Hedge Fund Outlook October 2011

Transcription

1 Hedge Fund Outlook October 211 Eric J. Petroff, CFA, FRM, CAIA Chief Strategist SEATTLE 999 Third Avenue Suite 42 Seattle, Washington tel fax LOS ANGELES 2321 Rosecrans Avenue Suite 225 El Segundo, California tel fax

2 REPORT OVERVIEW Some Germane Big Picture Issues Foremost on our minds are current macroeconomic conditions and how they relate to opportunities amongst hedge strategies. Secondarily, we believe the state of the hedge fund industry is an issue worth addressing as well. Our macroeconomic outlook going forward is one of weak real GDP growth as the US economy attempts to de-lever its societal balance sheet. The problem with delevering, is our economy, and the developed world for that matter, is essentially debt driven. So as the growth of debt slows, so does subsequent GDP growth, leaving us with a secular backdrop of weak GDP growth. This has a very real tendency to make downside tail events more common and severe than usual, which is one of the reasons why tail risk hedging has become so popular recently. This leads us to another notable issue for hedge fund investors a popularity of tail risk hedging products and vehicles. With market volatility much higher since 28 and numerous unresolved global concerns, the cost of hedging tail risk has gotten expensive. Because there is ample reason to believe capital markets volatility will persist for some time and that financial system leverage will likely exacerbate this volatility, tail events to occur and hedging against them makes sense. The problem of course is how it s executed, either systematically or tactically, and those effects on expected returns over time. For example, using expensive hedging instruments to protect against downside on a low returning asset class doesn t make a lot of sense, that is if you systematically hold hedges. This is why any attempt at tail risk hedging needs to be done on a highly tactical basis to be of any use. We would remind everyone not to let the tail wag the dog, as there are bigger fish to fry out there. Such as taking a position on whether Treasury rates will rise, a decision which could have a far bigger impact on returns than most anything. And you can hedge against such an event by simply reducing market exposures. The final big picture issue we re seeing nowadays is what appears to be the hedge fund industry s transition from a growing to a maturing industry. Every industry has a lifecycle, with each stage having its own unique attributes. It just so happens the hedge fund industry appears to be entering the mature phase of its life. Institutional allocations can t go much higher, hedge returns are not compelling in recent years and shouldn t attract large inflows, and total industry AUM has got to be peaking as a percent of our economy. This is an important issue, because you don t want to be investing with firms caught up in the consolidation that usually accompanies industries in maturity. Our Views on Various Opportunities When setting return expectations for any investment style or strategy, analysis must begin with a valuation based framework that takes into account the associated opportunity set. Through this framework we can analyze most strategies relative attractiveness from a top down point of view. The easy areas to apply this logic are the ones in which formulas (or recipes) for strategies drive the bulk of returns. Convertible arbitrage is the poster child for this logic, and expected returns for this strategy set don t look good based on valuations. Merger arbitrage is actually looking pretty good as concerns over global finances have pushed M&A spreads higher. M&A activity is generally driven by cash on the balance sheet and low revenue (or GDP ) growth, meaning your outlook on opportunities should ve essentially remained unchanged in spite of August211 headlines. The long/short equity space is more difficult to dimension, but is definitely not well positioned for alpha going forward. We re seeing a rise in correlations amongst stocks, which is bad for alpha opportunities, leaving managers only two real choices in producing alpha. One is a more focused approach on finding alpha with sector specialists, but again, this won t do any appreciable good if correlations stay high. And correlations staying high for some time is probable given all the liquidity sloshing around capital markets. This leaves the last choice being that of using a risk on/risk off, or market timing approach. Works great as long as your crystal ball does too. There is a similar issue facing macro strategies. Discretionary macro traders need a vision of the future to make things work, which is increasingly more difficult as the world continues to roam in uncharted financial territories. Systematic traders need sustained trends to reap profit, not oscillating ones. And who thinks that with liquidity at peak levels it ll take markets long to price in anything, which is a separate issue from pricing in unforeseen news events as they occur. Relative value strategies are ultimately linked to risk free rates as any arbitrage or relative value calculation centers around the cost of capital. So watching returns trend lower from here seems very likely with cash rates at zero. Credit is one bright area of opportunity. A problem is the opportunity set may be diminishing in many areas, ultimately pushing prices up and prospective returns lower. Another issue is absolute returns for higher quality credits don t mix well with hedge fee structures; too low of baseline returns to justify fees. So all in all it s a mixed bag of tricks in hedge fund land. We must also remember there is no theoretical relationship between fees paid and alpha earned. 2

