Commentary

Man FRM Early View

As John F. Kennedy said in his state of the union address in 1962, “The time to repair the roof is when the sun is shining”. With eight years of quantitative easing still compressing yields and inflating valuations, the sun still seems to be shining on pretty much all asset classes. In the first half of the year passive exposure to equities and government bonds returned 7.1%1 and 4.5%2 respectively. But confidence among asset managers in the sustainability of this move in risk assets appears stretched. The recent 20% peak-to-trough decline in the oil price has reopened the cracks in the high yield market, undermining expectations in credit more generally, but the government bond move speaks of a deeper unease. US 2yr notes are close to the highs in yield on the year, while the long end has rallied, flattening the curve by some 50bps since March.

In the very big picture, we believe forward returns on traditional assets simply do not square with the needs of ageing populations, but there are also concerns in the shorter term. A notable and rising proportion of our clients are thinking about ways to help protect against future volatility (the vogue terms are ‘Crisis Risk Offset’, ‘Tail Risk Protection’ or ‘Crisis Alpha’). We believe that this kind of fixing the roof deserves closer attention.

Rethinking Equity Long/Short Allocations For Retail Investors

The model for allocating to equity long/short funds is broken. The mentality of most allocators is to chase the “hot dot” – that is, invest with a fund that performed well recently and hope the hot streak continues. This approach is based on the discredited assumption that allocators can easily identify which funds will perform well going forward. In addition, the risk inherent in individual equity long/short funds is widely misunderstood – the equivalent of conflating the risk of a single stock with a diversified index. The net result is a decade of disappointment among clients who expected.

The alternative (and, we argue, superior) approach is to reframe investing in equity long/short as a “category” allocation – akin to investing in a passive, diversified index at low cost rather than making concentrated bets on high fee, volatile individual constituents. In fact, the actual, live performance of a simple, factor-based replication portfolio we’ve managed since 2012 has outperformed 80-90% of individual funds on a risk-adjusted basis with low fees, daily liquidity and transparency – a package that, overall, should be far more compelling to any allocator seeking to include equity long/short strategies within a diversified portfolio.

The factor-based replication approach that we advocate is the culmination of ten years of research and provides a data-driven solution to the pitfalls experienced post-crisis by many investors in liquid alternatives products.

Why invest in equity long/short strategies?
Why invest in equity long/short in the first place? The simple reason is that an allocation to equity long/short can improve the risk-adjusted returns of a diversified portfolio. Since January 2000, ELS hedge funds outperformed global equities with far less risk (see Fig.1).

The Hunt for Alpha Lies in the Short-Term

Quantitative or systematic investing is more competitive than ever. Cheap computation power, infinite storage capabilities, the proliferation of low-cost but state-of-the-art data analysis tools, online data scientist communities, combined with the progressive commoditization of well-known quant factors through the “smart beta” tag, undoubtedly raises questions about the value-add of a systematic managers in such an environment. If one hasn’t resigned oneself to the belief that all alpha has become beta, where is this alpha now to be found?

What are the elements that quant managers still can offer today to deliver differentiating results? A prominent factor of any systematic asset manager is ultimately to generate a distinctive return stream, which cannot be replicated by a simple combination of standardized, cheaply available financial products. Hence the objective should be to deliver independent and non-replicable return streams. It seems that in the current environment, this objective has become a much more challenging task than in the past.

To highlight where the value proposition of a systematic asset manager lies today, it helps to first understand the underlying drivers of a quant manager’s capacity to generate alpha or differentiated performance. The “Fundamental Law Of Active Management” introduced in 1995 by Grinold and Kahn states that an active manager’s value-add, which can be expressed by the Information Ratio (IR) is the product of his Information Coefficient (IC) and his Breadth (N):

IR = IC * SQRT(N)

The Science of Investor Communications

Old-school salespeople may rely on gut instinct when sussing out prospects, but we now live in a big world where it is not always practical for a small team (or even one individual) to keep up a rapport with thousands of potential clients. “Many hedge funds do not think enough about their communications strategy but there is a whole science behind building long term relationships,” says Alok Misra, CEO at Navatar, the investor relations platform used by alternative asset managers. Marketing and investor relations teams need to categorise contacts into an investor intelligence centre; use targeted segmentation to prioritise schedules for making contact; keep abreast of allocator news, changing staff and strategy preferences, and use all of this and historical allocation patterns to inform outreach, while also maintaining controls on the security of confidential data and documents. They may need to do all of this ‘24/7’, anywhere on the planet.

Categorising investors: How to build your very own LP intelligence centre
KAP Group co-founder and CEO, Jennifer Aleman Hutter, advises fund managers on communications and marketing, and was a placement agent in her former job at Credit Suisse. “It is not cost effective for all managers to build an internal IR team right away. Outsourcing the IR function can free up time for the team to focus on investing,” says Hutter. That said, many KAP clients do have an in-house IR function that dovetails with support from KAP Group.

UK Economy to Feel the Heat of a Complicated Brexit

The euro-zone economies are doing a little better in the eyes of the European Central Bank (ECB) while the UK economy is being slowly dragged lower by increasing Brexit fears in the aftermath of a surprising June parliamentary election. And, on the global scene, the pullback of the United States from its leadership position on trade and regulatory deals may well complicate the Brexit negotiations as the European Union (EU) is emboldened to assert itself more aggressively on the world stage, making Brexit a pawn in a much larger game. We will start with a quick review of the UK election’s implications for Brexit negotiations, move on to the economic analysis of the EU and UK, and close with some perspectives on how developments in the global trade and regulatory scene might impact everything from Brexit to job creation in the United States to global growth.

The Wrong Type of Macro?

