Man FRM Early View

Barring a significant polling shock in the second round of the French election, Macron winning the French presidency would seem to usher in a new era of confidence for risk assets. We are not so sure.

Beyond the brief respite from political worries, the positive case rests on the current state of global growth: it is broader, more robust and more sustainable than at any point since 2008. Emerging Markets are a growing component of that growth, but even there the issues around balance of payments and commodity dependency seem to be less prevalent than they have been for much of the last few years.

The problem is how Central Banks react to this better landscape and the implications for the risk free rate of return. Hidden in all the excitement around the French election were robust Purchasing Managers’ Indices and earnings data across the Eurozone. A Macron victory may be the last piece of the puzzle for Draghi to begin tapering Quantitative Easing at the June European Central Bank (‘ECB’) meeting. Add to this a snap UK election, which if polls are correct will give the Conservatives a stronger majority, and we could see the Bank of England (‘BoE’) reverse the emergency moves it introduced after the Brexit vote last summer. In this view, we have a world with three of the major Developed Market Central Banks reversing the policy of the last decade.

So perhaps the change in the direction of travel from Central Banks is now upon us (in hindsight, it clearly wasn’t in December – the Federal Reserve (‘Fed’) raising rates matters little to global risk assets when other Central Banks start pumping harder in their place), which may mean more normal markets: a higher risk-free rate, Bond yields up from their record lows, and Equity markets reacting to bad news without an enormous bid waiting on the side-lines to buy the dip.

Gold Options

In the one-and-a-half months after the US elections on November 8, gold prices plunged 12% on the assumption that the incoming president’s fiscal stimulus would boost the economy and lead to higher interest rates. However, with the Trump agenda running into numerous roadblocks since then, the yellow metal has rebounded, recouping nearly all its post-election losses. Gold options, meanwhile, have perked up from their recent lows, but with implied volatility at less than 14% they remain historically inexpensive (Fig.1).

Going forward, there are possibilities of big moves to the upside and downside that could reawaken the sleepy options market and lead gold options to significantly higher levels of implied volatility. Although many factors influence gold prices, we see two elements playing a dominant role:

1. Expectations for changes in US monetary policy.
2. Changes in gold mining output.

These two factors exert their influence in very different ways. The first is demand-based and moves gold prices on a day-to-day basis. The second is a supply-based influence that appears to move gold prices on a year-to-year basis. Both factors have the potential to create strong trends in gold prices and impact the implied volatility of gold options.

Japanese Hedge Funds

Two years ago we wrote in this publication about our conviction in Japanese hedge funds, due to their track record of generating consistent alpha and managing risk during down periods in the markets. Similarly, we explained how these managers had, over the course of almost two decades, acquired a unique set of skills which had helped them to navigate through tough market conditions and deliver attractive long-term risk adjusted returns. We discussed how the size and depth of the Japanese stock markets, coupled with low research coverage compared to other developed markets, provide the right investment framework for home-grown hedge fund managers to develop an edge over foreign institutional allocators as well as local retail investors, and how these managers were able to uncover mispricing opportunities.

We also looked into how a range of idiosyncratic factors such as cultural differences and the language barrier have made it harder for foreign investors to participate in the market, and have allowed local managers to be alpha generators. Our conclusion at the time was that while the changed macro outlook for Japan had triggered increased flows from global long only allocators, investors should challenge the prevailing wisdom that the main reason for betting on Japanese equities was the turnaround of a protracted Japanese bear market, and instead focus on the alpha generation opportunities available in this unique market based on identifying investment ideas generated and executed by the most experienced local managers.

BDC Fees and Structures Evolving

A proliferation of different fee levels and structures is evident throughout the alternative investment industry, and Business Development Companies (BDCs) are no exception. For instance, management and incentive fees within the BDC space vary widely between issuers, with management fees ranging from as low as 1% to as high as 2% of gross assets. Throughout the industry, common drivers for revisiting existing fee structures include changing market norms and pressure from investors. BDCs can face additional demands to alter fees and terms in view of their public nature. Being publicly listed opens the door to pressure from both analysts and activist investors, and BDC regulation, namely section 15 under the Investment Company Act of 1940, or the “1940 Act”, requires boards of directors of BDCs to review and reapprove fee agreements annually.

Advantages of Systematic Investing

Writing in 1923 about the famous discretionary speculator Jesse Livermore, the American author Edwin Lefèvre captured in a quote the frailties of human psychology when it comes to investing in financial markets: “It is inseparable from human nature to hope and to fear. In speculation when the market goes against you - you hope that every day will be the last day - and you lose more than you should had you not listened to hope... And when the market goes your way you become fearful that the next day will take away your profit, and you get out - too soon. Fear keeps you from making as much money as you ought to.”[1]

In this paper, we review the key advantages of the systematic approach to investing. In addition to the avoidance of investment error due to psychological bias, a systematic approach offers several key benefits including: the scalability to invest with a consistent approach twenty four hours per day across a global portfolio of securities; the implementation of consistent risk management at security, asset class and portfolio level; and, the scientific rigor which can be devoted to the continuous development of the core investing approach. We also review academic evidence comparing the performance of systematic and discretionary CTAs and hedge funds.

