Commentary

Editor’s Letter - Issue 117

If fewer hedge funds are launching than in prior years, this is partly due to the time taken to start funds, set up management structures, or get onto third party platforms. But various options are marketed as offering a faster time to market.

Offshore international financial centres, including Jersey and Guernsey, say their regulators are swifter in signing off new management companies and funds. Some onshore centres also offer fund structures with potential for ‘fast track’ approval.

For those that already have an AIFMD-compliant management company, unregulated funds can be approved in days or weeks. Luxembourg’s RAIF (Reserve Alternative Investment Fund) and Malta’s NAIF (Notified Alternative Investment Fund) are not authorised, supervised nor regulated by their respective regulators (the CSSF and MFSA), and can avail of AIFMD passporting rights. Ireland has not coined a new fund name nor acronym, but its unregulated limited partnerships, run by AIMFD-compliant mancos, offer the same two key features: as AIFs they can be passported, but are not regulated by the Central Bank of Ireland.

MiFID II

The countdown towards the new implementation date of 3 January 2018 has begun, and firms need to be getting to grips with the detail of MiFID II and preparing in earnest for the important changes under this new regime.

Are we there yet?
The final “Level 1” legal texts (comprising a revised Markets in Financial Instruments Directive (the MiFID II Directive) and the Markets in Financial Instruments Regulation (MiFIR), together MiFID II), which were published in June 2014, represent only one layer of the regime. The “Level 2” measures (delegated acts and binding technical standards) and “Level 3” measures (guidelines and recommendations) are in the process of being finalised. These expand upon the Level 1 legislation and contain (or will contain) crucial technical details and guidance that are necessary for firms (and regulators) to be able to comply with the high-level provisions in the Level 1 texts. The lack of finality and certainty over the Level 2 measures in particular has meant that many firms have, understandably, been reluctant to commit full budget and resource to their MiFID II implementation projects so far.

Despite the twists and turns, however, it seems that the end (or, rather, the beginning) is finally in sight. With the Level 2 measures almost finalised and the new implementation date of 3 January 2018 confirmed, there is now a much clearer road ahead to implementation. Although 2018 may still seem some way off, given the amount of preparation required it will remain a challenge for firms to meet this deadline, and (as we mentioned in our earlier alert) Brexit is certainly not a reason to delay or scale back MiFID II implementation plans.

Russia

In 2014 and 2015 Russia was given a substantial economic blow following a new oil price shock and the implementation of economic sanctions for its annexation of Crimea and its active role in destabilising Eastern Ukraine. This triggered its first significant devaluation crisis in December 2014. Following a series of emergency rate hikes, which were instrumental in supporting the rouble, the currency renewed its weakness to reach an all-time low of 80 versus the US dollar in January 2016, as oil fell below USD 30 per barrel. Since then a period of exceptional stability has prevailed globally and Russian assets are among the top performers this year. At this juncture, we deem it useful to look again at the current economic environment, corporate performance, and market factors to draw a reasonable near term outlook. We have identified the following catalysts:

A Testing Time For Europe’s PRIIPs Regime

PRIIPs is an acronym for Packaged Retail Investment and Insurance Products. It represents a cross sector initiative, affecting asset managers, insurance companies and banks, aimed at creating a new standard common disclosure document for retail investors. The premise of the legislation, besides supporting the European single market, is to enhance comparability of PRIIPS with UCITS funds and the overall comprehensibility of financial products for retail investors - as highlighted in the explanatory works to the proposal of the European Commission - through a standard pre-contractual disclosure that is the same across the various sectors and product types.
 
The PRIIPs legislation is undoubtedly amongst the most ambitious regulatory efforts in recent memory and, in some respects, also one of the most innovative pieces of financial services legislation currently under works at a European level. We are also now witnessing how it is becoming one of the most debated ones. In fact, the PRIIPs regime was created through a regulation, which dates from 2014, as well as regulatory technical standards as delegated regulation. The topic of PRIIPs has been heavily prevalent in the news during the past number of weeks because the process of adoption of PRIIPS legislation has been halted by a group of members of the European Parliament, which have managed to gain the support of the Parliament in rejecting the proposed level 2 legislation, which covers the Regulatory Technical Standards (RTS).