There has been a great deal of commentary and discussion recently about the struggles experienced by macro funds. As Fig.1 highlights, fund returns over the last five years have been relatively low in an absolute sense, but most notably relative to global equity markets. This reality and perception has intensified over the last twelve months after the sea change in market behaviour seen in mid-2016.


 
Amongst many, there have been two primary and related attempts to understand and explain this disappointment. The first argument is essentially that ‘macro’ as a strategy is based on economic forecasting, that forecasting is a built on pseudo-science and, as such, we should never expect macro strategies to work consistently. The world is a dynamic and complex place and systematically “getting it right” utilising superior forecasting insights is extraordinarily challenging… even if it is fun trying!

The second perspective is a more specific observation on the current environment; it points to the effects of QE and holds that macro managers have either simply been ‘wrong’ in not simply backing the obvious upward trend in equity markets that would result, or that the distortionary effects of central bank policy has made forecasting macro trends impossible. This view implies that when things are “normal” forecasting is likely to be more successful. The evidence for this is not compelling and the concept of “normal” of itself is highly questionable.

Editor’s Letter - Issue 124

In this issue, we showcase the AIMA/GPP Emerging Manager Survey 2017, Alive and Kicking, which reveals that the climate for starting a hedge fund is far more constructive than is perceived in some quarters. The long-term trend of asset inflows into hedge funds has resumed this year after the brief hiatus seen in 2016. And the 2016 EY Global Hedge Fund and Investor Survey found investors allocating 14% of their hedge fund portfolios to “emerging” hedge funds, defined as those less than three years old.

Granted, regulation has increased costs, and MiFID may add yet more expense, but not to an insurmountable degree. Outsourcing and technology can mitigate the regulatory burden, in many cases. Claims that funds cannot survive with less than $200 or $300 million are too sweeping and general. The AIMA/GPP survey identified an average breakeven point of $86 million. This varies by strategy, with global macro - where median headcounts are higher - having the highest at $136 million while credit had the lowest at $76 million.

Headlines suggesting low launch activity are often making mountains out of molehills, by reading far too much into small fluctuations in numbers that should probably be viewed as spurious “noise” in a statistical sense. HFR tracked 712 new fund launches in the year ending in 1Q 2017 and by any standard this signifies a dynamic industry.

Man FRM Early View

In hedge fund land we use the ‘Sharpe ratio’ to quickly assess the quality of an investment. It is calculated as the return from the investment, in excess of interest rates, divided by the variability of that return. Higher is clearly better. In late May the 5yr annualized Sharpe ratio of the S&P 500 Total Return Index exceeded 1.5. In other words, over the last five years US Equities paid you 15.3% per year to bear an annualized monthly volatility of returns of 9.9%. Over the past 30 years, the 5yr Sharpe ratio has seldom been higher (it has exceeded 1.5 only three times since 1987, and in each case only by a small amount), and the volatility seldom lower (annualized volatility has been lower than 10% only twice over the same timeframe).

Remember that global government bonds have also been in a 30 year bull market, and therefore pretty much any mix of traditional assets has performed well for the best part of a decade. It is not surprising that some investors have looked at the relative underperformance of active strategies, particularly hedge funds or managers without an explicit benchmark, and concluded that they aren’t worth the hassle. Is it any wonder, therefore, that investors are moving out of active investments and into passive replication strategies at a record rate?

Managing Complexity With Technology

The hedge fund industry is in the midst of a period of significant change driven by the pressure of both regulators and investors. Regulators are now requiring hedge funds to provide more transparency into their risk and control function by asking them to demonstrate if they could provide valuation services in-house, in case the fund administrator went bust. Investors are also becoming sophisticated, demanding more information on the valuation, liquidity and exposures of the hedge funds in order to assess potential risk factors.

To generate alpha, long/short equity strategies are no longer adequate and hedge funds are now relying on multi-asset strategies, which require them to operate at the highest level in terms of people, process and technology. Technology is not only an enabler for driving performance, but a critical factor for operating a multi-asset hedge fund. Technology by itself is no longer a differentiator; if it’s not there it simply will be impossible to run the business successfully. In its place it is vital to have the appropriate systems so hedge fund managers can remain in control of the diverse risks undertaken and demonstrate that they can react to the poorest situations.

To fully understand the state of software use within hedge funds, Dr Sven Kuenzel and Anika Schlien at the University of Greenwich Business School, in collaboration with Copia Digital, conducted a study to assess current and future trends. Questionnaires were forwarded to 556 hedge fund executives and the study analyses the following key issues in order to create a comprehensive understanding of the industry’s decision making when it comes to technology:

Canada

For most of the past six years, the Canadian dollar (CAD) closely tracked movements in West Texas Intermediate (WTI) crude oil. But from mid-2016, CAD began diverging, underperforming WTI significantly (Fig.1).

And the parting of ways was not the result of a generally stronger US dollar (USD). The Russian ruble, which also correlates highly with oil prices, has outperformed WTI over the same period (Fig.2). Both Canada and Russia are major producers of crude oil. CAD’s divergence from oil may have to do with deeper economic problems: the country’s extremely high levels of debt and overvalued real estate prices.

From 2007 to 2009, the United States underwent a period of reckoning as the real estate bubble popped, banks failed and unemployment soared from 4.4% to 10%. North of the US border, Canadians suffered as well but to a much lesser extent. Unemployment rose, but only by half as much as in the United States.

(Fig.3) and real estate prices never collapsed (Fig.4). From the peak in 2006, US real estate prices fell 30% before rebounding. Still, US residential real estate prices remain a few percent below their peak. By contrast, Canadian real estate prices are more than 30% higher today than they were in 2006 and certain property markets in Canada, notably in Toronto, may be experiencing significant real estate bubbles.

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