Deciding what strategy is best used in an investment cycle and monitoring market conditions is a key part of the hedge fund manager's role
The primary aim of most hedge funds is to reduce volatility and risk while attempting to preserve capital and deliver positive (absolute) returns under all market conditions. Hedge funds use a diverse range of strategies to achieve this but it is vital to choose a good manager.
Derek Doupe, associate director of alternative investments at Frank Russell, focuses on two diversified strategies for their hedge funds ' directional and non-directional.
In a directional strategy, market movements direct the scale of returns. Non-directional strategies focus on relative value and strategies include fixed interest arbitrage, distressed debt, convertible bond arbitrage and equity bond market neutral.
Doupe explains that a portfolio should be diversified across a number of different strategies. At Frank Russell, strategies used in a portfolio depend on what type of risks the investors would like to take.
The Frank Russell strategy is biased towards relative value bets. Doupe tends to move away from directional-type strategies, however, a small allocation is made to equity long/short strategies.
The Bank of Bermuda fund of hedge funds also uses a wide range of strategies. Hugh Burnaby-Atkins, investment officer for Europe at the Bank of Bermuda, explains the key to reducing risk is diversification. The Bank of Bermuda uses a mix of long/short equity and arbitrage strategies, including fixed income arbitrage, convertible bond arbitrage, merger arbitrage and options arbitrage.
Burnaby-Atkins says: 'The portfolios are very diversified and the underlying funds are not correlated with each other or traditional asset classes.'
At The Bank of Bermuda, convertible bond arbitrage has been a strong play this year as managers have benefited from high levels of market volatility. Merger arbitrage has also performed well but it has been important to select good managers who have been able to avoid pitfalls such as the break-up of the GE/Honeywell deal.
Burnaby-Atkins expects arbitrage strategies to continue to perform well as they continue to provide consistent absolute returns. Long/short equity has experienced a more difficult period given recent bearish conditions. However, equity hedge managers with a long bias are expected to outperform when there is an upturn in the market.
Another strategy used is mortgage-backed securities. Burnaby-Atkins points out that the US mortgage-backed market is one of the deepest fixed income markets in the world. This offers significant opportunities to fixed income arbitrageurs. Those who can trade a variety of underlying instruments can take advantage of interest rate moves.
Choosing a strategy
One area which Coutts focuses on to determine what strategy is best to use is the investment cycle. Bob Dawkins, head of investment products at Coutts, says: 'Post 1998, we favoured arbitrage as convertibles were very cheap and there were a lot of opportunities in this area. A year ago this changed to global macro because equity markets were at a high and we believed interest rates were going to come down.'
Dawkins is now interested in high yield debt, distressed securities, global macro and emerging market debt and equity. In the emerging markets, there appears to be tremendous value in some companies with excellent prospects for good performance. He is also more interested now in the developed markets because of the recent falls.
In addition, Dawkins agrees that investors presently favour low risk strategies. Coutts' portfolios are well diversified across a number of different manager styles, asset classes and geography to reduce risk.
Dawkins advises that as the market changes constantly it is important to monitor market conditions to know the best strategies to use.
However, Gartmore only uses equity long/short strategies in each hedge fund.
Martin Phipps, head of hedge funds at Gartmore, says: 'We currently have five hedge funds ' a large-cap European fund, a small- to mid-cap European fund, a Japanese equity hedge fund, a Pacific emerging markets hedge fund and a UK equity hedge fund ' and they all use equity long/short strategies.'
Furthermore, each hedge fund is managed with the same type of investment approach, although the long/short breakdown varies across the range of funds. The funds do not use leverage and have a diversified stock exposure. The maximum stock exposure to any one stock is 2% and each fund has between 40-65 holdings in it. The risk profile used for the funds is low volatility.
Phipps explains Gartmore uses long/short because it is a more natural extension to what the company does on the long side. It is also where the demand has been and it has been the most popular strategy for new assets.
The selection phase
However, selecting a good strategy is as important as choosing a good manager. At Gartmore, managers blend together a mixture of long and short-term ideas. The long-term ideas are primarily research driven. For example, managers examine whether earnings growth is properly priced in the market and assess management outlook. In the short term, managers look at how events in the market influence price, changes in management, new order announcements, and profit warnings. This is purely a bottom-up perspective.
Gartmore chooses managers who have a good long-term track record and have the ability to be able to attract money for a strategy.
Doupe looks to see what strategy is going to perform well in a number of different market environments and appoints managers that are correlated to the investors' risk profile.
At Coutts, managers to be used for the funds are identified through a rigorous selection process. The risk/return profile of the prospective manager must be in line with the objective of each fund, for example for the arbitrage fund, managers should have a long-term return in the 12%-15% per annum range with low volatility, whereas in the global opportunity fund the managers should have a long-term return in the 20% per annum plus region. Due diligence is carried out on the managers, for example Coutts examines, among other things, the investment process, legal structure and back office systems.
Managers' past performance is assessed as well as risks in the underlying investment. For example, if a manager has a 10%-15% per annum return over a three-year period with low risk in emerging market debt, is the return sufficient for the risks inherent in the asset class? Maybe a return of 20% plus is more acceptable given the historical risks associated with emerging markets.
At the Bank of Bermuda, managers are also identified through a rigorous selection process. There are two phases the Bank of Bermuda uses to screen potential candidates. Firstly, it uses a quantitative process. In this process the Bank of Bermuda looks at past performance of managers, funds, and how they behave in different markets.
The second phase involves portfolio construction to blend managers together. The Bank of Bermuda uses an optimisation computer model process that looks at what managers provide and shows best risk-adjusted returns. This is overlaid with a qualitative process examining what strategy performs best depending on market conditions. The Bank of Bermuda is overweight in those strategies that perform well. Burnaby-Atkins explains it is important to have a good mix of qualitative and quantitative methods to screen managers.
The manager chosen must provide high levels of liquidity and transparency. It is important to know what is going on in a portfolio and to stay away from the strategies that do not show transparency.
Burnaby-Atkins says it is difficult for individuals to conduct detailed due diligence and to be able to choose a good hedge fund by themselves. Very high minimum investment levels compound the difficulties for individuals wishing to build a diversified portfolio. He explains funds of hedge funds overcome these problems and can help reduce risk.
Hedge funds use a diverse range of strategies but it is vital to choose a good manager
Managers are selected through a rigorous process and their performance is constantly monitored.
It is important to monitor market conditions to know the best strategies to use.
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