Tactical Portfolios: Strategies and Tactics for Investing in Hedge Funds and Liquid Alternatives
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About this ebook
Take advantage of inefficiencies in the market by investing in alternative assets. Hedge fund and private equity investment diversifies your portfolio and helps shield you from market volatility, allowing your more passive assets to work the long game. In Tactical Portfolios: Strategies and Tactics for Investing in Hedge Funds and Liquid Alternatives, author Bailey McCann guides you through the principles of hedge fund investment and the associated philosophies of risk management strategies. McCann's background in reporting and analyzing government policy and regulatory issues positions her as a valuable source of strategic investment advice. As Senior Editor of Opalesque's Alternative Market Briefing, her take on the market is read by every one of the top 100 hedge fund managers on a daily basis. In Tactical Portfolios: Strategies and Tactics for Investing in Hedge Funds and Liquid Alternatives, McCann goes in-depth on important topics.
- Strategies for equities, managed futures and fixed income
- What to expect and common misconceptions
- Investment mechanics of specific strategies
- Valuation, red flags, and regulatory changes
If your passive approach has failed to produce the desired results, liquid alternative investment may be the answer. While long/short will always be around, external forces can change its impact on your portfolio and it may be time to expand your investment arsenal. Tactical Portfolios: Strategies and Tactics for Investing in Hedge Funds and Liquid Alternatives will help you get the most out of any market.
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Tactical Portfolios - Bailey McCann
Introduction
In just one decade, stocks have halved two times. After reaching a new high in the first quarter of 2000, the MSCI World stock index found a bottom in September 2002 following the dot.com crisis. The index, which captures large and mid-cap stocks, lost over 48 percent while hedge funds (as measured by the HFR Weighted Composite Index) were up net of fees 2.1 percent. When the global financial crisis took stocks down over 50 percent from their tops in early 2007 through October 2009, hedge fund investors were reaping over 6 percent during the same time.
Helped by floods of quantitative easing, many global stocks have reached new highs in 2013.¹
You would think that investors would now hedge their bets
and move to hedge funds to protect their assets and establish a meaningful diversification. The smart
money has done this, maintaining a significant allocation to hedge funds.
INVESTORS EXIT HEDGE FUNDS AT FASTEST RATE IN FOUR YEARS
Investors exit hedge funds at fastest rate in four years
, says a Reuters headline on January 13th, 2014. The article refers to the SS&C GlobeOp Capital Movement Index which calculates monthly hedge fund subscriptions (in-flows) less redemptions (out-flows). With −3.56 percent, December 2013 showed the biggest drop since September 2009. The article continues that while the end of the year period usually sees a pick-up in redemptions as investors look to move money around their portfolio ahead of the New Year, December’s reading is notably high. In the same month last year the index measured minus 2.61 percent.
²
For 2013, SS&C GlobeOp’s Hedge Fund Performance Index was up 12.32 percent, which is about half of the return of the MSCI World Index. So, hedge funds have performed well, but maybe not good enough?
Today (January 14th, 2014), as I write this introduction, another interesting story: Global stocks fall on concerns about earnings
—is angst coming back to the markets?³ Right now, we don’t know what will happen and may soon enter an environment where investors wish they had invested more in hedge funds and absolute return strategies than in long-only equity.
Alexander Ineichen, one of the most well-known researchers on hedge funds globally, offers the following advice: Equity investors have been dancing on thin ice and might continue to do so. It’s difficult to say how long the ice holds. I’m quite certain though, that at one stage a hedged approach will reveal itself as more intelligent than a long-only approach. Again. To stick with the metaphor: A long-only investment style is like dancing on thin ice, while a long/short investment style is like dancing on thin ice wearing swimmies: it might look odd at times but it’s safer.
⁴
LEARNING FROM YALE: 51 PERCENT ALLOCATION TO ALTERNATIVE INVESTMENTS
Yale’s $20bn endowment has included alternative investment strategies for over 20 years now. The so-called endowment model
aims to achieve superior returns by shifting a significant portion of investments away from traditional stocks and bonds into carefully selected alternative investments like private equity, hedge funds, real estate, and others.
