HEDGE FUND OUTLOOK. SEATTLE 999 Third Avenue Suite 4200 Seattle, Washington telephone facsimile

Transcription

1 HEDGE FUND OUTLOOK Eric J. Petroff, CFA, CAIA Bee G. Lim, CFA, CAIA SEATTLE 999 Third Avenue Director of Research Associate Director of Research Suite 42 Seattle, Washington telephone facsimile LOS ANGELES 2321 Rosecrans Avenue Suite 225 El Segundo, California telephone facsimile

2 Report Overview For most institutional investors, the hedge fund universe is too nebulous or poorly understood to be meaningfully discussed at the policy level outside of manager specific considerations. So as a substitute for well reasoned strategic planning, it is common to focus on historic returns, correlations to public market investments, and the associated asset allocation benefits of this asset class through the prism of mean variance optimization (MVO). There are of course fundamental flaws with this methodology that have been seemingly ignored by the consulting industry for many years. In spite of common perceptions, the truth is hedge fund returns and volatility thereof are not fixed, nor are they independent of the world in which they operate. Such arguments rest upon the concept of Alpha driving the preponderance of returns, which is simply untrue. One must never forget alpha is random, fleeting, not systematically discovered, and most importantly, is a function of competition, which coincidentally has become fierce given asset inflows over the last decade. We would point out however, that what is commonly seen as hedge fund alpha is what we would describe as Beta-Alpha, which is simply the practice of judiciously allocating amongst the various opportunity sets within the hedge fund universe in relation to public market opportunities. What is most interesting to us about this conventional wisdom is how unjustified it truly is when you understand the fundamental forces driving the returns of various hedge fund strategies. There is so much more that can be done besides simply looking backwards in time and tinkering with optimizers. Though individual The question of course is how do investors go about dimensioning the relative positions and funds may be too complex for policy level discussions, the underlying factors contributing to (or detracting from) their success are not. Demonstrating this reality is a major goal of this report. attractiveness of various hedge fund opportunities from a policy level standpoint? Furthermore, how can hedge fund strategy allocations be married with overall portfolio design? We believe the answer to both questions is through a top down view of the hedge fund universe. First though, we would offer elaboration on our perceived flaws with conventional hedge fund wisdom through the commonly heard pro-hedge fund argument vis-à- vis MVO. This line of reasoning usually states that 7-8 of all portfolio If you actually stop and take a look at the primary strategies employed in the hedge fund universe, you will find understanding di their behavior on a prospective basis is not volatility is derived from equity exposure, which of course is true because equities much more complicated than similar analysis for equities and bonds. You simply need pass through macroeconomic, capital markets, and valuation volatility on a daily to examine different subsets of risk factors, all of which are ultimately related to the basis. The argument continues by stating this problem can be rectified by shifting same four things that affect any risky asset - macroeconomic conditions, asset flows, into hedge funds which will produce short term volatility more along the lines of valuations and volatility thereof. And it is through this universal prism of market forces bonds, while also providing commensurate returns to equities. Or in other words, that appropriate allocations to various hedge fund strategies can be derived in the hedge funds offer afree lunchto investors s when viewed vewedthroughmvo. og context of overall portfolio o o design. Besides the fact there is no such thing as a free lunch or that optimizers are only meant to model fully liquid assets, there are other flaws with this line of reasoning. It is simply not possible to take risk exposures of any kind, diversify and repackage them into an offshore format, and somehow garner the benefits of taking risk while not experiencing the associated volatility, at least not over the long term. Even though hedge fund strategies offer access to risk exposures that are unavailable in public markets, the fact of the matter is any risk exposure is unavoidably affected by aggregate market forces in one form or another. This is the reason we publish this report, to remove the mystery surrounding those factors that drive hedge fund returns. Moreover, we hope to provide a framework through which our clientele can judiciously allocate to various strategies on a forward looking basis through the prism of top down strategic thinking, as opposed to simply embracing aggregate hedge fund exposures. Contrary to popular belief, success with hedge funds is not merely afunctionof access to managers, but instead is a function of holding the most appropriate strategy exposures. Just as is the case with total portfolio asset allocation, it is the risk exposures that drive the majority of returns. 2

