Guide to Hedge Funds Read online

  The result is that the industry is nowadays divided into quite a wide variety of sectors. These divisions are far from hard and fast; index providers who categorise the industry rarely have exactly the same descriptions. Some are pretty cynical about the whole exercise. “Hedge fund strategy descriptions are largely there for marketing purposes,” says Steven Drobny of Drobny Global Advisors, an expert on the industry.

  Part of the difficulty in defining hedge funds is their sheer complexity. Guy Ingram of consultants Albourne Partners says: “It is like cartographics. You have the problem that you are drawing in only two dimensions.” Ingram says there are really three: the exposure of the funds (whether they are net long or short); the style of management, whether they use computer models or human judgment; and the asset class they invest in. Mapped on that basis, it is clear that many strategies sit on the boundary of two or more sectors.

  But for this book’s purposes, we can roughly divide the industry into four categories:

  • The first is the Winslow Jones style of managers, those who play the stockmarket with both long and short positions.

  • The second can be described as arbitrage players, those seeking to exploit inefficient areas of the financial markets such as convertible bonds.

  • The third can be dubbed directional, those investors who attempt to exploit trends or inconsistencies in a wide range of markets, using either their own judgment or some kind of computer model.

  • The fourth is known as event-driven, those who exploit a particular situation, such as a merger or a bankruptcy.

  Out of these four broad categories, 10–20 subcategories can be created.1

  Because there is no universal agreement on sector definition, it is hard to be definitive about how large the individual sectors are. What is clear is that the industry is much more diversified than it used to be. As of 1990, Hedge Fund Research reckoned that 71% of assets were in global macro funds; by autumn 2009, the macro sector had just 18% of the total and equity hedges had 32%.

  Equity funds

  Equity long-short

  This is perhaps the fastest-growing hedge fund strategy, probably because of its familiarity to both potential managers and clients. For a manager coming from a long-only background, equity long-short seems a natural first step. It takes advantage of his ability to pick stocks. For investors, the style is closest to the traditional active management they are used to, but with the potential appeal of reducing market risk.

  But this does not mean it is easy. Managers can find it difficult to make money out of their short positions (for reasons explained in the short-selling section opposite). If the manager has a high exposure to the market, he starts to look like a traditional long-only fund, with much higher fees. Furthermore, clients may feel they are paying for beta (market exposure) rather than alpha (skill).

  However, if the manager reduces his exposure to the market, he will probably find he is lagging the leading indices during bull phases. That may tempt clients to switch away from hedge funds and back towards the long-only category. If hedge fund managers end up chasing the market, they can be caught out by a sudden downturn, especially if they are using leverage; this happened to the earliest generation of managers, many of whom were wiped out by the bear market of the mid-1970s. The SEC found 140 hedge funds operating in 1968, but a Tremont Partners survey in 1984 could discover only 68.

  Some managers may try to avoid these problems by having a semi-permanent asset allocation, aiming to be, say, a net 80% long most of the time. Others may want the flexibility to use their market timing skills (although it is far from clear that stock-pickers will also be astute at guessing the overall direction of the market). Despite the potential problems, long-short funds keep being created. “There are an awful lot of long-short funds because there are few barriers to entry,” says Simon Ruddick of Albourne Partners.

  One obvious reason the long-short sector is home to so many funds is that, like ice-cream, it comes in many flavours. Long-short funds can be geographical, focusing on the American market, Europe as a whole (or as individual countries) and emerging markets. They can also be sectoral, focusing on individual industries such as biotechnology or energy. The managers can be traditional stock-pickers or use computer models.

  The sector also intersects with a fast-growing product known as the 130–30 fund. Such funds (named after their long-short proportions) are often not constructed as hedge funds but are a way for institutions to benefit from hedge fund techniques (see Chapter 6).

  Market neutral

  This could be seen as the purest form of hedge fund investing, relying entirely on the manager’s skill. Long and short positions are equally matched so that the direction of the market should have no effect on performance (hence the name of the strategy). This approach is usually based on pairs trading, with the manager finding similar stocks and buying the one he likes and shorting the other – an obvious example would be to go long BP and short Shell.

  The trouble with this approach, says Dan Higgins of Fauchier Partners, a fund-of-funds group, is that there are no perfect pairs. Managers can delude themselves into thinking they are taking no thematic risk, but when all the positions are added up you find that they are exposed to dollar risk, commodity risk or some other factor.

  Furthermore, it can be rare for the manager to have equal convictions about his long and his short positions. So the client finds that while the manager is making money on his long positions, he is losing it on his shorts.

  Nevertheless, those investors who can find skilful market neutral managers can clearly add a useful source of diversification to their portfolios.

