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Credit strategies shine in morose environment

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By James Williams – Last year was a dismal one for hedge fund managers, who as a group plunged into negative territory for the second time in four years, and so far 2012 hasn’t been much better. Although most strategies have made money this year, they have lagged buoyant – some would say irrationally so – stock markets by some distance.

Many managers are unlikely to regain their high water marks this year, depressing further performance fee income, which had already fallen from 50 per cent of industry revenues in 2010 to just 25 per cent last year, according to a confidential Barclays report. That trend is unlikely to change soon in a market where chastened managers are more likely to batten down the hatches than make big, bold bets.

Jack Seibald, a principal at Concept Capital, a full-suite prime brokerage, acknowledges that the current low-volatility environment is continuing to depress trading activity and use of leverage because of less conviction in the markets. “As a result, fund performance has been lacklustre, as managers continue to miss the large moves when they occur,” he says.
Those who have done well, Seibald says, are what he refers to as “stock jockeys” – traders that actively build specific long and short positions, “not those who pick stocks on one side and then use ETFs or some other form of passive instrument to hedge. Several risk arbitrage and event-driven managers on our platform have also done well this year. The ones who aren’t distinguishing themselves are those trying to trade the market.”
Below the surface things aren’t all doom and gloom. Fixed-income arbitrage strategies, for example, are up 7.47 per cent so far this year. In a low interest rate environment, credit-focused strategies are really taking off, particularly those that focus on high-yield and stressed bonds.
Last month, Emmanuel Roman, chief executive of GLG Partners and president and chief operating officer of GLG’s parent, Man Group, argued at a conference in London that the capital constraints placed on investment banks today presented a great opportunity for hedge funds.
“I always said that 10 years ago our biggest competitors [for the hedge fund industry] were investment banks,” Roman said. “I envisage credit funds to do well. They are already the best performing strategy [in 2012], having returned 10 per cent for the year to date.”
With investors keen to find yield, it’s been a good year for New York-based distressed/stressed shop Phoenix Investment Adviser, which focuses exclusively on US junk bonds trading at depressed prices. Says founder and chief investment officer Jeff Peskind: “We try to shoot for equity-type returns in the bond market, and we’ve exceeded our annual target returns already.
“Earlier in the year we had quite a large exposure to home builders. More recently, we’ve been active in buying bonds of Indian casinos. We don’t make sector bets, though, we just wait for individual companies to fall out of favour.”
Typically this occurs when bonds get downgraded to CCC, forcing bondholders to sell into the secondary market at a discount. “We usually buy bonds at around 60 cents on the dollar,” Peskind says. “If our assessment is right, the company doesn’t go bankrupt, and the bonds climb to 90, we sell them.” With around USD50bn of US bonds trading below 80, there’s no shortage of buying opportunities.
Performance remains a key priority for managers, but as the industry, both in the US and globally, becomes more institutionalised, there’s an increasing need to expand operational expertise – which means added cost. There’s no surprise that middle- and back-office functions are being outsourced, and that managers of all sizes are turning to firms like Princeton-based CurAlea Associates for independent support in their risk management processes.
The firm positions itself as a ‘virtual chief risk officer’, providing an additional layer of objective expertise in portfolio construction and position sizing. Rather than crunching numbers, CurAlea’s expertise lies in interpretation and explaining exactly what those numbers mean.
“We’re helping portfolio managers with portfolio construction and position sizing by quantifying the risk contribution from individual securities or groups of securities, and highlighting any potential vulnerabilities in the assumptions of the risk models,” says co-founder Peter Ort.
“We don’t preach a particular risk framework, as we don’t believe there’s only one way to manage risk. To be effective, a risk process has to be in consonance with the client’s investment philosophy. We don’t tell clients that now is the time to increase or reduce risk. Rather, we help them understand better their overall portfolio risk levels and marginal risk contribution from the positions in the portfolio, and how that fits in with their long-term risk and return objectives.”
This year, Ort says, some long/short equity managers have underperformed because they were cautiously positioned in the summer months in anticipation of another period of market turbulence. “Consequently, they didn’t participate in much of the market rally in August and September,” he says.
