Commentary

Man FRM Early View

When does an increase in the price of an asset reflect a change in value, and when is it simply borrowing the return from the future? Did we really earn it or will we have to give it all back later? When are we assessing our reaction to profits rationally and when are we suffering from hubris? These are increasingly queasy questions. If the USD 70trn of global equities are up 15% this year, then in equities alone we have seen a repricing of asset values by around USD 10trn, or around three years’ worth of real global GDP growth. Was this earned or borrowed?

Of course, we know our colleagues in the asset management industry are mostly heroic, but the idea that we have somehow unearthed an extra three years of global GDP growth is something the pusillanimous world outside is struggling to appreciate. Last month, one highly credible asset management research group showed their ten year forecast for a ‘balanced portfolio’ to be lower than any they had ever previously seen. This may suggest that at least some of the gain is ‘borrowed’.

Returns have come fairly easy to most long-only investors this year. The S&P 500 has gained 17% or so with a couple of c3% drawdowns. Compare that with 2016 when a 13% drawdown was rewarded with a 9% return, or 2015 when you had a worst loss of 10% and a loss on the year. Meanwhile, the Barclays Capital Global Aggregate Bond Index has returned +7% YTD, the best year since 2007. That can’t all be coupon payments, so given USD 40trn-odd worth of global bond assets, perhaps we found something closer to four years’ worth of real global GDP growth in long-only asset revaluation this year. This is exhilarating stuff.

What’s New In Washington

December is often the busiest time in Washington, and this year is no different as Congress races toward the holiday finish line. There is still a multitude of problems to solve before members can head back to their districts, with the two most pressing issues being tax reform and funding the federal government beyond December 22.

On December 5 and 6, the House and Senate, respectively, each voted officially to begin conference negotiations on the Tax Cuts and Jobs Act of 2017 (TCJA). However, there are a number of key differences between the two chambers’ proposals that need to be resolved related to the corporate tax rate, individual tax brackets and rates, whether to keep the alternative minimum tax and how to provide tax relief to pass-through entities, to name a few.

All of this must be achieved while remaining under the $1.5 trillion reconciliation instruction established as part of the Fiscal Year 2018 budget resolution. President Trump has been urging Congress to get a tax bill on his desk before Christmas, and the pressure is especially high in the wake of Republicans’ failure to repeal and replace Obamacare.

While Congress managed to pass a stopgap funding measure yesterday to avoid a government shutdown, it will last for only two weeks, leaving a December 22 deadline for a budget cap deal and a number of expiring programs looming on the horizon before the holidays. It is not entirely clear whether Democrats in the minority or frustrated conservatives might thwart or delay a year-end package by using this must-pass deadline as leverage on other pressing matters, such as the Deferred Action for Childhood Arrivals (DACA).

Here are a few things that we believe are worth focusing on since our last issue.

Demise of the Caliphate

Iraqi government forces and their allies have inflicted near-terminal blows to the military capacity and territorial ambitions of the so-called Islamic State (Daesh) in Iraq. Meanwhile, the Kurdishled Syrian Democratic Forces (SDF) are set to oust jihadist units from Raqqa, and elsewhere in Syria, Daesh is in retreat, suffering humiliating reverses, losing forces, materiel and territory. However, military campaigns in the central Middle East will have a far more limited effect on the threat that Daesh’s strain of radical political Islam poses more widely across the region. Just as Daesh’s capacity is crushed in the Euphrates Valley, its offshoots and those of its ideological fellow travelers, particularly in the form of its parent organization Al Qaeda and its franchises, continue to attract followers, stoking risks across the Middle East and North Africa (MENA). While the jihadist message appeals only to a minority of the region’s population, it will continue to fester as symptom of the government incompetence, corruption and violence across the region.

In economic terms, these government failures have had a repellent effect on inward investment, at least outside the hydrocarbons sector. Obstacles to direct investors stemming from skill deficits in, for example, GCC populations, regulatory hurdles and protectionism exacerbate economic weakness and foster a cycle of economic underperformance. Against this background, the additional risk of terrorist violence exacerbates macro-economic risks and deters FDI.

