Allocators enjoy the ‘low risk-taking world’ of hedge funds

Date: Tuesday, November 6, 2012
Author: David Walker, Investment Europe

Low net positions and the popularity of relative-value strategies suggest that hedge managers are reining in their risk.

Go to the cinema these days and you will see hedge fund managers being portrayed as high-flying risk-takers, in films such as Arbitrage and Cosmopolis.

Then turn instead to the choppy and politically-driven financial markets, and you will find the reality in regards to risk-taking is quite different.

These days, it seems clients prefer the reality to the myth. This year to June, fund buyers sharply cut their exposure to strategies that historically have taken larger directional bets. Two main protagonists, equity long/short and event-driven, suffered withdrawals of $4.3bn and $1.8bn, respectively.

Relative-value managers were the main beneficiaries of a rotation, as they took in $22.3bn fresh business. These managers invest according to the relative value of related instruments, rather than the directional movement of either instrument on its own.

If current net flow patterns persist, relative-value will soon overtake equity hedge as the industry’s largest strategy by assets. By June the race was tight – relative-value held 26.4% of the industry’s $2.1trn assets, just behind equity hedge’s 27.1%, according to Hedge Fund Research.

Equities strategies had $1.3bn drained from them in the second quarter, and they lost nearly 20 times more than that on their investments. Relative-value strategies lost only $479m on their investments, but enjoyed $9.9bn of inflows.

Morten Spenner, chief executive officer of allocator International Asset Management Ltd, says the move towards relative-value strategies has been one of the hedge fund industry’s defining features since the 2008/2009 crisis.

Allocators were hurt by the 18% loss from relative-value funds in 2008, showing it is not a risk-free strategy, but they suffered sharper losses of 26.6% from equity long/short and 21.8% from event-driven.

Spenner says: “For the last three or four years it has all been about global macro and relative-value, and now allocators are tending more towards relative-value.”

They have been vindicated in their preferences so far this year. Relative-value strategies made 6.5% by August, the third best strategy HFR tracks. Global macro made 1.0%, and hedge funds overall returned 3.5%.

Relative-value funds were fairly flat last year, but markets then made simply avoiding losses an achievement. In 2010 relative-value made 11.4%, slightly above the industry average.

Top-down influences

In strategies that could take more directional risk – from equities to currency – managers have also reduced the extent of their directional bets. They blame markets being driven back and forth by top-down influences, rather than by fundamentals, as the reason for their risk aversion.

Allocator FRM noted, even when the European Central Bank announced that it would buy unlimited quantities of bonds from countries on central support, the subsequent increase in risk-taking was only “small, and tentative at best, with managers generally continuing to refrain from taking large directional exposures.”

Anthony Lawler, portfolio manager at allocator GAM, said in August managers kept “low risk levels with upside risks remaining from policy interventions and central bank actions. These were balanced against the downside risks of a global growth slowdown and stubbornly high unemployment levels.”

In June, hedge funds overall were a modest 43% net long, down from 49% in the first quarter, according to Goldman Sachs analysis published in August. The recent measure might have been higher than the 36% net long in the volatile third quarter of 2011 – as Europe’s sovereign debt crisis intensified – but it was well below the 52% from the first quarter of 2007, before the series of global economic and banking crises began.

Directional view

Adrian Owens, who manages about $2bn in the Global Rates and currency absolute return strategies at GAM, has thematic convictions in some assets – long Mexico’s peso and a stronger economic outlook for North America than Europe and Asia, for example – but he is less willing to be directional in others, largely because of the influence central banks on markets.

“In bonds and interest rates, for example, we do not necessarily want to take an outright long or short position. If you want to sell bonds in an aggressive way you are fighting central banks, so you focus on relative-value macro trades, being short one bond market versus another, for example.

“We like flattening trades in Europe on the view that rates do nothing and from a risk management point of view you can put that against a trade somewhere like Canada, where we are trading [on the view] that the [yield] curve will steepen a bit. We are also looking for opportunities to be short the US market but long Europe on a macro view.”

In currency markets, where price moves are by definition relative in nature, Owens believes the euro will remain under pressure and weaken versus sterling.

Owens voices one ‘directional view’ that is shared by many of his industry peers – that commodity currencies such as Canada’s and Australia’s dollar are too high. “They have done incredibly well and are causing problems [for those countries].”

Even those equities strategies that reduce their directional bets by balancing assets in long positions with assets in short positions – so-called ‘market-neutrality’ – have been seeking new ways to reduce their risks.

Ian Heslop, manager of Old Mutual Asset Managers’ Global Equity Absolute Return hedge fund, says market-neutral hedge fund managers have reconsidered over past years the whole concept of ‘market neutrality’, and whether balancing long assets with shorts actually “squeezes out market risks from a portfolio”.

“We as an industry used to think about that as being a portfolio construction conundrum, and it is true you must have effective portfolio construction processes being beta-market-neutral. But it is not just this that is important. Macro impacts or correlation can have huge impacts on your outcome.

“You may think you have a market-neutral portfolio, but you invest heavily in value. You may not have market risk at the beta level, so you may think you are market-neutral. But fundamentally value is correlated to the market because of the risk appetite. So even though you have no net exposure to the market, your returns are correlated to that market.”

Heslop’s concerns on market exposure risk are borne out by global equities analysis from software firm Axioma, which showed various factors have produced widely divergent returns since mid-2011.

The ‘value’ factor has actually been quite neutral, generating less than 3% gains over the period, but exposure, intended or not, to the factor of ‘volatility’ would have lost investors nearly 15%.

Melissa Brown, senior director, applied research at analytical software provider Axioma, said: “With the factor ‘volatility’ you can just get clobbered. You have to think about risk and return being two sides of the same coin and if you are a good return forecaster but not thinking about risk at the same time, you may end up getting hurt, although it has nothing to do with your skill.”

Brown said part of a manager’s skill should be knowing what risk they are better equipped at taking, and focusing on that.

Heslop acknowledged, during May as events in Athens/Brussels swayed whole asset classes that “not making the wrong decision is as important as trying to make the right one.

Risk-on, risk-off

“In the long term, you can end up with mis-priced stocks and you can tap into that, but you must also recognise that in the short term, there can be extreme jumps that can hit you. When you have an unstable macro environment, like in 2010 when you had ‘risk-on’ at nine in the morning and ‘risk-off’ by noon, it was very difficult, and managers could be either lucky, or not.”

FRM suggested managers’ general reticence to take risk was raising important questions: “With no major change to the outlook for the financial environment and cautious positioning continuing to serve as a key determinant of survival in the hedge fund industry, the key question posed by investors is: where will returns come from through to the end of 2012 and beyond?”

FRM gives three answers. One is liquidity provision, where funds undertake activities that banks used to do; second is structured credit; and third is commodity sectors.