Investors appreciate managers using specialists like CurAlea; it inculcates further trust. Risk management is an inexact science, so why not use extra help? Anything that can differentiate a manager from its peers has to be an advantage, particularly as capital-raising remains devilishly tough.
Regulatory, compliance, reporting and investor pressures make for a heady cocktail of costs, raising barriers to industry entry and making it even harder for small- to mid-sized managers to expand their asset base. According to Hedge Fund Research, there were 245 fund launches in the second quarter, down from 304 over the previous three months and the lowest quarterly total since late 2010.
Ted Jasinski, general manager of Admiral Administration’s office in Richmond, says that around 70 per cent of new fund launches have been in the long/short equity space. And while six years ago launches of USD20m-25m were the norm, “a launch of USD10m-15m is considered good today”, he says. “We’ve heard that one group backed with Goldman Sachs capital of USD60m-70m is a top 20 launch, so it really shows how tight the market is.”
Seibald believes the calibre of new talent coming into the industry is improving. “The resumés of managers launching new funds have become more impressive over the past 12 months, and so have their average levels of assets under management,” he says.
Todor Todorov, an investment analyst for hedge fund research at Towers Watson in New York, believes that an exciting new trend is established managers exploring new strategies using so-called ‘smart beta’. This involves return drivers that are separate from manager skill – pure alpha – but cannot easily be achieved using passive strategies.
“This is basically a reaction to what investors are looking for,” Todorov says. “More established managers are launching smart beta strategies, giving clients a more efficient way to access diversified return drivers to which they don’t necessarily have exposure in their portfolios.”
Credit and distressed strategies continue to attract the smart money, and US high-yield bonds have become one of the most popular areas of investment. According to Peskind, Phoenix has raised more than USD200m this year to reach an all-time high of USD525m under management. “There’s still a decent spread for high-yield bonds in relation to US Treasuries, with around 550 basis points of additional yield,” he says. “Historically, that’s been fair value.”
Probably the biggest issue for hedge fund managers at the moment is the colossal volume of new regulation with which they are having to cope, and that arguably represents a bigger burden that that imposed on other areas of the financial industry.
According to Ron Geffner, the partner overseeing the financial services group at law firm Sadis & Goldberg and a former SEC enforcement attorney, the general sentiment among managers of alternative investment vehicles is that “it’s too much all at once, at a time of economic uncertainty.
“The key regulatory changes over the past 24 months include the registration of many managers as investment advisers, Form PF, and the expiration of the Section 4.13(a) (4) exemption under the Commodity Exchange Act at the end of 2012, requiring managers either to register [with the CFTC] as commodity pool operators or to modify their investment style. You also have FATCA and the Jobs Act coming on line.”
One piece of legislation that seems to encapsulate the negative sentiment surrounding hedge funds, especially in the light of the Galleon insider trading case, is the Dodd-Frank whistleblower provision. This is intended to facilitate the early detection of fraud by encouraging people to come forward with information that the SEC can use to investigate possible wrongdoing.
“In addition to all of the regulatory obligations that managers face, Dodd Frank codified rules regarding whistle-blowers,” Geffner says. “Managers are strongly advised to review their policies and procedures to provide employees with a channel for their complaints.”
But Peskind says that while regulation is an issue for managers, it’s far from a deal-breaker. “Our view is that we’ll be ready, willing and able to comply with whatever regulation comes down the line,” he says. “It’s a bit more of an administrative burden, but not a terrible one at this point.”
With hedge fund performance lacklustre at best this year, it is understandable that investors are once again looking critically at fees. That trend could give additional momentum to the upsurge in smart beta approaches as investors tire of paying for alpha that often seems hard to discern.
“A lot of what managers are delivering is beta masked as alpha,” Todorov says. “Investors increasingly understand that when the book returns from a hedge fund are split into traditional beta and alpha, some of that alpha is in fact smart beta. The fees should be structured to reflect this.”
He insists he is not dismissing the ‘2 and 20’ model as the wrong fee structure, period, but argues that it could deliver rewards that are excessive for some strategies but insufficient for others. “What we don’t agree with is that it should used as a universal model,” Todorov says. “There are so many different strategies that it’s impossible for them all to charge the same fees.
“We believe managers should be incentivised properly for delivering alpha. A fair split would be for one-third to be paid to the manager and two-thirds to the investor. After all, they’re the ones putting their money at risk.”

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