Guide to Hedge Funds Read online

  There is no reason, in theory, why current fixed income arbitrage managers should run into the same problems. They have two main avenues for profit: the yield curve and credit spreads. On the yield curve, as in the LTCM example above, they can bet on its shape. Traditionally, long-term bonds have yielded more than short-term bonds; if the shape does not conform to this pattern, they can bet on a return to the status quo. On credit, they can bet that wide spreads will narrow or that narrow spreads will widen. However, it is easier to bet on narrowing than on widening because of the way the trade works: narrowing involves buying a higher-yielding bond and shorting a lower-yielder. The trade has a positive carry. Betting on wider yields would mean losing money in the short term until the spread corrected.

  The sector was given a lot more flexibility by the development of credit derivatives, particularly credit default swaps (CDSs) and collateralised debt obligations (CDOs). The former allow investors to insure their bonds against default, or alternatively to bet that default will occur; the latter slice and dice portfolios of bonds into different tranches, based on risk. The result is that the corporate debt market became much more liquid. But the potential for risk-taking has increased sharply, as the problems facing two Bear Stearns funds in June 2007 illustrated (see Introduction). Hedge fund managers were forced to sell some of their fixed income securities in 2007–08, driving prices sharply lower and exacerbating the scale of the crisis.

  Directional funds

  Global macro managers

  Global macro managers dominated the industry in the early 1990s but have since become much less significant. As well as George Soros, the likes of Julian Robertson and Michael Steinhardt were renowned for making big plays on currencies, bonds and stockmarkets. But Steinhardt retired in 1995 and Robertson gave up the ghost in 2000. Each suffered problems towards the end, with Steinhardt making big losses in the bond market sell-off of 1994 and Robertson being caught out by the dotcom boom of the late 1990s.

  Soros continues to run hedge funds; indeed, his assets under management jumped 41% to $24 billion by mid-2009. But he is much better known for his political and philanthropic works these days; there has been no triumph on the scale of his bet on sterling’s devaluation in 1992.

  A separate group of managers developed from the commodities markets, particularly the likes of Paul Tudor Jones, Bruce Kovner (of Caxton) and Louis Bacon (of Moore Capital). These are generally known as managed futures managers (see next section).

  Global macro is hard to define. As Drobny writes in his book Inside the House of Money:3

  Global Macro has no mandate, is not easily broken down into numbers or formulas, and style drift is built into the strategy as managers move in and out of various investing disciplines depending on market conditions.

  That makes the style a difficult sell now that the dominant investor class in hedge funds is institutional. The institutions, and the consultants who advise them, like to put hedge funds in a box, so that they can work out how much of their money is devoted to a particular asset class or risk approach. They like predictability and dislike style drift. In contrast, a global macro manager appears to be saying: “I’m really clever. Trust me to navigate the markets.”

  These days, there may be a general cynicism among investors about the ability of hedge fund managers to make big successful bets on macro events such as devaluations. With the advent of the euro, there are fewer fixed exchange rates to aim at and those that remain, such as China’s, have capital controls and are thus more difficult to speculate against.

  Some global macro managers have diversified into becoming multi-strategy funds, a term that sounds more up-to-date but still, in essence, depends on the ability of one person (or small group of people) to allocate capital to asset classes based on his view of the world. The key formal difference between multi-strategy and global macro is that the former allocates money to sub-managers as he sees fit and the latter is running all the money himself. In practice, the divide is not quite so sharp, since a big global macro manager will delegate certain asset classes to different trading teams.

  Managed futures or commodity trading advisers

  Technically speaking, this is not really a hedge fund sector at all. Its name springs from its regulatory origins; these are funds that deal in the futures markets and, as a consequence, are overseen by the Commodity Futures Trading Commission in Chicago. They are required to disclose their activities, particularly the costs incurred in trading. “It’s a much cleaner business than the hedge fund business,” says David Harding, one of the pioneers of the sector; he set up AHL and now has his own firm, Winton Capital.

  Nevertheless, commodity trading advisers (CTAs) are generally lumped in with the hedge fund industry, perhaps because they often take big risks and can earn outsized returns and perhaps because some of the big names of the hedge fund industry, such as Tudor Jones, started in this sector. But they also attract a lot of suspicion, and some fund-of-fund investors will not include them in their portfolios. Recent fund performance has been mixed. The funds did extremely well in 2008, reporting an average gain of 18.2%, while the typical hedge fund lost almost 20%. But in 2009, the average managed futures fund lost money while most other hedge funds were rebounding.

  One of the leading managers, Anthony Todd of Aspect Capital, says: “Managed futures is the most misunderstood sector.” However, this is hardly surprising when managers are so reluctant to explain exactly what they do. Firms are highly dependent on “black box” models – computer programmes that scour the market for profitable opportunities. If a manager gives away how the model works, his business could be destroyed since another manager could copy it. But that limits what they can tell clients. The best they can say is: “We have a system that has beaten the market in the past. Here are the results. Trust us when we say this will also work in the future.”

