Why do funds of funds perform poorly in periods of market stress?
Emily Porter, Senior Analyst, Asset Alliance, examines the increasingly short equity market downside risk being taken on by many funds of hedge funds.
Over the last year, fund of funds managers have been busily reducing allocations to strategies that should perform well in increasingly volatile conditions or sharp market drawdowns.
Allocations to strategies such as Statistical Arbitrage, Convertible Arbitrage, some CTAs and trading orientated equity hedge managers have been noticeably reduced since 2004. The Deutsche Bank Global Markets 2005 Alternative Investment Survey July 2005 indicates, for example, that 44 per cent of respondents were considering reducing the Convertible Arbitrage exposure and 14 per cent reducing Statistical Arbitrage exposure.
The reduction is probably partly in response to muted strategy returns in an environment of low equity market volatility, fuelled by low real interest rates, robust corporate health and markets buoyed by consistent consumer spending (largely from the US).
The VIX Index has consistently fallen over the period from levels of 45 in 2002 to finish 2005 at 12.1. As a consequence, returns from strategies that benefit from increased equity market volatility have been relatively low, as witnessed by the HFRI Equity Market Neutral Index: Statistical Arbitrage returns from January 2003 to December 2005 annualizing 4.8 per cent, and the HFRI Convertible Index down 1.6 per cent in 2005 (although I note that these lower returns are also driven by factors such as the amount of capital in the strategy compressing returns and issuance in the case of Convertible Arbitrage).
By contrast, and due in part to the lack of volatility, low financing rates and corporate balance sheet strength, Event Driven funds in general have performed well; between January 2003 and November 2005, The HFRI Event Driven Index annualized 15.7 per cent. Returns from this strategy have been aided by the large coffers of private equity funds, which have ensured corporate activity has been high and looks set to stay that way in a flat to positive equity market environment.
There have been a number of high profile launches of funds, with significant assets gathered, that have borrowed private equity investment techniques in order to generate returns. The investment style of some of these managers is relatively conventional: typically identifying companies that will look attractive to private equity investors and then taking a stake before a private equity firm does.
Other hedge fund managers may take a large position in a company and using various approaches such as being a 'friendly' activist, or aggressor, attempt to force management changes. The media has in turns lauded and criticized this investment approach heavily in recent months from an overall market perspective.
For many hedge fund allocators, struggling to identify managers able to provide returns in keeping with traditional hedge fund performance expectations, and tempted by the recent returns, event driven managers have been a natural refuge.
They also offer allocators a clear chance to identify an 'edge' that hedge fund managers have on each investment; a definable and documentable reason for allocating to these managers and a way to explain seemingly excess returns. So it comes as no surprise that the Deutsche Bank Global Markets 2005 Alternative Investment Survey July 2005 indicates that 55 per cent of respondents were considering increasing their Event Driven exposure at the time of survey.
Whilst there is undoubtedly a space in most Fund of Hedge Fund portfolios over the medium term for these kinds of Event Driven hedge funds, - and returns have admittedly vindicated allocations here in the last year - the impression is left that allocators are switching more liquid strategies to those that arguably carry increasingly short equity market downside risk. This risk and that of a classic liquidity trap are predicated on the following factors:
• The positions taken are often large in relation to the company size, in order to influence the management and/or as the large amount of private equity type due diligence implies fewer positions across the Fund.
• There is a limited pool of potential opportunities in the larger capitalization stocks. In the better known examples of hedge fund event driven investing of the past year, there appears to have been a significant number of hedge funds acting in a similar manner. This allows them to leverage off each other's expertise and increase shareholder power, but may impact liquidity, particularly on exit as many managers require an anticipated event in order to be able to take a position.
• If the market sells off sharply corporate activity may reduce suddenly as business confidence waivers.
• Certain sectors appear to offer more attractive opportunities at certain points in times leading to a possibility of significant sector positioning that may not have been anticipated by investors when allocating to event driven funds.
• Certain strategies have the opportunity to benefit from increased market volatility to the downside, whereas in most cases event driven fund managers, with their longer term holding strategies and more illiquid positions, cannot benefit with such ease.
Going forward, there appears to be reason to be cautious on both corporate fundamentals and investor sentiment impacting the market negatively. After a sustained period of good corporate health, easy financing for companies, high corporate earnings growth and a compression in risk premiums - witness Emerging Market spreads - any significant change or concern in corporate outlook could have a sharp effect on optimistic valuations.
Market commentators point to factors such as the change in Federal Reserve leadership, over-extendedness of US consumers, shifts away from the US Dollar, and increased competition from China as areas of concern which may impact markets in 2006 and beyond.
However it could be argued that, lulled by the recent market strength and lack of volatility, allocators have not been protecting their portfolios for cases of increased volatility by selecting Funds in strategies likely to do well if volatility increases (as suggested by the Deutsche Bank Global Markets 2005 Alternative Investment Survey July 2005 noted above).
Instead, with the exception of reduced allocations to Distressed Debt, they are allocating towards the potentially more illiquid strategies, that whilst very dependent on individual manager skills, as a group are driven largely by market dynamics.
It should not come as a surprise then, that in periods of market stress, Fund of Hedge Fund portfolios are likely to perform increasingly poorly and with higher downside deviations, despite lessons of caution about liquidity, strategy concentration etc learned from previous market crises.
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