Investing in equities can be a wild ride. Like any rollercoaster you’ve ever ridden, the slow climb up is a serene experience. The higher you get, the better the view. Wonderful. Then you descend, the G force kicks in, and you start to scream with exhilaration; fear and adrenaline forming a heady mix.
Hedge fund investing, by analogy, is less a rollercoaster ride, and more a steady drive in a Rolls Royce; designed specifically to get the investor to their end destination as smoothly as possible.
Despite this, traditional media continue to compare hedge funds to equities which are having another great year; equities are up 16 per cent whereas hedge funds are up approximately 7.5 per cent.
People gloss over the fact that in periods such as Q4 2018, there was almost a 20 per cent drawdown in equities, while the average hedge fund strategy was down 2 or 3 per cent. Thereby doing exactly what they are supposed to in volatile environments; minimising drawdowns.
SkyBridge Capital is one of the industry’s leading hedge fund multi-managers. Although 2018 proved challenging for hedge funds, both of SkyBridge’s FoHFs returned about 3.6 per cent and 4.5 per cent, according to Bloomberg.
In a recent conversation with Ray Nolte, the firm’s co-CIO, he remarked: “Hedge funds are doing a good job of managing volatility. I think the correlation properties we see are actually fairly attractive. If there were a disappointment, I’d point to the fact that absolute return levels are lower than I’d like to see. Overall though, hedge funds are complimenting clients’ portfolios.”
A lot has changed in the industry over the last twenty years. Back then, one would find a lot more RV and arbitrage strategies exploiting market inefficiencies. But things have matured, markets have become efficient in part due to the explosion in information flow and systematic trading, and the annualised returns posted by hedge funds, on average, are not hitting the lights out.
“Its mission has evolved but I don’t think the rationale for utilising hedge funds has changed much from those days. That said, investors are waiting to see when hedge funds are going to produce higher returns again. Until then, flows will remain muted,” suggests Nolte.
Of course, like any statistical exercise, there are always going to be some managers who post stellar returns, some who rack up huge losses, and a vast number who generate modest, single-digit returns. Investors should adjust their return expectations and accept that returns of 30 or 50 per cent are not the norm; and that those managers who do achieve this are just as likely to experience significant losses the following year.
“I think if you have a year or two of hedge funds generating mid-digit returns, with stock markets flat to down, the narrative might change,” says Nolte.
When asked for his perspective on how the industry has changed during his time at SkyBridge, Nolte agrees that information flow has been one key theme.
“The sheer volume of information in the marketplace has eroded some of the edge that hedge fund analysts used to have,” remarks Nolte. “This has exacerbated some of the volatility in the market because so much of the trading process has become systematised. A news event comes out, it triggers algorithmic models and you get this rapid, accelerated downdraft. That’s been a key change in the industry.”
That said, increased regulatory scrutiny and disclosures such as Reg FD, have led public companies to become more sensitive on how and when they disseminate information.
Five years ago, it wasn’t uncommon for an equity l/s manager to call people within the supply chains of companies to get a read on what was happening internally. Now, if they want to speak to a company they have to go through their IR department.
Whereas before, good analysts used to have a lot of access points to glean information and weave a story now, everything is scripted.
It’s not making a hedge fund manager’s life any easier.
For any good FoHF manager it is imperative to seek out where the alpha generators are. Who are the managers who are best adapting to today’s market conditions and delivering good returns?
When asked about the types of strategies the team is allocating to in SkyBridge’s flagship fund, Nolte confirms that equity long/short funds are not on the menu. “We don’t think as investors we get paid enough for taking on market beta,” he says. “Also, leveraged loans issued to corporates have become cheaper so we’ve reduced the fund’s exposure to CLOs substantially this year.”
Nolte also confirms that the investment book is predominantly focused on credit-related strategies with a US consumer focus, broadly speaking; residential mortgages, regional and community banks.
“This is based on the relative strength of the US consumer,” he explains. “Consumers haven’t levered up their personal balance sheets, wages have been rising, and if you look at income/debt ratios they are pretty attractive to the consumer. Unemployment at 3.5 per cent is attractive, and more surprisingly, at this stage in the market cycle, the savings rate is still quite high. Typically, in latter stages of market cycles, when the consumer feels emboldened, they go out spending and run up their debt levels but we’re not seeing that.
“The opposite is true on the corporate side; debt/equity levels are rising and corporates have re-levered their balance sheets. The managers we are backing are hedging their books by going long consumer-facing credit assets and short corporate-facing credit assets.”
He says that commercial real estate “still looks attractive as well,” before adding: “Another theme we are looking at for the first time in a while is on the macro side; CTAs and systematic macro strategies. We made a recent allocation in this space and might lean more into it but first we need to see more of a bear market environment. We’re not there yet. But with the chances of recession next year going up, US elections etc., we think more defensive strategies make sense to us.”
SkyBridge has also allocated a small percentage of the portfolio’s assets to volatility managers as we head towards 2020. “Finally, we have also looked at the convertible bond space, which is another way to play volatility,” confirms Nolte.
At the top of this article, the rollercoaster analogy was used to describe the wild peaks and troughs that equity investors experience. But as geopolitical risks creep up and fears of a global equity market correction rise, investors would be wise to look to hedge funds to enjoy an easier ride; or in a portfolio context, smooth out returns. Equity markets cannot keep going up indefinitely.
As Nolte concludes: “The whole argument for holding alternative investments in a portfolio is that they deliver unique return streams that you don’t get from traditional markets. Done well, they should help smooth out the volatility of the portfolio. It’s not so much that the end destination changes (steady returns), rather hedge funds create a smoother path to that end destination; and as a result, help investors sleep better at night.”