Editor’s Letter - Issue 122

A higher proportion of long only than hedge fund assets are publicly branded as being run on ESG (Environmental, Social and Governance) criteria, but that might change in future. The UNPRI (Principles for Responsible Investment) has finally unveiled a new due diligence questionnaire (DDQ) covering ESG considerations. AIMA, which has developed a suite of DDQs for over 20 years, belonged to the 17-strong working group as did the Hedge Fund Standards Board (HFSB).

The HSFB addresses some concerns around the G in ESG, through its support for fund and manager governance policies on conflicts of interest and valuation policies; reports such as administrator NAV transparency reports, and risk aggregation formats such as Open Protocol Enabling Risk Aggregation. Beyond this, governance at investee companies, and the E and S, are also attracting more interest.

The impetus for the DDQ comes partly from institutional investors. Albourne Partners started examining ESG more closely in 2011, initially in response to interest from allocators in Northern Europe and Australasia. Albourne now reports growing concern from the US.

Man Group’s GLG was an early mover. The firm has run a sustainability fund since 2008, and has been involved with the UNPRI advisory board. Man GLG’s approach avoids both “black boxes” and potentially simplistic box-ticking. “As managers have different styles the aim is to educate them internally and let them adapt,” says COO Carol Ward. Indeed, no one size may fit all. Many in the industry believe that DIY research is needed to complement various rankings supplied by providers such as Sustainalytics, Trucost or TruValue Labs. Additional research is essential partly because there are gaps in providers’ coverage, particularly in emerging markets and China, where disclosure can also be less extensive.

Hedge Fund Branding Drives Asset Flows

Since the market correction of 2008, a vast majority of hedge fund net asset flows have gone to a small minority of hedge funds with the strongest brands. A recent report from Hedge Fund Research shows that approximately 69% of hedge fund assets are controlled by firms with over $5 billion in assets under management and 91% are controlled by firms with over $1 billion in assets. This is a significant increase from the 2009 percentages of 61% and 86% respectively.  

Each year many hedge fund investors are inundated with thousands of emails and phone calls from managers requesting a meeting. To filter through the overload of information, investors are turning more and more to a firm’s brand when choosing which funds to meet and ultimately invest with. However, having a strong brand is not limited to just the largest managers.

For example, many investors will allocate to startup firms that spun-out of other high profile organizations, despite the fact they have no audited track record. In reality, a strong brand is even more important for hedge funds with less than $250 million in AUM. Despite the fact that these managers represent a vast majority of the approximately 15,000 hedge funds, they only represent 2.94% of assets.

What’s New in Washington

As the Trump presidency completes its first 10 weeks, the administration is celebrating big wins on the regulatory reform front while nursing some wounds from a major defeat on efforts to repeal and replace the Affordable Care Act (ACA). While health care reform is on pause for the moment, Republicans are turning to tax reform as the next major policy priority and continuing to use executive orders (EO) and the Congressional Review Act to roll back Obama-era regulations. Funding for the government expires on April 28, 2017, so Republicans and Democrats will face the first test of bipartisanship in the next few weeks as they seek to fund government agencies, including the Department of Defense, through the end of September. All eyes will be on the Senate next week as the Supreme Court nomination of Judge Neil Gorsuch takes center stage.

Here are 10 things that we believe are worth focusing on from the last two weeks:

Life Beyond the Founder

In 2017 hedge funds have effectively made the transition from investment niche for the super wealthy and risk-hungry endowment to becoming an established asset management model that is part of the investment mainstream. However, the nature of the business does not lend itself to deep existential thoughts on the future of the firm. Invariably hedge funds are founder-operated businesses. They are often opportunistic, possess deep skill-sets in one or more trading strategy or asset class, are increasingly systematic and quantitative, and usually have distinct cultures which allow them to take risks, think deeply about the market and recruit/reward those people built in their own image.

But after two decades the natural life-cycle of any business kicks in and thoughts turn towards the future and founder succession. Hedge funds face a unique set of challenges when it comes to succession planning since the reason they can raise capital and manage money in the first place is due to the skill and reputation of the founder(s) themselves.

In this article I will look at succession planning in its widest sense. Not just as a means by which a hedge fund lives beyond its founders but also more holistically; what a hedge fund might look like in the future beyond the specific set of strategies and operating model that the founders conceived initially.

The maturity of the industry over the past two decades, the rise of passive managers and the 2008 financial crisis have all meant that allocators have become more discerning (e.g. in terms of fees/performance), regulators have become more concerned about systemic risk in the market, and LPs have demanded more transparency into portfolio performance and risks.

Hedge Fund Benchmarking and Absolute Returns

How can we test whether a hedge fund programme is adding value to large institutional investor portfolios? This question has grown in importance since the financial crisis, as an eight-year equity bull market has made hedging unattractive. Frequently, hedge fund programmes are compared to the asset class they most resemble (for example, a hedge fund programme is sometimes compared to a long-only equity index, such as the MSCI All Country World Index). In this context, the performance of many hedge fund managers has lagged significantly since 2009. Given that hedge funds may have lower market exposures than a long-only equity benchmark, is this fair? If not, how should they be measured? We argue that a beta-matched mix of stocks and bonds is the most appropriate measuring stick for customized hedge fund programmes, as it compares them to the risk profile that investors could achieve using traditional markets.

Determining the appropriate benchmark mix
To determine the appropriate mix of stocks and bonds to use in comparison with a hedge fund programme, first consider its long-term equity beta. While the beta exposure can vary from one year to the next, over a reasonable three-to-five year evaluation period, the beta of most diversified programmes does not vary greatly.


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