In its latest outlook, FRM, Man Group’s $19.5 billion fund of hedge funds and managed accounts business, identifies three potential sources of return for hedge funds. The preferences that FRM expresses are based on a specific market outlook.
Europe’s largest independent FoF has an outlook on markets that remains broadly unchanged: FRM thinks that the choppy, range-bound conditions are likely to persist while policymakers continue to be motivated to provide a floor and while weak fundamentals and political risks continue to impose an upper limit. In short, the multi-manager thinks there is a high probability that these frustrating conditions are here to stay.
The ECB announcement and subsequent reduction in tail risk in Europe led to a small increase in hedge fund risk levels through September. This increase, however, has been tentative at best with managers generally continuing to refrain from taking large directional exposures.
There had been some concern among managers regarding the proposed ban on naked sovereign CDS (effective from 1 November) but much of this concern has fallen away as the details have become clearer. As it stands now, most managers do not consider the proposed changes to be an impediment to their trading activity. The latest EU draft legislation on the topic suggests that sovereign CDS can be held within a portfolio as long as a correlated asset is also held.
The correlation can be judged either quantitatively (Pearson’s correlation coefficient of 0.7 or above over the preceding 12 month period) or qualitatively (proof of a similar level of correlation over a different 12 month period or using a proxy asset if the history is unavailable). By way of example, a manager could quite conceivably hold a short position in German Bunds to hedge a long position in a Dutch Telecoms company if the historic 12 month correlation has been above 0.7 at some period before the date of execution.
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 (particularly since the second half of last year), the key question posed by investors is: where will returns come from through to the end of 2012 and beyond?
Broadly, FRM thinks that the sources of return that will continue to be valuable to hedge funds are:
1) Liquidity provision. In the absence of the banks this return source can be observed across a number of strategies. It is most obviously demonstrable in the returns of technical Statistical Arbitrage managers who are able to fill the market-marking functions previously dominated by the banks. It is to be noted, however, that over the past couple of months, returns have been weaker from this group of managers: there seems no clear pattern as yet and there is no visible reason why it should persist going forward. Money flows into the space continue to be low key (many of the better managers are capacity constrained and closed) and for some time now, these managers have been operating on relatively low levels of leverage, corroborating our view on the
quality of returns in this strategy.
2) Structured Credit. Though FRM thinks that the available return across the board in mortgages are now less attractive on a relative basis (following the Fed’s QE3 announcement), the FoF company thinks that asymmetric return profiles still exist in the non-agency mortgage space. Both relative value and deep value approaches
continue to work well, particularly as the propensity for assumptions among market participants to vary considerably in terms of projections for home prices, loss severity and servicer advances, remains high. Much of our earlier case for buying this sector did not depend on any recovery in the US housing market − clearly, conditions are improving now. That said, September saw the continuation of a straight-line move in pricing which should almost certainly need some time to consolidate before investors can think about adding more on an outright basis.
3) Commodity sectors. In the FRM view, the idiosyncratic moves in specific commodity markets represents a strong source of return for specialist managers who have a good understanding of the fundamental and technical quirks of the sectors in which they have an expertise. In order to optimise the return potential in this space, Man Group’s multi-managers think it is imperative to have a flexible and dynamic approach that allows for nimble trading.
The current environment is not, however, congenial for all hedge fund strategies. The strategies that we broadly consider to be challenged are those that rely too keenly on the transmission mechanism between fundamental observations on market value and price action to generate return. For example, discretionary trading managers in both developed and emerging markets have been impaired by the intermittent failure of this transmission mechanism. Moreover, the increase in the concentration of trades, as a means of managing downside risks, among these managers has also been a problem since returns are reliant on too few ideas, which in turn have too little associated alpha. In Equity Long-Short, where approaches are ‘fundamental’ and managers have a higher degree of commitment to their positions, managers have tended to deliver better returns in the longer term; this has, however, come at the expense of a Sharpe ratio that is hardly appealing at first sight.
Additionally, FRM think that some of the medium to long term trend-following strategies may struggle while market direction is so changeable. Notwithstanding this, some of the higher frequency models, that offer more dynamic exposures, may offer attractive portfolio diversification benefits. This is not to say, however, that longer term models do not offer good protection against moves outside the range: the central case is by no means the only case, according to FRM.