Hedge funds look for new game plans

Does anyone mind style drift? | Amplitude Capital: maximizing short-term trends | Joe Feshbach Partners: 180 degree turn | Axis Capital: revolutionizing arbitrage

Helen Avery looks at the ways in which they are switching strategies to keep up with the pack.

NABIL DEBS STARTED running hedge fund Plutus Convertible Europe at the beginning of 2004. As its name suggests, Plutus was predominantly a convertible arbitrage fund. One year on, however, most of its assets are invested in equity long/short, with convertibles only 15% of the portfolio. Debs had shifted the fund to follow a multi-strategy discipline, and renamed it Plutus Valorem. Behind this decision lay capacity restraints and reduced opportunities in the underlying markets.

Five years ago, Debs’s move would have rung alarm bells with investors. “Style drift” was a derogatory phrase implying that a manager had lost his edge in his own strategy. Switching into a strategy in which a manager might be less qualified caused concern. Nowadays, however, investors demand that their managers alter their strategies if returns are falling. “No-one wants to be stuck in a failing strategy,” says Debs.

It’s a glimpse of where the hedge fund industry is headed. In a survey by KPMG this year, hedge fund managers agreed that multi-strategy hedge funds, where a manager implements two or more strategies in a fund, would be the second most important strategy of the next three years after long/short equity. Up to that point, they had ranked multi-strategy below convertible arbitrage, global macro, event driven and equity market neutral. Similarly customers are shifting focus to multi-strategy funds. An end-investor survey by Deutsche Bank this summer indicated that some 56% of banks, consultants, corporations and insurance companies would be seeking to increase their allocations to multi-strategy hedge funds.

Is multi-strategy a panacea for capacity restraints and tougher market conditions, though? Some managers do not believe it is possible to maintain an edge if they are so diversified, yet they know they must evolve if they want to keep up with the pack. Instead this group is reacting to the challenging environment by tweaking their single strategies. “There’s a stark realization dawning on those in the industry that the strategies that brought us to this point are not those that will take the industry forward,” says Barry Colvin, president of fund of hedge funds Tremont Capital.

In the article and profiles that follow, Euromoney examines the strategies that are losing favour with investors, and the managers that are altering their businesses as a consequence.

Is arb dead?

Colvin’s observation that the strategies that once produced high returns are no longer viable is perhaps illustrated most clearly by returns in convertible arbitrage. Convertible arbitrage has been a key hedge fund strategy for more than a decade and has offered steady positive returns regardless of market direction. Although the strategy has returned an annualized 6% over the past five years, according to Hedge Fund Research Index, annual returns have declined significantly from 25.6% in 2000 to just 1.18% in 2004. Year to date the strategy has returned –3.86%. Almost 60% of managers surveyed by KPMG said the strategy had been the most used over the past three years, but fewer than 10% believed it would be a dominant strategy over the three to come. Returns are improving – returns for June, July and August were positive – but for many convertible arbitrage players, such as Debs, last year was a signal to move out of the strategy.

Debs says: “While there were compelling reasons to be invested in convertibles in the earlier part of 2004 (borne out by reasonable returns in that strategy in the first quarter), it became increasingly evident during last summer that there had been a secular shift in that market – volatilities were grinding lower and playing the credit improvement story (since the wide point of end of 2002/early 2003) had pretty much exhausted itself. We saw a dearth of new issues coming to market, which is never a good omen. Although others held in there either because they were simply too big to exit gracefully or they hoped the demand/supply imbalance might be enough to drive valuations higher, this never really materialized and so the strategy has lingered for the best part of 18 months.”

During the last quarter of 2004 Debs began to emphasize long/short equity strategies and became increasingly involved in event-driven trades, particularly as M&A activity picked up in early 2005. “By early 2005, upon agreement from our investors, we had effectively made the shift to being much more multi-strategy,” he says.

It’s a move that many in the convertible arbitrage space are making – the most obvious examples being Citadel and Highbridge. And it is not irrational. Convertible arbitrage managers have a broad skill set and experience in a wide range of markets. “It appears to be a natural progression given the fact that convertible bonds straddle different asset classes, such as debt, equity, options/volatility, and require many disciplines within the approach such as macro, FX, debt analysis, equity analysis and technical skills,” points out one manager.

One former convertible arbitrage player says that his $1 billion fund is now a multi-strategy credit fund, looking at credit arbitrage in addition to convertible arbitrage. He is disdainful of those moving away from convertibles to entirely different sectors of the market, and claims present difficulties are only a stage in the asset class’s cycle. “Once again it is one of the ironies of this business that as the market picks up, people leave,” he says. “No one wants to be seen to be dabbling in convertibles at the moment, but the risk/return profile looks better than any other asset class out there. Plus, much of the competition has left – just look at Commerzbank’s significant exit from the field.”

