The hedge fund industry has experienced an explosive growth over the last few years. Its success relies on the combination of attractive returns and low volatility. Therefore, it offers, while being uncorrelated to traditional assets, an outstanding risk/return ratio. With a substantial inflow of funds from institutional investors into alternative investments, capacity constraints have become a concern among the industry.
Beyond an optimum size, hedge funds would be forced to increase the number of their positions, which could lead to performance dilution. Therefore, by limiting their access, hedge funds preserve optimal conditions to carry out their strategy and avoid dilution to the benefit of final investors. However paradoxical it may seem, capacity constraints actually prove to be beneficial and reassuring to investors as beyond a certain size, quality hedge funds will control the inflow of assets into their fund to preserve performance or limit the proportion of assets held by any single investor for diversification purposes and to avoid client risk.
Not all strategies are affected by capacity constraints. Generally, strategies intervening in very liquid markets, such as global macro and CTAs tend not to be capacity sensitive. For other strategies, such as long/short equity, it depends on the sub-strategies, i.e. large caps are more liquid and are therefore less capacity-sensitive than mid- and small caps. Event driven, distressed securities, high yield debt and all relative value or arbitrage strategies which are ‘niche’ strategies are severely constrained.
Critical size
In a universe where the number of closed or selectively open managers is growing, only experience and expertise can help to overcome such difficulties. With $12bn under management and a 13-year track record, CA-AIPG is one of the top 14 funds of hedge funds worldwide (InvestHedge, September 2005). Our critical size and stable client base is of importance to hedge funds because they prefer few and stable investors. Hence our analysts have the possibility of negotiating capacity with quality hedge funds where smaller and more volatile investors are penalised.
Long-term investor
Being a long-term investor has also been essential to obtain additional capacity. CA-AIPG has been in the business since 1992 and has built up trust relationships with many quality hedge funds. Therefore, when there is spare capacity, CA-AIPG is among the first ones to be served.
Being a stable investor and benefiting from the financial backing of the Crédit Agricole Group has become a major plus to obtaining capacity in this crowded environment. Top quality hedge funds frequently invest in sometimes less liquid markets or need time to implement long-term investment strategies and hence need stability in their assets. Therefore, our sustained growth of assets reassures hedge funds on our potential of being a long-term investor as our stability of assets means we will remain invested and will not redeem unless the hedge fund underperforms.
Global presence is essential to secure capacity. Access to quality hedge funds is enhanced by our global coverage of the hedge fund industry: our investment team is based in Paris, London and Chicago, thus giving us a global coverage, rather than purely European or US reach in manager research. Hedge funds usually start in their own market and then expand to other markets. As a global fund of hedge funds, CA-AIPG has established real partnerships with high quality hedge funds who need investors who can accompany their international development.
Emerging managers
Our policy with emerging hedge funds has been very proactive as we have consistently invested a portion of our assets under management in promising emerging hedge funds. The advantage of size is that such investments are sufficiently significant for emerging hedge funds – and hence our ability to negotiate future capacity – and yet it only represents a small proportion (less than 10 per cent) of our assets under management and enables us to maintain our very low risk profile. CA-AIPG closely monitors new entries into the hedge fund universe which are spin-offs from proprietary trading desks from investment banks or spin-offs from existing hedge funds who do not have an actual track record within their newly set-up business but have a long and proven track record at other firms: hence CA-AIPG’s proprietary database (over 13 years of in-depth data) will help our analysts to get the track record of the CIO at his previous position. In being able to identify highly promising managers and invest with them from the start, CA-AIPG secures future capacity.
Our momentum indicators often give us a contrarian approach which means we avoid investing in the overcrowded strategies and we privilege the less popular strategies, which enables us to negotiate capacities with hedge funds within a strategy with a positive momentum before the main influx of funds enters into this strategy. Due to the very cyclical nature of all strategies, it is imperative to have a strong quantitative and qualitative analysis of the overall investment universe and adapt the portfolio in accordance to the positive or negative momentum indicators. Strategic asset allocation plays an essential part in detecting such momentums.
Early-stage investment
Similarly, being an early-stage investor within an emerging strategy is also key in negotiating and securing capacity with talented hedge funds. At CA-AIPG, when a positive momentum has been identified for a specific strategy, our analysts negotiate and secure capacities with our best hedge funds within this strategy well in advance.
