Narrow asset classes constraining managers
Liberating an investment strategy from asset class constraints can position a portfolio to reap the rewards from volatile and illiquid markets
The old adage “love everything, be attached to nothing” may appear to ring hollow in the complex universe of event driven capital structure arbitrage, but given due consideration, the axiom could have a profound effect on portfolio managers who choose to heed its simple wisdom.
When applied to the investment world, its lesson is both unassuming and incisive. A fund manager with no investment constraints, or a strong bias to one asset class, can fluidly move up and down the capital structure between different asset classes, creating interesting event driven ideas with positive asymmetry just by using volatility and illiquidity to their advantage.
Consider for a moment last October’s equities sell-off and decline in bond rates, events spawned by concerns over global growth, weak economic data and uncertainty over the repercussions of a rise in US interest rates. Credit markets reacted particularly poorly to the market’s anxiety, as investors were virtually tripping over one another in a race to the exit.
All, however, was not lost. Funds that approached event driven strategies and capital structure arbitrage from an asset-class-agnostic stance were those best positioned to navigate through this market volatility.
The key to maintaining performance, whether managing a fund through bull markets or during periods of intense volatility, is to always know where risk lies, simultaneously ensuring you have effective hedges in place. The use of hedging tools to generate risk-adjusted returns in turbulent markets creates opportunity from what might otherwise be a challenge.
Managers without experience running hedged portfolios during erratic markets are likely to find themselves playing defence when they could be proactively taking advantage of market volatility. Accordingly, investors should seek individual short alpha ideas instead of looking for broad index hedges like a high-yield index or S&P 500 index puts.
Looking to October again, the Volatility Index spiked to more than 30 for the first time since late 2011, crossing into territory generally associated with a large amount of volatility resulting in investor uncertainty and equity markets were battered as risk assets sold off. Conversely, in the flight to quality, 10-year Treasury bonds rallied, with yields tumbling 35 basis points to touch 1.86% within the space of a few minutes. While the decline was mostly reversed by the trading day’s end, it signalled the impulsive nature of investors.
Higher volatility is a fact we will likely have to live with for the foreseeable future, in part because the Fed will no longer be shelling out $85 billion every month to buy Treasury bonds. This latest round of quantitative easing to resuscitate the US economy effectively ended in October, which impacted the sell-off in bond markets. The benchmark two-year US Treasury note yield moved up to 0.485% in what was the biggest intra-day rise for two-year yields in more than three years.
Looking outside the US, the major global growth concerns feeding the market’s volatility stem from China’s slowdown and Europe’s challenged economic dynamics. In fact, over the last 12 months, the eurozone economy has grown by just 0.15%, with the second quarter’s GDP growth rate stagnating at 0%. These factors are likely to continue to support elevated market volatility, providing opportunities globally for hedge funds with tactical and event driven strategies.
Illiquidity is opportunity
With the Volcker rule and other federal regulations firmly in place, financial markets have become less risky since the 2008 banking crisis. One of these regulations, the Dodd-Frank Act, limits banks from committing bank capital for market-making activities. Recent regulations also place higher costs on debt that the biggest US banks use to finance their assets. Ultimately, by restricting banks’ business models and prohibiting what could be seen as risky activities, the rule aims to reduce risk-taking by banks and increasing banks’ financial stability.
The unintended consequence of restricting banks’ capital committed to facilitating market-making activities is likely to be larger and more frequent illiquidity gaps in credit and OTC markets. This can provide those with longer-term capital better positioned to opportunistically take advantage of dislocations. Investors with liquid portfolios and asset-class-agnostic strategies are best situated to profit by opportunistically providing that needed liquidity. Historically, this was the province of market-makers or big banks but, because of new regulations, bank dealer desks have a smaller presence in these activities. Asset managers that cultivate relationships within the high-yield, derivative and convertible bond desks at investment banks can help to provide the needed market liquidity.
In an effort to consistently generate excess returns, it is advantageous to invest through various strategies, including relative value credit, capital structure arbitrage, distressed, convertible arbitrage, event driven credit, and equities. So how do asset managers go about constructing an asset-class agnostic portfolio? Incorporating the following elements into one’s investment process can provide some insight:
- Idea generation. Having an overwhelming majority of investment ideas generated internally will lay the foundation for a portfolio rooted in event driven opportunities, with less exposure to broader market volatility.
- Defining the relative value of the asset. It is necessary to produce macro and liquidity analysis to understand the richness/cheapness of a security – that is, ensure the cheapness of an asset is not due to the lack of liquidity. A bottom-up fundamental analysis of each individual security is essential to take into account the asset’s capital structure, comparables, and industry valuations.
- Correlation comparison. When constructing the portfolio, each individual idea needs to be dissected and analysed as to how much better its risk/reward profile is going to be in the context of the existing positions. As part of the process, a potential new position will go through a correlation analysis between it and the portfolio’s other positions.
- Assessing risk. When sizing an investment, a maximum downside loss tolerance for an individual position should be established. This process is designed to avoid having one investment skew the portfolio’s overall performance.
All investments should be made with an eye on risk and protection on the downside as well as high risk-adjusted returns. The best active strategies typically have high Sharpe ratio because they maintain a focus on profit potential along with downside protection. Although at times, these kinds of strategies might underperform some portfolios, in volatile months these strategies should be vindicated.
An example of this kind of opportunity during the volatile month of October was a short position in convertible bonds of Cubist Pharmaceuticals, a US-based biopharmaceutical company. The convertible bond was richly valued, thus a strategy would have been to sell expensive volatility in the convertible bonds and buy cheaper volatility in the listed option on a delta neutral basis. A delta neutral position balances out the response to market movements, bringing the net change of the position to zero. A fundamental reason for shorting these bonds was an expectation of a change in the company’s top management or ownership. On October 20, the company announced a change of chief executive and the bonds traded lower which benefited the short convertible position.
Managers able to trade across the corporate capital structure can also establish trades that are long inexpensive volatility. A long volatility exposure could have been established by securing a long position with Twitter convertible bonds as opposed to shorting the stock outright. In September, Twitter raised $1.8 billion in convertible bonds. The five-year tranche of the issue carried a 0.25% interest rate due in 2019, while the seven-year notes bear 1% interest, set to mature in 2021. The trade on was to buy the convertible bonds at a discount to the realised volatility exhibited in the underlying stock. These bonds initially traded lower delta neutral, which created an opportunity to buy cheap volatility.
This was an inexpensive way to be long volatility in Twitter regardless of the direction of its stock. This trade structure created opportunities for investors to actively manage the exposure of the underlying stock and realise trading profits.
Thus, asset managers that have ‘broken their chains’ from narrow asset class constraints are positioned to benefit the most from volatility and illiquidity in the marketplace. It is a good time to look at the world from the long and short side, within multiple asset classes and in different sectors to find great opportunities.
Doug Teresko is managing director at Advent Capital Management.
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