While the global financial crisis also managed to drawdown the value of Yale’s endowment 24.6 percent in the fiscal year ending June 2009, the endowment model is still regarded the most viable proposition for long-term investors. How does Yale invest? For 2014, Yale’s investment targets include a massive 51 percent allocation to alternatives, while only 17 percent is reserved for international and domestic U.S. equities.⁵
Yale’s investment team, made up of 26 experts, are of course, not the only institutional investors who look to create tactical portfolios using alternative investments for both return and diversification goals. Ninety-four percent of institutional investors surveyed by Russell Investments said they already allocate to some form of alternatives, on average 22 percent of total assets. This already represents a significant allocation, which over time will only continue to go up. In the last three years, alternative mandates accounted for over 40 percent of all institutional hiring activity made during this period.
HEDGE FUNDS, EMERGING MANAGERS, LIQUID INVESTMENTS, AND MANAGED FUTURES
With an average allocation of probably in the single digits, private investors, together with a lot of their investment advisers, stand on the other side in this game of investing. There is a lot to catch up, and like in sports, a good start is always to look at the rules, and how the other players play the game.
When I started to research and publish about hedge funds and alternative investments in early 2003 under the umbrella of my company Opalesque, little did I know that hedge funds would grow from around $600 billion at that time to close to $3 trillion. Still, compared to endowments, family offices and foundations, hedge funds and alternative investment are largely underrepresented in the portfolios of insurance companies, private and public sector pension funds, sovereign wealth funds, and, of course, of private investors.
Liquid alternatives are one of the fastest growing sectors of the financial industry globally. Depending on the respective regulatory framework of the funds, liquid alternatives are mostly offered in a mutual fund format. They often have smaller minimum investment thresholds, making investments in alternative strategies easier for many investors. The investment options for professional and retail investors are growing rapidly, but still, the number one requirement when selecting any alternative investment is to understand the strategy.
In this respect, managed futures are probably among the least understood investment strategies, even for many institutional investors. On the other hand, managed futures have been around for decades, and many programs have been going for long periods during which they have proven their value of adding true diversification to a portfolio during periods of market stress and crisis.
We wrote this book to help you to better understand and utilize the new options tactical portfolios of alternative investments are offering you. Myself and the editorial team of Opalesque are at your disposal—you can email us any time your questions, suggestions and feedback at tacticalportfolios@opalesque.com.
Matthias Knab
Founder and CEO of Opalesque
NOTES
1. MSCI World, www.msci.com/products/indices/performance.html.
2. www.reuters.com/article/2014/01/13/us-hedge-funds-data-idUSB REA0C1GK20140113.
3. www.livemint.com/Money/t9gCdLJUksAnPkDPca2EUP/Opening-Bell-14-January—Global-stocks-fall-on-concerns-abo.html.
4. www.opalesque.com/RT/ZurichRoundtable2014.html.
5. http://news.yale.edu/2013/09/24/endowment-earns-125-return.
Preface
Tactical Portfolios is a book designed to help investors, investment advisors, and anyone interested in alternative investments understand what hedge funds and liquid alternatives are and what they do. The book attempts to show different strategies hedge fund managers employ and how they work in a portfolio. We also walk the reader through the various service providers and regulations impacting the industry in the wake of the financial crisis.
The book closes with a discussion of what diversification and hedging really are in an effort to help investors avoid the potentially fatal flaw of exposure risk. I hope you find the text valuable and easy to read.
I would like to thank all of the managers who have been generous with their time and expertise, as well as the Opalesque editors, Opalesque Publisher Matthias Knab, and Olivier Blanchard, who gave me great starting advice for this book. Finally, I’d like to thank E’lona McCann for her advice and support.
