Where do hedge funds fit in a bull market?

Before a customer even gets to the point of talking about bull market or bear market strategies for hedge funds, one must bear in mind that clients often have relatively strong views in the following areas, which drive recommendations:

1. Nature of the strategy
2. Single- versus multi-manager funds
3. Size and independence of the organization
4. Track record

Before considering market conditions, let's take a closer look at each of these areas first:

1. Nature of the strategy: According to CSFB/Tremont's website (www.hedgeindex.com), there are anywhere from 10 to 15 major hedge fund strategies depending upon how one wishes to define "strategy". Some investors have an aversion to particular strategies such as global macro or convertible arbitrage on the grounds of perceived volatility, illiquidity, etc.
2. Single- vs multi-manager funds: Some investors do not wish to own multi-manager funds because they refuse to pay multiple layers of fees (i.e., at both the fund of fund and underlying fund levels), because they believe that multi-manager funds diversify too much thereby reducing the chance to earn meaningful returns, etc.
3. Size and independence of the organization: Our experience has shown that there are basically four tiers of hedge fund organizations: i) Large hedge fund groups that are affiliated with banks or other financial institutions ii) Relatively large independent hedge fund organizations that are unaffiliated with any financial institution but which have significant assets under management ("AUM") that are typically in the $500 million plus range iii) Relatively small hedge fund organizations that are independent but have AUM anywhere from $50m up to several hundred million and iv) Start-ups that are independent and have AUM less than $50m. In addition to AUM, size is often measured by the number of employees and offices that a hedge fund group has.
   Some investors have an aversion to smaller and/or independent hedge funds due a perceived risk of fewer internal controls, lack of qualified back office support, etc. On the contrary, some investors have an aversion to large hedge fund groups because they believe a large AUM base will lead to reduced returns, or because of conflicts of interest within a large diversified financial institution, etc.
4. Track record: Most investors like a hedge fund group to have at least a two or three year track record but some investors are willing to invest with hedge funds at the time of their start-up. Some investors place less importance on a track record because of other perceived benefits such as strategy information, market information, etc., that a particular hedge fund team can provide.

Now that we've addressed some issues that are critical in our efforts to satisfy customers regardless of market direction, let's take a look at where hedge funds might fit in during a bull market run. When assessing a bull market, one needs to consider the overall market environment:

• Is the bull market broad-based or limited to a few sectors such as technology?
• Is the bull market driven by liquidity or fundamentals?
• Has the bull market stretched valuations?
• Is the bull market global or limited to particular regions?
• Is the bull market more apparent in certain styles (value, growth) or market caps (small, mid, large)?
• Are interest rates historically high or low?
• How have the various asset classes, securities, and hedge fund strategies been affected by the bull market (e.g., are credit spreads historically narrow or wide? Has convertible bond issuance been replaced by straight equity issuance? Has too much money poured into a particular hedge fund strategy? etc.)
• Has bond issuance been robust or are credit conditions relatively tight?
• Has market volatility dropped off during the bull run?
• What are the downside risks that could stop the bull in its tracks?

Now let's take a look at the major hedge fund strategies in light of the above considerations1:

Convertible arbitrage

Convertible arbitrage strategies typically earn profits by purchasing cheap convertible bonds and selling short equity as a hedge of each specific issuer's risk. Convertible bonds are often issued in bear markets as firms are unable to issue straight equity due to lackluster investor demand. However, once markets start to hot up, firms are able to access the equity markets and only the firms on the lower end of the credit spectrum might still be compelled to issue straight secured debt or unsecured convertible bonds. In addition to lower supply (and thus less opportunities to find undervalued issues), convertibles also tend to suffer in bull markets because equity volatility is often inversely related to market direction. In bear markets, investors are scared and volatility is often high. In bull markets, investors are euphoric and volatility tends to wane. Convertibles managers who purchased cheap convertible bonds on the premise that the embedded equity options were trading at implied volatility levels much lower than historical volatility may find it difficult to realise forecasted historical volatility levels.

Despite the concerns above, it still makes sense for investors to consider convertible arbitrage even in bull markets because nimble hedge fund managers will often reduce their hedge ratios (i.e., to take advantage of rising equity markets) which could continue to lead to outsized gains. On the other hand, reduced hedging will lead to higher risk. Furthermore, investors must be cautious to ensure that a particular convertible arbitrage manager has not increased leverage in order to squeeze more returns out of less favourable market conditions.

