Gauging risk sentiment among hedge fund investors is more art than science but there are some indirect signals that one can use to examine this. If one looks at total inflows into hedge fund strategies in 2016, a clear picture emerges: CTAs attracted USD26 billion in net inflows, in stark contrast to all other strategies, which suffered USD110 billion of aggregate net outflows. The biggest losers in all of this were equity strategies, shedding USD50 billion of net assets; this despite generating 6.85 per cent returns.
What this would suggest is that large institutions, by favouring CTAs, view hedge fund allocations (of which CTAs can broadly be included) as more of a risk diversification exercise than relying on them for pure performance reasons; they’ve been able to rely on traditional markets for this.
“It doesn’t feel as though there’s been a specific change in risk appetite among our investors,” says Alexandra Coupe, Associate Director, PAAMCO, one of the industry’s leading fund of hedge fund managers. “I think a bigger change has been for this low volatility environment to persist and grind lower. Since return expectations have to match risk, and large institutional investors are hungry for returns, investors have started to think about how to increase risk to meet their return expectations.
“We also are not seeing complacency with current low risk levels, but rather a creative thought process to address risk: `How can we manage risk in a way that also optimises the Sharpe ratio?'”
This persistent, low volatility environment has created nuanced responses. As mentioned, CTAs have been increasingly favoured by institutions as a way to diversify risk and generate uncorrelated returns. In response, CTAs and global macro strategies – whether they are being encouraged by investors or not – have jacked up their risk appetite, feeding off benign market conditions. Conversely, bottom-up strategies, such as equity and credit long/short strategies and event-driven strategies, are still using modest leverage, requiring investors to look for innovative solutions.
“A few years ago, large US institutions invested in hedge funds for pure performance reasons. Today, it is more for risk diversification purposes. The fact that CTAs did well in 2008 explains why they currently favour them, ahead of any future market correction. They are cherry picking strategies precisely for this purpose. It is not just a performance-based decision,” opines Philippe Ferreira, Chief Strategist at Lyxor Asset Management.
That said, family offices and smaller institutions are still very much hungry for returns and will be more inclined to juice returns across their hedge fund allocations, not just use them to protect against the downside.
As such, risk appetite and risk taking is very much bifurcated depending on the type of strategy, and the type of investor. Ferreira says that whereas leverage ranges anywhere from 5 to 10X among global macro and CTAs, it is still between 1.5 and 2X for event-driven and equity long/short strategies; well within the five-year average.
“Broadly speaking, hedge fund investors would be willing to see hedge funds take more risk. While low volatility returns are good for conservative investors such as pension funds, for others they want to see higher volatility returns.
“For instance, on our platform we have launched leveraged versions of hedge funds including one CTA that we offer as a 2X leveraged version of the flagship strategy, and a merger arbitrage fund that uses 1.5X leverage. There is a general acceptance of higher volatility of returns, but over recent years hedge funds have remained far less leveraged than in the past,” explains Ferreira.
Coupe says that leverage is probably at the higher end of the usual range but hasn’t become excessive at all. Part of this could be because the banks are more protective over their balance sheets. Another reason why hedge funds are checking leverage levels is because the low volatility environment scares them.
“Hedge funds and hedge fund investors have been burned before using too much leverage in a low volatility environment and then getting hit hard when volatility increases, as happened in ’08. It is a lesson that the industry has learned and this seems to be keeping a check on leverage rising to uncomfortable levels,” suggests Coupe.
How then, can those investors who want higher risk/returns, achieve this at a time when leverage remains modest?
One of the techniques employed by PAAMCO is to build customised portfolios.
As Coupe explains: “We’ve always thought of hedge funds as delivering two types of risk: market risk and idiosyncratic risk. The way we can best serve our investors is by focusing on increasing the idiosyncratic risk component. I like to think of hedge funds like pizza. The crust is the market risk, the various toppings make up the idiosyncratic risk – so we’re in the business of delivering thin crust pizzas with a lot of different toppings to suit the risk/return appetite of our clients.”
To continue this culinary analogy, the more jalapeno peppers on the pizza, the more risk the investor is willing to take.
Coupe says that one of the preferred customisation tools that PAAMCO uses with hedge fund portfolios is known as `custom levered pari passu’.
“We look at the return stream of a particular hedge fund, the ability for it to deliver returns in a variety of market conditions, and then we leverage the portfolio while simultaneously keeping the market risk exposure the same. That shifts the contribution of risk from market risk to idiosyncratic risk.
“The trick is to increase leverage and manage risk in a thoughtful way to ensure you are delivering more idiosyncratic risk and therefore `alpha’ as opposed to simply taking more market risk, or `beta’,” explains Coupe.