3 AN INDUSTRY IN TRANSITION MATURITY FROM GROWTH TO 2 There s this really interesting concept of industry life cycles that is usually reserved for the chalkboard, but is of great use in forming a top down view of hedge fund opportunities. What the theory discusses is how industries behave from an economic point of view during various life stages. Onecouldarguethehedgefundindustryisinthe mature portion of its life: declining revenue growth and profit margins, and ensuing industry consolidation. If you believe this a reasonable possibility, then mitigate business cycle risk by allocating to well established firms with diversified products and revenues. True alpha is hard enough to find as it is, let alone if you re worried about money. But keep in mind bearing individual business risk is a not systematically compensated pursuit. HFR Estimated Industry Assets as a % of Nominal GDP 1 1 Implied Returns & Public Fund Alternatives Allocations Average Public Pension Fund Allocation to Alternatives Implied Return of a 6/4 (S&P/Agg) Portfolio Linear (Implied Return of a 6/4 (S&P/Agg) Portfolio) Source: Barclays, Shiller, Public Fund Survey. Wurts 4 Alternatives were supposed to be the alternative to low public market returns. Could allocations of this size remain indefinitely? Sure, but are they going to keep rising from here in the face of higher potential returns in public markets? Hedge Fund Returns & Asset Flows 9% 1 9% 7% This data is rather interesting when you think about it. Unlevered assets pursuing the exploitation of capital markets inefficiencies is about 1/7 th of GDP With the exception of 27, returns seem to have a relationship with subsequent flows. Setting aside any industry life cycle issues, returns do not portend large asset inflows. 1 9% 11% 7% 7% 13% 1 1 3% 11% % Subsequent Annual Net Flows as % of Industry AUM (211 est) HFRI FOF Annual Return -21% Source: HFR, BEA, Wurts Source: HFR, Wurts 3

4 DON T LET THE TAIL WAG THE DOG Tail risk hedging is a recent investment fad, and not without good reason. If the economy continues to de-lever, the backdrop of GDP growth will weaken, which leads to more potential downside than upside The Relationship Between Societal Leverage & GDP This relationship didn t always exist, but it does now! The US economy is very sensitive to leverage. We can t keep growing debt at a faster pace than GDP forever. The relationship self corrects one way or another Protecting against market downturns is one thing, but it cannot be done on a cost agnostic basis. If you think about the cost of such protection from a macro context, you will find the cost thereof is at all time highs. A high cost of protecting an asset with modest expected returns is not a long term recipe for success. If tail hedging is done, it had better be tactical in nature to capture profits Don t fixate on short term hiccups in GDP expectations that we know will invariably err on the low side for some time. Instead focus on bigger issues, such as whether to plan on sustained low Treasury rates (or rising ones) Scenario Returns: 6/4 (S&P 5/BC Credit) Portfolio 4 2 Source: BEA, Fed, Wurts 25 Rolling 5 Year Growth in Total Domestic Debt (%) Rolling 5 Year Real GDP Growth (%) 3 Month Implied Volatility Skew on S&P If you think Treasury rates will stay low for a while and risk premiums will center around them as they should, then good days are ahead pretty much no matter what. But rising rates could change that easily. 2 This chart demonstrates implied volatility in puts is greater than calls, and by a wider margin than in a while. Also keep in mind implied volatility stands for implied cost. So the cost of downside hedging is at its highest levels too Year Return (%) 5 Year Return (%) Scenario analysis dimensions changes in implied equity and credit return premia to BC Treasury Index, separately and combined with changes in Treasury yields; last 2 years of monthly observations; as of Aug Implied Volatility Skew (9 strike put minus 11 strike call) Strong (Risk premium 2-tile) Base (Risk premium Weak (Risk premium 5-tile) 7-tile) Strong (Risk premium & Treas. Yield 2-tile) Base (Risk premium & Treas. Yield 5- tile) Weak (Risk premium & Treas. Yield 7- tile) Source: HFR, BEA, Wurts Source: Bloomberg 4

