Volatility the dominant theme for managers in 2011
By James Williams – With a flood of new regulations set to emerge over the next few months, US hedge funds and service providers need to pay close attention to compliance and regulatory issues even as they battle to stay abreast of their performance forecasts.
Delivering the keynote address at the Hedgeweek USA Awards 2012 held recently in New York, Jeffrey Rosenthal, Partner and head of the financial services practice at Anchin, Block & Anchin LLP, noted that with the growing institutionalisation of the hedge funds market, managers need to build and maintain strong record keeping procedures in areas ranging from compensation agreements to compliance.
Opening the event, held at the Gansevoort Hotel in NYC, Hedgeweek Publisher Sunil Gopalan noted that this year’s winners are a diverse cross-section of managers and services providers from across North America, proving that the industry is thriving outside established centres such as New York and Chicago, with the winning managers demonstrating resilience and consistency in the face of tough markets.
2011 proved a tough year to be a hedge fund manager, unless you were trading volatility, fixed income or distressed asset strategies. The HFN Hedge Fund Aggregate Index finished the year down 4.9 per cent; BarclayHedge put the figure at -5.48 per cent. Either way, significant performance was tough to attain at the industry level.
Of particular concern was the performance of Long/Short Equity strategies, which significantly underperformed market indices. For example, thanks to a late rally in October the S&P 500 index ended the year flat. By comparison, long/short equity managers in the US, as a group, returned -3.5 per cent according to EurekaHedge, and -4.58 per cent (globally) according to BarclayHedge. Whichever way you cut it, performance just wasn’t there.
Without doubt, trading conditions for fundamental stock pickers were highly challenging. Continued political headline risk because of the Greek debacle in Europe, the tragic nuclear disaster in Fukushima in March, the US credit rating downgrade: all of these macro events created substantial headwinds, fundamental valuations flew out of the window, and a pervasive risk on/risk off sentiment dominated; and indeed continues to dominate.
Whitney Tilson’s USD250million T2 Partners LLC has generally outperformed the major stock market indexes but last year the fund lost 25 per cent reported Reuters, quoting Tilson in a letter to his investors as saying: “It has been an extremely frustrating – and humbling – experience.”
A research note written by a team of Goldman analysts headed up by chief US equity strategist David Kostin, and referred to in the same Reuters article, pointed out that the poor performance of so many managers last year was surprising since the opportunity for stock picking wasn’t much worse than in any other year over the past three decades.
Not to say that all LSE managers hit the skids. Chase Coleman’s Tiger Global Fund was number one in Bloomberg’s 100 Top Performing Hedge Funds list published at the end of the year. The fund returned an impressive 45 per cent through October 2011. Others that fared well included industry stalwart Philippe Lafont whose Coatue Management returned 17 per cent, John Thaler’s JAT Capital, up 12.7 per cent, and Steve Cohen’s SAC Capital International, up 7 per cent.
Looking at the wider context, fixed income strategies were one of the best performers, returning 5.14 per cent in 2011 and already up 4.85 per cent YTD according to EurekaHedge. Global macro returned 2.08 per cent, and although down 1.18 per cent last year, Relative Value strategies have found momentum and are up 6.04 per cent YTD.
Speaking with hedgeweek, Sol Waksman of BarclayHedge says that while he was surprised by the volatility of global equity markets as markets moved from risk-on to risk-off and back again, “under those circumstances the returns to hedge funds were not that bad at all. As a group, they made the most of a very difficult situation.”
Investors certainly appeared to keep faith, reinforcing the fact that this industry has become far more institutionalised post-08; pension funds and endowments are happy to take a longer-term view, which is no doubt helping managers. And despite a tough year for finding alpha, 2011 still managed to attract USD70billion of net new capital – the highest since 2007 - according to Hedge Fund Research.
Waksman doesn’t think investors are especially happy these days no matter what they are investing in: “In the hedge fund space, the big are getting bigger.” On the list of most investors are managers like Ray Dalio’s Bridgewater Associates. Which is unsurprising when you consider that the firm’s Pure Alpha II – a macro fund – returned 23.5 per cent through October. The biggest and the best not only have the operational infrastructure that institutions demand, they deliver on performance.
Chris McGuire is the CIO and CEO of Chicago-based Phalanx Capital. The firm manages a market neutral volatility multi-strategy fund that invests in Japan, Asia ex-Japan and Australian markets. McGuire notes that hedge fund returns across most strategies “have, and continue to remain bifurcated. That being said, in a zero interest rate environment where equities have fallen, a return of a few hundred basis points above risk-free should be appreciated a great deal from investors.”