  Short-selling

  This is probably the most difficult of all the sectors for the managers concerned; few have made a long-term success of it. Some of the problems facing short-sellers were explained in the Introduction. For a start, they are fighting the tide; markets generally go up over the long term. Second, exchanges can impose restrictions on short-sellers and even when they do not, it can be difficult (and costly) to get hold of stock to sell. Third, the mechanics are unfavourable; the maximum gain that can be achieved is 100%, whereas the loss is potentially infinite and losing positions steadily form a greater and greater part of the portfolio.

  Companies can also be aggressive to short-sellers, mounting press campaigns against them. And because the overall level of short positions in a stock have to be disclosed, other investors can try to push the market against them, forcing the price higher “in a short squeeze”, reasoning that, eventually, the shorts will have to crack and buy back the stock.

  Nevertheless, some investors like to have short-selling funds within their portfolios as a diversifier for when markets fall. But even in bear markets for shares such as 2000–03 or 2007–08, short-sellers have not done quite as well as investors might have expected. As a result, this is a difficult business; David Smith of GAM reckons there are only around 25 short-sellers operating in the world.

  Arbitrage funds

  These aim to exploit anomalies in the mispricing of two or more securities. For example, take Dixons, once a leading UK high-street retailer, and Freeserve, once a hot internet stock. There was a point during the dotcom boom when Dixons’ stake in Freeserve was worth almost as much as the market value of Dixons itself. Unless you thought the high-street chain was worthless, it made sense to buy shares in Dixons, short shares in Freeserve and wait for the anomaly to right itself.

  It is important to make the distinction between riskless arbitrage and other types. Riskless arbitrage occurs when the same asset is selling for different prices at the same time. Provided that the transaction costs are smaller than the gap in prices, it is possible to profit by buying at the low price and selling at the high. Such chances are rare. Most hedge fund strategies are based on the theory that normal relationships between asset prices should hold. But they might not, which is why risk is involved.

  The attraction of arbitrage funds, according to Higg
ins, is that they are in theory less correlated with the overall stockmarket. The problem is that with lots of clever people scanning the markets every second, arbitrage opportunities are likely to be fleeting. If enough capital is chasing these opportunities, returns are likely to fall.

  “The main driver of the returns is the supply of the inefficiencies relative to the amount of capital invested,” says Higgins. Thus the funds generally perform best after a period of great volatility, when there are wider spreads to be arbitraged away. For example, there were some attractive opportunities after the collapse of Enron and WorldCom, two big American companies mired in scandal, in 2002.

  Convertible arbitrage

  This sector has recently provided a textbook example of how too much capital can drive down returns. It invests in convertible bonds: fixed income instruments that give investors the right to switch into shares at a set price.

  Such bonds go through spurts of popularity, usually when stockmarkets are rising. In such circumstances, investors like them because they give them a geared play on the stockmarket (the bond becomes much more valuable when the market price of the shares rises above the price at which the shares can be converted). Companies like them because they carry lower interest rates than conventional bonds; it seems as if the market is giving them a subsidy.

  But hedge fund managers looked at these bonds in a more sophisticated way, as a bond with a call option attached (a call option is the right to buy an asset at a certain price). They reckoned that these call options were often underpriced, something they could calculate by looking at the price of options on the underlying shares. (In the jargon, the implied volatility of the bond was lower than the implied volatility of a conventional option.) As a result, convertible arbitrage managers would take advantage by buying the bonds and selling short the shares (using a technique known as delta hedging to calculate the number of shares they should short).

  In effect, companies had sold the right to buy shares at too cheap a price. “It was a transfer of wealth from minority shareholders to the arbitrage community,” says Ruddick.

  How did managers make money? The simple version is that they would wait for the bond to be repriced relative to the shares. The more complicated version is that either the value of the bond would rise (its implied volatility would go up) or the manager would profit from the hedging process (since delta hedging would naturally lead him to buy low and sell high).

  There were further advantages to the strategy. Corporate bonds pay a yield, which the fund would accumulate, offsetting the cost of selling the shares short. Managers also gear up the returns by using borrowed money.

  According to Higgins: “In the early years of the strategy, it had very low volatility and high returns.” Naturally, the promise of easy money lured a lot of capital into the sector. The bonds steadily became less cheap and then started to trade at a premium to their underlying value. Higgins says:

  By 2001–02, the trade was getting crowded. In 2002, it got bailed out by higher volatility. You were buying expensive fire insurance, but there was a fire.

  The crunch eventually came in 2005. A lot of convertible arbitrage funds lost money, and many managers went out of business.

  As a result, the cycle started again in 2006. The withdrawal of capital from the sector meant there were more profitable opportunities and the surviving convertible managers started to perform again. Some managers may also have moved into capital structure arbitrage, which looks across all the instruments issued by a company to see if one looks cheaper than another. For example, if a company is in trouble, a manager could buy the senior debt (with the greatest rights over the assets) and short subordinated debt (with far fewer rights). If the company then went bust, the manager would make more money on the short position than he would lose on the long. With more and more instruments being created (such as credit derivatives), capital arbitrage may be a rapidly expanding sector.

