Investor protection and the focus on governance: from a slow start to the centre of attention
One of the structures often encountered by insolvency practitioners who reside and practice in jurisdictions outside of the United States, and those who act for them, are hedge funds. Given the proximity of the Caribbean to the United States (and specifically those jurisdictions that are recognized international financial centers such as the Cayman Islands, the British Virgin Islands and Bermuda; anecdotally referred to as ‘offshore’), and the specialization in those jurisdictions in the provision of certain financial services and products to the US market (for example hedge funds registered offshore), it is no surprise that when things go wrong, legal advisors and other professionals are often called upon to look back as to what may be available in the US. This especially applies when assessing what assets or information may exist in the US and what options are available to investigators to retrieve or collect them. This is certainly the case with offshore hedge funds, where the connection to the US may be as simple as an account with a bank or an US institution, or as elaborate as the hedge fund having been managed, administered and, for all intents and purposes, operated out of the US despite being registered offshore.
The year 2017 saw the juxtaposition of heightened policy uncertainty with relatively complacent markets and low volatility, especially in equities. Much of the policy uncertainty may find some answers in 2018. It is decision time for NAFTA and Brexit. Elections will be in the spotlight, too. Italy in March, Mexico in July, Brazil in October, and November 2018 will see a ferociously contested US election for the entire House of Representatives and one-third of the Senate. At the Federal Reserve (Fed), the focus will be on inflation and the shape of the yield curve as it decides how aggressively to push rates higher or not. The weather will play a role, too, as we find out if La Niña deepens and brings droughts to Brazil and Argentina or fades away quietly.
Event risk can present some interesting risk management challenges. The two possible outcomes are typically binary in nature, like an on/off switch. Before the event, markets may price an average of the two vastly different outcomes in terms of their impact on selected products or securities. After the event, the market’s ‘average’ of the two outcomes will definitely not survive the outcome, as markets move quickly to price the actual outcome as it becomes known. In these types of market environment, options can be a favored risk management tool. In addition, if the probability of a price break or gap is substantial around the time the outcome becomes known, the options prices will add a premium for price gap expectations in addition to the typical estimate of future volatility. This means that implied volatility calculations using models that assume price gaps/breaks do not exist (i.e., basic Black-Scholes-Merton) may over-estimate volatility by the amount of the potential price break premium.
Sussex has been strongly advocating an active Japan equity exposure, either via hedge funds (long/short) or specialist long only managers, for a number of years now, and have been quite vocal about the opportunity in this space. This conviction was expressed early on to investors, including in past articles for The Hedge Fund Journal. The goal was to explain the rationale for the strong belief that Japan warranted an allocation on a standalone basis, irrespective of what macro views investors may hold on Japan. The stated view was that, unless investors ceased taking a simplistic, macro-based view on Japan, stopped trying to chase beta, and instead started focusing on the alpha opportunity presented by this market, they risked missing out on the real opportunity and the reason to get excited about Japan in the first place. Over the past 6 months, not a day seems to have gone by without yet another investment bank upgrading Japan to a “buy” or “overweight” rating. There has been a significant increase in investor interest as a direct result of this and corresponding asset flows into Japan (almost 2 trillion of net investment by foreigners into Japanese stocks were recorded in October alone, for example). In response to investor inquiries, Sussex has decided to provide allocators with a succinct overview of the Japanese hedge fund market, its anatomy, and thoughts on how to best approach such investments. It should be noted that, since our advocacy of investing in Japan began, many of the best managers, capable of rewarding existing investors with very attractive risk adjusted returns, have now hard closed to investors. Therefore, just as investors seem to have awoken to the hedge fund opportunity in Japan, the task of actually finding suitable hedge funds with capacity has become increasingly challenging. The following Q&A is meant to assist allocators in better understanding the market, its dynamics, and the opportunity.
In recent years, the concept of responsible investment (‘RI’) has started to gain traction across our industry. But as markets continue to transform – driven by shifting regulation, technological development and the changing needs of institutional investors – how should we think about building responsible strategies for the long term? Institutional investors are increasingly asking this question, faced with a tough challenge in de-coding a varying set of responses from the asset management community. Indeed, despite progress in recent years, there remains little consensus about what responsible investment really means, or what it will take to ensure that these principles remain in focus through time.
This article sets out three elements which we believe are important in responsible investment. First, responsibility around environmental, social and governance (‘ESG’) factors must be integrated into mainstream investment processes, rather than used to create niche ‘ESG-labeled’ products. Second, we believe asset managers must be prepared to work flexibly with clients to determine the best ways of implementing RI – in everything from strategy design to the investment process itself. Third, and most important in our view, our industry must reconcile RI considerations with our broader responsibilities to investors – and in doing so, make the case for responsible investment in the context of performance, and even as a potential source of alpha. We believe that these principles can help support the case for responsible investment over the long term, and guide our industry’s approach along the way.
A recent CAIA Association and UN Principles for Responsible Investment (PRI) event, hosted by Man Group, explored why and how quantitative investment managers are using ESG factors in their investment processes. The impetus comes partly from pension funds. Some 90% of them have a Responsible Investing (RI) policy, but less than 50% have formalised guidelines, with only 20% currently using ESG to guide allocations, according to Redington’s Tom Wake-Walker. These percentages should grow. Pension fund trustees think that incorporating ESG factors, such as climate change, into the investment process, is completely consistent with their fiduciary duty, according to HSBC Pension CIO, Mark Thompson.
The perception that discretionary investment processes are more amenable to ESG, than are quant processes, need not apply. Nearly half of assets run by Man Group’s fundamental quant unit, Man Numeric, have an ESG component, and the firm has been employing ESG factors since the mid-1990s, says CIO Rob Furdak.
Data is a greater challenge for quant strategies however, as many are exposed to thousands of companies: far more than some discretionary strategies. Man Numeric combines data from specialist providers (such as MSCI, Trucost and Sustainalytics) with its own analysis of new and unstructured data. Albertus Rigter of LGT Capital Partners notes that ESG data is not always as clean as he would wish, partly as some companies do not disclose enough detail. Systematica’s Gregoire Dooms sees very limited standardisation in ESG data but does not judge it to be any worse than other datasets such as financial statements. Louise Dudley of Hermes Investment Management finds data quality is generally improving and is often better in the UK.
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.
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.
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.
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.