Question

As a Hedge Fund Manager what unconventional investment strategy would you implement to generate “absolute returns” ?

i.e. irrespective of broader market performance? How would your strategy would work over then next 6 mon– 1 Year

Answer 1

Absolute return is the return that an asset achieves over a certain period of time. This measure looks at the appreciation or depreciation, expressed as a percentage, that an asset, such as a stock or a mutual fund, achieves over a given period of time. Absolute return differs from relative return because it is concerned with the return of a particular asset and does not compare it to any other measure or benchmark.

Absolute return refers to the amount of funds that an investment has earned. Also referred to as the total return, the absolute return measures the gain or loss experienced by an asset or portfolio independent of any benchmark or other standard. Returns can be positive or negative and may be considered uncorrelated to other market activities.

Hedge funds have seen demand to invest more in unconventional products than traditional macro strategies.

Investors use SMAs to obtain cheaper fees and more control in exchange for committing more money and time to the hedge fund. Co-investing, a process whereby allocators participate in investments alongside their hedge fund managers, have become extremely popular.

Adopting an Absolute Risk and Return Approach to Portfolio Construction and Management

1. Develop investment objectives, which should be absolute return in nature and incorporate risk. The objectives should be relevant to the client base and not generic.

2. Establish pool of investment options. Rather than constraining the allocation to traditional asset classes, a broader range of asset classes and strategies should be considered from the outset. Incorporate nontraditional investments at this early stage.

3. Construct portfolios. Base the analysis on realistic expectations of assets’ risk and return characteristics. Optimisation methodology may be used to gain a broad understanding of efficient options and the portfolio characteristics of different investments. Portfolios should be analysed from a factor risk perspective to ensure they are robust, and the optimisation analysis should be conducted and compared over different time periods. Stress testing and / or scenario analysis of the resulting portfolios should also be performed. Only the investments that are consistently well represented in the portfolio analysis process, and fare well in the risk analysis described, should have strategic allocations. Investments that are volatile, exhibit high drawdowns and have high correlations with well observed risk factors should be used on a tactical basis. Consider liquidity requirements: assess what proportion of the assets may be illiquid given investor requirements.

4. Monitoring and ongoing management. Actively monitor managers and the valuations of the underlying asset classes. Risk considerations should be clear and the ability to dynamically change the portfolio in response to changing circumstances must be developed. Be prepared to make decisions to lighten up on expensive assets or to reduce allocations if bubble characteristics become apparent. Take advantage of attractive pricing opportunities, when volatility is low for example, and focus on insuring the most significant risks.

5. Organisation • Define policies, measurement methodologies and risk management roles and responsibilities • Study the likely broad investment risks: market risk, liquidity risk etc. • Establish predefined guidelines or decision rules, and in particular implement damage control strategies to reduce impact of sudden and unexpected events • Develop culture of compliance and appropriate risk taking and ensure incentive systems mirror these objectives

There are principles that can be followed, priorities that need to be changed and practices that need to be adopted that will facilitate this change and help achieve Absolute Return objectives. The best outcome is the management of a multi asset class, multi strategy portfolio by an objective advisor that has a clear understanding of the needs of his or her clients and is able to reflect those needs in the portfolio decisions made. This however requires a degree of investment sophistication and client interaction which many advisors currently would find hard to attain. A reskilling of the industry is required, and a re-engagement with the end investor. We need to change from short term salesmanship to long term stewardship.

Hedge funds are alternative investments that use market opportunities to their advantage. These funds require a larger initial investment than others, and generally are accessible only to accredited investors. That's because hedge funds require far less regulation from the Securities and Exchange Commission (SEC) than others like mutual funds. Most hedge funds are illiquid, meaning investors need to keep their money invested for longer periods of time, and withdrawals tend to to happen only at certain periods of time.

As such, they use different strategies so their investors can earn active returns. But potential hedge fund investors need to understand how these funds make money and how much risk they take on when they buy into this financial product.