Shareholder Activism Knows No Bounds

US activist hedge fund managers are targeting the world’s largest listed companies, such as Procter & Gamble (P&G), which has a market capitalisation in excess of $200 billion. Schulte Roth & Zabel’s (SRZ) leading shareholder activism lawyers are advising those managers, including Trian Partners, Elliott Management, Greenlight Capital and JANA Partners. Among numerous campaigns in the past year, SRZ advised Trian Partners in its campaign at P&G, the largest company to ever be the subject of a proxy contest.

‘We expect activists will continue going after large caps and mega caps’, says SRZ partner Marc Weingarten, co-chair of the firm’s global Shareholder Activism Group. ‘Their fund sizes are now so large that in order to move the needle, they have to go after large- or mega-cap stocks. They cannot invest enough in small- and mid-cap stocks. Indeed, Elliott runs $34 billion, Trian Partners $13 billion, Pershing Square $12 billion, and JANA Partners $7 billion.

The size constraint is heightened by activists’ tendency to run concentrated, high-conviction portfolios with hefty positions. For instance, Trian had around $3.5 billion, or near 25 percent of its assets, invested in P&G. It became the company’s sixth largest shareholder with a 1.5-percent stake. The return to activists targeting large-caps was among the many current trends discussed at SRZ’s 8th Annual Shareholder Activism Conference in October 2017. The event was held in New York.

If some campaigns have not (yet) obtained their stated objectives, some proxy votes have been so unbelievably close that Weingarten expects ‘both activists, and companies, will be emboldened to fight harder’. For instance, in the P&G case, Nelson Peltz won 973 million votes, or 48.6 percent, against the 979 million, or 48.9 percent, won by the other candidate. Clearly, this could have easily gone the other way.

Volatility and Uncertainty

Volatility in equities, bonds, and other asset classes remained at very low levels compared to historical norms in 2017, as measured by the standard deviation of daily market price movements. Yet, at the same time, uncertainty was exceptionally high concerning a wide-ranging array of potentially market-moving events which were often in the daily news and getting considerable attention. The co-existence of relatively low volatility and high uncertainty presented an interesting conundrum.

The list of potential volatility-inducing questions was quite long during the year 2017. Would the future course of fiscal policy in the US involve a big corporate tax cut or not? How would trade relationships around the world change as the US pulled back from its former world leadership role? Would the Brexit negotiations hang over the UK economy like Damocles’ sword for years to come? The financial path of Saudi Arabia, the largest oil producer in the Middle East, depended in no small way on how the initial public offering for Aramco goes in 2018, which in turn depended on the price of oil. How would Saudi oil production strategy change before and after the pending IPO? The Federal Reserve embarked on incremental plans to shrink its balance sheet with the European Central Bank followed with adjustments to its asset buying programs. How will asset classes that positively benefited from QE respond to the unwinding? Diplomatic tensions with potential military implications abounded.

A Solution for Both Sides of the Brexit Divide

With the Brexit ‘deadline day’ now seemingly set in stone as 29th March 2019, there has been much media focus in recent weeks on the challenges faced by British businesses, including the UK’s sizeable hedge fund community, in a post-Brexit environment. Industry bodies have, for instance, been quite vocal in seeking reassurance about what a post-Brexit trade deal for financial services might look like, with the likes of the City of London Corporation and the CFA Society UK claiming that there is a real risk of an exodus of talent from the UK should a favourable trade deal not materialise. The UK Chancellor responded fittingly with plans to create a “bespoke deal” for the UK financial services sector, in a move to calm Brexit-related fears. However, whilst the media focus has been on the potential damage of a bad trade deal to Britain’s financial services industry, including its alternative fund industry, the reality is that the EU has a lot to lose too.

As far as hedge funds are concerned, for instance, a hugely significant proportion of investors are based in the UK. With no EU Member State currently able to compete with the likes of London in the area of financial services, access to the City is as important for EU managers as the EU is for UK managers – arguably more so.