5 ALPHA OPPORTUNITIES IN THE LONG/SHORT EQUITY SPACE ARE DIMINISHING There are two primary reasons alpha is reputed as being random in nature. First, because it is. Second, because the conditions for its production are not constant over time. We know alpha is not constant and cannot be predicted with accuracy, but that doesn t mean we can t at least try to dimension the probabilities of achieving it. Pricing inefficiencies that don t exist cannot be exploited. When stocks start moving similarly to one another it is hard to find alpha because relative valuations are unchanged. During such times managers are left with few options, one of which is risk on/risk off (or market timing). The problem with this strategy is it s very dependent on the ability to foresee the short term future of markets. This is actually a pretty hard thing to do consistently. 135 Number of Daily Price Moves > 1. S&P 5 25 Cross Volatility & Sub. Equity Market Neutral Alpha Source: Russell, HFR, Wurts 8 This index basically measures the standard deviation of equity returns within the Russell universe. It s telling us alpha likes to grow in areas with high or stable volatility in stock returns. Russell CrossVol index Value (3 Month Average) Subsequent 1 Year Est. Alpha (%) for HFRI Equity Market Neutral S&P 5 1 Yr. Correlations & Equity Market Neutral Alpha Daily market volatility is actually about average the last twenty years. But this does not mean it can t go higher. Prospective market timing or trend following strategies may not be in the best hunting grounds with widely shifting markets Another broad measure of the equity opportunity set (correlations) indicates high correlations lead to low subsequent alpha. Alpha is likely headed lower from here Number of > 1. Price Moves Rolling 25 days Average 2 1 SPX Rolling 1 Year Average Realized Correlation Subsequent 1 Year Est. Alpha (%) for HFRI Equity Market Neutral Source: HFR, BEA, Wurts Source: HFR, Wurts 5

6 SO WHAT LOOKS GOOD ON THE MENU TODAY? (CONVERTIBLE & MERGER ARBITRAGE) The recipes for producing convertible and merger arbitrage returns are just that recipes. Instead of mixing milk and sugar, you blend things like deltas and gammas, and you try to produce more alpha than omega. But anyone can follow a recipe, and for all intents and purposes the strategy becomes a commoditized risk exposure. Sometimes it s cheap, other times it s expensive. Assets chase valuations and revenues go up/down, which may be why focused funds are less popular. Plus, any good multistrategy fund should be able to follow a recipe. Pricing is telling us convertible arbitrage is not looking so good, but that merger arbitrage returns are. Deal premiums have shot up given various macro concerns, but conditions for M&A activity remain conducive. Convert. Bond Cheapness & Sub. Convert. Arb. Returns 12 7% 3% 1% Source: Barclays, Shiller, Public Fund Survey. Wurts 5 History of Convert. & Merger Arb. as % of Industry AUM Notice how convertible and merger arbitrage strategies share of industry assets has not only declined, but stagnated. Convertible Arbitrage: Strategy AUM/Industry AUM Merger Arbitrage: Strategy AUM/Industry AUM M&A Deal Pricing and Sub. HFRI Merger Arb Returns When convertible bonds are cheap, returns are usually pretty good with the benefits of leverage. But pricing at these levels doesn t leads us to believe strong returns are in order soon The real factors driving M&A activity are high levels of cash on the balance sheet (unchanged by recent events) and low GDP growth prospects (lower now). Higher deal premiums may have shifted upwards for no underlying fundamental reason Discount to Theoretical Value Subsequent HFRI Convertible Arb. Return Average M&A Deal Premium Subsequent 1 Year HFRI Merger Arb Return - -1 Source: HFR, Bloomberg, Wurts Source: HFR, Bloomberg, Wurts 6

7 EVEN THE MORE ALPHA CENTRIC STRATEGIES HAVE THEIR LIMITATIONS (MACRO & RELATIVE VALUE) It is during times of economic and capital markets volatility that people turn to alpha because it s supposed to be uncorrelated to other market factors. This should be true because alpha is a random event. But even for alpha centric strategies (macro & relative value), capital markets constrain potential returns. Cheap capital is bad news for relative value, as a dearth of capital is more likely to create inefficiencies. We also have to keep in mind arbitrage returns should track risk free rates. Macro managers are often touted for their lack of correlation to markets and downside protection. Returns do appear to offer protection during market downturns. But with global liquidity at record levels, the chances of sustained market downturns are not that high; economic cycles should be quicker given all the money sloshing around. 5 Relative Value Returns & Risk Free Yields (1) (2) Prime Rates & Sub. Macro & Relative Value Returns Borrowing rates seem to have a relationship with macro and relative value returns. The more expensive capital is, the less people can afford to use it, which in turn loosens the grasp of market efficiency. HFRI Macro (Total): Subsequent 1 Yr.% Return HFRI Relative Value: Subsequent 1 Yr. % Return 12 Month Average Prime (%) Source: Barclays, Shiller, Public Fund Survey. Wurts HFRI Macro (Systematic) vs. Market Trends (DJ UBS) (2.5) 4 3 When considering any arbitrage or relative value opportunity, the cost of capital always comes into the equation, literally. That s why returns track the risk free rate over time. 1 Do macro managers protect during downward trends? Yes. But with all the liquidity sloshing around the world, what are the chances it ll take capital markets a quarter to price in any economic event, let alone longer HFRI Relative Value Trailing 1 Yr. Return 12 Month Avg.: 1 Year Treasury Note -2 Source: HFR, Fed, Wurts 4.1% % % % % Positive Trend Negative Trend No Trend 2 Month Trend 3 Month Trend 4 Month Trend 5 Month Trend 6 Month Trend Duration of Trend (+/-) Source: HFR, Wurts 7