• Hedge funds are versatile investment vehicles that can use leverage, derivatives, and take short positions in stocks.
• Because of this, hedge funds employ various strategies to try to generate active returns for their investors.
• Hedge fund strategies range from long/short equity to market neutral.
• Merger arbitrage is a kind of event-driven strategy, which can also involve distressed companies.

Strategies of hedge funds:

Long/Short Equity

The first hedge fund used a long/short equity strategy. Launched by Alfred W. Jones in 1949, this strategy is still in use on the lion’s share of equity hedge fund assets today. The concept is simple: Investment research turns up expected winners and losers, so why not bet on both? Take long positions in the winners as collateral to finance short positions in the losers. The combined portfolio creates more opportunities for idiosyncratic (i.e. stock-specific) gains, reducing market risk with the shorts offsetting long market exposure.

Long/short equity is basically an extension of pairs trading, in which investors go long and short on two competing companies in the same industry based on their relative valuations. It is a relatively low-risk leveraged bet on the manager’s stock-picking skill.

Market Neutral

Long/short equity hedge funds typically have net long market exposure, because most managers do not hedge their entire long market value with short positions. The portfolio's unhedged portion may fluctuate, introducing an element of market timing to the overall return. By contrast, market-neutral hedge funds target zero net-market exposure, or shorts and longs have an equal market value. This means managers generate their entire return from stock selection. This strategy has a lower risk than a long-biased strategy—but the expected returns are lower, too.

Long/short and market-neutral hedge funds struggled for several years after the 2007 financial crisis. Investor attitudes were often binary—risk-on (bullish) or risk-off (bearish). Besides, when stocks go up or down in unison, strategies that depend on stock selection don’t work. In addition, record-low interest rates eliminated earnings from the stock loan rebate or interest earned on cash collateral posted against borrowed stock sold short. The cash is lent out overnight, and the lending broker keeps a proportion.

This typically amounts to 20% of the interest as a fee for arranging the stock loan, while "rebating" the remaining interest to the borrower. If overnight interest rates are 4% and a market-neutral fund earns the typical 80% rebate, it will earn 3.2% per annum (0.04 x 0.8) before fees, even if the portfolio is flat. But when rates are near zero, so is the rebate.

Merger Arbitrage

A riskier version of market neutral, merger arbitrage derives its returns from takeover activity. That's why it's often considered one kind of event-driven strategy. After a share-exchange transaction is announced, the hedge fund manager may buy shares in the target company and short sell the buying company's shares at the ratio prescribed by the merger agreement. The deal is subject to certain conditions:

• Regulatory approval
• A favorable vote by the target company's shareholders
• No material adverse change in the target’s business or financial position

The target company's shares trade for less than the merger consideration's per-share value—a spread that compensates the investor for the risk of the transaction not closing, as well as for the time value of money until closing.

In cash transactions, target company shares trade at a discount to the cash payable at closing, so the manager does not need to hedge. In either case, the spread delivers a return when the deal goes through, no matter what happens to the market. The catch? The buyer often pays a large premium over the pre-deal stock price, so investors face large losses when transactions fall apart.

Because merger arbitrage comes with uncertainty, hedge fund managers must fully evaluate these deals and accept the risks that come with this kind of strategy.

There is, of course, significant risk that comes with this kind of strategy. The merger may not go ahead as planned because of conditional requirements from one or both companies, or regulations may eventually prohibit the merger. Those who take part in this kind of strategy must, therefore, be fully knowledgeable about all the risks involved as well as the potential rewards.

Convertible Arbitrage

Convertibles are hybrid securities that combine a straight bond with an equity option. A convertible arbitrage hedge fund is typically long on convertible bonds and short on a proportion of the shares into which they convert. Managers try to maintain a delta-neutral position, in which the bond and stock positions offset each other as the market fluctuates. To preserve delta-neutrality, traders must increase their hedge, or sell more shares short if the price goes up and buy shares back to reduce the hedge if the price goes down. This forces them to buy low and sell high.