On The Style Edge

In our 2015 paper, ‘Hypercube in the Kitchen: Reading a Menu of Active Investment Strategies1 by Gnedenko and Yelnik, we showed how asset managers may be classified based on their skills. Our classification could be viewed as a five-dimensional hypercube. In this discussion we focus on one of its edges: discretionary versus systematic.

The systematic style represents a combination of a systematic strategy (a.k.a. systematic model)’s decisions, and those of the portfolio manager. Whilst the model’s trades are implemented by changing positions in financial instruments, the systematic manager’s trades are changes made to the systematic strategy itself.

Evaluation through statistical methods of investment managers, be they discretionary or systematic, is only possible within certain limits.

Similarities between discretionary and systematic investment management firms, in terms of their exposure to the key person risk, are stronger than is commonly believed to be the case.

Trade and its limits to statistical evaluation of managers
Understanding the differences between discretionary and systematic managers begins with an understanding of trade: for a discretionary manager, a trade is a one-time activity in buying or selling financial instruments. For a systematic manager, buying or selling financial instruments is the model’s trade, not his or her own. The systematic manager’s equivalent is making a change to the model.

When a discretionary manager makes his or her trade, the decision is based on conviction (which is, in turn, based on analysis, experience, mood, etc.). Expected return of any one trade of a well performing discretionary manager is only marginally positive. It is impossible to statistically reject the hypothesis that such return is zero, since every trade is unique and not repeatable.

Negative Rates

Negative rates are a central banking idea based on a poorly conceived and constructed linear view of the efficacy of monetary policy. They do not work to encourage either economic growth or inflation. And, it is very likely that over the next six to 12 months, as evidence of their failure grows, bankers at the European Central Bank (ECB) and Bank of Japan (BoJ) may try to find graceful ways to back away from negative rates, and instead embrace a view of linking monetary policy to more stimulative fiscal policies to encourage economic growth and inflation.
 
Negative rate policies were first introduced in Switzerland and Sweden, aimed at keeping their currencies from rising relative to the euro since the eurozone was their key trading partner and the strength of their currencies was perceived as an impediment to their exports. Sweden and Switzerland are relatively small countries, and the negative rates, effectively a penalty on holding their currency instead of their trading partners’, had some limited success on the currency front, but had little to no impact on economic growth or inflation.

Negative rates were introduced into the eurozone by the ECB, designed to initially charge commercial banks holding deposits at the central bank a -10-basis-point interest penalty, which was expanded in March 2016 to a -40 basis point penalty. The BoJ followed the lead of the ECB in late January 2016, charging a -10-basis-point penalty on certain classes of deposits held at the central bank. The eurozone and Japan are very large economies and parallels with small economies do not apply, and the negative rate policies have not borne out as hoped to increase growth and inflation.

CQS Insights

In this Q&A, Sir Michael Hintze, Chief Executive and Senior Investment Officer of CQS, presents an update on the risks and opportunities he sees in markets in 2016 and beyond.

Q: It has been a decent first half in performance terms for CQS in what is proving to be a volatile and challenging year for markets thus far. At the end of 2015 you expressed caution. Are you still concerned?

A: I continue to be cautious and mindful of ‘potholes’. There are uncertainties created by global geopolitical turbulence, rising populism, and political uncertainty in the US ahead of November’s Presidential elections. In Europe, the UK voted to leave the European Union (EU). Looking into 2017, there is a pretty heavy electoral calendar in Europe, including German parliamentary and French presidential elections, as well as Czech, Hungarian and Norwegian elections, all of which are likely to add to the debate around what kind of Europe EU citizens want. Across Asia, the macroeconomic picture is weaker. China’s growth rate is moderating and its economic structural adjustment is ongoing, while the government has to balance concerns around possible unemployment, social unrest, rising debt levels, forex outflows, and tension around maritime issues. In Japan, Prime Minister Abe received a resounding new political mandate, but growth remains constrained by an economy and stock market that have been slow to respond to progressive monetary easing. It now looks like Japan’s government will undertake further fiscal policy responses to stimulate the economy. In contrast, the US economy appears to continue to grow, labour markets are tightening and the Fed is considering a more hawkish monetary policy.