  Statistical arbitrage

  Those involved in this sector are the real rocket scientists of the industry, using highly sophisticated models to try to find statistical relationships between various securities. A prime example is Jim Simons of Renaissance Capital (see Chapter 2), a firm that focuses on hiring scientists, not fund managers. The idea of statistical arbitrage (or stat arb) is that certain securities are linked; for example, some companies have dual classes of shares. Such securities will not always move exactly in line but will move within a range of each other’s values, say 90–100%. When the upper or lower bands of that range are reached, a statistical arbitrage fund will bet on reversion to the mean. Unlike managed futures funds (see below), which bet that a trend will continue, stat arb funds bet that it will stop.

  Some of these profitable opportunities may last for only a fraction of a second. So, rather like gunslingers in the wild west, stat arb managers have to worry that there will always be someone faster than they are. There has been a kind of arms race to execute trades as quickly as possible, with trades now executed in a thousandth of a second. Some even site their computers as close as possible to the stock exchange to minimise the time it takes their orders to travel down the wires. Stat arb managers also need markets to be liquid. Higgins says:

  There is clear evidence that they need very deep pockets to invest in research and development and to develop computer power.

  Because the models are so sophisticated, it is hard for managers to explain how they work (indeed, it is not in their interest to give too much detail away). The investor can only really be guided by their track record – not always a great predictor of future performance – and take their brilliance on trust.

  According to Ruddick: “For a 10–15 year period, stat arb was one of the most reliable generators of value.” He says that the funds were really acting as synthetic marketmakers. They benefited because many investors were trying to offload large positions on the market and there were not enough players with capital to take the other side of those positions; this gave the stat arb funds a chance to make a profit.

  One source of profit disappeared when Wall Street shifted from quoting share prices in fractions (sixteenths, eighths) to quoting in decimals. That allowed for much keener prices (lower spreads) and one-third of all marketmaking profits disappeared overnight. Since then, stat arb funds have faced keen competition from the proprietary trading desks of investment banks, from order matching systems, which link buyers and sellers without going through a marketmaker, and from specialist operators.

  It is a tough business. Even though stat arb funds are trading more frequently, and spending more on research, it is generally agreed that returns have been far less impressive since the stockmarket peak of 2000.

  The stat arbs ran into particular difficulty in the summer of 2007. It seems as if the problem began when some multi-strategy hedge funds lost money on mortgage-backed securities. They needed to realise some cash and sold their most liquid securities on the stockmarket. But those shares were the ones that stat arbs tended to own. In turn, the resulting share price declines triggered selling by the star arb funds. As everyone tried to exit from the same positions at once, traditional relationships between asset prices broke down. The stat arb funds resolved to redefine their models.

  Fixed income arbitrage

  This carries the burden of Long-Term Capital Management (LTCM),2 the huge (and hugely-geared) hedge fund that collapsed in 1998. LTCM was founded by John Meriwether and a bunch of fixed income traders from Salomon Brothers who tried to replicate their success at the investment bank. Thanks to their record and their contacts, they received a lot of backing, and had powerful people as investors (it helped that two Nobel Prize winning economists advised them).

  Their essential idea was that some securities in the market were irrationally mispriced; for example, the Treasury bond market used to have the 30-year issue as a benchmark. Everyone would want to own that bond, hence a bond with only 29 years till maturity would trade at a discount. If this discount got too wide,
it would eventually correct (after all, the bonds were guaranteed by the American government). Because prices got only slightly out of line, it was necessary to use a lot of leverage to make money.

  LTCM essentially ran into two problems. The first was what is known as the “gamblers’ fallacy”. You might have a system for beating the casino; for example, doubling up after every losing bet. This might work, but only if you have infinite capital. If luck runs against you, you will be bankrupt before you succeed. This is what happened to LTCM. When Russia defaulted in 1998, everyone wanted to own riskless assets. But LTCM’s bets were essentially all of one type: to be long risky assets and short riskless ones. Spreads widened more than history suggested they would. Eventually, they should have returned to normal (indeed, those who took over LTCM’s positions made money). But because of the leverage, LTCM ran out of money before that happened.

  The second, and related, problem was that LTCM’s models did not allow for the kind of market move that occurred. In part, this was because extreme events occur more often in the financial markets than conventional models assume. This is particularly the case when markets are illiquid and one player (such as LTCM) has a large position.

  There is an old story of an enthusiastic investor who piled into a penny stock (a small company with a share price of a few pence or cents). As he bought, he was delighted to see the share price move higher, so he increased his position. Finally, having more than doubled his money, he called his broker and said, “Now I’d like to sell”. “Who can you sell to?” asked the broker. “You were the only buyer.” LTCM faced the problem that it had large positions that were well known to everyone in the market. It had to offload those positions at a fire sale price.