3 Hedged Equity & Market Neutral Strategies A common misnomer of equity hedge fund strategies is they offer more efficient risk adjusted equity exposure than long only managers, or higher risk adjusted returns. Of course manager specific issues always come into play, but there really is no way to repackage equity risk without ultimately experiencing equity volatility and performance patterns over time. The only true difference between hedge and long-only managers is their relative levels of market exposure, which are dynamic and appear to be a function of equity valuations. Hedge strategies are also beholden to the same limitations on adding value as are long-only managers, as dispersion of sector returns is generally directly related to alpha generation; more dispersion equates to more opportunity. 2. Rolling 3 Year Alpha Estimates vs. Sector Return Dispersion (Mar. '1) Rolling 3 Yr. HFRI Equity Hedge, Market Neutral, S&P 5 Returns (Mar. '1) HFRI Equity Hedge S&P 5 HFRI Equity Market Neutral Index Investing in equities results in equity-like behavior. Of course returns and volatility thereof are a function of market exposure and/or leverage. Source: HFR, Ibbotson, Shiller PE vs. Subsequent Rolling 3 Year Betas to S&P 5 (Mar. '1) Similar to traditional equity managers, dispersion of sector returns is key to adding value as relative opportunities must exist for managers to act upon. 2.8 As equity valuations go down, managers are more willing to bear market exposure; and vice versa HFRI Equity Hedged 3 Yr. Alpha Estimate to S&P 5 HFRI Market Neutral 3 Yr. Alpha Estimate to S&P Year Average S&P Sector Return Dispersion (Max-Min). -.3 HFRI Equity Hedged Subsequent 3 yr. Beta HFRI Market Neutral Subsequent 3 yr. Beta Shiller PE Ratio 1 Source: HFR, Ibbotson Source: HFR, Ibbotson, Shiller 3

4 Convertible Arbitrage Like any investment, returns from convertible arbitrage are Asset Flows and Pricing in Convert. Bonds (Mar. '1) 15 constrained by asset flows, market volatility, and valuations. In comparison to corporate and Treasury debt, convertible bond markets are relatively small. So even relatively modest asset flows (billions) can have a material impact on valuations, which can be measured by the theoretical cheapness of these bonds. Billions) valuations, which can be measured by the theoretical 4% To some extent managers can overcome asset pricing through increasing levels of leverage, but would do so at the cost of potentially higher downside and volatility. Asset Flows ($'s, 1 5 As more money flows into convertibles valuations go up, which of course is the same for any risky asset. Because these strategies are inherently levered, market All Converts - Theoretical Cheapness -1% volatility is a consideration beyond its effects on valuations, -15 New Issue Converts - Theoretical Cheapness -2% as sudden and extreme spikes thereof can render risk Mar. management models ineffective and lead to large losses. Source: HFR, BOA/Merrill Lynch Market Volatility and Subsequent Returns in Convert. Bonds (Mar. '1) Market volatility affects pricing of all risky assets and therefore prospective returns for convertible arbitrage strategies; lower volatility equates to higher prices and vice versa HFR Convertible Arbitrage Asset Flows Pricing and Subsequent Returns in Convertible Bonds (Mar. '1) As valuations go up, subsequent returns go lower. Regardless of the availability of leverage, managers will ultimately be constrained by prices. 12.4% 15.6% 8% 7% 6% 3% 2% 1% Theoretical Ch heapness % 1.7% 1 VIX Index - Rolling 1 Yr. Average HFRI Convertible Arb. Subsequent 1 Yr. Return Source: HFR, Yahoo Finance, Wurts -2-1 Subsequent 1 Year HFRI Convertible % -2 < -1% 1%-2% 2%+ Range of Theorectical Cheapness Source: HFR, BOA/Merrill Lynch, Wurts 4

5 Relative Value Relative value strategies are constrained by several key top down factors, including the cost and availability of leverage, shape of the yield curve, interest rate and equity volatility, and new security issuance. 4 Yield Curve Spreads and Subsequent Relative Value Returns (Mar. '1) Relative value returns tend to follow yield curve spreads over time as the size of these interest rate differentials affect the potential to add value. 8 6 Yield curve spreads not only affect fixed income focused managers who borrow at short term rates and invest in longer term assets, but all relative value strategies that rely on leverage (and cost thereof) to exploit mispricings; generally leverage is attained at short term rates Because the shape of the yield curve affects returns, so does its volatility. Unstable yield spreads reduce the ability to apply leverage out of risk management concerns. New issuance is essential too in that these securities tend to be highly liquid and more attractively priced at issue Consumer and Corporate Debt Issuance vs. Relative Value Returns New credit based bond issuance appears to hold a relationship with returns from relative value, especially for fixed income and credit strategies. -2 HFRI Relative Value Subsequent Rolling 1 Yr. Return 3 Month Average Spread (Fed Funds -1 Yr. Treasury) Source: Fed, HFR, Wurts 3 Implied Interest Rate Volatility and Relative Value (Mar. '1) It appears relative value strategies are indeed dependent on interest rate volatility in generating returns, but on an inverse basis Growth Rate in Cons. & Corp. Debt as % of GDP HFRI Relative Value Subsequent Rolling 1 Yr. Return - 75 MOVE Index (3 month average) HFRI Relative Value Rolling 1 Yr. Return -1-2 Source: Fed, HFR, Wurts Source: Bloomberg, HFR 5

