Emergence of divergence renews lure of hedge funds

Hedge fund managers have had a hard time generating attractive returns during the surging market since 2009, especially when compared to their equity and fixed income counterparts.

Abundant liquidity injected by central banks clearly fuelled a huge bull run. In hindsight, one wonders whether it made any sense at all to include hedge funds in portfolios. Just buying cheap ETFs would have made attractive returns for investors. 

Hedge funds lagged traditional asset classes during the past few years, but it is important to look at investments on a risk-adjusted basis, says Andrew Lee, head of alternative investments in the Chief Investment Office Wealth Management at UBS.

“On a risk-adjusted basis hedge funds certainly have an important role in portfolios to reduce volatility and increase sources of return drivers,” he says. 

In a strategic asset allocation designed to perform over a five to seven year cycle, the role of hedge funds is to act as a diversifier, as a non-correlated component of the portfolio, and not to capture the bull market, says Mr Lee.  

Although UBS is still positive on equities, with returns this year expected in the high single digit range – 7 to 8 per cent – volatility is expected to rise to the high teens. On the other hand, traditional fixed income and high grade bonds are predicted to return low single digits, with mid-single digit volatility. 

In this context, hedge funds, with expected returns in the mid-single digit and with mid-single digit volatility, “look reasonable”. 

Most importantly, looking forward, higher volatility and dispersion, divergence in banks’ monetary policy as well as increased corporate activity are believed to be a favourable backdrop for these alternative assets. 

With volatility returning to more normalised levels, the global bank is overweight equity long/short strategies, preferring managers that want less directionality and therefore less dependent on market movements.

“We think that for equity long/short the beta contribution to returns this year will be lower, given our market expectations,” says Mr Lee. “And we focus on those managers that are delivering the alpha component more.”

The normalisation of volatility is expected to drive greater dispersion across regions and sectors, and also create the opportunity for mispricing of equities relative to the underlying intrinsic value, both on the long and short side, explains Mr Lee.  

Opportunities are more attractive in the economies which are more advanced in the cycle, such as the US and the UK, since the market should be less driven by policy and unlimited liquidity. 

The continuation of corporate activity, including not only mergers and acquisitions, but also corporate actions such as spin-offs and restructuring, are supporting the bank’s overweight in both merger arbitrage and equity special situation strategies.

Last year there was $3.5tn (€3tn) worth of M&A activity globally, and this strength has continued into 2015 particularly in the pharma, energy and telecoms sectors.

Financing remains cheap and available, with plenty of cash on corporate balance sheets, and pressure to deliver top line and profit growth in a relatively low growth environment. Finally, corporate boards and CEOs confidence remains at high levels. 

Global divergence across central bank policy, dispersion across asset classes, geographies and sectors drive interesting trade opportunities for discretionary macro players, potentially in the currency and rates areas. 

“Many clients have less actively managed exposure to those types of return drivers and that’s why we particularly like discretionary macro,” says Mr Lee.

However, the good performance of the past five months in commodity trading advisers (CTAs) is not expected to continue, says UBS, as there has not been sufficient emergence of trends. The bank is underweight this strategy, recognising it still provides diversification of return drivers. “We believe the traditional medium and longer-term follower are still challenged from a long-term perspective,” says Mr Lee.

K2 Advisors, a California-based independent fund of hedge funds manager acquired by Franklin Templeton in 2012, which oversees approximately $9bn in aggregated assets, holds a different opinion.

The firm started overweighting CTAs as well as global macro in August 2013, having been significantly underweight the sector since 2009. “The markets were very focussed on single factors and we didn’t see the dispersion,” says head of research Robert Christian. 

“The correlation between equities, bonds, fixed income, foreign exchange and commodities were at all time highs, but started to break down in the summer of 2013. Central banks on different policy waves have created big moves in the currency and interest rate markets, which will probably be sustainable going forward.”

The firm has also been overweight event-driven hedge fund strategies for more than two years, mainly to gain diversification. Although this sector has outperformed over the last three years, interest rate rises will prove a hurdle for these strategies, as a large catalyst of their outperformance was “artificially cheap financing” for good companies. “The strategy is getting crowded and is probably very sensitive to interest rate changes and central bank dispersion,” adds Mr Christian.

Private bank Credit Suisse is currently overweight equity long/short and event-driven strategies, and is increasing exposure to quant strategies, as they can benefit from the “more rational relationship between equities”. Global macro strategies are also gaining importance. 

Over the past 12 months, in the long/short space the bank has moved to lower net exposure managers, choosing managers with “lower beta to market, market neutral or getting towards market neutral”. 

“We really don’t feel there is going to be much upside from being exposed to the markets, so we’d rather have managers that truly try and deliver alpha or returns from idiosyncratic situations,” says Chris Vaz, hedge fund advisory and selection in Private Banking and Wealth Management at Credit Suisse

BNP Paribas Wealth Management favours neutral long/short, and systematic macro strategies, with a preference for single managed hedge funds, as level of fees in funds of hedge funds can be “too high”. 