Convertible arbitrage thrives on volatility. The more the shares bounce around, the more opportunities arise to adjust the delta-neutral hedge and book trading profits. Funds thrive when volatility is high or declining, but struggle when volatility spikes—as it always does in times of market stress. Convertible arbitrage faces event risk as well. If an issuer becomes a takeover target, the conversion premium collapses before the manager can adjust the hedge, resulting in a significant loss.

Event-Driven

On the border between equity and fixed income lie event-driven strategies. This kind of strategy works well during periods of economic strength when corporate activity tends to be high. With an event-driven strategy, hedge funds buy the debt of companies that are in financial distress or have already filed for bankruptcy. Managers often focus on senior debt, which is most likely to be repaid at par or with the smallest haircut in any reorganization plan.

If the company has not yet filed for bankruptcy, the manager may sell short equity, betting that the shares will fall either when it does file or when a negotiated equity-for-debt swap forestalls bankruptcy. If the company is already in bankruptcy, a junior class of debt entitled to a lower recovery upon reorganization may constitute a better hedge.

Investors in event-driven funds need to be able to take on some risk and also be patient. Corporate reorganizations don't always happen the way managers plan, and, in some cases, the may play out over months or even years, during which the troubled company’s operations may deteriorate. Changing financial-market conditions can also affect the outcome – for better or for worse.

Credit

Capital structure arbitrage, similar to event-driven trades, also underlies most hedge fund credit strategies. Managers look for a relative value between the senior and junior securities of the same corporate issuer. They also trade securities of equivalent credit quality from different corporate issuers, or different tranches, in the complex capital of structured debt vehicles like mortgage-backed securities (MBSs) or collateralized loan obligations (CLOs). Credit hedge funds focus on credit rather than interest rates. Indeed, many managers sell short interest rate futures or Treasury bonds to hedge their rate exposure.

Credit funds tend to prosper when credit spreads narrow during robust economic growth periods. But they may suffer losses when the economy slows and spreads blow out.

Fixed-Income Arbitrage

Hedge funds that engage in fixed-income arbitrage eke out returns from risk-free government bonds, eliminating credit risk. Remember, investors who use arbitrage to buy assets or securities on one market, then sell them on a different market. Any profit investors make is a result of a discrepancy in price between the purchase and sale prices.

Managers, therefore, make leveraged bets on how the shape of the yield curve will change. For example, if they expect long rates to rise relative to short rates, they will sell short long-dated bonds or bond futures and buy short-dated securities or interest rate futures.

These funds typically use high leverage to boost what would otherwise be modest returns. By definition, leverage increases the risk of loss when the manager is wrong.

Global Macro

Some hedge funds analyze how macroeconomic trends will affect interest rates, currencies, commodities, or equities around the world, and take long or short positions in whichever asset class is most sensitive to their views. Although global macro funds can trade almost anything, managers usually prefer highly liquid instruments such as futures and currency forwards.

Macro funds don’t always hedge, but managers often take big directional bets—some never pan out. As a result, returns are among the most volatile of any hedge fund strategy.

Short-Only

The ultimate directional traders are short-only hedge funds—the professional pessimists who devote their energy to finding overvalued stocks. They scour financial statement footnotes and talk to suppliers or competitors to unearth any signs of trouble possibly ignored by investors. Hedge fund managers occasionally score a home run when they uncover accounting fraud or some other malfeasance.

Short-only funds can provide a portfolio hedge against bear markets, but they are not for the faint of heart. Managers face a permanent handicap: They must overcome the long-term upward bias in the equity market.