Since the start of 2017, leverage has started to move higher for certain strategies, in particular CTAs and global macro funds. This is a cyclical trend, rather than structural. When volatility is low, managers tend to increase leverage because they feel more confident in the positions they hold in the portfolio.
If one looks at the major equity indices, they have risen some 20 to 30 per cent over the last 12 months. Macro data has been more supportive, in Europe in particular, volatility has fallen across the equity and fixed income, and markets have rallied.
“That explains why the global macro and CTA strategies are willing to take more risk because they want to take advantage of stronger risk appetite in the market,” says Ferreira.
It’s also worth pointing out that both of these strategies use embedded leverage through futures and options – they don’t need banks to lend them capital. They are less constrained in that regard. Bottom-up fundamental strategies are still constrained from a leverage perspective but global macro managers can dial up leverage much more easily.
If investors go down the customisation route, perhaps using carve-out strategies that focus on a sub-set of a manager’s strategy, to increase the idiosyncratic risk component, they can take confidence in the knowledge that firms like PAAMCO have the technology tools and infrastructure in place to monitor risk forensically.
“Any deviation from what we expect, in terms of ex ante risk, should be red flagged. We have reassessment triggers so if there is a change in behaviour – let’s say we hire a manager whose DNA is in value equities and all of a sudden he starts rotating into growth equities – it would quickly be a cause for concern. And one we would want to understand more fully. We are laser focused at making sure the return stream generated by a manager is what we expect,” states Coupe.
One way to increase risk is to allocate to strategies operating further out on the liquidity curve – hybrid strategies, distressed debt, direct lending, bank loan funds have all gained in popularity recently. While harvesting illiquidity premia is an option, Coupe says that PAAMCO prefers to focus on liquid hedge fund strategies. “We believe we have enough levers to increase idiosyncratic risk and make investments that are closer to home. We do have distressed debt exposure, event-driven exposure but we make sure it is kept at an appropriate size/level for our investors.”
Looking at manager behaviour in 2017, Ferreira confirms that net exposure in equity long/short and credit long/short strategies has increased as evidenced by the re-weighting of portfolios into more cyclical sectors than defensive ones.
“There has been stronger capital investment into cyclical stocks that have benefited from the improving macro environment, and less investment in defensive stocks that are more favourable when economic markets are depressed.
“Higher net exposure and higher exposure to cyclicals are two indications that equity managers, in particular, are increasing risk. They are rotating into financials, as well as consumer discretionary and technology stocks. So I would say there is more risk appetite among equity long/short and event-driven managers.
“However, as mentioned, these bottom-up strategies are still using less leverage than global macro and CTAs, which are more top-down strategies that invest in broader underlying securities and can be more reactive to market changes,” comments Ferreira.
One important consideration here is that fundamental-based strategies and RV strategies, such as fixed income arbitrage strategies which make returns by using massive amounts of leverage to exploit tiny price inefficiencies, no longer find it easy to put risk on the table, even if they want to.
This is because the banking sector has, following the ’08 financial crash, been subject to much tighter regulation. Basel III, for instance, requires banks to shore up their Tier 1 capital ratios. Suddenly, using the bank’s balance sheet to support hedge funds has become greatly reduced. Banks simply will not provide as much leverage as they once did.
“If the regulator is asking you to monitor more closely your counterparty risk, and you have to put aside higher levels of capital to serve hedge funds, meaning leverage is more expensive and less available because of these tightening banking standards,” says Ferreira. He confirms that within the fixed income arbitrage space, “we’ve seen the number of funds reduce because the smaller funds just don’t have access to the necessary leverage to fully deploy their strategy”.
Coupe points out that banks have their preferred strategies that they will be willing to extend more leverage and balance sheet to i.e. those that are the most profitable to them.
“It’s therefore a bit easier for the equity long/short, and equity market neutral strategies, given the amount of trading they do. But it gets a bit harder for credit managers and event-driven managers to get balance sheet because it’s a slower moving book,” says Coupe.
To finish on a positive note, it just might be that President Trump’s administration becomes a white knight, given that there are signs he wishes to deregulate the banks and roll back on things such as the Volcker Rule.
“This might provide US banks with a renewed incentive to start lending again and start providing fund managers with more leverage. We will have to wait and see. Several elements will need to be passed by Congress but US banking regulation could be softer in the years to come. That could facilitate access to leverage,” concludes Ferreira.
Whatever the future holds, `risk’ will always remain different things for different people. Some investors, some strategies, will always be more inclined to put greater risk on the table than others. One thing that is certain, though: market regulation and better technology means that the 30X leverage levels that were seen pre-crisis are likely to remain a thing of the past.
