Providing consistent returns on client portfolios has been a challenge for investment advisors over the past few years. While consistent, risk-averse performance is available, few investors are willing to pay management fees for returns paralleling those of money market funds. The quest for investment alternatives has thus led increasing numbers of advisors and their clients to the doorstep of hedge funds, in hopes of earning consistent returns, even if they are unspectacular, as well as diversification and lower overall portfolio risk.
Even institutional investors have been converted; they now account for nearly 40% of hedge fund assets globally, up from just 5% a decade ago. One reason is that hedge fund managers are free from regulations governing other types of funds, permitting them to use strategies unavailable to mutual fund managers to achieve greater leverage in their portfolios. Moreover, concerns that had deterred some advisors from embracing hedge funds, including fitting their strategies into conventional asset allocation matrices as well as a lack of portfolio transparency and benchmarking issues, have begun to abate as the industry has matured.
To be sure, the majority of hedge funds still do not provide much information beyond their performance numbers. And while it is not necessary for the manager to disclose every position–even mutual fund managers aren’t obliged to do that in real time–investors should have access to key risk parameters, including leverage, concentration, hedge ratios, credit quality, and other vital statistics. Such information can be disclosed without jeopardizing the quality or performance of the portfolio, and can help advisors to understand and be able to explain the risks in a portfolio to their client investors.
There are now more than 7,000 hedge funds with diverse investment mandates ranging from simple long equities to esoteric derivatives to global macro strategies. While the uninitiated may regard hedge funds as a homogeneous universe, the opposite is true. Hedge funds vary greatly in terms of structure, volatility, investment strategy, market correlation, and performance. In fact, they are dissimilar in just about every meaningful way imaginable. Some, such as dedicated short bias and long/short equity, are accompanied by relatively high volatility; others, such as risk, fixed-income, and convertible arbitrage strategies, tend to be lower. In addition, individual funds within each strategy represent widely diverse risk elements.
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A review of performance data for three different hedge fund strategies illustrates the significant impact these differences can have on investor portfolios. The CSFB/Tremont Arbitrage Index, which embraces all hedging strategies, was up 15.44% for 2003. However, the subindices varied wildly. Emerging Markets had a standout year, rising 28.75%; Convertible Arbitrage emulated the overall index, climbing 12.90%; but Dedicated Short Bias staggered in with a 32.59% loss.
Standard deviation, which measures historical volatility, is another hedge fund statistic worth comparing. The lower the standard deviation, the less volatility a fund will exhibit. Over the past five years, the average annualized return for Emerging Markets (up 15.86%) and Convertible Arbitrage (14.17%) are comparable. However, the annualized standard deviation for Emerging Markets (13.42) is about triple that of Convertible Arbitrage (4.03). Risk Arbitrage, another conservative hedging strategy, has standard deviation (4.19) comparable to Convertible Arb. But its five-year annualized returns (8.09%) are not comparable.
Over the past decade, the historical annualized average return, standard deviation, and best and worst months for various hedge fund subindices bears out the notion that the industry is hardly homogenous (see table, page 60). Among hedge funds displaying lower volatility, those that claim to deliver “market neutral” performance are generally chosen for more conservative portfolios and for those seeking performance uncorrelated to equity markets. Market neutral (MN) strategies seek to produce investment returns uncorrelated to the underlying equity markets by hedging–or arbitraging–long and short positions against one other in an effort to remove, or at least minimize, inefficiencies.
Constituting the most popular segment of the hedge fund industry, with some $344 billion in assets, market neutral funds are designed to outperform U.S. Treasuries while limiting portfolio exposure to equity market fluctuations. The perception that all MN strategies produce uncorrelated investment returns is inaccurate, however. Just as with the other subindices, there are critical differences between the various MN strategies, and investment advisors evaluating or recommending an MN strategy should be aware of these distinctions. The most important element contributing to true market neutral performance is convergence–that is, a discernable correlation between the long and short positions.
The MN strategies regarded as the most conservative include risk (or merger) arbitrage; fixed-income arbitrage; convertible arbitrage; and, to some extent, equity long/short strategies. Despite similar investment mandates, there is a noteworthy disparity between these strategies in terms of stability, volatility, noncorrelation to underlying markets, and true market neutral or absolute return performance.
Risk or merger arbitrage falls within the event-driven category, and involves evaluating the probable outcomes of announced mergers and acquisitions. Risk arbitrageurs access the probability of all relevant factors in a proposed transaction. They also look for a combination of trades that will be profitable, assuming their assumptions are correct. According to data from the CSFB/Tremont Hedge Fund Index, over the past 10 years, the average annualized return for risk arb is 8.39%. Its best month was 3.81%, the worst, a 6.96% decline. Its standard deviation is 4.48.
Typically, risk arb specialists invest simultaneously in long and short positions of companies involved in an announced merger or acquisition, generally going long on the stock of the company being acquired and shorting the stock of the acquiring company. The hedge here is that companies frequently finance takeovers by issuing more stock, diluting the value of existing shares, and offer a premium over the current share price of the company they seek to acquire. Shareholders of the takeover candidate benefit from the premium they receive for the shares they hold, while the acquiring company faces the operational cost and risk of integrating the acquired company’s business. The best scenario is when the deal is completed, subject to regulatory review, antitrust laws, unforeseen or undisclosed debt in the company being acquired, and similar issues. The principal risk is the uncertainty as to whether the deal will close. Should the deal come apart, the share price of the takeover candidate often plummets, while the stock of the acquiring company can rise. This exposes merger arbitrage to the risk of high losses. The strategy is also reliant on a healthy mergers-and-acquisitions environment, as well as economic cycles and prolonged bear markets.
In a recent article for Harvard Business School’s Working Knowledge Web site (hbsworkingknowledge.hbs.edu) author Emily Plishner discusses the risk arbitrage models developed by Harvard Business School Professor Mark Mitchell and Todd Pulvino, an assistant professor of finance at Northwestern University’s Kellogg School of Management. The two researchers, she says, “did not assume that returns on arbitrage investments were independent of overall market trends. What they found was that market-related risk is small when the stock market as a whole is rising, but considerable when it is falling.” Indeed, Plishner notes that Mitchell and Pulvino discovered that the overall excess returns for risk arbitrage transactions were only about 4% annually, “a far cry from the conclusions of other studies that had put that number anywhere from 12% to several hundred percent.”
Risk arbitrageurs also frequently invest in equity restructurings, commonly known as spinoffs or “stub trades.” Here, an opportunity for arbitrage occurs when the market value of an entire company is less than the market value of its publicly traded subsidiaries. The company, hoping to boost value for its investors, offers a portion of assets it determines to be undervalued to the investing public.
Fixed-income arbitrage attempts to profit from opportunities to leverage interest rate securities, such as government and non-government bonds, interest rate swaps or futures, and other securities. Fixed-income arbs seek to achieve consistent returns through a relative value approach by exploiting opportunities on the yield curve. For example, an arb may try to profit from price anomalies between related securities. Many managers trade globally within the market neutral mandate of generating steady returns with low volatility. Positions are generally based on technical or fundamental views. The primary risks lie in the amount of leverage employed, which can be significant, and, in some market conditions, a lack of liquidity.
A related arena is mortgage arbitrage, which exploits inefficiencies in the mortgage-backed securities market by playing the spread between short- and long-term interest rates. Mortgage arb managers typically buy one maturity and sell the other, expecting the two rates to eventually converge. As maturity approaches, the short-term rate will approach the long-term rate, much like bonds. Interest-only, principal-only, and other tranches are utilized in the strategy.