Although there have been some optimistic views voiced recently about how long the credit crisis will last, the uncertainty surrounding global markets is showing no signs of abating. This has shifted the focus of wealth managers to questions like how to survive current trading conditions, how to preserve what is invested, and which strategies will keep bringing in profit, despite tighter financing and weaker equities?
The wealth management industry is now taking a closer look at managers of funds and is beginning to ask which ones will be able to continue bringing in good returns.
Unlike managers who were just riding the bull market, managers who will be able to make positive returns during a down cycle will typically be nimble enough to move from strategy to strategy at fairly short notice rather than sticking to one or very few trading strategies. According to UBP, this is not a set of skills that can be found very frequently.
“Exceptional skills”
“A manager in these times requires exceptional skills. That’s generally the case in every environment but it becomes imperative in a challenging environment,” says UBP Alternative Investments’ Senior Portfolio Manager, Shoaib Khan.
UBP is one of the major Swiss asset management banks for private and institutional clients and a world leader in alternative investments. UBP describes itself as a cautious investor and prefers funds that can capture small arbitrage opportunities, rather than large ups and downs. Over a longer period this tends to add more value than highly volatile players.
“We’ve all seen the hedge fund industry change over the years. It is not a good position to be with a fund that’s going to get a 40% return, and then give up that 40% return a month or two later,” says Khan.
The fundamentals that have created current uncertainties in the markets are not temporary or short-term in nature, but at the same time this type of economic and trading environment is creating profit opportunities for seasoned managers.
UBP’s Khan says that although investors tend to enter a ‘fear mode’ when markets around them move in one direction, “We’re in a mode of delicate balance where we are preserving capital and shifting exposures, positioning ourselves in recognition of this uncertainty.”
What stands out, despite the bearish mode of the market, is that hedge fund performance overall is still above traditional asset classes or traditional indices over the long term. The one exception are emerging markets indices, mainly because of China and India, but this kind of investment carries a different risk return profile to other funds.
Hedge funds have mostly withstood recent downturns. While there are draw-downs, hedge funds overall preserve capital relatively well and provide a decent risk-reward profile for investors. They still need to be aware, however, that despite the theory of hedge fund trading decoupling from the direction of traditional long-only investment, the correlation remains fairly high.
A look at the strategies
Two significant areas which have thrown up opportunities recently are currencies and commodities. Fixed income had patchy results recently, with some managers being less than successful. Volatility trading and emerging markets are two other areas that will provide opportunities for value creation.
Global macro managers are well positioned to exploit current opportunities, particularly trade-oriented managers with a number of years of experience, capable of thinking out of the box and shifting from one sub-strategy to another.
A number of global macro managers tend to have a directional view on commodities but Khan says that, while UBP is bullish on commodities, opportunities will not only present themselves in one simple direction but also on the relative value side within the commodities space.
Fixed income can fall into directional decisions or the relative value space, but requires careful handling in both cases. “We have seen fixed income curve trades played out relatively well in some instance and not so well in others. A number of funds are in trouble because they’ve had a contrarian view but have not been able to hold onto positions long enough and have seen redemptions,” adds Khan.
Volatility, again, will provide good opportunities as it falls into both the relative value and global macro trading categories. One could argue that volatility has spiked up and come down - why would anyone want to be buying long volatility at this point? However, both good options traders and global macro managers currently exploit this space and add a lot of value.
Volatility arbitrage is proving a good strategy. Looking at the last 12 months, volatility has risen significantly and may now be expensive but UBP says that, while it has no firm view on whether volatility will go up or down, it expects that there will be a lot of movement in the market going forward and that nimble fund managers will be able to capture that volatility. UBP positioned itself in this market early and, given that this strategy has produced some good results, may potentially expand it in the future.
In emerging markets, a fund needs a strong presence on the ground and a very good understanding of the region. At this stage there is only a handful of such funds that are attractive on this basis. Typically, emerging market funds rely heavily on beta returns, or returns in line with the overall market. However, managers in this space need to be able to not just capitalise on the beta, but look across the market and structure the fund’s portfolio in such a way that there is some downside protection.