Long/Short Commodity Investment for Diversified Portfolios

The global search for uncorrelated returns continues as institutional investors deal with “priced to perfection” fixed income and equity markets in a risk on/risk off binary environment subject to economic and geo-political headlines. Various stages of Quantitative Easing (“QE”) have led to a rally in most asset prices as well as growing correlations between their seemingly unrelated return streams, against a backdrop of uncertain economic fundamentals. In this environment, those seeking to add a true alpha strategy should take a fresh look at the uncorrelated commodity sector. More specifically, a compelling opportunity exists in long/short commodities accessed via a discretionary commodity-specific multi-manager platform. This multi-manager approach produces superior risk/return ratio versus more diversified funds of hedge funds. It provides access to talented managers, some of whom are not otherwise available, that are able to profit from the inefficiencies in the various commodity sectors regardless of direction. Long/short commodities are one of the few areas which remains highly underinvested by institutions and offers a sustainable source of alpha with little correlation to other assets.

CTA Performance During the Brexit Vote

On 23 June 2016, the UK electorate voted 51.9% in support of an exit from the European Union. This resulted in significant market turmoil over the following trade day. The voting outcome came as a surprise to many, who saw the exit as unlikely. Perhaps more surprisingly, medium- to long-term trend followers benefited from the announcement: the SG CTA Index increased 2.27%. Why? Were CTAs forecasting the event?

Qualitative examination of price movements suggests that markets were trending in the direction of the Brexit exit in the prior months. This is supported by systematic analysis over the same period. There are many ways to define the concept of “trend,” and while it is useful to visually examine the evolution of prices themselves over time, creating a trend metric has its own utility in terms of creating a less subjective view of market behavior. Signal-to-noise ratio (SNR), which attempts to quantify the strength of a price trend by looking at how uniformly it increases or decreases, is one such measure.

In terms of its computation, the SNR is simply the absolute price change over the lookback period divided by the sum of the absolute daily price changes. The lookback period of choice depends on the timeframe of interest. For medium- to long-term trend followers that can mean anywhere from 40 to 120 days. The closer the price path is to a straight line over that period, the higher the SNR. A perfectly straight line will have an SNR of 1, while a completely flat path will have an SNR of 0. Below are some examples with generated data.

Editor’s Letter - Issue 116

The Deal’s and ArrowCon Partners’ Corporate Governance and Activist Investing in Europe event, held in London this month, highlighted how activism is a global phenomenon that has coined a new word: “Bumpitrage”, or the practice of persuading acquirers to increase their bid.

EY’s Julie Hood has seen a doubling of activism in Asia, including in China, but the event mainly focused on Europe, where there are different corporate governance frameworks to navigate in different countries. It is crucial to understand the roles of dual management and supervisory boards. Many boards in Southern Europe lack a majority of independent directors, according to CIAM’s Anne Sophie D’Andlau. Amber Capital founder, Joseph Oughourlian, has often seen conflicts between controlling and minority shareholders in Southern Europe. Speakers from Germany, including EY’s Gerrit Frohn, argued that special rules applying to investor communications in Germany are much less clear than SEC rules. Schulte Roth & Zabel’s Jim McNally observed how thresholds for blocking stakes vary between European countries. Though activists in Europe generally start with a gentle approach, they can sometimes end up replacing boards. Teleios Capital, Makuria Investment Management, and Constructive Capital Partners, installed a new board at Kongsberg Automotive, for instance. Yet the obstacles to activism can sometimes seem insurmountable: workers represented on boards, under co-determination rules in Germany, have been blamed for scuppering the Linde/Praxair merger.

Most activist investors are private funds, often with long-term, locked-up capital. Some publicly listed closed ended funds pursuing activist approaches include Tony Attwood’s Gresham House, Edward Bramson’s Sherborne Investors, Richard Bernstein’s Crystal Amber, Bill Ackman’s Pershing Square Holdings and Dan Loeb’s Third Point.

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