Hedge Fund Strategies Adapt to Changing Investor Appetites

"Never accept failure, no matter how often it visits you. Keep on going. Never give up. Never"

Dr. Michael Smurfit, Jefferson Smurfit

Heading into 2007 it is clear that the search for higher returns is leading investors to adopt three broad tactics. First, a greater willingness to allocate to "newer", smaller managers trawling global liquid markets. Second, investors are going down the liquidity spectrum. Third, they are opting to "go freestyle" most notably with a long-bias exposure.

As an institutional investor how do you know which road to take? That is the key issue that many of them are facing and one that their "gatekeepers" are wrestling with, very often with mandates to exclusive sectors rather than looking at the totality of the investor's portfolio. It is tougher if that gatekeeper/consultant has had a traditionally US-bias as well...

Numbers are always going to be difficult to get when looking at the US$1.375 billion hedge fund industry. But that said, there is no doubt that money has been flowing into more niche-oriented strategies in 2006 - in many cases following opportunities as they arise: uranium, metals, oil, natural gas, China, Russia, real estate to name a few.

But what is sure is that a number of smaller, less-established managers have begun to get traction with bigger institutional investors who have come to realize that you cannot wait for a 3-year track record before you start to invest. The opportunity to reap the biggest outsized returns (over 20% p.a. net of fees) might have evaporated by then.

Illiquidity premium strategies have also gained an awful lot of attention. While there a school of thought that puts the onus of global excess liquidity at the door of the Middle East (courtesy of their swollen oil rich capital reserves) I believe it is the longer term savings trends out of Asia in addition to the yen-carry trade that has fueled money flows into many high priced assets.

Hence, the paradox that despite tight spreads heading into 2006 in global distressed security markets prices keep on going up. Spreads keep on tightening and demand for "junk" paper still outstrips supply. Another beneficiary have been unrated bank loans, CDOs of ABS and NPLs ( a favorite of Japanese financial institutional investors), structured credit, small and mid-cap equities (especially of the international or ex-US variety), private equity style deals and emerging markets. All of these have thrown off great average returns for investors in the 15%-25% band over 2006.

But underlying problems remain if their directional tilts suddenly start to sour. In many cases the underlying managers will face pricing problems initially and then liquidation issues, especially when investors head out of the door at the same time (as they usually do).

Markets will likely be subject to "gap down" movements. In the worst cases of liquidation some fine print of the distressed security offering memos even suggest that the hedge funds can pay back investors with the actual paper that they hold!

So there is a probably greater assymetry of various types of risks involved with these securities than is currently observed in a simple annualized standard deviation calculation and incorporated in the typical mean-variance portfolio construction by the vast majority of investment consultants. Opps!

For managers and investors alike the trick is going to be timing (when to get out) and one's tolerance for a long lock-up in order to ride through volatile market conditions. For now, the world seems rosy.

The other main focus for institutional investors who might not opt for the illiquidity route are the growth of so called "freestyle funds". Yes, it looks like hedge funds put up great numbers in 2006, but when compared to many traditional benchmarks they fell far short and without the cost. Noone can dispute that.

Hence the growth of unconstrained long-only funds with concentrated portfolios and some risk collaring thrown in. This is a booming opportunity for hedge funds to get larger institutional allocations, especially with sophisticated quantitative models (see "The Rise of the Mega Fund").

Expect State Street, BGI, GS and others to explore more product development in this area with other copy-cats emering in 2007. Remember too that these products also have lower fees or at least the fees are properly aligned to the performance of the vehicle.

These appear to be able to match and exceed the performance of traditional long-only benchmarks, something that hedge funds are, as a group, not able to do.

Another area that appears to be getting some traction with institutional investors are sector funds (e.g. global financials), funds that promote concentrated or best ideas, and, activist funds which have been particularly effective in the US, Japan and Korea and are now looking further afield in more exotic locations.

All of the above developments reinforce the notion that hedge funds are best considered a legal form that execute a diverse set of strategies and not a separate asset class.

The key for investors is to identify the risks and costs of each of these attractive choices. This is not easy when all you notice each month are attractive returns. But wasn't this a similar situation that faced investors in Amaranth in the 1H06? Mahalo.