“Emerging markets are typically long buyers’ strategies. With that sort of strategy, managers could lose the beta very quickly and very sharply, which has been seen over and over again,” says Khan. “To us, that’s not an attractive proposition.” Instead, it is being able to hedge, or think differently about acquiring exposure to that region, that works.
When it comes to currencies, there is no consensus at present as to which direction they are moving. While some houses have positioned themselves for a dollar rally, and have being going long on the dollar and short on other G7 currencies recently, that scenario has yet to play out fully. Global macro funds are best positioned to gain from currencies as they are already very attuned to currency moves. They should be able to take either of these positions and make money on both sides of the trade.
Another strategy UBP is looking at is relative value. This strategy adds value from a risk perspective because it concentrates on arbitrage opportunities and thus decreases risk. “We are mindful of correlation, we are mindful of beta risk out there, which is why relative value is attractive for us,” explains Khan.
However, on a cautionary note, Khan thinks not every sub-strategy within relative value is currently attractive, convertible arbitrage being one of them. Convertible arbitrage is a combination strategy between credit and options on equities. Given how equity markets have been behaving, financing has become less available. Investment banks, and banks in general, are reluctant to provide financing, which is already resulting in a higher issuance of convertible bonds. While this is attractive from a liquidity perspective there is less of a case for this type of strategy from an implied volatility point of view, or from a cheapness perspective as the market is already at fair value. UBP has some exposure to convertible arbitrage but is cautious about adding more, at least until the market starts showing signs of a turnaround.
Distressed investment opportunities
However, of particular interest to UBP right now is the distressed sector. Jan Frogg’s view it that the opportunities in the dislocated credit market and distressed strategies will be second to none. The market has arrived at an entry point for a three to five year distressed cycle which investors can capitalise on. To this end, UBP is launching a specialist distressed fund of funds which includes the option to invest in both underlying hedge funds and private equity managers who specialise in distressed opportunities (see below).
UBP estimates that there has been a significant increase in the number of new issues rated B- and below, and in the size of both the high-yield bond market and the leveraged loan market, to the point that today the leveraged loan market is larger than the market for high yield bonds.
CLO (collateralised loan obligation) and CDO (collateralised debt obligation) funds which have been natural buyers of loans are no longer on the buy side, creating valuation declines. The maturity schedule of outstanding below-investment-grade U.S. debt indicates that an increasing amount will reach maturity between 2008 and 2013. Default rates are currently at very low levels but are expected to increase and so create a supply of attractive investment opportunities. The structured credit market is also in turmoil, resulting in additional investment opportunities.
According to UBP’s Shoaib Khan, “we have just gone through a boring period in credit and we think we are looking at the next period which is going to be exciting, because default rates are going to increase, and there’s going to be a bigger supply of paper. And, this time around, it’s going to be a different opportunity, because there are more types of securities in the market place, CDSs are more commonly used, and LCDXs (loan credit default swaps) are out there”.
On the U.S. mortgage market, Khan says that not only are subprime delinquencies still on the rise, but so are defaults on prime mortgages. There is a contagious element to subprime defaults in communities and neighbourhoods, he says. “If there is a house next to you that’s financed through sub-prime, the prime borrowers are also going to be reluctant to keep making those payments because of significant valuation declines and it’s an incentive to walk away.” For investors, this represents a shorting opportunity, with some funds making significant profits in this area. However it will also represent selective long opportunities.
Alt-A mortgages are another example of an area within housing that will be attractive. Additionally the levels of revolving consumer debt, already high, have recently increased and that doesn’t point to a recovery any time soon. Data on credit card defaults is pointing in the same direction, steadily rising. The CLO market has had a massive run year after year, but effectively topped out in 2007. Natural buyers of these loans are no longer there, and this will impact valuations and create good selective buying opportunities.
A question of financing
UBP considers itself as a cautious investor and as such will likely avoid highly volatile funds. Fixed income relative value funds fall into that category. This is a strategy that is supposed to hold up well in a difficult environment because it is part relative value, part fixed income arbitrage, but it has proved more volatile than it should have been. The main problem managers of these funds are facing is frozen financing lines. “Where we’ve seen the pain within fixed income arbitrage has been with funds that have a huge amount of leverage,” says Khan. And while leverage is part and parcel of a fixed income arbitrage strategy, the bank has tended to be cautious of it, particularly because investment banks are not out of the woods yet and will continue to be conservative with financing.