Bailey McCann
January 2014
CHAPTER 1
Hedge Fund Strategies and How They Work
Until recently, most investors maintained a traditional portfolio construction of 60 percent in stocks, 20 to 30 percent in bonds, and the rest in cash. That 60 percent was managed passively, using the buy and hold method, with bets placed only on the long side of the trade. That means that investors’ only hope was for equities to go up in perpetuity, which as we all know, never actually happens. Markets correct, outside events force sell offs, companies go bust. This is where alternatives come in, helping some of the biggest players in the market mitigate losses during those tough times.
Another term for hedge funds is absolute return, meaning that hedged strategies are designed in order to provide a return instead of 0% and/or mitigate losses in the event of a market correction. The way this works in practice is, if an individual invests in a mutual fund, that fund will likely return 3 percent a year in a positive market. In a down market, that mutual fund could potentially go to zero return and post losses. This is because mutual funds typically place bets that the market will go up.
Hedge funds, on the other hand, have plans in place for both sides. They’ll take the view that the value will go up (going long), and also have insurance bets in place in case the market goes down (going short). Sometimes these bets are made together, other times the manager reacts dynamically to a change in market conditions. In a positive market, a hedge fund could post a 10 percent return over the year, in a market that is going down that return might be slightly less, say 6 to 9 percent, because of the fund’s ability to react and move into short positions. Only in extreme market movements like 2008, where sell offs hit depression levels, did we see a significant number of hedge fund strategies fail to post positive returns for the year. This gives them a competitive edge over mutual funds, which can go negative in a year that is only marginally bad, relative to crisis years like 2008.
In this chapter, we will examine at a broad level how this plays out by highlighting the differences between the most common strategies, and why it is important to understand that allocating to hedge funds as though they are an asset class may not be the best way to reap the rewards of absolute return strategies. Instead, learning the role of each individual strategy can lead to more optimal portfolio construction and better returning allocations.
INVESTOR EVOLUTION
In terms of investing, hedge funds are still a new kid on the block. They’ve been around since the 1950s, but they didn’t really pick up steam until much later. High net worth investors and family offices got into hedged strategies first, relying on in-house expertise and big tick allocations to gain access. The biggest banks and richest family offices quickly learned how to effectively allocate to hedge funds, and pensions and endowments followed. Each year, when rankings come out about the size of Harvard’s endowment, for example, you can thank hedge fund investing for much of that.
For other, less well-resourced investors, before 2008 the trend was often to allocate generally to alternatives or hedge funds, subscribing to a few blue chip names or a fund of funds claiming to offer access to best-of-breed managers. For a while, this generic allocation became a trend, a means of diversifying portfolios by somewhat passively adding hedge funds and hoping for the best. During the crisis, many of those investors realized that without fully understanding how their portfolios were constructed, different investments were actually heavily correlated to each other, resulting in greater exposure risk and broad-based losses.
Perhaps surprisingly, after 2008 investors started looking at hedge funds more than they have in the past. A number of factors contributed to this, including a lack of diversification in portfolios, even lower returns from long-only vehicles in a low-growth/low interest-rate environment, and improvements to investor education following large losses. Let’s unpack these drivers and look at how investors are evolving on hedge funds and what it might mean for the industry.
The biggest hedge funds, like their mutual fund counterparts, have a quality reputation and good brand recognition. As such, these funds attract assets easily. Think of it like the crowded restaurant rule, if one restaurant is packed to the gills, and the one next door sits empty, more often than not, people wait for a table at the crowded one. However, it is precisely because of this trend that those blue chip funds lose a bit of their edge over time. As we will learn in the emerging managers chapter, as funds grow they lose the ability to be reactive or take advantage of small wins. A stampede of elephants is still slower than a pride of lions.
Bigger funds tend to group into the same positions, like going long Apple or GE. These trades are safe, and their capacity allows big funds to deploy big blocks of investor capital. This is also true for many of the largest mutual funds, because they need a surer bet. So, if an investor blindly allocates to both types of funds and thinks they are diversified, in reality they only doubled their exposure to the surer
bets. In that instance, during a correction investors will still see less of a loss from the hedge fund allocation because it will also have a different loss-mitigating short position. Enough to account for double exposure? That’s unlikely.