Maintaining a workable route into the UK that extends beyond 29th March 2019 is absolutely vital and should be on the list of priorities for hedge fund managers. Jersey has been working hard to make sure it can offer managers the infrastructure and environment onshore European locations simply can’t guarantee post-Brexit.

The Growing Interest in Cryptocurrencies

The Hedge Fund Journal spoke with the leading lawyers of Schulte Roth & Zabel’s (SRZ) Blockchain Technology & Digital Assets Group. The growing interest in cryptocurrencies is among the many trends the lawyers will discuss at SRZ’s 27th Annual Private Investment Funds Seminar in New York in January 2018.

This Q&A features: Stephanie R. Breslow, SRZ partner, co-head of the Investment Management Group and a member of the firm’s Executive Committee; Brian T. Daly, SRZ partner in the Investment Management Regulatory & Compliance Group and Seetha Ramachandran, SRZ partner in the Litigation Group, all also members of the firm’s Blockchain Technology & Digital Assets Group.
 
Q. How do you start up a fund to invest in digital assets and blockchain technology?

Stephanie R. Breslow: Digital assets and blockchain technology are creating novel investment opportunities. Digital asset funds are privately placed, so there are rules about how they can be advertised and offered, and who the investors can be. Sponsors haven’t yet been able to do retail public offerings in this space.

Privately placed funds pursue a variety of strategies, including investing in a single digital currency, strategically investing in multiple digital currencies, investing in initial coin offerings (ICOs) or in venture opportunities relating to blockchain technology, and acting as a fund of funds into other funds in the space.

Your choice of strategy will determine the best choice of terms, with liquidity ranging from almost daily liquidity (for funds that basically act as wallets) to locked-up, private equity structures (for funds that invest in venture-stage companies). Fund sponsors should be aware that the tax and regulatory treatment of these assets is in flux.

Editor’s Letter - Issue 128

The inaugural 2010 ‘Tomorrow’s Titans’ report was the first piece of work I did for The Hedge Fund Journal. It became a biennial fixture, with subsequent reports published in 2012, 2014 and 2016, all supported by EY. Each report has featured managers who went on to show spectacular asset growth and performance. We therefore thought it opportune to revisit the 180 managers featured in the four reports published so far and highlight forty or so who have done particularly well both in terms of asset growth and performance. We have listed these managers and written a small piece about each. Over the course of the next few months we will run extended profiles on several of these managers. We kick things off in this issue with an extended profile of Kairos’ Federico Riggio.  

The Tomorrow’s Titans – primarily managers who have spun out of large hedge funds to set up their own firms – are rather different from the rest of the industry. If UCITS and liquid alternatives have been important sources of asset growth in general, the great majority of Titans do not run these vehicles.

The Titans illustrate the diversity of the hedge fund industry. In equities, some mainly trade mega-caps or large caps while others focus on mid-caps or small caps. Some are long-biased, while others are market neutral. Notably in the event driven space, some of the most successful funds are run with low market correlation. Even within strategies that have, on average, not been the best performers post-crisis – such as discretionary macro, discretionary commodities, and long volatility – there are winners who have performed well and raised a billion or more.

Of course, some new launches have returned capital to external investors, and shut down. But some of those Titans have gone on to obtain senior roles in large hedge funds, become family offices, or moved onto their second launch.

Inside the Morningstar Style Box for Alternatives

We recently introduced the Morningstar Style Box for alternative funds, a new research framework for evaluating liquid alternatives investments that will be available to Morningstar Direct clients at the end of October. We first introduced the alternatives style box in our October 2016 paper, which showed how its main components of correlation and volatility can help investors quickly and intuitively gauge a fund’s diversification potential. In this follow-up report, we take a bottom-up look at the alternatives universe by placing each liquid alternative fund into one of the alternatives style box’s nine regions. We find significant diversity among alternative strategies, even among those in the same Morningstar Category, underscoring the potential importance of tools like the alternatives style box for making good comparisons and conducting thorough evaluations.

Key takeaways

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