Certainly one positive consequence of the falling returns of the strategy is that many have abandoned it, opening up more capacity for those that have stayed. According to HFRI, more than $5 billion left the strategy over the first two quarters of this year. For this previous manager, longer lock-ups have ensured his investor base stayed put. “We had the sense to make it difficult for investors to leave. Some are loyal, but some are not happy with it at the moment. They will be in the long run.”

Tremont’s Colvin believes issues of capacity are affecting the entire arbitrage sector and sees little hope for the strategies for the foreseeable future. “The amount of money in the arbitrage strategies is the controlling factor. And if arbitrage is to revive, the opportunities had better increase substantially or a lot of money needs to flow out. This isn’t just convertible arbitrage, but risk arbitrage, statistical arbitrage as well.” He points to merger arbitrage as a prime example of capacity constraints. “The amount of opportunities in merger arbitrage has increased, yet returns have decreased. We’re in a great M&A environment, but there are too many managers in there.”

Indeed merger arbitrage returns have steadily declined. In 2003, HFRI’s merger arbitrage index returned 7.47%. In 2004, the return was 4.08%, and year to date it is 3.65%. Indeed in the second quarter of this year, the strategy experienced outflows. Similarly HFRI’s relative value arbitrage index and fixed-income arbitrage index have posted declining returns since the beginning of 2003. “At the heart of all this is the move to a more directional industry,” says Colvin. “One of global macro, managed futures and directional fixed income. It’s no coincidence that it is these directional strategies that have been driving performance for the last three years – that is where the capacity is.”

Forward planning

Switching to a multi-strategy approach certainly has advantages for both manager and investor. Investors gain access to different strategies, and, in theory, multi-strategy managers can move capital between strategies faster than funds of hedge funds and without the extra layer of fees. For managers, diversification of their portfolio allows them to switch styles without having to consult their investors each time and to spread risk. Debs says: “The investment landscape has become so competitive that one cannot afford to wait for a specialist market to hit sweet spots. We’re at an important inflection point in the markets – commodities are at all-time highs, credit spreads are at all-time tights, volatilities are at multi-year lows… Marrying yourself to any one of these markets makes it very hard to justify a credible risk-reward ratio.

“Having the flexibility to move in and out of trades and markets is key. You can spend years honing a specialism, tweaking a model, but if you’re too big to be nimble when it counts, you end up getting stuck in positions if liquidity recedes and undoing any ‘edge’ you may have built up. We’re not saying you need to be a ‘jack of all trades and a master of none’ – far from it, but you need to continue to adapt to market conditions and play your convictions across a greater swathe of instruments or strategies, as opportunities present themselves.”

But adopting a multi-strategy approach is not something to be done on a whim. Bob Morette has experienced at first hand the evolution of the hedge fund industry. He was chief strategist with Citadel Investment Group – a convertible arbitrage fund that has evolved into a $12 billion multi-strategy fund, and now is a partner at Bain & Company. “Without a doubt successful managers need to be thinking about where the capacity is 24 months down the line,” he says. “That’s the biggest issue – capacity planning. And the great funds have always done this. If you look at the top 50 hedge funds, five years ago most of those were single-strategy, now they are multi-strategy. The concern, however, is when managers shift to a multi-strategy reactively. You do not want to see a situation of ‘oh, it’s not working, let’s do something else’.”

Morette says many single strategy firms have a few obvious new strategies they can go into, but “managers need to think about strategies six, seven and eight”. And then, he adds, the issue becomes one of sufficient infrastructure. “When you start to have to add people, that’s when the risk sets in. All of a sudden you need more talent, but you have to find the right people who have the same idea of risk. Fifteen people sat in one room with the same ideology is okay. But the challenge is when you start adding senior people to run new strategies that are not part of that culture.”

Furthermore, multi-strategy funds aren’t a panacea for capacity restraints. Managers need to be aware of the need to control their diversification and size so as not to dilute returns. Steven Bloom began running multi-strategy fund Sagamore Hill in 1999. At its peak it had reached more than $2.7 billion, but Bloom was aware that alpha had begun to diminish. “We had been managing growth from the beginning and had closed the fund many times and turned away money. But there was demand and confidence in what we were doing and the fund grew and grew,” says Bloom. “But we’d seen a shift in the business away from some strategies where there had been economies of scale – particularly in those arbitrage strategies where the market had become more efficient, and using bottom-up fundamental analysis was becoming more difficult.” As a result, Bloom decided to shrink the fund to $650 million, returning money to investors. “It was hoped that by reducing the size we would have a concentrated book and would increase our performance. I think with a smaller fund you can look at small-cap opportunites, and trading can have a more significant impact on returns. You can be more uncorrelated by being small and a lot more nimble.”