At an oversimplified level, this is what happened to a number of investors in 2008. When correlations went to one (meaning everything tanked together), not only did diversification have limited mitigating effects, any redundant exposures were magnified. Since then, there has been a growing trend among accredited investors to take a step back, become better educated, and bring in professionals to help them ensure that their portfolios are actually diversified and durable. Hedge funds have benefitted precisely because of the diversification and durability they offer to qualified investors.
Since 2008, markets have started to recover, but very gradually. Savers are being punished with low interest rates and investors are being punished with equally low yields on equities. In this environment, hedge funds can provide enhanced returns because they take uncorrelated long and short positions. If you are a public pension and you have to make an 8 percent return each year to meet obligations, hedge funds will look intriguing right now, as an 8 percent return seems like a dream from a bygone era. Hitting that benchmark moves back into the realm of the possible with a mix of alternative investments that could include hedge funds, private equity, and real estate.
With this renewed interest the hedge fund space itself is changing. The largest hedge funds are starting to resemble more traditional asset managers; some are even offering hedged mutual funds to retail investors. New regulations aimed at driving perceived risk out of the marketplace are also forcing some changes in how these funds operate, making them slightly more vanilla versions of their former selves. While the go-go days of hedge funds may be behind us, they can still provide better returns and more diversification than traditional portfolio structures. Next, we will break out the major strategies and how they work in a portfolio.
MAJOR FUND STRATEGIES
Hedge funds can take on a variety of trading strategies and styles, with each manager offering his own variation on some archetypal trading themes. We offer an explanation of the biggest buckets, along with specific fund examples. It would be impossible to cover all the types of funds as new variations enter the market each day, but the following provides a solid framework that can be used to inform the diligence process around a given fund.
Equity Long/Short
Equity Long/Short funds are probably the most populous group of hedge funds. As the name suggests, these funds typically trade listed equities, taking both long and short positions. Managers will take variations on this by focusing on a particular market cap, sector, industry, whether the equity offers a dividend, or by analyzing individual securities against a set of balance sheet fundamentals.
In a pitch book, you might see phrases like value investing or fundamentals-based stock picker. These phrases are indications of how a manager picks securities. Value investors typically want securities that are sound companies at a cheap price. Warren Buffett is an example of a value investor. He made his biggest plays on being able to find those diamonds in the rough. Managers that pick stocks based on the fundamentals are going to look at factors like health of a corporate balance sheet, growth opportunities, debt-to-equity ratios, and price/earnings ratios, and then drill down to a list of companies that meet their criteria. Fundamental shops typically add an overlay like politics or other macroeconomic indicators to their secret sauce.
One example of an Equity Long/Short fund is Varus Fund, ¹ from Varus Capital Management. The Varus Fund is a long/short equity fund focusing on German mid and large caps and their European competitors. In their description, the firm describes the funds as investing in pair trades and catalyst-driven longs and shorts. Investments are based on quantitative and qualitative analysis and strong competence in German stocks. With a focus on strict risk/reward thinking, trading discipline, and tight risk management, Varus Fund aims for absolute returns with low correlation and volatility.
If we unpack what that all means, basically, in addition to looking at German companies, portfolio managers are also looking for market catalysts that might cause one or both companies in a paired trade to break a certain way. To find these catalysts, the firm not only runs the numbers but also considers qualitative factors. These factors are proprietary, but they could include measures like brand equity, management team, or other overlays that aren’t based strictly on the numbers.
One of the first principals of long/short equity trading is trading discipline. Essentially, this means holding true to your analysis and stock picking even as markets change from day to day. Self-directed traders, retail investors, and even some institutions can get caught up in reactionary trading behaviors, especially in markets that have been as sideways as those since 2008. Long/short absolute return strategies are meant to perform over the long haul, with rebalancing done based on pre-determined signals or on a discretionary basis as market conditions warrant.