This is why UBP’s Research Team and the Structural Risk Management Team (the team that investigates all risks unrelated to investments and has a right of veto in the selection of a fund on the UBP list of approved funds) had a very close look at all the funds in the Bank’s portfolio to establish if they have good financing lines in position. It checked prime brokerage agreements, terms of financing agreements, and checked to see if those agreements can be recalled.
This type of check is normally performed once a year, but given the current situation in the markets, UBP decided not to wait but rather to acquire a quick snapshot of the situation. It wanted to scrutinise the agreements underlying funds had negotiated with prime brokers, and assess how these agreements affected risk profiles.
UBP subsequently reduced exposure to those funds in which it saw potential risk because they had not been sufficiently active in negotiating their financing. The reduction was focused primarily on multi-strategy funds, and some parts of the fixed income space. Khan estimates that UBP has moved 5% to 6% “out of the strategy bucket” and into other funds.
“We’ve been pleasantly surprised by the funds within our suite and how they’re positioned in terms of financing and in terms of leverage,” says Khan. He credits the due diligence done in early stages with giving UBP a good idea about the funds and their leverage/liquidity procedures, but he adds that UBP remains in “constant dialogue” with these managers. It is better to be safe than sorry.
With some of those funds “at the end, there may be no problems at all, but we’d rather just have less exposure, or no exposure, to those funds, than be on the riskier side,” says Khan.
UBP has reduced exposure to some multi-strategy funds, which in the past reaped the benefits of a strong M&A environment and event-driven trades. Now that the volume of mergers and acquisitions has declined, UBP is focusing on those funds that are strong in credit and able to trade around relative value and other strategies.
It also reduced exposure to long/short equity, particularly in funds that were less focused on exposure management.
UBP also addressed the adequacy between the liquidity of the underlying portfolio and the liquidity terms funds were offering to their own investors, trying to make sure that if some investors decided to pull their money out and triggered a snowball effect, the fund would be able to withstand it. No investor wants to be last in the queue.
The wealth management industry is now taking a closer look at managers of funds and is beginning to ask which ones will be able to continue bringing in good returns.
Unlike managers who were just riding the bull market, managers who will be able to make positive returns during a down cycle will typically be nimble enough to move from strategy to strategy at fairly short notice rather than sticking to one or very few trading strategies. According to UBP, this is not a set of skills that can be found very frequently.
“Exceptional skills”
“A manager in these times requires exceptional skills. That’s generally the case in every environment but it becomes imperative in a challenging environment,” says UBP Alternative Investments’ Senior Portfolio Manager, Shoaib Khan.
UBP is one of the major Swiss asset management banks for private and institutional clients and a world leader in alternative investments. UBP describes itself as a cautious investor and prefers funds that can capture small arbitrage opportunities, rather than large ups and downs. Over a longer period this tends to add more value than highly volatile players.
“We’ve all seen the hedge fund industry change over the years. It is not a good position to be with a fund that’s going to get a 40% return, and then give up that 40% return a month or two later,” says Khan.
The fundamentals that have created current uncertainties in the markets are not temporary or short-term in nature, but at the same time this type of economic and trading environment is creating profit opportunities for seasoned managers.
UBP’s Khan says that although investors tend to enter a ‘fear mode’ when markets around them move in one direction, “We’re in a mode of delicate balance where we are preserving capital and shifting exposures, positioning ourselves in recognition of this uncertainty.”
What stands out, despite the bearish mode of the market, is that hedge fund performance overall is still above traditional asset classes or traditional indices over the long term. The one exception are emerging markets indices, mainly because of China and India, but this kind of investment carries a different risk return profile to other funds.
Hedge funds have mostly withstood recent downturns. While there are draw-downs, hedge funds overall preserve capital relatively well and provide a decent risk-reward profile for investors. They still need to be aware, however, that despite the theory of hedge fund trading decoupling from the direction of traditional long-only investment, the correlation remains fairly high.