Emerging markets

If we can describe 2003 as a bull market, emerging markets was the top performing hedge fund strategy in 2003 returning close to 29%2. Unfortunately, some of the top hedge fund index providers such as CSFB/Tremont and HFRI do not split out emerging market hedge fund returns between equity and fixed income strategies. Nonetheless, I believe that it is not just a coincidence that in 2003, the MSCI Emerging Markets Free Index (an equity long-only index) was up about 58% and the JPM Emerging Market Bond Index (a fixed income long-only index) was up over 20%, and the average emerging market hedge fund was somewhere in the middle. It is common industry knowledge that emerging market hedge funds are somewhat of an oxymoron: they rarely have the tools to hedge as a result of onerous local market restrictions and/or due to a lack of derivatives.3 But as investors are often painfully aware, this does not stop many emerging market hedge funds (that are long-only) from calling themselves hedge funds and charging hedge fund fees!

Getting back to the point of whether emerging market "hedge funds" are good investments in a bull market, while being aware of the long-only bias of most emerging market hedge funds, it of course makes sense from a diversification perspective for every investor to have some exposure to emerging markets. The extent of the exposure should vary depending upon the investors' risk appetite and expectations regarding equity valuations and bond credit spreads. If we take the current market environment as an example, emerging market equity valuations are relatively attractive in comparison to developed markets, but bond credit spreads are at historically narrow levels. This would most likely lead towards relatively higher exposure to emerging market equities and relatively lower exposure to emerging market bonds. If an investor can find an emerging market hedge fund that is able to hedge market exposure in a meaningful way, then there could be other opportunities that are worth exploring but these are most likely covered in the other hedge fund strategies below.

Equity long-short

There are generally at least four main types of equity long-short strategies:

• Long-bias
• Short-bias
• Variable-bias
• Market neutral

In a bull market, long-bias hedge funds should strongly outperform the other three types because long-bias hedge funds typically maintain a certain minimum net long exposure to the market (known as "net long beta equivalent exposure"). This has indeed been the case as market-neutral funds have struggled to keep up with the gains of both the general markets and long-bias hedge funds. But this doesn't mean that investors should rush out to sell the other three types of equity long-short funds mentioned above and purchase only long-biased hedge funds, in a bull market. Instead, investors need to determine whether the risks of going too long the market can lead to similar results as was experienced in the first three years of this decade. Accordingly, even in a bull market prudent investors must consider holding a portion of all four of the above types of hedge funds and the portion of each will depend upon some of the overall market environment factors mentioned above.

Distressed debt

The supply of distressed debt typically rises during bear markets, and falls off during bull markets as credit markets are usually more forgiving in good economic times. Distressed debt hedge funds typically make money by focusing on one of the following three areas of the credit spectrum4:

• Senior secured debt and bank loans
• Unsecured junk debt - no-corporate-control
• Unsecured junk debt - corporate-control

In the beginning of a bull market and subsequent economic recovery, credit spreads tend to narrow across all debt classes thereby causing all prices to rise along with the rising tide of narrower yields. Afterwards, it's much more up to manager skill to be able to earn satisfactory returns from this particular strategy. In the current market environment, prices have already been lifted by the narrowing of credit spreads to very tight levels as the chart shows below. So the easy money has already been made.

The following chart shows that the new supply of distressed debt in the US has steadily dropped which means that managers in this strategy will have fewer opportunities to choose from once the existing supply from the past few years has been worked through.

However, there are still opportunities for crafty managers to sift through the wreckage at the lower end of the credit spectrum especially by taking control positions in unsecured bonds and gaining significant equity stakes in a bankruptcy reorganisation. Profits come by selling the shares to a strategic buyer or to the public in an IPO assuming the bull market is still in place. The risk is obviously higher because corporate reorganizations can take years to complete and by the time an equity stake is obtained, the market could be in another bear phase, thereby making it difficult or impossible to sell the shares!

Event driven - merger arbitrage

Like distressed debt strategies, timing can play a significant role in gauging opportunities for merger arbitrage strategies. Merger arbitrage hedge funds typically profit from shorting the stock of a company that plans to acquire another company, and buying the stock of the company that will be acquired. Bull markets generally lead to significantly increased merger and acquisition activity as companies use high stock prices as currency to acquire competitors or complementary firms. However, the recent bull market5 shows that this is not always the case as mergers and acquisitions have been quite slow to regain the momentum they had in the late 90's.

A reduced number of deals leads to less opportunities for hedge funds to choose from. Although merger arbitrage has had a rough time over the past few years due to the dearth of deals, investors are optimistic that this strategy will prove fruitful if the recent bull market proves to be sustainable and the expected rise in deal activity comes to fruition.

