The hurricane screaming through markets in September blew away plenty of hedge funds. Many of those still standing saw significant assets sucked into the vortex. They face short-selling restrictions, and can expect tighter regulation; if their prime brokers aren’t freezing assets, calling for margin or going bust, they are certainly demanding bigger haircuts.
“From their investors most are encountering a hostility that can hardly be unexpected,” says Aoifinn Devitt of Clontarf Capital, which advises family offices and institutions on alternative investments. “For some groups, typically those most exposed to high net worth and retail money, the outflows will be nothing short of catastrophic - up to 50 per cent of assets in some cases.”
According to HFR and Eurekahedge, September saw about $30-35bn (E23.4bn - E27.3bn) yanked from the industry. Assuming they want to stay in the game, what questions should wealth advisers ask their fund of funds manager?
The first might be, “Who’s investing alongside me?” Many redemptions have been from investors forced to sell to cover losses in other, less liquid parts of their portfolios, so it pays to allocate alongside long-term investors with decent cash buffers.
“It can be difficult to be sure who your co-investors are within hedge funds ,” notes Paul Sarosy, managing director and head of product and sales management at Credit Suisse's private bank. “But it’s a valid question, and I think we will see an increased focus on transparency in the future.”
Chris Manser, global head of hedge funds with AXA Investment Management, which has just started marketing its funds of funds after two years running $4bn of Axa insurance money, talks up the stickiness of that capital. “It makes the difference between being able to run the portfolio you want or the portfolio you are forced into,” he says.
And what is “the portfolio you want”?
If you expect more volatility logic suggests rebalancing away from market-neutral and arbitrage towards directionality. “Volatility creates opportunity,” says Julian Shaw, head of risk management at $38bn fund of funds firm Permal, whose clientbase is three-quarters private wealth, and as such has always had a directional bias.
“The storm creates the opportunities and the calm is when you realize the profit from those opportunities. You need to find managers who can weather the storm without panicking or being stopped-out.”
Lately the markets have made Permal’s slightly higher volatility – but low tail risk – a much easier sell.
“I can’t help feeling a bit of schadenfreude towards some of the funds investing in things like fixed income arbitrage,” Mr Shaw admits. “People kept saying they knew a fund that offered returns like ours but with ultra-low volatility, and it was tough to persuade them that that was not necessarily the same as low-risk: you have to look through to the assets being traded.”
trading strategies
How those assets are traded is important, too, as senior executive officer Omar Kodmani observes. Permal reduced relative-value strategies because they are less liquid and more reliant on leverage – a source of tail-risk in a credit crisis. And although arbitrageurs will eventually regain access to banks’ balance sheets – their trading volumes make them a key revenue source – how long will it take to re-establish confidence?
“Do we look for hedge fund managers to be directional?” Mr Sarosy of Credit Suisse asks. “Yes we do. With funds of hedge funds we want flexibility and a manager who will allocate to the appropriate drivers in the market. We prefer those who are more geared towards macro at the moment.”
Axa, diversified more traditionally across both directionality and non-directionality, has put its macro and CTA allocations up. But Mr Manser defends fixed income arbitrage: some managers and strategies have fared better than others, he argues, and in any case a good mix of risks remains the best bet.
“Some of our strategies will have tail risk,” he says. “To avoid that you will end up with directional strategies and beta in the portfolio – and I’m not sure that that is going to be the right approach.”
The moral of all this is that allocators should look for the “flexibility” which Mr Sarosy describes, and expect their managers to be edging towards directionality. However, because that entails loading up on betas (and therefore correlation risks), managers need to have sophisticated risk-management processes in place to model those correlations, especially in stress scenarios.
Allocators should avoid immediately dismissing anything with “arbitrage” in the title, and consider the nuances.
Finally, allocators should ask how funds of funds are preparing for long-term value plays in distressed illiquid assets. The attention of most will be on mortgage- and other asset-backed securities, but Permal has even launched a Hedge Fund Opportunities Fund, ready to pick up hedge fund allocations that cash-strapped investors can no longer afford.