  Not everyone is comfortable about this arrangement. David Swensen, who runs the highly successful Yale endowment fund (and has been a big investor in hedge funds), has said: “You cannot be a partner with somebody who has a black box.”4

  So what are the systems trying to do? According to Todd:

  Markets are not completely efficient.5 There is a tendency for trends to persist and there is a tendency for investors to act as a herd. We believe such trends will exist whatever market you look at and over multiple timeframes.

  He says his firm attempts to exploit trends on a systematic basis, covering a wide range of markets (90 or so). The business started in the commodity markets (hence the CTA name) and uses futures contracts, a cheap way of getting exposure to an asset class.

  Markets do indeed seem to show trends. They have long periods of rising prices (bull markets) interspersed with falling prices (bear markets). Once a managed futures fund believes such a trend has set in, they will jump on the bandwagon. They are thus vulnerable to two things: a sudden break in the trend (such as a crash), or a period of range-bound markets, where prices keep changing direction. “We don’t buy CTAs because we think they get whipsawed when trends change,” says Higgins.

  A further problem is that they are not the only ones looking for such trends. If it was obvious that a bull market was under way, lots of people would spot it and prices would rise quickly, before the managed futures fund had positioned itself. As Todd admits, “The difficulty is that markets are always developing. The half-life of any given systematic approach is shrinking.” That means managers have to devote a lot of money to research, so they can keep ahead of the game. And it also means they have to be adaptable without changing tactics so often that clients start to wonder whether they are guessing.

  The need for new ideas is such that CTAs often have a lot of mathematicians and academics on their staff. Winton has set up two academies, one in Hammersmith in west London and the other in Oxford, and the Man Group (the parent company of AHL) has sponsored the Oxford-Man Institute of Quantitative Finance. It all sounds a long way from Brideshead Revisited.

  Tim Wong, chief executive of AHL, says his firm spends a lot of time trying to improve on the execution of its ideas:

  It’s difficult to find new ideas where you can guarantee alpha, but if you lower your trading costs, you know exactly what return you are going to get.

  Some argue that managed futures funds offer a poor trade-off between risk and reward (in technical terms, a low Sharpe ratio) compared with other hedge funds. This is true. But Todd argues that funds with good Sharpe ratios tend to have short track records or are invested in illiquid assets, where the volatility is essentially hidden (because prices move less frequently). The Aspect Diversified fund has 17% annualised volatility, similar to that of the stockmarket, but 15–20% annual returns.

  Defenders of the sector argue that it does provide genuine diversification. Although managed futures funds do usually fall at market turning points (because they have been following the trend), they quickly adjust to falling markets.

  Event-driven

  Distressed debt

  Managers in this sector invest in bonds or loans issued by companies that are in trouble. Traditionally, they hope to exploit the fact that investors generally panic when companies look in danger of default, and that drives the bond price down to depressed levels.

  It is a sector where managers often need a lot of expertise and a fair amount of stubbornness, fighting their corner against other classes of creditors when companies get into trouble. A distressed debt manager may feel he has spotted something in the documentation that gives him greater rights than other people suspect. Or he may parlay his position into equity rights in a restructured company, hoping there will be substantial upside.

  Higgins says that managers in this sector “want to own debt that earns more than the cost of leverage and hope that the possibility of default is less than the market thinks”. Ironically, thanks to their willingness to buy debt in troubled companies, they may prevent more companies from going into bankruptcy; in the old days, many companies would be in debt to banks, which would foreclose while they still had a good chance of reclaiming some value.

  Merger arbitrage

  Although this sector has an arbitrage label, it really is an event-driven approach. There is nothing that gets a stockmarket more excited than a big takeover. Not only does the share price of the target company shoot up, but the shares of other potential targets tend to rise in sympathy. Since the initial offer is rarely successful, investors eagerly await details of the second, higher bid or a rival offer from an outside group. Or perhaps the target company will try to buy investors’ loyalty with a cash dividend or the spin-off of a division.

  It is a situation that creates a lot of volatility, something that hedge funds love. And their interests tend to dominate when bids are announced. Twenty years ago, both predator and prey would have had to cultivate the big pension funds and insurance companies which were the long-term holders of the shares. But these days, such institutions are tempted to sell after the initial surge in the target’s price; they would rather lock in a sure profit than risk losing out if the bid collapses.

  If there is money left on the table, merger arbitrage funds try to exploit it. Higgins says:

  If the deal were priced at $50 per share, mutual funds and pension funds would often get out at $49 because the upside was limited. But hedge funds would be attracted by that final dollar. With the use of leverage that can be turned into an attractive annualised return.

  Takeover bids, like other auctions, are subject to the “winner’s curse” – the successful predator ends up paying too much. As a result, shares in the predator generally fall when a bid is announced, while those in the prey rise. So a simple merger arbitrage would be to go long the shares in the prey and short those of the predator. One academic study suggested that such a strategy would have delivered a return of 0.8% a month (around 10% a year) over the period 1981–96.

