Overall, last year was a positive year for hedge funds in the sense that assets continued to grow, to the point where the industry reached USD2.8trn in total AuM. However, from a performance perspective it certainly wasn’t an easy one.
There are three aspects to explaining this. First, the beginning of 2014 saw quite strong market rotation. There were sector rotations in equity markets in March and April, leading to losses in long/short equity funds to the tune of -0.63 per cent and -0.89 per cent according to Barclayhedge.
Second, on the macro side, fundamental macro traders were positioned in expectation of rate normalisation, in particular in the US, which didn’t materialise. And third, a dramatic development in the second half of the year was the collapse in oil prices, which caught many hedge funds off guard.
On the other hand, 2014 did display some improvements that were already present in 2013, notably stock dispersion which was high throughout the year. This proved beneficial to equity market neutral funds, for example, and multi-strategy funds. Trends also re-emerged in 2014.
“If you look at the managed futures space, trend followers were the bright stars of last year. Last year was also good for active managers, especially those trading in an uncorrelated fashion and who benefit from stock dispersion. On the niche side, commodity managers saw their environment improve dramatically. A lot of commodities became totally unrelated to the macro environment. As well as oil, there were strong price movements in grains,” comments Alexandre Rampa, co-head of alternative investments at Syz Asset Management.
Stock dispersion is a welcome development for active managers. The divergence of monetary policy around the world will create trends, which long/short equity managers and global macro managers should be able to benefit from. Moreover, in the event-driven space, the fall in oil price is creating opportunities in distressed credit in 2015.
“At Lombard Odier, we construct a diversified equity long/short portfolio with low market directionality, with the aim of delivering attractive absolute returns while mitigating market volatility and lowering downside correlation,” comments Steven Bulko, CIO of 1798 Fundamental Strategies at Lombard Odier Investment Managers. “Historically, we have delivered our returns with half the volatility of the US equity market as we manage our portfolio with the objective of protecting assets during market sell-offs.”
The fund referred to above is LO Funds – Fundamental Equity Long/Short; a US-focused vehicle that invests in five portfolio managers targeting Consumer, Healthcare, Industrials, Energy and TMT (Technology, Media, Telecom). It launched in 2007 and has since grown to USD1.2bn in AuM through January 2015. A UCITS version of the fund launched last July.
Although improving employment conditions, access to credit, lower oil prices and strong equity markets have boosted consumer confidence, Bulko thinks it is too soon to tell how big an impact these factors will have on consumption.
“The US consumer is exiting a multi-year deleveraging process that we believe has significantly altered their behaviour. Additionally, the dual benefits of an improving wage environment and lower energy costs do not come without risks as wage growth may cut into profit margins at corporations and energy companies are already cutting investment budgets as the outlook for oil and gas weakens.
“Despite the near-term challenges, we still view the US as the best option for equity investors based on the relative strength of the economy, low yield on fixed income securities and the high level of cash on balance sheets, which can be used to buy back stock or invest for future growth,” explains Bulko.
With respect to the oil situation, this could present attractive near-term shorting opportunities in weaker E&P companies within the energy sector, says Bulko, as “oil at USD50/barrel calls into question their entire business model. Longer term, this “flushing out” of weaker competitors should present attractive long opportunities over the medium to longer term as we see oil prices recovering.
“Staying with oil, we see the drop as a medium-term tailwind for the consumer and TMT sectors. Our outlook on TMT suggests that growth in the sector will be more consumer than business driven. Semiconductors should continue to benefit as more devices and appliances get connected to the Internet with demand increasing alongside consumer confidence.”
Hedge fund managers still have a lot of work to do to convince investors – especially those in Switzerland – of the merits of investing in this asset class. There is, according to Pius Fritschi (pictured), Managing Partner at LGT Capital Partners, still limited demand in Europe for hedge funds. “Traditional markets have performed well over the last five years and investors remain sceptical about the worthiness of investing in hedge funds. I think that’s still the broad sentiment among institutional investors.
“What still exists, undoubtedly, is the need for investors to find strategies where they can generate uncorrelated returns. That need is not going away. We see a return to CTAs and trend-following strategies, driven last year by a decrease in correlation between asset classes. I believe we’ll see more demand for CTAs in 2015,” says Fritschi.
LGT Partners currently invests in approximately 70 to 80 hedge funds, with CTAs and global macro managers featuring strongly.
“The collapsing oil price and currency movements are offering good trading opportunities. Global macro players should be able to profit in this environment. We are more neutral on long/short equities. Stock pickers should add value, we just don’t believe the environment is completely favourable right now,” adds Fritschi. “In addition, we see investment opportunities for illiquid credit, especially buying loan portfolios from European banks.”
Any hedge fund investor wants to see an environment where multiple themes are developing, offering the opportunity to capture multiple uncorrelated return streams in the portfolio. This is the case today: in the US and Europe there is a clear divergence in monetary policy, with the ECB having finally bitten the bullet and introduced an asset purchasing programme worth USD1.3trn a full six years after the Fed introduced its own QQ programme. The same paper printing exercise is taking place in Japan as the US and the UK prepare – at some point – to introduce a rate hike. Factor in geopolitical tensions in Ukraine, and a large degree of differentiation within Emerging Markets as a result of lower oil prices and the opportunity set for hedge funds looks encouraging.