Last year was a favourable time for volatility traders like McGuire, and 2012 is proving no different. Phalanx focuses its strategy on Asia due to the magnified volatility and dislocation in the relative value space. Says McGuire: “We have increased our allocations to pure volatility strategies to over 50 per cent of our business as the opportunities are immense. We see tremendous scalability and potential returns for the rest of the year.”
Russell Abrams founded New York-based Titan Capital in 2001 and was one of the industry’s first pure play volatility fund managers. Titan trades volatility non-directionally using a relative value strategy to exploit option arbitrage opportunities in both its funds: Titan Global Return Fund and Titan Asia Volatility Fund.
Like McGuire, Abrams is bullish in his sentiment: “You had every opportunity you could care to want as a volatility trader last year.
“The main volatility trading opportunities were in equities and commodities: those are the ones where you saw really big price movements. Right now, FX is interesting for us because volatilities have been so low. A lot of the issues people are talking about are macro issues: once things move they tend to move very quickly out of nowhere, especially for many of the Asian currencies that are pegged to the US dollar. That makes for good asymmetric trades.”
People who made money in 2009 and 2010, says Abrams, did so from being short volatility. When the markets went into meltdown in the summer, a lot of these volatility funds gave back returns to the market. “That’s a statistical fact. From August to September they didn’t perform well because they were collecting time decay (theta) in short volatility.”
Titan’s strategy when building long volatility positions is to optimise where they hold them so that when they’re wrong, the losses are well mitigated. “We’re trying to limit the losses when nothing happens (in benign markets) and volatility is low,” says Abrams.
McGuire thinks that headline risk will continue to promote volatile moves. He says that the inflation and deflation of options prices as well as significant moves in the Hang Seng and Nikkei provide “incredible absolute moves and trading opportunities associated with those moves. We are more bullish on return prospects than we have been in quite some time.”
Although volatility traders like market dislocations, the prevailing risk-on risk-off environment presents certain challenges. Volatilities change rapidly, making for much smaller margins for error when building positions. Abrams admits the firm has had to tweak its systems given that implied volatilities have become unstable.
“Whenever we get any type of vega exposure (implied volatility) from the market moving we have to adjust it very quickly. You have to rebalance fast because volatilities today move so quickly,” states Abrams.
Macro headwinds have meant that the best-performing strategies have involved trading in McGuire’s view. “That is, owning and holding positions for the long term has been a risky position. Remaining nimble, active, and able to take profits relatively quickly has been the prudent mechanism to generate hedge fund returns.”
As if finding new sources for alpha wasn’t hard enough, US managers are having to embrace massive regulatory change into their operational models. Dodd-Frank and EMIR are pushing managers towards centralised clearing of OTC derivatives, quarterly/annual filings under Form PF are to become mandatory, and then there’s the small matter of FATCA to contend with.
Tom Davis, CEO of Meridian Fund Services, says that, like other administrators, the firm is busy looking at Form PF and how to provide a value-added service. However, he also notes that another major push is occurring on the governance side.
“We are ramping up our governance services capability for clients and being pro-active: not waiting for clients to say can you do this or that but developing our own best practices for hedge funds and we’ve hired some good people in this area of the business,” confirms Davis. Offshore clients have long had AML procedures in place, for example, but for onshore US managers it’s always been more difficult because of the way hedge funds are structured: as LPs or LLCs the investment manager basically has the same control that a board of directors has in the offshore world.
“US managers are being pushed by institutional investors who are saying they need something more robust and similar to what managers have, from a governance perspective, in the offshore world,” says Davis. “We want to make sure that our clients, particularly smaller ones, can stand up to review by an institutional investor. It’s better to get everything in place at the start and have a shop that meets the standards rather than rushing to put it in place when an investor comes along and expresses an interest.”
Some worry that increased regulatory and compliance costs will raise barriers to entry and prevent talented managers from getting their firms off the ground. But this isn’t a view shared by Bill Mulligan, CEO of HedgeOp Compliance.
“I truly don’t think that regulatory and compliance costs will rise to a level where it will be a “true” barrier to entry. At the end of the day, I think the opportunities posed by the private fund marketplace are good enough to allow qualified participants to make decisions on costs versus benefits and move forward.”
Looking ahead, McGuire believes the industry will continue to see a rise of smaller, boutique-like money managers who recognise that generating returns is what ultimately makes a hedge fund business most successful. It’s not all about launching a fund with stars in your eyes and dreaming of reaching USD1billion in AUM.
Says McGuire: “Striving to manage billions will ultimately limit returns. Offering investors [a strategy] with a nimble ability, while having more prudent controls on risk management will be the best area in which investors can achieve needed returns.
“The primary goal is making money for investors. Period. Without that a hedge fund business is worthless.”
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