Breaking Bad: Better Call Hedge Funds?
In this unsettled environment, with the full impact of the pandemic on the global economy and financial markets largely unknown, institutional investors have developed a renewed appreciation of prudent measures to both protect and grow their capital. Since that dual objective is the mission of hedge funds, Callan examined how they are positioned to potentially help investors. We see four key opportunities.
Cash Is Dead, Long Live Cash
Today’s paltry yields for Treasuries fail to compensate investors against embedded duration risk when inflation reappears. Unlike a bond fund, hedge funds typically have a short-term investment horizon and therefore little, if any, duration risk. Fresh cash in the hands of hedge funds is a valuable asset amid a much greater opportunity set of mispriced securities that face a highly uncertain future.
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But some managers are more deserving than others. The unusually large dispersion of recent hedge fund returns provides investors with a rare opportunity to discern which funds warrant consideration. Furthermore, many “hard-closed” hedge funds are open to new capital, creating a short-term opportunity for investors to upgrade their hedge fund portfolios. Also, since hedge funds are motivated to find new investors to replace those that are redeeming, they will often be willing to negotiate fees.
Getting Paid by Structural Sellers Needing Liquidity
The next opportunity set that Callan sees for hedge fund investors stems from the need by other investors to sell assets quickly to fund their obligations or reduce leverage. This wave of structural selling will not be easily absorbed, especially for illiquid investments, creating an advantage for those with patient capital to buy these assets at a discount and resell later when market conditions improve. Investors can participate in such dislocated markets in three ways: closed-end hedge funds, co-investments, and hedge fund secondaries.
Structured to call capital from an investor when hedge funds find heavily discounted assets to buy, closed-end funds typically target double-digit returns over a five- to nine-year investment cycle. Given a threshold of returns before the managers collect incentive fees, closed-end funds better align the financial interests of the manager and its investors. Since participants are locked in place for the duration of the fund, all investors are treated equally.
If positions are too illiquid or too large to fit within the investment guidelines of a manager’s commingled fund, the manager may share these one-off trades as co-investment deals with existing investors at discounted fees. These co-investments are typically sourced by a fund-of-fund or hedge fund that is trusted to properly vet these opportunities selling at a discount to fair value. Investors willing to provide this liquidity will likely need to hold these illiquid interests for a year or more until other bidders return to the market.
Our last example will come from other hedge fund investors that were caught with too much leverage or illiquidity in their broader portfolio and need to liquidate their hedge fund interests in secondary markets. Unable to wait for the manager’s next redemption window during a prolonged financial crisis, these investors are willing to sell their interests below their NAVs, often at a discount of 20% or more. When implemented by an experienced adviser with an extensive network, investors in hedge fund secondaries can expect double-digit returns, well above direct hedge fund investments.
Harvesting Trends and Spreads
The third set of opportunities involves macro trades that are not obvious today but will be in hindsight. Top-down trading strategies, such as trend-following, systematic macro, and macro hedges, typically involve the most liquid markets across equities, rates, currencies, and commodities.
Trend-following thrives on market volatility and diverging economic outcomes. When economic cycles across the globe make distinctive moves up or down, they impart long-lasting effects on equity, rates, currency, and commodity markets. A trend-following strategy is constantly managed with disciplined risk-control guidelines to catch these waves of momentum. Trend-following strategies often have a different cycle of performance relative to traditional stock-and-bond portfolios because they can be long or short markets.
Systematic macro strategies based more on underlying fundamentals across global markets are also worth considering. These strategies are designed to methodically extract the historically positive spreads from value, momentum, carry, and other secondary risk factors found across stocks, bonds, currencies, and commodities. Such a diversified mix of liquid, scalable alternative risk premia that hedge explicit market exposures often exhibit little correlation to each other or the markets associated with them.
While hedging against another stock market decline with put options involves significant costs, other macro hedges can offer asymmetric returns in times of extreme economic uncertainty. For example, gold has served investors well as a crisis-risk hedging tool in the short run and a store of value over the long term, at least relative to cash. Gold-mining stocks can also provide an added hedge against unexpected inflation and currency debasement that investors may not get from other equities, and proven reserves of gold held by mining stocks continue to sell at significant discounts to the spot price.
Profits Beyond Markets Sensitive to Economic Growth
Our last set of opportunities focuses on investments in businesses whose profits are not tied to economic growth. One example is reinsurance, which finances insurance companies needing to offload excess insured risk from natural or man-made events. Since its investment risks are uncorrelated to major asset classes, reinsurance also serves as a strong diversifier in a typical stock-and-bond portfolio.
Finding the Right Chemistry in Cycles of Change
The pandemic has created an unusual level of disruption in capital markets. In this setting, investors diversifying their stock-and-bond portfolios have a number of attractive opportunities with hedge funds. To successfully implement these opportunities, investors need to fairly assess their resources, skill sets, and styles of governance and identify strategic partners with solutions that appropriately fit the investor profile. That chemistry needs to work for investors, not against them. Breaking Bad’s Walter White would probably agree.
For more about hedge fund opportunities, I invite you to review my recent paper on the subject here.