The inefficient frontier

If you believe everything you read and heard in the media about the financial crisis, you would think hedge funds are responsible for the mess we currently find ourselves in. This is a myth that needs to be dispelled. When we examine what is occurring in the hedge fund industry, the truth is that we are likely headed into a golden period for hedge funds.

In the case of funds of funds, hedge funds on average significantly outperformed all global stock indices with considerably less volatility during 2008 and early 2009. These positive attributes are not reflected in the criticism hedge funds have received in the wake of the market turmoil.

Much has been made of the $2 trillion size of the hedge fund industry in 2008 (before redemptions began) and its resultant clout. This is simply wrong—there are at least five investment management firms which singly manage that sum of assets and there are at least 8,000 hedge funds. Compared to the $21.8 trillion in the global mutual fund industry, hedge fund assets are paltry.

Many believe hedge fund selling drove down markets. This generally involves two transactions—selling the long positions and buying back the short positions. Take convertible arbitrage for example. The unwind means repurchasing the stock and selling the convertible bond. Downward pressure on markets is minimal.

Many regulators, spurred on by uninformed politicians (who were lobbied by banks), banned short selling in total or at least for financial stocks. This exercise proved futile. Stocks fell further and more quickly after short selling was curtailed. No academic study has found that short selling is destructive. Indeed, they conclude that the activity improves the efficiency of markets by narrowing the bid/ask spread and increasing liquidity. So how did hedge funds fare during the crisis? And in what ways will they surprise us in the future?

Hedge fund surprise Probably the biggest surprise has been the inability of the business to provide ‘absolute returns.’ It will take some time for the average fund to recover its losses: the average fund of funds lost 18%. Claims of providing absolute returns will likely be excised from most marketing material. With the carnage in equity markets, many investors sought liquidity from all available sources in their portfolios. Hedge funds and funds of funds received waves of redemption orders as everyone simultaneously headed for the fire exits. Hedge fund managers, trying to control the panic and the potential adjacency risk, invoked gates to create an orderly flow of redemptions. These were not well received, especially when the managers insisted on continuing to charge fees on the funds they would not return. Problems became evident in funds of funds because of the liquidity mismatches between the fund of funds and its constituent funds. Other concerns surround the structure and size of fees and, like the lock-up question, there are no clear answers.

There have been calls for longer lock-ups but these do not solve any problems. Instead, they shift the problem into the future. Investors queuing up to redeem from a fund to prevent adjacency risk often create problems if they are planning to move their assets to another similar fund. They give up the high-water mark right and go into a fund that immediately exposes them to higher fees because they have essentially reset the high-water mark.

Managed accounts Up until now, the main access point for a hedge fund or fund of funds investor was through the manager’s commingled flagship fund. For the institutional investor the problem was the inherent lack of transparency and the lack of control over its own investment—even to cash out. Managed accounts solve both of these problems.

A managed account is owned or sponsored by an entity that is independent of the hedge fund manager. They are generally established as a clone of the manager’s flagship fund. The manager’s only role is as sub-advisor to the managed account. The sponsor of the account establishes who will provide middle and back office services, prime brokerage functions and custody of assets.

The sponsor of the account receives all the ongoing trade information from the sub-advisor and the custodian. Generally they have established comprehensive investment guidelines. Each transaction must comply with the guidelines or it is reversed.

At the same time, many institutional investors are currently concerned about how to position their portfolios going forward. Many have deferred their rebalancing activities until some clarity emerges as to when the economy will begin to recover. With markets in disarray and their direction unknown, a massive amount of inefficient pricing has crept in. This is a result of liquidity seekers indiscriminately selling their portfolios. One thing we know for sure is that pricing inefficiency represents an investment opportunity.

Future inefficient Let’s distinguish the active and passive opportunities as alpha and beta respectively. Alpha is the return earned from exploiting mispricing opportunities and beta is the return from exposure to markets. The return earned in a typical long-only equity portfolio is almost entirely derived from beta exposure. A small measure of the return would be alpha. This suggests that return seekers have no certainty that beta bets will pay off in the near term. The probabilities are much higher that pricing inefficiencies will correct before markets themselves begin any sustained upward advance. Hedge funds are the only group that can take advantage of pricing inefficiencies in any meaningful way and make money.

For example, the worst performing hedge fund strategy in 2008 was convertible arbitrage, down about 50%. The best performing strategy in the first quarter of 2009 was convertible arbitrage, up 12% to 25% depending on the database being referenced. The converse is managed futures, up 10% to 20% in 2008 and slightly down in the first quarter of 2009.

What makes this even more compelling is that there has been a significant withdrawal of retail investment assets from the hedge fund industry, freeing up enormous capacity. Once crowded trades are now vacant and, more compelling, alpha opportunities are now sufficiently large so that leverage will be unnecessary to exploit them profitably.

Low correlation How can investors take advantage of this shift? First, think of hedge funds as an asset class competing with other asset classes in operating a diverse portfolio. Their low correlation, low volatility and Libor+ returns make them attractive. Institutional investors often carve out some portion of their equity or bond (or both) exposures and allocate it to hedge funds. For example, taking 5% from equity, 5% from bonds and allocating to a fund of funds is a common implementation construct. Second, think of hedge funds as a strategic investment in a purely actively managed sense: portable alpha. Here, hedge funds need to be added to a beta source, often long bonds where exposure is gained through a swap.

Hedge funds are one of the few places an investor has a reasonable chance of consistent positive returns over the near and medium terms. And, through the use of managed accounts, institutional investors now have a means to implement hedge fund strategies in a manner consistent with their fiduciary comfort level.

Tristram Lett is managing director and partner, Alpha Beta Strategies, Integra Capital Management.

(07/20/09)