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:


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.

Shareholder Activism In Asia

Shareholder activists have long been a feature of corporate life in the United States. But as the field becomes more crowded at home, established US-based activist investors are looking overseas for opportunities. And their focus has been on companies in Asia.

Analysis from Activist Insight highlights the number of activist public actions in the region has steadily increased in each of the past four years. Asian companies are now more targeted by activists than their counterparts in Europe.

There is no doubt that the public profile of engagements between activists and boards in Asia is growing, be it arguments over corporate structure in South Korea, questions regarding capital in Japan, or demands for reorganisation and divestitures in Australia.

Previously, Asia has been seen as a relative backwater for shareholder activism. This is partly due to a greater propensity for listed companies to have controlling shareholders, often founders and family interests, or embedded government interests. The prevalence of cross-shareholdings among groups of affiliated listed companies is also an issue, as is greater relative passivity among institutional and retail investors, cultural resistance to US-style activism, and local environments that are generally less litigious and confrontational.

However, while culture is important, the disparity in shareholder activism between Asia and other markets is also a reflection of the maturity of the markets in question.

Editor’s Letter - Issue 123

Shareholder activism is gathering momentum and going global. It is most prevalent in the United States, where Schulte, Roth & Zabel recently scored an unprecedented litigation victory on behalf of venBio Select Advisers LLC, in the Immunomedics proxy contest. For the first time, a major corporate deal that sought to entrench incumbent management was unwound in the context of a proxy contest. In this issue we interview some members of the SRZ teams who advised venBio. Canada may even be more activist-friendly than the US in several respects, say local lawyers, Goodmans.

The tally of public activist campaigns in the US has almost quadrupled from 123 in 2010 to 476 in 2016, according to Activist Insight. In the UK the number has fluctuated between 21 and 43 without any clear uptrend over the past seven years, but both US and UK managers have secured notable successes. Paul Singer’s Elliott Advisers managed to install independent directors, and new management, at Alliance Trust. Jeffrey Ubben’s ValueAct has obtained a board seat at Rolls Royce and Martin Hughes’ Toscafund has got one of its nominees onto the board of Speedy Hire.

In Europe outside the UK, the number of public actions has multiplied six-fold from 10 in 2010 to 60 in 2016. But there has been mixed success. Elliott has, thus far, found corporate governance in the Netherlands less conducive to activism. Elliott, and other shareholders, including the UK’s largest pension fund, the Universities Superannuation Scheme (USS), were denied the chance to discuss, and vote on, the chairmanship of Akzo Nobel. USS co-Head of Responsible Investment, Daniel Summerfield, said “this portrays Dutch governance in a very negative light”. The Akzo board has thrice rejected PPG’s takeover offer.

SYZ Hedge Fund Summit 2017

I have been investing in hedge funds for more than 30 years. The first time was in the early 1980s, when I was a stockbroker on Wall Street, and friends of mine were doing a lot of business with what they called hedge funds. I didn’t know what hedge funds were so I tried to find out. The next thing I knew I was standing in George Soros’ office, and didn’t know who he was. Soros was managing a few hundred milliondollars at the time; and that’s how I got acquainted with hedge funds.

I started to invest in hedge funds, and ever since I’ve been investing in hedge funds. Of course, in those years we got 15 to 20% returns by just allocating to 10 or 12 different hedge funds but we had an interest rate environment which was very, very different. People tend to forget that in those years hedge funds were returning in the 20s and 30s but interest rates were in the double digits.

Now, in the current environment with the risk-free rate of return being where it is, it’s very hard to perform anywhere, for hedge funds as well. Having said this we’ve always been investing in hedge funds even though the times were hard, and they fell out of favour.

One of the reasons why we decided to launch this conference was that the interest rate environment is getting back to a more positive note in the United States and around the globe. I think the deflationary period is over and people are no longer scared of deflation. I was just talking with somebody who thinks that there’s a possibility Europe will see higher rates over the next few quarters, and that is a positive environment for hedge funds. It’s disruptive for the market, but this often means there are also opportunities for hedge funds. I think there’s going to be a new revival for this investment style.

Product Governance and Investor Protection

MiFID II is looming and the entire industry is still grappling with some of the additional obligations - some of them unusually burdensome and costly to implement - the recast directive will impose on market participants.

In particular, MiFID II introduced a new set of product governance rules designed to increase the level of investor protection. As stated in the ESMA Consultation Paper on Draft Guidelines on MiFID II product governance requirements, these new rules aim at ensuring that product manufacturers of financial instruments and structured deposits, as well as distributors, have at all times the best interests of the investors in mind. The new product governance requirements under MiFID II are introduced having in mind the best interests of investors. When it comes to presenting a client with an investment product or solution, according to the new rules this will have to be perfectly suitable for their best needs and interests, which should at all times prevail over commercial or funding needs of investment firms.

Whilst the importance of clients’ best interests - boldly emphasized throughout MiFID II both in the first level directive as well as secondary level delegated directive - is not necessarily new, the approach now adopted in the European legislation on financial services with regards to investor protection appears to be innovative, at least at a first glance. It was felt - as also stressed in the Draft Guidelines - that the mere existence of conduct of business rules was not always sufficient to ensure investor protection. Efficiently and effectively enhancing such protection required that the consideration of the needs of the investor was not only anticipated at the very moment when a specific investment product is manufactured, rather than simply at the time it is offered or sold, but also maintained during the life-cycle of the product.


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