8 GOOD OPPORTUNITIES IN CREDIT, BUT NO DOUBLE-DIGIT RETURNS WITHOUT RISK LIBOR Spread (basis points) With credit spreads of all types at very high levels, it seems a no brainer to pursue strategies in this area. One catch though, any sort of reasonable credit risk is not providing much more than single digit returns with cash at zero; higher rates for lower credit quality abound though. The problem is most people are pretty averse to taking large amounts of credit risk after 28. So to get double digit returns while avoiding it, leverage will be required. So take your pick. Go up the risk spectrum or use leverage to magnify returns. Keep in mind leverage generally interacts best with lower volatility instruments. This is why if leverage is the choice, it s best to lever higher quality assets as opposed to swinging for a home run and trying for both at the same time (high risk and leverage). 3, 2,5 2, 1,5 1, 5 Spreads to Maturity for Various Debt Instruments This chart only shows yields for higher credit quality issues. We d otherwise show a series of lower quality issues as well, but the two sets of numbers are too different to fit on the same chart. First Lien BBB- Middle Market Large Corporate 25 High Yield Spreads to Treas. & 1 Year Sub. Defaults Source: Barclays, Wurts 9% 7% 3% Interestingly, the market seems to provide a pretty consistent premium for bearing credit risk (~3%) and it s a bit above average now. Credit risk seems to be well compensated given defaults. Subsequent 1 Year Default Rate: Net of 3 Recovery Spread: BC High Yield - BC Treasury Bank Loan Spreads to LIBOR Bank loans spreads to LIBOR are at very attractive levels. The question you have to ask yourself is whether recent events really warrant a higher premium. Or, if not, then this is an opportunity to pick up extra return for relatively unchanged secular economic risks. Source: GreyWolf Source: Highland Capital Mgmt., Wurts 8

9 AND DON T FORGET LESS SUPPLY & MORE DEMAND EQUAL HIGHER PRICES, LOWER RETURNS The opportunities to earn large spreads to risk free rates are pretty tremendous in this environment. But what about going forward. Will the opportunities persist? One way to analyze this would be to think about supply and demand conditions. We could argue there will be greater demand for credit in a low return and high liquidity landscape. It also appears our supply of high yielding debt is on the decline. Non-agency RMBS is withering away, the volume of defaulted debt has fallen off the map, and LBO s and resulting securitizations are but a fraction of recent levels. $3, $2,5 $2, $1,5 $1, $5 Supply of Non-Agency RMBS ($BB's) As it stands with the mortgage market dominated by Agency issues, residential mortgages are a quickly dwindling opportunity set. Prime Alt-A Subprime So what happens when demand goes up and supply goes down. Prices go up and expected returns decline. So you might want to get while the getting's good. 5 Moody's Corp. Bond & Loan Default Volumes ($BB's) $ Source: Vichara, Loan Performance, Doubleline 225 Leveraged Buyout Volume & Number of Deals 4 3 The real trick with distressed managers is finding companies entering into distress. That s not happening so much nowadays by Moody s data, which is bad for current and future investors The levered buyout craze got stopped dead in its tracks by the fall of the CLO market. Activity is picking up and the opportunity set may expand, which would be welcomed by credit managers LBO Volume ($BB's Number of Deals Source: Moody s Source: Bloomberg 9

10 SUMMARY OF CONCLUSIONS Merger Arbitrage Convertible Arbitrage Hedged Equity Market Neutral Relative Value Global Macro (Trend Followers) Credit Valuations/Pricing Normal to attractive Not looking cheap Equities valued for mid single-digit returns Cash rates are near zero and should drive returns lower Not really material as these are alpha strategies, not an asset class or defined opportunity set. Spreads are very wide, absolute returns are low outside of riskier instruments Overarching Strategy Considerations Economic uncertainty is likely to keep spreads high, perhaps a legitimate mispricing over the near term More and more dominated by multi-strats as dedicated strategies decline Stock correlations are high and tail hedging is getting expensive for equities Large amounts of liquidity lead to fewer inefficiencies to be exploited Economic uncertainty and liquidity portend quick Either embrace high levels capital markets reactions to of risk or leverage to justify new events, not sustained fees trends Manager Alpha Conditions Formulaic - limited true alpha Formulaic - limited true alpha The potential for true security selection alpha is diminished Declining due to liquidity and low borrowing rates Not good in strongly oscillating markets Very good given the variety of instruments and associated credit spreads Outlook Positive Negative Negative Neutral Negative Positive 1