6 Distressed Debt This strategy is dependent on the availability of distressed debt, which is a function of maturing debt, the circumstances at its issuance, and the ability to refinance. Allocating assets in advance of potential distressed debt opportunities is key, as opportunities will be quickly priced away by hedge and private equity investors. Looking forward it appears as if there could likely be a tremendous opportunity for distressed debt strategies. Debt issuance in recent years was huge, and much of it was issued with too much balance sheet leverage. With the de-levering of financial institutions and lack of a robust securitization market, firms will find themselves with few options to refinance. This of course will increase the opportunity for distressed investors. 6 4 Default Rates & Distressed Hedge Returns (Dec. '9) There is a direct relationship between default rates and subsequent returns for distressed investors, illustrating the importance of prevailing conditions in credit markets. 4 3 $8 $6 $4 Billions Recent High Yield & Levered Loan Issuance The spike in lower quality debt issuance towards the height of the credit bubble portends ample distressed opportunities when these bonds mature, especially given a weaker economic environment than at the time of issuance. HY Issuance Volume JPM Leveraged Loan Issuance Levered Loan Enterprise Value/EBITDA Multiple $2 $9 $154 $36 $387 $38 $184 $34 $58 $71 $95 $68 $152 $158 $16 $149 $148 $53 $181 $ Source: JPM, S&P LCD $8 $6 Maturity Schedule for Institutional Loans In just a few years, many hundreds of billions worth of bonds and loans will be maturing, which will likely offer a tremendous opportunity. 13.x 11.x 9.x 7.x 5.x 2 13% 11% 1 4% 3% 1% 1% 1% -2 Altman Annual HY Default Rate Subsequent 1 Yr. HFRI Distressed/Restructuring Return Source: Altman, HFR 2 $13 High Yield Bonds Institutional Leveraged Loans $4 $265 Commercial Real Estate Owned by Banks/Thrifts 1 $236 $279 $98 $211 $2 $173 $62 $45 $188 $11 $26 $5 $1 $44 $17 $66 $72 $94 $136 $136 $122 $19 $33 $ Source: JPM, S&P LCD Billions 6

7 Merger Arbitrage Constraints to this strategy s s success include the availability of mergers and acquisitions (M&A) and competition as a result of asset flows and associated pricing pressure. The pace of corporate M&A is a function of profitability and therefore the availability of cash on corporate balance sheets, which is a factor that can be dimensioned through aggregate economic data. As the volume of mergers and acquisitions increases, so do returns from this strategy on a directional basis, which demonstrates the sensitivity of returns to M&A deal flow. llions Bil 2,5 2, 1,5 1, 5 8 M&A Volume and Merger Aribtrage Returns (Mar. '1) Without M&A activity, hedge funds have no opportunities to trade upon, making deal flow a major component of returns. Rolling 1 Year Global & US M&A Volume ($'s, Billions) Rolling 1 Year HFRI Merger Arbitrage Return Nonetheless, even if deal flow is robust, strategy asset flows -1 are a consideration as more competition for deals will push prices higher and prospective returns lower, especially in the presence of leverage. Source: Bloomberg, HFR Strategy Asset Flows and Merger Arbitrage Returns (Dec. 9) Although dedicated merger arbitrage funds are not the only players in this space, their asset flows do serve as a proxy for deal competition and illustrate their effect on pricing and subsequent returns. 3.3 Source: HFR HFR Merger Arb Net Flows ($'s, Billions) Subsequent HFRI Merger Arbitrage Return lions Bill -2 Corporate Profits and Subsequent M&A Activity (Dec. '9) The relationship between corporate M&A activity and profit growth is relatively straightforward. Without growth in profits, firms do not have the assets to engage in these activities. Source: Bloomberg, Fed, Wurts Subsequent Quarterly Global & US M&A Volume ($'s, Billions) Rolling 1 Year Corporate Profit Growth (NIPA)