“We are more optimistic about investing in hedge funds in 2015 than we have been for the last few years for these very reasons,” emphasises Rampa.
“As an investment, hedge funds make a lot of sense right now. A lot of markets are “toppish”. It’s difficult to call the end of the rally but equally it’s difficult to see the US markets get much higher than they are now. The environment is moving away from one of holding long, in the wake of liquidity injections, to one where it will favour stock pickers and thematic allocators.”
At Unigestion they’ve been expanding their cross-asset selection team over recent months to strengthen their expertise in bonds, FX, commodities to be in the best position to support clients in this evolving market environment.
Identifying bona fide hedge fund talent is one of the core activities at Unigestion and is spearheaded by Nicolas Rousselet, Managing Director and Head of Hedge Funds. Too many managers take huge directional bets, employ leverage, and consider themselves hedge funds, when in reality they aren’t.
Take the recent decision on 15 January 2015 by the Swiss National Bank to unpeg the Swiss franc against the euro. The previous day one euro was worth 1.2 Swiss francs; 24 hours later, at one point, it was worth just 0.85 francs. The chaos that ensued hit some hedge funds hard but as Rousselet comments:
“None of our managers are losing money, despite what we’ve seen with the SNB and the appreciation of the Swiss franc. I’m satisfied on a relative basis that our hedge fund managers are doing well but I’m unhappy because the EUR/CHF is not a trade that managers should have got involved in. There were 5 basis points of monthly gains by holding this position before the carnage of mid-January. It was a classic case of picking up dimes in front of a steamroller.”
For hedge funds to remain attractive, and indeed boost their PR image, something has to be done about the fee structure. The debate rages on, it’s nothing new. But there needs to be more consistency within the industry. The fee structure should, unequivocally, reflect the level of returns a manager is generating.
Years ago, the management fee was merely pocket money. What mattered most to managers was earning the 20 per cent performance fee. Today, some managers have grown so huge that they earn a fortune from the management fee alone. These “asset gatherers”, it could be argued, do not have the same hunger and motivation to generate performance fees as a young start-up with sub-USD100m in assets.
“In theory, hedge funds should use a 0/20 fee structure. In reality, the zero management fee is a business issue for managers. They need to cover the costs of running the fund, but this fee should not be taken in addition to the performance fee. What we recommend, and have had some success in doing, is a fee structure that rewards managers when they do well, and doesn’t reward them when they don’t do well.
“Say a manager aims to deliver 15 per cent (20 per cent gross) – so five per cent for him, 15 per cent for his investors. Fine, they deserve to get paid five per cent if they generate those returns, which is effectively a 0/25 per cent fee structure. The manager will receive even more incentive fees if they return more than 20 per cent gross. To resolve running business costs, let’s then give them an advance of 1 per cent in exchange of a hurdle rate of 4 per cent (25 per cent of 4 per cent). At least this puts the manager in closer alignment with the investors, which is the original point of hedge funds,” explains Rousselet.
Another critical development, which is also putting hedge funds increasingly under the microscope, is the rise of liquid alternatives; UCITS-compliant hedge fund-like strategies that aim to replicate offshore flagship funds whilst offering enhanced liquidity, transparency, and lower fees.
“In the wake of increasing regulatory pressure and considerable demand for alternative sources of returns, the industry has developed liquid, transparent and cost-efficient strategies in a UCITS format that offer investors the possibility to access diversified sources of return, which in the past were only available via traditional hedge funds,” comments Dr. Jan Viebig, Head of Alternative Investments at Vontobel Asset Management.
Harcourt currently offers three such funds, developed by its Research-Driven Strategies, along with a fourth absolute return fund – Vontobel Fund – Absolute Return Bond – which is designed to deliver performance in all weather conditions; in stable, inflationary as well as deflationary scenarios.
The three Pure Strategy funds, Vontobel Fund – Pure Momentum Strategy/Pure Dividend Strategy/Pure Premium Strategy, have been designed to benefit investors for the next decade or more says Viebig.
“Liquid Alternatives could be an excellent addition to a balanced portfolio due to their low correlation with traditional asset classes such as equities and bonds. They offer significant diversification benefits and the potential for steady returns in various market environments. Each of our three Pure Strategies offers a different risk/return profile. By combining them in a portfolio, one can create super stable return profiles over time; and that’s what we recommend to our clients,” confirms Viebig.
Coming back to the cost issue of hedge funds, Fritschi notes that Swiss investors are very focused on the TER of hedge funds and are searching for alternative solutions:
“For example, factor-based and rules-based strategies (alternative beta funds), that seek to filter out some of the risks of value trades, momentum trades, yield trades. They are more simplistic, rules-based strategies that seek to emulate hedge funds.
“We have seen significant inflows over the last 12 months, but not exclusively into hedge funds; more into multi-alternative solutions where we are trying to add alternative content to clients’ portfolios: private debt, private equity and real estate, insurance-linked strategies combined with hedge funds. Investors are searching for different risk factors today.”
Viebig believes that investors who diversified not only across different asset classes but also incorporate liquid alternatives in their portfolios, will be well prepared when equity markets, after a sharp increase in recent years, correct and interest rates, sooner or later, rise again.
“With the aim to minimise losses and stabilise portfolios especially in adverse market phases, investors increasingly see Liquid Alternatives as an opportunity to power their portfolios. This is a trend that will definitely intensify in the near future,” concludes Viebig.
