indices fulfill a specific mandate and do it well: simple to understand, efficient, liquid and representative of the industry's average performance. Even more importantly, the indices are a major factor in bringing innovation to the industry: you can now overweight a strategy in the short term for tactical asset allocation; you can also create systematic long/short strategies whereby you are long a particular fund of funds and short the MSCI HII Index, and wrap the strategy with a guarantee or leverage. This may be of interest to alpha-hungry investors! All this is possible thanks to the development of large investible indices.
ED, Credit Suisse These indices are valuable from a reference point of view, as well as providing clients with vehicles to concentrate on styles without necessarily exposing the investor to significant single-manager exposure. Essentially the private investor is able to invest in index-tracking instruments. Added-value for sophisticated hedge fund investors comes from the ability to create innovative structured products around these indices, including leverage, capital protection (contingent or otherwise). Investors must, however, make sure they take into consideration any tracking or structuring costs when making their investment decision.
GI, Albourne Partners It's not dissimilar to the traditional investment world: there are lots of active managers and plenty of passive index products as well and people have their reasons for investing in both.
RH, Mercer I don't think the comparison with the long-only world is quite right. A benchmark in the long-only world is a representative of the universe of underlying assets that you can replicate at minimal cost. You can go to an index tracker that can replicate the benchmark for you and charge you a few basis points. That doesn't apply in investable hedge fund indices. First, the actual underlying hedge funds are still charging their standard fees, so you can't replicate it at low cost. And, if you want to buy into an investable index there's usually an additional charge on top of that, so you're still effectively paying a fund of funds fee. It doesn't replicate what you would do passively if you were buying the underlying securities. In terms of whether it's a good idea to invest in, considering the dispersion within hedge funds returns, clients don't want to be an average. Investable indices invest in a fairly random way in hedge funds, and are not a particularly value-adding proposition.
JW, Hermes Does anyone have a view on what impact it has on the marketplace in terms of the actual funds, that there's money going into such a broad set of funds? Is that a good thing or a bad thing?
RHo, Barclays Capital For us, the ability to look at investable indices every day is helpful because at least you have an idea of what liquid hedge fund strategies are doing on average. Also it does offer structured product providers such as ourselves the ability to package mildly exotic products which you would not normally be able to do for a fund of funds with, say, monthly liquidity. And I think at the end of the day something is better than nothing as a benchmark.
CF, Fauchier Partners I think they're a stroke of marketing genius, but not much more than that. And I'm not sure they are indices. They are funds of segregated accounts. If you add up the dollars managed by the people in these indices, they're going to be quite a small percentage of the hedge fund industry. If you get greater divergence between managers, they risk being less and less representative of what a dollar-weighted exposure to the trillion dollars of the overall market would be giving you.
New strategies
OK, Permal How are hedge funds dealing with return compression in their traditional areas? Is Asia a potential response?
GI, Albourne Partners Yes. With the current lack of anomalies, you have to look at new things, particularly where things are changing and opening up strategies that didn't previously exist. In Asia, although it's still not easy to borrow shares, you can effect reasonable shorts in some markets that previously you couldn't. And sometimes old strategies that have been almost forgotten come back – like Japan where a lot of the factors that have made alpha generation on the short side in the US so difficult don't exist. Add to that changes in corporate behaviour there and you can use old strategies in a new market.
ED, Credit Suisse And the universe of Asian managers is also changing. It used to be dominated by long/short managers (they still now account for 60% of the around 500 Asian hedge funds), but it's moving towards more trading and relative value strategies in markets that offer more inefficiencies that can be exploited by hedge fund managers.
CF, Fauchier Partners I think we would draw a clear distinction between Australia and Japan and the rest, because it seems to be very difficult technically to extract alpha on the short side outside those two markets. People talk about Asian credit funds, but there's not much of a corporate bond market. What seems to work in Asia is moving in and out of countries at the right time – intelligent beta. Market timing within the regions – that's really been a big source of profit for hedge funds, who don't have to follow some MSCI benchmark.
RHo, Barclays Capital Well I have no doubt that there will be opportunities in Asia, but the risk can also be significant. Hedge funds, by virtue of their ability to shift money and invest aggressively, can push valuation to extremes very quickly. We've seen the run-ups in a lot of emerging markets, and that's a reflection of how you may actually confuse beta with alpha. A lot of the investment opportunities could just be glorified beta plays and not real alpha.
The end of easy money?
OK, Permal How else can hedge funds cope with the change from a falling to a rising rate environment?