8 Global Macro (Trend Followers) For all intents t and purposes, global lmacro trend following strategies are constrained by market volatility and the presence/absence of trends in major capital markets forces. These strategies trade frequently, need high levels of liquidity, and the ability to employ leverage. This is why these managers operate in the realm of highly liquid futures markets which broadly encompass global commodity, interest rate, currency and equity markets. Because these managers trade a basket of futures exposures, their long term performance patterns mirror the behavior thereof, as is the case with long/short equity. Over shorter periods of time however, returns are clearly related to market trends of either direction (+/-), as well as overall implied market volatility. 8% 6% HFRI Systematic Diversified vs. Trends in Comm. & Treas. (Mar. '1) As long as markets are trending in one direction or another, global macro managers have shown the ability to generate solid returns. The opposite is true for non-trending markets HFRI Systematic vs. Major Futures Markets - Rolling 5 Yr. Returns (Mar. '1) Even though global macro managers are traders, they cannot escape the underlying behavior of the assets they trade, resulting in directionally similar performance to commodities, interest rates and currencies over long periods of time. Source: HFR, Ibbotson, Wurts 6% 4% HFRI Macro: Systematic ti Diversified ifi Index Equal Weighted Blend (S&P GSCI, IA SBBI LT Govt, & US Dollar Real) HFRI Macro Systematic vs. Market Volatility - VIX (Jan. '199-Mar. '21) 3.9% 3. During times of heightened volatility global macro managers tend to perform poorly, which is likely due to frequent reversals of trends % % % 2% 1.4% 1.3% 1.6%.7%.4% 2% 1.8% 1.4% Median Quarterly Return vs. DJ UBS Commodity Index Median Quarterly Returns vs. IBBA IT Treasury Index Positive Trend (3 periods) Negative Trend (3 periods) No Trend Source: HFR, Ibbotson, Wurts -.1% -.3% Median Monthly Return Median Quarterly Return -2% Range of VIX Source: HFR, Yahoo Finance, Wurts 8

9 Macro Outlook & Summary of Conclusions As mentioned at the beginning of this report, we believe it important to view hedge fund opportunities through a top down prism based on prevailing and prospective macroeconomic and capital markets conditions. As such, below is a brief summation of Wurts & Associates current outlook that we will subsequently apply to specific hedge fund strategies. Macroeconomic & Capital Markets Outlook Near Term A near term resurgence in economic activity is highly likely, but may come under threat in 211 due to sharp tax increases and scaling back of fiscal stimulus; some uncertainty remains near term. Bond and securitization markets should recover alongside economic activity, but are unlikely to reach previous peak levels. Corporate profitability is on the rise and should stabilize as GDP returns; M&A activity should rise as well. Cash rates are likely to rise slowly due to societal reliance on leverage and a steep yield curve should persist for some time. Credit opportunities remain more attractively valued than equities and will likely remain so for some time given recent systematic changes to financiali industry (i.e., fewer major players and de-levering of balance sheets). Long Term Long term barriers to economic growth remain due to increasing societal debt, expansion of government as a percent of economic activity, and sustained growth in tax burden over coming years. Economic and market volatility should be heightened due to societal leverage and uncertainty over future economic growth. The threat of inflation continues due to unprecedented monetary and fiscal stimulus. Cash rates will eventually rise as the economy strengthens and inflationary expectations increase. The threat of inflation is likely to increase future interest rate volatility. Given lower long term GDP growth prospects and potentially higher volatility, capital market valuations are unlikely to expand to recently seen levels; a sharp fall in valuations is also unlikely given a pending recovery. (Individual strategy outlooks are on the following page.) 9

10 Macro Outlook & Summary of Conclusions (Cont d) Column1 Hedged Equity Market Neutral Convertible Arbitrage Relative Value Distressed Merger Arbitrage Global Macro (Trend Followers) Valuation Equities fairly valued with low probability of strong valuation swings (+/-) Fairly valued to cheap Steep yield curve Credit yields attractive Normative Normative capital markets valuations Market Conditions / Volatility Betas likely heading upwards due to valuations Overall heightened market volatility in relation to recent years Interest rate volatility is stabilizing, but likely subject to spikes Pending volatility in coming years as opportunity set arrives Stabilizing and rising corporate earnings Choppy markets likely with few sustainable trends from current valuations Opportunity Set Sector dispersion narrowing and not stabilized New issuance of convertibles is slow Slow pace of new issuance (ex-treasuries) Short-term: poor Medium-term: very good M ergers and acquisitions activity likely to increase alongside profitability Difficult for long term trend followers; accomodative to short term traders Supply / Demand Heavy recent strategy outflows Heavy recent strategy outflows Supply likely to outpace demand Heavy recent strategy outflows Financing / Liquidity Appropriate to strategy Limitations on leverage in relation to recent years Limitations on leverage in relation to recent years Limitations on leverage in relation to recent years Outlook Neutral (on a risk-adjusted basis to public equities) Positive Positive Near-term: Neutral Mid-term: Positive Positive Negative 1