Delivering Alpha 2011

Post-Crisis, Nimble Hedge-Fund Strategies Survive

Jennifer Leigh Parker, |Writer,

The financial crisis of 2008 was a turning point for the hedge-fund industry. More than 200 funds went out of business, according to Hedge Fund Intelligence.

And outflows of investor capital in 2008-2009, exceeding $70 billion, pressed those still standing to justify their management and performance fees. This year, with a meager 1.2 percent return year-to-date according to Hedge Fund Research, the pressure's still on.

"Hedge funds are supposed to provide real diversification—a source of return that's presumably not related to other asset classes. I'm not quite sure what the argument for being in the hedge-fund space is these days," says Mark Spitznagel, CIO of Universa Investments.

Recent inflows, however, show a newfound support for the industry. So far this year, hedge funds have raised more than $16 billion—almost double the amount in 2010. To manage all this new money, managers are getting creative by changing or tweaking their strategies.

There are four traditional strategy categories: Equity Hedge, Relative Value, Global Macro, and Event Driven. Of late, some have become more attractive than others.

Global Macro

Global Macro has replaced Equity Hedge as the darling of the industry. Since 2007, Global Macro funds have attracted more than $20 billion, while Equity Hedge funds lost more than $40 billion in outflows. Macro is the only strategy that has received inflows of capital every year since 2007, according to industry researcher Morningstar.

Global Macro managers enjoy the widest playing field of investments. They choose from all asset classes, including commodities, currencies, bonds, and equity markets. Fund managers say the appeal lies in the liquidity of these markets—allowing managers to move in and out of positions quickly.

“While there is a distinct lack of trust and confidence in the developed market’s financial and political system, the macro environment continues to offer considerable trading opportunities. It is the most nimble strategy,” says Alastair Crabbe, vice president and head of communications at Permal Investment Management. Permal's assets under management stood at $23.1 billion at the end of the second quarter of 2011, and counts Global Macro as its largest investment strategy.

Lionel Erdely, CEO of Lyxor Asset Management, adds that Global Macro's flexibility can also mean better risk management: “For example, managers might go long silver and gold exposure to protect themselves in case they’re wrong on stocks. You can diversify your exposure."

Next up in net new money is Relative Value, with $1.25 billion in net new assets since 2007. In terms of performance, 2011 has belonged to Relative Value more than any other strategy, returning 3.2 percent year to date, according to Hedge Fund Research.

The basis of this strategy is to exploit price differences between either different types of securities or the same security in different markets.

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Although he's a long-term equity investor, Bill Browder, CIO of Hermitage Capital Management,is adding Relative Value to his skill set: “It’s almost impossible to find anything that’s screamingly cheap in this world. As a result, about nine months ago, we started to go into Relative Value pair trades in emerging markets. The objective is to find one company that was doing well, one overvalued, and match them off against each other.”

"Matching off" in this context means eliminating market exposure by selling the overvalued security and using the proceeds to buy the one you think is cheaper, or simply better value.

Most Relative Value managers apply this concept to bonds—making money by identifying value in the different types of bonds (corporates vs. Treasurys, or asset-backed bonds vs. municipals).

The downside is that credit-focused relative value funds do not enjoy the liquidity of the macro managers. Nadia Papagiannis, Morningstar's director of alternative fund research, explains: "Bonds in general are an illiquid market relative to stocks, and relative value funds invest in even less liquid markets, seeking price inefficiency. Global macro funds, on the other hand, trade highly liquid derivatives like futures contracts and currency forwards."

Event Driven, Equity Hedge, and the newcomer...

Lyxor’s Erdley says this poses a potential problem: “the main risk [in Relative Value] is that we enter another recession, where in high-yield bonds, sell-offs will accelerate a decrease in prices, and liquidity will deteriorate.”

Event Driven

Since 2007, Event Driven managers have lost approximately $4.5 billion in assets under management. This strategy is experiencing the lowest inflows of the four major strategies in 2011, with $2.25 billion for the first half of 2011. However, positive performance—up 2.8 percent year to date—is being driven mostly by the category’s sub-strategy “Merger Arbitrage,” up 4.21 percent.

In general, Event Driven strategies do well as corporate merger activity, IPOs, or bankruptcies accelerate (thus exposing the strategy to equity market movements). Mergers illustrate the basic concept: When one company buys another, merger arbitrage managers buy the shares of the target company, and they sell the shares of the acquirer.

Lyxor Asset Management's CEO Lionel Erdley adds, “Provided you don’t have an extremely bearish view on the market, you will generate return on the contraction of the spreads.”

The “spread,” in layman’s terms, refers to the difference between the share price of the buyer and the seller. If this spread moves dramatically, and you’ve placed the correct bets—you can make money. But you need the one you bought to go up in price, and the one you sold to go down in value. “Arbitrage” is simply the act of taking advantage of this price difference.

Here, timing can be both an advantage and a risk, evidenced in historically uneven returns. As one fund manager observed, “patience is a key part of this strategy.”

Equity Hedge

Equity Hedge is only just beginning to recover from large outflows in 2008 and 2009 that totaled more than $44 billion. This year, Equity Hedge attracted just $2.27 billion, compared with the $11.1 billion it took in during the second half of 2007. As for performance, the strategy is only slightly higher than flat for 2011—a dramatic recovery from a disastrous 2008 (down 26.7 percent).

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Equity Hedge managers invest in global, regional, or sectoral equity markets. They invest long and short, generally meaning they borrow stock and sell it, hoping the price will fall by the time they have to return the stock to the lender. Some equity managers short the market to hedge risky positions, while others use shorting to make money outright. Theoretically, this strategy is able to make returns both when the market rises and when it falls.

How has this strategy—which most closely resembles the original definition of “hedge fund”—lost so much ground?

Managers say good shorts are hard to find. “Its very difficult to find stocks that are overvalued. You have 1,500 hedge-fund managers in the U.S. chasing the same market inefficiencies. Often, equity managers are more heavily weighted in longs than shorts,” says Hermitage Capital's Browder.

Mark Spitznagel of Universa Investments agrees: “I prefer niches where there are clear competitive advantages. These are smart guys chasing essentially the same inefficiency. They're also all in a very short time horizon. I would never want to be in that game."

Universa, launched in 2007, runs a niche strategy called “tail risk,” which is more akin to risk-management strategy than a hedge fund. This manager buys and sells options that will benefit if a very rare, large market event occurs.

Is this the next hot strategy? In this "Black Swan" decade—marked by the fall of Lehman and the flash crash—nothing seems impossible.