A look at the strategies
Two significant areas which have thrown up opportunities recently are currencies and commodities. Fixed income had patchy results recently, with some managers being less than successful. Volatility trading and emerging markets are two other areas that will provide opportunities for value creation.
Global macro managers are well positioned to exploit current opportunities, particularly trade-oriented managers with a number of years of experience, capable of thinking out of the box and shifting from one sub-strategy to another.
A number of global macro managers tend to have a directional view on commodities but Khan says that, while UBP is bullish on commodities, opportunities will not only present themselves in one simple direction but also on the relative value side within the commodities space.
Fixed income can fall into directional decisions or the relative value space, but requires careful handling in both cases. “We have seen fixed income curve trades played out relatively well in some instance and not so well in others. A number of funds are in trouble because they’ve had a contrarian view but have not been able to hold onto positions long enough and have seen redemptions,” adds Khan.
Volatility, again, will provide good opportunities as it falls into both the relative value and global macro trading categories. One could argue that volatility has spiked up and come down - why would anyone want to be buying long volatility at this point? However, both good options traders and global macro managers currently exploit this space and add a lot of value.
Volatility arbitrage is proving a good strategy. Looking at the last 12 months, volatility has risen significantly and may now be expensive but UBP says that, while it has no firm view on whether volatility will go up or down, it expects that there will be a lot of movement in the market going forward and that nimble fund managers will be able to capture that volatility. UBP positioned itself in this market early and, given that this strategy has produced some good results, may potentially expand it in the future.
In emerging markets, a fund needs a strong presence on the ground and a very good understanding of the region. At this stage there is only a handful of such funds that are attractive on this basis. Typically, emerging market funds rely heavily on beta returns, or returns in line with the overall market. However, managers in this space need to be able to not just capitalise on the beta, but look across the market and structure the fund’s portfolio in such a way that there is some downside protection.
“Emerging markets are typically long buyers’ strategies. With that sort of strategy, managers could lose the beta very quickly and very sharply, which has been seen over and over again,” says Khan. “To us, that’s not an attractive proposition.” Instead, it is being able to hedge, or think differently about acquiring exposure to that region, that works.
When it comes to currencies, there is no consensus at present as to which direction they are moving. While some houses have positioned themselves for a dollar rally, and have being going long on the dollar and short on other G7 currencies recently, that scenario has yet to play out fully. Global macro funds are best positioned to gain from currencies as they are already very attuned to currency moves. They should be able to take either of these positions and make money on both sides of the trade.
Another strategy UBP is looking at is relative value. This strategy adds value from a risk perspective because it concentrates on arbitrage opportunities and thus decreases risk. “We are mindful of correlation, we are mindful of beta risk out there, which is why relative value is attractive for us,” explains Khan.
However, on a cautionary note, Khan thinks not every sub-strategy within relative value is currently attractive, convertible arbitrage being one of them. Convertible arbitrage is a combination strategy between credit and options on equities. Given how equity markets have been behaving, financing has become less available. Investment banks, and banks in general, are reluctant to provide financing, which is already resulting in a higher issuance of convertible bonds. While this is attractive from a liquidity perspective there is less of a case for this type of strategy from an implied volatility point of view, or from a cheapness perspective as the market is already at fair value. UBP has some exposure to convertible arbitrage but is cautious about adding more, at least until the market starts showing signs of a turnaround.
Distressed investment opportunities
However, of particular interest to UBP right now is the distressed sector. Jan Frogg’s view it that the opportunities in the dislocated credit market and distressed strategies will be second to none. The market has arrived at an entry point for a three to five year distressed cycle which investors can capitalise on. To this end, UBP is launching a specialist distressed fund of funds which includes the option to invest in both underlying hedge funds and private equity managers who specialise in distressed opportunities (see below).
UBP estimates that there has been a significant increase in the number of new issues rated B- and below, and in the size of both the high-yield bond market and the leveraged loan market, to the point that today the leveraged loan market is larger than the market for high yield bonds.