RHo, Barclays Capital I don't think high interest rates per se damage hedge funds. In fact, you could argue that high interest rates could lead to potentially higher risk premiums elsewhere and more volatility and so more opportunities. A dramatic rise would be a problem but not the moderate rises currently priced in. However, a lot of relative value trading models have liquidity bias, which means that they could get into trouble if a rise in rates caused a sudden drop in liquidity.
GI, Albourne Partners Yes. Look at the equity long/short sector, which is probably about half of the hedge fund universe. One of the interesting features of the last couple of years has been the sheer difficulty on the short side which is why so many of the long/short managers are rolling out long-only product: they have typically built this tremendous alpha engine on the long side and keep bleeding on the short side. Part of the reason has been the fact we've had a very low interest-rate environment. You're typically short companies where, because the best you can do is 100% return and the worst you can do is an infinite loss, you have to have a relatively short-term trade to get the kind of IRR that you want to justify the risk, and therefore you have to have a catalyst. In a good liquidity environment companies can keep delaying the catalyst. And, more to the point, not only does the duration of your trade keep moving away from you, but quite often the market thinks that the company's fixed, and the short rises against you. So I think the availability of good liquidity has caused shorting to be a very difficult discipline. And so I expect, as rates start to rise, and particularly as credit spreads start to widen, liquidity will fall, and we'll start to see more problems for corporates, and I think that will be positive for alpha on short equity positions. Fixed-income arb will be difficult if the curve inverts, but I really think it could make shorting equity more profitable.
DE, SG CIB The key is volatility. In my view investors should be favoring macro managers right now; there are large imbalances in the markets and volatility has been hovering at historically low levels for years; it is due to rebound sooner rather than later.
CF, Fauchier Partners The short-only funds have done very well recently but the difficulty is that we're likely to have pretty mediocre performance as rates rise, but this should then create a very attractive environment, relatively speaking, for hedge funds.
ED, Credit Suisse Yes, I think maybe the worry is not so much interest-rate rises as what's going to happen to volatility.
GI, Albourne Partners Higher rates might help the convert market. With easy liquidity, volatility was sucked out of the market and with tight credit spreads issuance moved to the high-yield space. Higher rates could fix both problems.
CF, Fauchier Partners And if you had a combination of rising interest rates and declining economy, then the event-driven managers who are willing to provide capital to companies in distress, having to raise some sort of capital, could do very well.
OK, Permal Robert, does it affect your general asset allocation recommendations to clients?
RH, Mercer No. Many hedge fund managers have been reliant on cheap money and will suffer. Our clients will be trusting their fund-of-funds managers to weed out those managers from their portfolio. So it doesn't change the asset allocation from an institutional client's perspective.
RHo, Barclays Capital Higher rates obviously make leverage more expensive – and if rates rose too fast then there would be problems. But higher rates will make guaranteed products cheaper.
Is a long-only fund a hedge fund?
OK, Permal What other strategies are interesting? There seem to be more and more long-only offerings – is that a valid strategy to include in a hedge fund programme?
CF, Fauchier Partners Would you let your clients pay 20% performance fees on long-only?
RH, Mercer A number of long-only managers are moving to performance-related fees, and some of them already charge 20% of outperformance of the benchmark.
GI, Albourne Partners Obviously it is a supreme irony because managers are going from the long/short world to the long-only. But for those firms that have built up the infrastructure and the resources and have big people-count and big operations it's natural for them to want to use the alpha engine on the long side to tap into a different client base to help with that cost structure. Now the issue is how much capacity there is on the long side. But we could reach a stage where we're reaching saturation point in some of these shorter-term valuation situations that hedge funds like trading.
CF, Fauchier Partners I don't see how you can have long-only funds and have a strong absolute return mandate. For example, in 2002 even the very best stock-pickers tended to be negative on the year if they were long-only. Speaking for most of the business we have, we aim for low correlation to the equity market. Therefore long-only funds would have to be amazing alpha generators for us to be able to include them.
RHo, Barclays Capital Certainly long-only hedge funds may confuse investors with liability management in mind. Instead of Libor plus double alpha, you have beta plus alpha. Unless your liability is linked to beta, it would be difficult to reconcile that.
ED, Credit Suisse Our strategy on the long-only side has been to select those high-tracking-error, long-only funds that are benchmark-free and absolute return focused. In brief, the more "boutiquey" type of set-ups.
RH, Mercer We are seeing more unconstrained equities and aggressive equities funds. They remain long-only, and instead of having short positions, if they do not see opportunities they will hold large amounts of cash. And they tend to be, in terms of mindset, not dissimilar to hedge fund managers.
New strategies: commodities
OK, Permal I think the blurring of the lines between long-only and long/short is more dramatic than between hedge funds and private equity. More and more you're going to see that hedge is just a variation of active management. But let's change sectors. Are commodities the new place to make core exposures longer term and are there interesting inefficiencies that one can play?