Each strategy has its own cycle which is largely determined by macro-economic factors and/or factors related to its underlying market. That is why strategic asset allocation is a major source of added value provided by funds of hedge funds. At CA-AIPG, strategic asset allocation is performed on an annual basis. We define, based on our views for the coming 12 months, a model portfolio at the beginning of each year. The model portfolio describes our target allocation for each strategy and this portfolio will be implemented when market conditions are favourable. Asset allocation needs to be a pro-active and forward-looking process focused on identifying risk and return perspectives for each strategy. A number of different quantitative and qualitative criteria are used when analysing individual styles and strategies. The team continuously reviews and evaluates the universe of alternative investments to estimate the relative attractiveness of each strategy. We conduct a tactical allocation to adjust our strategic asset allocation on an on-going basis in order to benefit from market opportunities. This ‘momentum approach’ has positioned our portfolios with a slightly contrarian approach as our portfolio construction team tends to enter or exit a strategy in advance (usually six to eight months) to the industry average.
Total assets in fixed income strategies have more than doubled over the last three years. Both large amounts of capital invested but also limited volume of opportunities would tend to forecast low performance expectations in the future. Our strategic allocation team quantified a strong negative correlation between fixed income arbitrage and the Fed’s progressive monetary tightening. Fixed income arbitrage opportunities tend to shrink as the Fed’s continues to increase its interest rates. The leverage cost which is associated with this strategy also mechanically becomes high. How will the fixed income market evolve? On the one hand, speeches on inflationary concerns and sustained activity are being held by Alan Greenspan. On the other hand, bond markets forecast economic slowdown with no inflation. The conundrum currently raises two radically different points of view, but uncertainty still remains on the evolution of rates market. Without any clear trend, our outlook on the fixed income arbitrage is neutral to underperform.
The convertible bond arbitrage strategy presents a very good example of how the strategic allocation team identified structural risks within the strategy in 2004. Primary issuance in the convertible bond sector which represents an essential part of the arbitrage opportunities for hedge funds declined sharply as from 2001 while the inflows within this arbitrage strategy continued at a sustained pace. The consequence was an abnormally low implied volatility and credit spreads on convertible bonds compared to comparable securities or indices. Such early warning enabled CA-AIPG to reduce the allocation to this strategy well before the ‘credit crunch’ of April 2005. We believe record low levels in terms of implied volatility and valuations were reached during the April 2005 crisis. Furthermore, portfolio liquidations by less robust hedge funds led to very attractive valuations. From April 2005, our approach has become opportunistic in order to increase progressively our weightings with convertible bond arbitrageurs. Interestingly, a ‘distressed’ convertible bond market has evolved, which we think can provide an excellent investment opportunity.
Equity markets were in a deep downturn until mid-2003. Our momentum indicator detected the turn around as early as the end of 2003 for most of equity related hedge fund strategies. Following the equity crisis, the ‘flight to equity’ reflects an exceptional environment: companies have gone through major restructuring of their balance sheets and have positive net cash flows. Corporate earnings are exceptionally strong, M&A activity is steady among all sectors and restructuring activity has picked up. With a less volatile equity market than during previous bull markets, stock-picker hedge funds should be able to achieve a very high hit ratio. Event driven concentrates on such sub-strategies as merger arbitrage, corporate restructuring and special situations. The remarkable performance and substantial contribution of event driven to all our portfolios in 2003 and 2004 should continue as globalisation within the corporate sector has contributed to this exceptional activity (such as M&A deals and stronger balance sheets).
The hedge fund industry concentrates a significant part of the talent within the asset management industry. Key to their future success is their ability to quantify financial niches (e.g. arbitrage in mature or emerging markets) and their capacity to foresee future trends.
As emerging markets are opening up to modern financial tools (e.g. futures contracts, stock borrowing, repos etc.) arbitrage opportunities will be plentiful.
In mature markets, a shift in government policy and/or the Fed’s policy will be immediately exploited by hedge funds which are most nimble and through their highly skillful teams will be able to take advantage of trends in area like commodities, fixed income and foreign exchange.
Deep fundamental research on possible events, changing environments will give event driven and long/short hedge funds the edge to adapt their stock picking from large cap to small cap and vice versa. Their activist approach as an investor will increasingly give them information and insight into their targets which may be denied to more passive investors.
We therefore maintain a high level of confidence that funds of hedge funds will be able to maintain superior Sharpe ratio compared to more traditional asset classes as hedge funds provide a real value for money by searching for alpha with very low beta. Investors will therefore continue to recognise the complementary nature of combining strategies with a high alpha, e.g. funds of hedge funds within their existing portfolios.
Carl Dunning-Gribble is global head of sales and marketing at CA-AIPG.