Hedge funds, and alternatives such as real estate and private equity are included in portfolios as assets decorrelated from equities. 

Although last year hedge fund returns were relatively low, especially compared to bond yields, so was volatility, says Florent Brones, CIO at the French bank. 

“Markets will continue to move up and down and we will use dips to increase position on risky assets,” states Mr Brones.

According to HSBC Alternative Investments Limited (Hail), this is not the year where one hedge fund strategy in particular will prevail, but investment opportunities are found across a range of different areas.

Central in 2015 outlooks is the theme of divergence, not just in terms of fundamentals, growth outlook or monetary policy – with the Fed expected to raise rates while Europe and Japan commit to further easing – but also in terms of security prices and performance of asset classes. 

The HSBC risk on, risk off index (see chart) shows correlation has decreased significantly from its highest at the end of 2011/beginning of 2012, when the world was in the grip of the eurozone crisis, and assets were moving together, creating a very difficult environment for active managers. Today’s backdrop is very different, and favours active managers particularly in the macro and managed futures space. 

Some of these divergent macro moves will also be a source of dispersion within equity and credit markets. 

“We think it’s a fairly balanced opportunity set,” says Simon Garfield, head of portfolio management at the firm. “And our portfolios have a fairly balanced profile.” 

The key constraint on absolute returns delivered by the hedge fund industry post-crisis has been the level of short-term rates, according to Hail. 

The annualised excess returns achieved by the industry post crisis are exactly the same range as that achieved in the last decade. The main difference is that libor was 5 per cent in 2007 and now is close to zero. 

“If we do see short-term rates start to rise again towards the end of the year, and assume the industry achieves a similar excess return over cash to that achieved historically, then we will see absolute returns from hedge funds rise,” says Mr Garfield. 

This is one of the key reasons driving high inflows into hedge funds.

Also, investors may not always be able to rely on the diversification benefits between equity and fixed income. Over the past 15 years, multi-asset portfolios have benefited from the positive correlation between bond yields and equity prices. When equities sold off, government bonds, acting as a safe haven, rallied. But before the year 2000, in many occasions the correlation was negative, and bonds and equities sold off at the same time (see chart). 

“This year you can paint a certain scenario when equity markets get nervous about rate rising and sell off, and then rates do rise and the bond yield has increased too,” says Mr Garfield. 

“That would be very damaging to a balanced portfolio. What you need to bring into that portfolio is a return stream that has
limited sensitivity to both equities and fixed income. And we think that’s what hedge funds could provide over the longer term.”

Manager selection

Higher volatility in the market is expected to generate higher dispersion in manager returns, and boost the importance of manager selection in the hedge fund space. 

“Picking the managers who have a repeatable investment process and those who have shown the ability to generate profits in difficult environments is key in these types of environments, because dispersion in manager return should increase as well,” says Mr Vaz at Credit Suisse.

 ‘V shape movements’ in the market are expected to be a feature going forward, but are not necessarily good for hedge fund managers, says Mr Vaz. “If managers cut their risk aggressively, when stockmarkets are falling and then try and put risk on again as the stockmarket goes back up, then they can miss out on some returns. So choosing managers with good risk management techniques is essential in those types of markets.” 

Managers should make a judgement call on whether the market may drop further. “What we don’t want to see is managers panicking and taking risk off. It needs to be an orderly assessment of whether to take risk down or not.”

What has disappointed with certain strategies is excessive crowding into particular trends in recent times. Managers should come up with “more unique and differentiated trades and approaches to hedge fund investing,” says UBS’s Mr Lee. 

The desire to capitalise on what is working at a particular time often results in crowded trades and serious damage to returns, as seen by the sector and momentum rotation in March to April last year. The big rotation out of growth stocks into value stocks was a big blow to many equity long/short managers, who had been long growth stocks, mainly in technology and biotech, and short some value stocks, and were caught out.

When it comes to manager selection, whereas before 2008 it was all about returns, Madoff and other frauds were a wake up call. “After 2008, the focus was all about operational due diligence, risk, and liquidity management, nobody talked about returns,” says Mr Christian at K2 Advisors. 

Today, a viable hedge fund has to be very ‘institutionalised’, ie generate a reasonable return and be very well risk managed. 

But compliance and legal accountability barriers makes it very difficult for small hedge funds to keep going, he says, especially when operating a global entity. This, and the need to offer more customised solutions, has driven the firm towards more established hedge funds, which have capital and infrastructure. 

The American firm seeks niche, specialist hedge fund managers, either market or regional, sector or type trading specific, as opposed to more generalist ones. And this has driven up the number of managers used in portfolios.

At Hail, the philosophy has rather been to “deliberately reduce” the number of managers three years ago, with multi-asset portfolios today generally managed by 15 to 25 closely monitored managers.

While both strategy and manager selection add value, finding the right manager is paramount, says Peter Rigg, CEO of Hail.

“We found that having fewer managers in the portfolio meant there is much more focus, where we could pick high conviction names within the space and really emphasise manager selection,” he states