ED, Credit Suisse I don't think it should be a core exposure, I think it should be part of a diversified portfolio, not just to gain diversification benefits but also because there is a lot going on in the sector. As an example, energy trading, which lost momentum ever since Enron went bankrupt and which was followed by the withdrawal of liquidity from the energy trading market. Investment banks and hedge funds have started re-entering the market and opportunities seem to be large for those who have the right structure to exploit them.
RH, Mercer Some institutions are buying passive long-only exposure to commodities. There is not a strong economic rationale as to why there ought to be a risk premium on commodities. In theory you could argue that if there's skill, there could be alpha. But it's difficult to argue a risk premium on commodities without having a tactical view. But it's a big market and managers ought to be able to generate some sort of alpha from it, if skill is applied to it.
CF, Fauchier Partners You can access commodities through the equity markets and a lot of long/short managers have been very active in this sector. The problem is that commodities as such are not great for long/short, because the dispersion of returns is not there in related sectors. So to extract alpha, managers have to understand the more indirect commodity exposures. But I don't think commodities are the new El Dorado.
RH, Mercer There ought to be lots of hedgers, such as manufacturers, who are in the market not directly to make profit, so it ought to be a fruitful place.
CF, Fauchier Partners Agreed, but I don't see why the opportunities are any greater today than they were two years ago.
RHo, Barclays Capital I do see significant opportunities. We've seen in the credit market how on the back of the derivatives market, credit arbitrage strategies have prospered – hedge fund managers using new technology to extract alpha. Today, a lot of investment banks are successfully trading commodities and their derivatives, which I think ultimately is the harbinger of what will happen to hedge funds. However, they will be different to today's outright commodities market timing hedge funds. There is a lot of beta in there.
GI, Albourne Partners In an environment where most sectors have lacked volatility, the existence of volatility clearly throws up opportunities and, again, even playing physical versus an oil stock as an option does open up some interesting possibilities. Part of the problem with commodities, though, is the dominance of oil, a commodity with a very "eventy" price. It's very hard for hedge funds to analyse and predict Opec policy or supply issues and that takes away the biggest single lever in that strategy.
RHo, Barclays Capital My view is that the more resourceful hedge funds can be successful liquidity providers in commodities, insurance markets and power markets.
GI, Albourne Partners But again the problem with being a liquidity provider is you have to have the capital base to sustain that. And there is also that dynamic of never really knowing when a country will turn the tap on and turn the tap off. As an asset, oil feels materially different to most of what hedge funds trade.
Looking ahead
OK, Permal To finish up, can I get people's thoughts on the industry and its future?
RHo, Barclays Capital I'm truly excited by the development of the hedge fund industry, which has matured significantly over the past few years. Having said that, the road ahead is going to be rocky at times. But I do see the market becoming more institutionalized and there will be more opportunities for investors to diversify, to enhance returns, to gain capital protection if required, and I think hedge funds will figure strongly in all these opportunities.
CF, Fauchier Partners It is difficult to generalize, but I suspect that long/short equity and long/short corporate credit are in their infancy. In some other areas, opportunities are clearly more finite – some of the relative value strategies – and it may be that capital drains away from some of those areas because of disappointing returns.
DE, SG CIB The hedge fund industry is stronger than ever. It has proven it can successfully adapt to a changing world and it will continue to be a major factor of innovation and performance for investors in the years to come. Because of our strong focus on flow and structured derivatives as a firm we are constantly involved with the hedge fund industry and challenged to come up with new services and solutions. I don't see any of this changing anytime soon!
RH, Mercer I think hedge funds will continue to offer opportunities for investors, both institutional and individuals. What I do think is important are two things. First, the selection of a fund of funds or of individual hedge funds is going to become even more important – everything will depend on successful selection of the best managers. Second, because capital moves around the world, portfolios need to be managed so that the portfolio profits from where there's the best opportunity. Whether this is done by a fund-of-funds manager or directly, that process has to be in place and work.
ED, Credit Suisse Yes, I agree, I think it's the most exciting place to be at the moment. Sure it is going to be a lot more difficult for us to select the right hedge fund manager and to differentiate between the good and the excellent. Hedge funds are there to stay and in the future they will become a bigger portion of a client's portfolio.
GI, Albourne Partners The hedge fund industry is where the best talent receives the best remuneration and I think that's going to continue to throw up all kinds of opportunities. I also think we're coming out of an environment where we've been lacking volatility – and thus have faced a temporary lack of opportunities – into one that will generate new ones.
OK, Permal That's where we'll end. Thank you to our participants.