Typically, firms that are better at discipline will trust their models and methodology in an effort to avoid behaviorally based trading changes. A good manager will employ back testing, along with other modeling methods, when building their strategy. From there, managers often start trading the strategy with their own money to build an initial track record to show investors along with their foundational research. This approach not only allows for strategy testing, but also adds a bit to investor confidence—investors like to see that a manager has some skin in the game.
The focus on risk in Varus’ description is also an important change to note since 2008. In the go-go days of the 1990s and mid-2000s, funds were putting up enough in returns that few investors focused on risk. However, in the wake of the financial crisis of 2008, that viewpoint has changed considerably. Now, both investors and regulators are focused on the amount of risk taken by a manager (including leverage) and the potential losses in the event of another downturn. Taken to the extreme, focusing too heavily on the risk portion of a risk/reward profile can mean missing out on a skilled manager and unique opportunities. But, for institutions, pensions, endowments, or even just conservative investors, that may be a tradeoff they prefer. Indeed, some pension funds are limited in the amount of risk they can even consider when looking at a given fund. Given this shift, funds will often point out in much more detail than they would have before what the risks are and how they view risk.
Ultimately, when evaluating a long/short strategy, investors will have to look at both sides of this profile to determine what’s right for them. The ability of a manager to go both long and short can be a risk-mitigating factor by definition, as the investor is not exposed to the long-only side of a trade.
Macro
Funds will often classify themselves as macro or global macro. Within this bucket, funds are largely driven by macroeconomic conditions. Common strategy variations include event-driven or special situations. Both of these variations look to capture market dislocations that are the result of specific macroeconomic events.
Macro funds will typically hold both long and short positions in a variety of asset classes including equities, fixed income, currencies, and so on. Unlike the long/short funds explained above, the macro strategy isn’t asset-class specific—that is, equities—instead, managers will look at various economic and political risk overlays to determine where they make investments on either side. For example, if a manager looks at Australia they may take a long position on Australian currency or in Australian equities given the overall strength of that economy and relatively low political risk. Whereas if a macro manager was looking at Turkey, they may take a look at that country’s thriving private sector against its growing political uncertainty and take on more hedged positions there, going both long and short.
Third Wave² is a macro fund that relies on both qualitative and quantitative factors to identify opportunities. The fund looks at model-driven trades from a macroeconomic vantage point. Within that view, Third Wave uses systematic modeling to look at discretionary opportunities. The fund differentiates itself by being at the nexus of macro approaches; most macro funds are either purely discretionary or are systematic commodity trading advisors (CTAs)³ that rely on trend following. Instead, Third Wave opts to take a little from column A and a little from column B. Along with their systematic models, they add a variety of economic and qualitative overlays to find opportunities.
Unlike other systematic shops that may rely entirely on their computer-based models, Third Wave also allows for human intervention by the manager, and this is really what makes macro strategies stand out as a separate group. Macro managers take the view that not all relationships and not all economic activity can be modeled effectively. To this end, macro managers may adjust a trade away from what a model says to do based on a change in information or economic conditions. In some cases it could also be based on the direct involvement of a fund in a specific economic activity (like bond buying) itself.
Larry Smith, Chief Investment Officer and Co-Founder of Third Wave, gives an example of how this works in practice—Take the Australian dollar, our model loves the Australian dollar. The currency has rallied dramatically over the past six months, but the fundamentals all suggest it will go higher. There is a good reason to expect this. Chinese economic policy has been extraordinarily successful in stimulating growth and Australia is a beneficiary of that. China’s focus on commodities means that they will invest heavily in Australia. So we see no reason not to follow the model with respect to this trade. At the same time, our model is not particularly sanguine on the Canadian dollar, yet our discretionary process leads us to believe that it, too, will improve relative to the U.S. dollar.
At the same time