Fixed income arbitrage

Fixed income arbitrage is another contradiction in terms in that most fixed income hedge funds are relative value players, whereas arbitrage implies a "money machine" (i.e. riskless profits). A few examples of fixed income arbitrage:

• "Butterfly" and other curve strategies whereby managers try to earn profits as a result of bond yield and swap curves that are temporarily distorted
• Long/short debt positions that may earn profits often because one portion of debt is more liquid than another (e.g., on-the-run vs. off-the-run US Treasuries)
• Swap spread positions that may earn profits if a particular spread narrows or widens
• Mortgage arbitrage whereby mortgage-backed securities, collateralised mortgage obligations ("CMO's"), and other similar instruments are hedged in the US Treasury securities and derivatives markets

Fixed income arbitrage is one of the most difficult hedge fund strategies for investors to understand because hedge funds focusing on this area typically use derivatives to a heavy extent, many of which are not as simple as plain vanilla options and futures. Furthermore, depending upon how far out on the yield and swap curves a particular manager likes to trade, the strategies can be very illiquid. And finally, these strategies are often highly leveraged both explicitly (in the repo market) and implicitly (through the derivatives market).

Determining whether fixed income arbitrage makes sense in a bull market is a bit more difficult than with other strategies due to the many different types of fixed income arbitrage. It probably makes sense for investors to think about fixed income arbitrage on a case by case basis as opposed to making a blanket statement either for or against fixed income arbitrage. In other words, some fixed income arbitrage managers rely heavily on high or low interest rate volatility, high or low bond issuance, high or low swap issuance, high or low swap volatility, relatively high or low interest rates, etc. Accordingly, investors must take a more open minded approach with fixed income arbitrage and determine whether the whole spectrum of economic and market conditions are conducive to a particular fixed income arbitrage strategy. For all of the reasons mentioned in the paragraph above, it's probably a good idea for most investors to go the fund of funds route rather than selectively pick single managers in this area.

Global macro

Global macro hedge funds typically take bets on big picture economic and market indicators, such as commodities, currencies, interest rates, and equity indices. Hedging is often done across markets such as by going long US Treasuries and short Japanese government bonds. Global macro is a strategy that investors seem to have a love-hate relationship with. Many investors are aware of the fact that it is extremely difficult for global macro hedge funds to earn substantial returns over long periods of time6. These funds also typically have relatively higher volatility than other strategies. However, like a siren's call, most investors are attracted to the huge returns that many macro funds earn over the years. Furthermore, many global macro funds have very low correlations with other asset classes and hedge fund strategies, and this gives powerful diversification benefits to an investment portfolio.

Although I believe that a global macro program can add value to an investor's portfolio in both bull and bear markets, I prefer that it's done via a fund of funds approach due to the inherent volatility in these strategies and the inevitable incorrect calls that will made by a particular manager.

Managed futures

Managed futures hedge funds earn profits by buying undervalued futures contracts, and shorting overvalued futures contracts7. Managed futures are good strategies to have in both bull and bear markets because distortions in the futures markets are often unrelated to overall economic and market trends. In other words, these managers find futures contracts that are mis-priced and such mis-pricing can occur in any market condition and the "supply" of such mis-pricings can be quite random. A word of caution is warranted however, in that futures are inherently leveraged and the key to judging a managed futures manager is to understand his or her risk management process. Most investors would be well advised to consider investing in this strategy through a fund of funds rather than investing direct with a single manager, unless a particular investor has the time and resources to obtain comfort that a particular manager has the proper risk controls in place.

Now that we've determined what strategies might be useful in a bull market, the onus is on the investor or his or her investment advisers to ensure that the hedge funds selected are actually executing the desired strategies. Unfortunately, the hedge fund industry is still coming to terms with the fact that many hedge funds cross-over between strategies (e.g., event driven managers who could not find any merger arbitrage deals to do suddenly find themselves in the distressed debt space, global macro funds often use futures for execution, etc.). Others provide limited transparency so it's difficult to figure out which strategies they are pursuing. Each of us has arrived at different sub-optimal solutions to this problem, such as by creating our own strategy definitions and assigning hedge funds accordingly, or by calculating correlations between a particular hedge fund's returns and the average returns for a particular strategy and questioning a manager in the case of low correlations. All of this makes selecting individual hedge funds just as challenging as selecting strategies in a bull market!

Notes to text

1. The strategies selected below are representative of the major hedge fund strategies as promulgated by CSFB / Tremont at www.hedgeindex.com.
2. According to CSFB/Tremont. HFRI, another top hedge fund index provider (see www.hedgefundresearch.com) shows emerging market hedge fund returns for 2003 at about 40%. According to these index providers' websites, emer-ging market hedge funds also did exceptionally well during the bull market of the late 1990's, with the exception of 1998 as a result of the Russian default and Asian crisis.
3. To their credit, both of the above websites mention that emerging market strategies are often long-only.
4. Like emerging market strategies, many distressed debt "hedge funds" are actually long-only, although some earn profits by shorting expensive debt to hedge undervalued debt across a firm's outstanding credit issues.
5. To be fair, some market observers believe that we are still in a bear market.
6. Soros and Tiger are just two hedge fund "heroes" that were brought to bear as a result of ill-timed macro bets.
7. Positions are often much more complex, such as by trading across contract months and markets, and in conjunction with other derivatives markets.

By Robert Jones, ALPS