Quantitative

Quantitative hedge fund strategies look to quantitative analysis (QA) to make investment decisions. QA is a technique that seeks to understand patterns using mathematical and statistical modeling, measurement, and research relying on large data sets. Quantitative hedge funds often leverage technology to crunch the numbers and automatically make trading decisions based on mathematical models or machine learning techniques. These funds may be considered "black boxes" since the internal workings are obscure and proprietary. High-frequency trading (HFT) firms that trade investor money would be examples of quantitative hedge funds.

Investors should conduct extensive due diligence before they commit money to any hedge fund. Understanding which strategies the fund uses, as well as its risk profile, is an essential first step.

The changing landscape caused by the Coronavirus will lead to the largest shake out in the hedge fund industry since the 2008 market crash. Below are some of the ways we believe the Coronavirus will impact the hedge fund industry.

1.      Change how people communicate – The Coronavirus will radically change how people communicate and interact within the hedge fund industry. There has been a significant increase in people telecommuting from home and an almost complete stoppage of in person meetings. The hedge fund industry will quickly embrace video technology, which minimally requires a computer and telephone. We will be coming out shortly with a more in depth, separate paper on this subject.

2.      Most investors will be satisfied with how their hedge fund portfolio performed. Through mid-March, the HFRX hedge fund index was down 4.26% which is in line with expectations as compared to a 60/40* balanced portfolio down 8.79% through March 15. Larger price movements provide more opportunities for skilled hedge fund managers. It creates an environment in which managers can add value through security selection in strategies that capture greater price distortions in the market. It can also accelerate performance as security prices more quickly reach targets.

Temporary contraction in the hedge fund industry. Despite most investors being satisfied with performance, we expect the hedge fund industry assets under management to temporarily decline 10% to 15% based on a combination of negative performance and redemptions. We expect most of the assets from redemptions to be invested in money market funds by cautious investors and reinvested back into the hedge fund industry once the markets stabilize.

4.      Significant increase in redemptions based on relative performance – During periods of low volatility there is typically little performance dispersion among managers with similar strategies. With no clear signal for relative performance, hedge fund redemptions are muted. However, during periods of high volatility, dispersion across managers significantly increases. We expect managers who underperform relative to their peers, will experience heavy withdrawals. Unfortunately, for illiquid strategies, this could lead to an increase in gating or suspended redemptions. We expect most of these assets to stay within the hedge fund industry. Some will be reinvested with better performing managers in the same strategy. Most will flow into other strategies as investors re-position their portfolios based on where they think active managers have the best opportunity to add value.

5.      Major rotation of assets across strategies. One trend we identified earlier this year was an increase in demand for hedge fund strategies with low correlation to the capital markets. We expect this trend to increase over the next 6 to 9 months. Some strategies that will see increased demand include CTAs, arbitrage oriented and neutral strategies, specialty lending and reinsurance.

6.      More hedge funds shutting down. The hedge fund industry remains over saturated with an estimated 15,000 funds. We believe approximately 90% of all hedge funds do not justify their fees, as evidenced by the mediocre returns of hedge fund indices. Fed-up with poor performance, investors are increasingly more likely to redeem from underperforming managers leading to an increase in fund closures. This will impact both large established managers as well as emerging managers. The hedge fund industry is Darwinian and constantly evolving. Some prominent managers’ strategies may no longer offer the alpha generating opportunities that historically drove performance. Some large managers are simply too large to maintain an edge. Managers with less than $100 million in assets, who represent a majority of hedge funds, are being squeezed from both the expense and revenue sides of their businesses. No matter the size or tenure of the fund, poor performance will accelerate the outflows of capital and in some cases result in fund closures.

7.      Greater opportunity to add value – We expect the capital markets to be turbulent for quite some time with the potential for major disruptions in liquidity. The selloff in the capital markets we are experiencing are both fundamental and emotional. This combination causes correlations to rise and creates large inefficiencies in securities pricing. Active managers should be able to capitalize on these inefficiencies. Once the dust settles, we expect the best buying opportunities since 2009 and a rotation back into higher beta/riskier strategies.