CLO (collateralised loan obligation) and CDO (collateralised debt obligation) funds which have been natural buyers of loans are no longer on the buy side, creating valuation declines. The maturity schedule of outstanding below-investment-grade U.S. debt indicates that an increasing amount will reach maturity between 2008 and 2013. Default rates are currently at very low levels but are expected to increase and so create a supply of attractive investment opportunities. The structured credit market is also in turmoil, resulting in additional investment opportunities.
According to UBP’s Shoaib Khan, “we have just gone through a boring period in credit and we think we are looking at the next period which is going to be exciting, because default rates are going to increase, and there’s going to be a bigger supply of paper. And, this time around, it’s going to be a different opportunity, because there are more types of securities in the market place, CDSs are more commonly used, and LCDXs (loan credit default swaps) are out there”.
On the U.S. mortgage market, Khan says that not only are subprime delinquencies still on the rise, but so are defaults on prime mortgages. There is a contagious element to subprime defaults in communities and neighbourhoods, he says. “If there is a house next to you that’s financed through sub-prime, the prime borrowers are also going to be reluctant to keep making those payments because of significant valuation declines and it’s an incentive to walk away.” For investors, this represents a shorting opportunity, with some funds making significant profits in this area. However it will also represent selective long opportunities.
Alt-A mortgages are another example of an area within housing that will be attractive. Additionally the levels of revolving consumer debt, already high, have recently increased and that doesn’t point to a recovery any time soon. Data on credit card defaults is pointing in the same direction, steadily rising. The CLO market has had a massive run year after year, but effectively topped out in 2007. Natural buyers of these loans are no longer there, and this will impact valuations and create good selective buying opportunities.
A question of financing
UBP considers itself as a cautious investor and as such will likely avoid highly volatile funds. Fixed income relative value funds fall into that category. This is a strategy that is supposed to hold up well in a difficult environment because it is part relative value, part fixed income arbitrage, but it has proved more volatile than it should have been. The main problem managers of these funds are facing is frozen financing lines. “Where we’ve seen the pain within fixed income arbitrage has been with funds that have a huge amount of leverage,” says Khan. And while leverage is part and parcel of a fixed income arbitrage strategy, the bank has tended to be cautious of it, particularly because investment banks are not out of the woods yet and will continue to be conservative with financing.
This is why UBP’s Research Team and the Structural Risk Management Team (the team that investigates all risks unrelated to investments and has a right of veto in the selection of a fund on the UBP list of approved funds) had a very close look at all the funds in the Bank’s portfolio to establish if they have good financing lines in position. It checked prime brokerage agreements, terms of financing agreements, and checked to see if those agreements can be recalled.
This type of check is normally performed once a year, but given the current situation in the markets, UBP decided not to wait but rather to acquire a quick snapshot of the situation. It wanted to scrutinise the agreements underlying funds had negotiated with prime brokers, and assess how these agreements affected risk profiles.
UBP subsequently reduced exposure to those funds in which it saw potential risk because they had not been sufficiently active in negotiating their financing. The reduction was focused primarily on multi-strategy funds, and some parts of the fixed income space. Khan estimates that UBP has moved 5% to 6% “out of the strategy bucket” and into other funds.
“We’ve been pleasantly surprised by the funds within our suite and how they’re positioned in terms of financing and in terms of leverage,” says Khan. He credits the due diligence done in early stages with giving UBP a good idea about the funds and their leverage/liquidity procedures, but he adds that UBP remains in “constant dialogue” with these managers. It is better to be safe than sorry.
With some of those funds “at the end, there may be no problems at all, but we’d rather just have less exposure, or no exposure, to those funds, than be on the riskier side,” says Khan.
UBP has reduced exposure to some multi-strategy funds, which in the past reaped the benefits of a strong M&A environment and event-driven trades. Now that the volume of mergers and acquisitions has declined, UBP is focusing on those funds that are strong in credit and able to trade around relative value and other strategies.
It also reduced exposure to long/short equity, particularly in funds that were less focused on exposure management.
UBP also addressed the adequacy between the liquidity of the underlying portfolio and the liquidity terms funds were offering to their own investors, trying to make sure that if some investors decided to pull their money out and triggered a snowball effect, the fund would be able to withstand it. No investor wants to be last in the queue.