  But this is another market that is highly competitive, since most hedge funds are following similar strategies. In the event, the funds are often betting on the bids going through, since if the deal fails, the shares in the prey will fall and those of the predator will rise (causing the hedge funds to lose money on both legs). They thus have an interest in pushing the target company to accept an offer. This may well lead to more takeovers occurring than happened in the past – a point that hedge fund critics (who worry about short-term pressures on company executives) are rapidly taking up.

  Activist funds

  The hedge fund group currently creating most of the headlines is activist funds. Its philosophy can best be summed up by a popular cartoon featuring two vultures. “Patience, my ass,” says one vulture to another. “I’m going to kill something.”

  A classic example is the fund TCI, which took a stake of just 1% in ABN AMRO, a Dutch bank, and demanded action to break up the group and create value for shareholders. With such a small stake, the bank’s management might have felt it could safely snub the hedge fund; certainly that might have been the case in earlier decades, when continental European companies felt free to ignore their shareholders. But within weeks, ABN AMRO was on the receiving end of a friendly bid from Barclays Bank, and then a more hostile (and ultimately successful) bid from the Royal Bank of Scotland.

  The philosophy behind activist hedge fund investing is that company boards need to be pushed into action. Ruddick says:

  Sometimes you can spot an anomaly but you still need a catalyst to turn that anomaly into a profit. Activist funds are the catalyst.

  This can be an expensive process, since lawyers need to be used and other shareholders canvassed. Other investors can also get a “free ride” over the hard work done by the activists. One leading activist, William Ackman of Pershing Square Capital Management, says:6

  Our preference is not to be activist if we can find a management team that is already doing the right thing.

  However, there are also advantages. With a small stake, activists can get a lot of leverage over executives, who may fear a shareholder revolt if they do not act. Ackman says:

  What we do is akin to private equity, but we don’t have to pay an auction price, we don’t have to use leverage and we don’t have to pay a premium for control.

  Traditionally, activists were seen as a force in the American market, but recently they have been moving their attention to Europe. This helps explain why they have been the subject of controversy; in continental Europe, shareholders have traditionally been seen but not heard.

  However, Guy Wyser Pratte of Wyser Pratte Investments says Europe has some advantages for the activist:7

  In Europe, the activist manager has a captive audience in terms of Anglo-Saxon fund managers who think the same way. Also in Europe, the company bears the cost of a proxy battle, whereas in the US it is the outside investor. And in Europe, shareholder resolutions are legally binding; in the US, they are not.

  Finally, Wyser Pratte adds that in Europe, not many shareholders vote, making it easier for an activist resolution to be successful.

  An academic study8 looked at the record of 110 activist hedge funds, mounting 374 campaigns in the course of 2004 and 2005. It found that activists typically targeted companies in the value stock category with low price to book or asset value and strong cashflows. There was a definite bias against targeting the largest companies, probably because of the cost of acquiring the initial stake. Around 40% of the cases involved a threatened shareholder vote, takeover or lawsuit and a quarter of all cases involved hedge funds acting as a block. On average, the campaigns resulted in improved returns for all shareholders.

  Other funds

  Hedge funds are ever inventive and there are some funds that do not fit plausibly into any of the above categories. Volatility arbitrage funds, for example, look at the fluctuations of different markets. If they expect volatility to rise, they might buy options that will rise in value. If they expect volatility to fall or be low, they will sell options (the equivalent of offering insurance).

  Some strategies can be dubbed “alternative beta”, in that they are not so much hedging as trying to exploit the potential for outsized returns in unconventional asset markets. One example is film finance. Traditionally, movies have been financed by the big studios or by banks; returns have been patchy, with most films failing to break into a profit and a few blockbusters making up for the rest. The big money has been made by the likes of Tom Cruise and Julia Roberts. Hedge funds have moved into this area, using various strategies: picking only low-budget films, or films in certain genres; or picking films that computer models suggest might be successful.

  Other alternative beta approaches have included betting on footballers’ careers, bankrupt power stations and weather derivatives. In some ways, the more obscure the asset class, the better. If few investors follow it, the chances are that prices will be set inefficiently and excess returns can be achieved. Furthermore, obscure assets are unlikely to be correlated with stock or bond markets.

  Multi-strategy funds

  Multi-strategy is a term that covers two distinct trends. The first relates to the managers. It makes sense for them to diversify their businesses, so many move from, say, convertible arbitrage into other strategies. As a group, they can thus be described as multi-strategy managers (many of those described in Chapter 2 fit into this category).

  The second trend is for individual multi-strategy funds. For many of the strategies described earlier in this chapter there are periods when they are successful and periods when they struggle to earn decent returns. In an ideal world, investors would be able to anticipate those changes of fashion and would switch their funds accordingly. But even if they were blessed with perfect foresight, hedge fund investors would still find it difficult to transfer money because of notice and lock-up periods.