The long and short of it

It is not just arbitrage managers that have decided to diversify their strategies in response to capacity constraints. Managers involved in short-selling have been following the trend.

Of the 8,000 or so hedge fund managers, some 70% short equities to some degree as part of their strategy. Convertible arbitrage managers, equity long/short managers, equity market neutral managers, macro managers, merger arbitrage managers and, of course, pure short sellers are all required to short equities. With so many managers looking for shorting opportunities, however, short-selling has become a tough game. Although recent research from Citigroup Alternative Investments claims that there are no concerns about capacity and that the markets for shorts in the US would not be exhausted within the next 30 years, managers claim increased competition has made finding profitable short positions problematic. And as volatility in the underlying equity markets has dropped off and financing for corporates has become easier, the task of the short seller has become tougher still.

“There is a lack of volatility and that means that the equity markets are not focusing on risk or on companies that could be running into trouble. You short because you expect specific stocks to be punished but in this environment this has happened rarely, and that makes shorting difficult,” says Guy Ingram co-founder and head of hedge fund analysis at Albourne Partners. HFRI’s short-selling index is up 7.07% year to date, but in 2004 it returned –3.83%, and in 2003 –21.78%. It has forced many out of the market. Pure short sellers now account for just 0.3% of the overall hedge fund universe, and that figure is predicted to fall further.

Dedicated short bias is the least favourite strategy of managers for the next three years, according to KPMG’s survey. Joe Feshbach, a one time short-seller, doubts that even those that claim to be pure short-sellers are truly so. “There is a lot of what I call ‘chicken shorting’ going on,” he says. “Some hedge funds owe their investor a short book, so short things like ETFs or indices so can say they have short exposure. The truth is that they are not doing shorts using fundamental research as they may have indicated to their investor base.”

As a result of the challenging environment, managers who have relied on shorting are expanding their strategies to include long-only funds. Managers estimate 10 to 20% of long/short players have launched a long-only fund. Gianluca Cicogna runs the Zanett Lombardier Fund, a small long/short equity fund. “Due to investor demand, we’re now in the process of stripping out the long part of the fund and running it as a long-only portfolio,” he says.

“Managers feel they have done well on the long side and want to play to their strengths. It allows them to tap into a different investor base that is looking for long managers with alpha, which is a different universe than hedge fund investors,” says Ingram. He says there has been a trend towards managers offering equity portfolios that are predominantly long but with some shorts so that there is a constantly net long exposure of 100%. By doing so, Ingram says that managers can sell the products to long only investors but with a “double alpha” kicker that in part comes from shorting. “For some, offering a long only fund is a chance to diversify business risk. Some hedge fund managers are concerned that hedge funds will become uninteresting. Building a long only business is perhaps the last hedge for their overall business strategy,” says Ingram.

But the move to long only is raising eyebrows. Surely the point of hedge fund managers is the trading techniques they use. If they are running long-only funds, aren’t they just active managers, rather than hedge fund managers? And can managers continue to charge high fees for products that are essentially offered by the traditional asset managers for half the charge? Jacques Lussier is vice-president of securities investments and financial engineering at DesJardins Asset Management, which runs a $25 billion portfolio for several entities in the Desjardins Group. He has had enough of high fee charges. As a response, in May this year, the company decided to set up a new $200 million equity market neutral hedge fund with a difference. The fund employs 15 traditional long-only managers and does the shorting side internally. “It just doesn’t make sense to pay every hedge fund manager in a portfolio the 2% and 20% fees. So we hired traditional long-only managers that appear to have the same alpha generation capabilities as hedge fund managers at less than half the cost of a hedge. They are all operating under the same administrator, so we have daily liquidity and transparency and have access to more than 1,000 positions each day.”

A horizontal industry

Adding strategies to a portfolio or fund collection is not necessarily the answer to capacity constraints and difficult underlying markets, but Colvin sees it as part of the industry’s evolution. “In five years from now, the present vertical orientation of the industry where strategies are siloed will have evolved into a more horizontally oriented approach. Managers will be looking across more opportunity sets and leveraging their infrastructure across more asset classes. Multi-strategy managers are an early version of this, but they still need to focus on operating their individual strategies as one organization rather than in silos.”

But this does not spell the end of boutique single-strategy hedge funds, Colvin suggests. “It is inevitable that the industry will move towards bigger multi-strategy players,” he says, “but there will always be a need for small managers that have an edge in what they do: running cutting-edge strategies.

“But these single-strategy players need to evolve their strategies. There needs to be a constant research effort in search for the next opportunity. It can be a heavy load.”

Morette says that the key for managers will be thinking about which strategies they want to be using in three years’ time. “The industry is changing rapidly, and managers are stewing at the moment. They need to pick a point on the horizon and aim for it.”  

 > Click here to see table 1: Outlook for capacity of current strategies 

Table 2: