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

Europe: How Markets View Integration Versus Disintegration

Opposing forces championing integration versus disintegration are assailing Europe. In the past two years both sides have scored important victories. Britain’s Brexit, Spain’s Catalonian independence referendum and the entry of the nationalist Alternative fur Deutschland (‘AfD’) party to the German parliament, or Bundestag, were victories for proponents of lesser European unity. The electoral defeat of far-right forces in the Netherlands and the victory of Emmanuel Macron in France were celebrated by those favoring the guiding principle of an ‘ever closer union’.

Whatever one thinks of Brexit, the prospects for deeper European integration and the legitimacy of the various national independence movements, the currency markets’ view is unambiguous: they strongly favor deeper political integration:

The Cryptocurrency and Blockchain World

Three vantage points have given me an insider’s insight into the growing cryptocurrency sector and who are the likely winners and losers. As an investment manager, I regularly get to see the latest innovations − both good and bad − early. Even a curmudgeonly bear would have kind words to say about the incredible number of new disruptive technologies changing the world including DNA sequencing, virtual reality, drones, 3D printing, robotics and blockchain. None would have been possible without the incredible innovations in microprocessor power over the last 10 years.

In September 2017, the market capitalisation of all cryptocurrencies briefly passed $150 billion. Adding in the value of the exchanges and other ancillary companies the cryptocurrency industry is conservatively worth >$200 billion and growing daily.

My company, Altana Wealth, runs a cryptocurrency trading vehicle (Altana Digital Currency Fund), lends margin to bitcoin traders (Altana Digital Services) and has co-invested in blockchain ventures such as futures exchanges and ATM providers. Over the past three years our clients have benefited from the growth in cryptocurrencies to the tune of ~1000%.

I’m a member of the Young Presidents Organisation, a global platform for chief executives to engage with more than 25,000 members in over 130 countries. In May, I moderated the blockchain panel at their annual fintech event. Amongst a very sophisticated audience discussing a diverse range of subjects (including robo-advisors and peer-to-peer lending) the least followed or understood of all was bitcoin/blockchain.

So, while bitcoin may be a disruptive booming technology, it is not yet properly understood and as with all innovations, it needs to have a profitable niche to grow.

The initial, most common reaction I receive is: “I don’t understand blockchain”.

Editor’s Letter - Issue 127

The inaugural ESMA conference, held in Paris in October 2017, touched on a wide range of interconnected regulatory topics. There is much to play for if regulations are to attain their aims. The fact that 10 trillion Euros are sitting in deposit accounts paying sub-zero interest rates is viewed as a lost opportunity by ESMA’s Chairman, Steven Maijoor. This is partly because, after years of various initiatives (simplified prospectuses, KIIDs and now PRIIPS), fund literature is not intelligible to the vast majority of people. Clearly, the Capital Markets Union (CMU) project has yet to give European savers the confidence to embrace a US-style culture of investing into capital markets, which are still much smaller than in the US. Hence, Europe’s 23 million SMEs are still over-reliant on bank debt. Therefore, alternative lending, both directly and via capital markets, which many hedge fund and private equity managers pursue, has a long and strong runway of further growth ahead.

High hopes that MiFID II may enhance transparency and reduce costs are weighed against fears that MiFID II could have unintended consequences including further fragmenting equity markets and threatening liquidity, which could also be hampered by the levels of capital requirements for market makers (imposed by other regulations). These are perceived as excessive if market makers are not deemed to be systemic institutions. Additional MiFID II concerns are that it raises barriers to entry as larger asset managers can more easily absorb research costs, and that it may reduce (already patchy) sell side research coverage of smaller and medium sized companies. That could also impair liquidity.

Man FRM Early View

One of the difficulties of commenting on financial markets in real-time is that the magnitude of the importance of events is only truly apparent in hindsight. In February 2007, HSBC warned that bad-debts from their sub-prime mortgage book would be higher than expected. That month the S&P 500 Index fell by around 2% but then rallied back to fresh highs over the next four months. Of course, from our current vantage point it is now easy to draw a causal path from that point through to the collapse of Lehman Brothers in September 2008.

We may look back at August 2017 as another turning point in the risk appetite of investors. Once again, the S&P retreated following a good run, down around 2% during the month, only to rally over the last two days to finish the month flat. Of course, the late rally probably means that things have returned to normal – the macroeconomic backdrop remains strong enough to carry risk assets in the absence of a large exogenous shock (Trump making a mess of the presidency doesn’t appear to be enough of a shock while the data stays good) and Central Bankers seem to be competently managing the end of Quantitative Easing (“QE”). The long-awaited Jackson Hole Symposium failed to deliver anything seismic and, in isolation, there is no reason for us to believe that Central Banks could not start to collectively shrink their balance sheets in a controlled manner. But as history shows things do not take place in isolation, and it is the improbabilities of the current outlook that interest us, since they appear to be growing in our view.


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