It seems that hedge funds as a group are playing a much more important role within the credit markets today than they did three or four years ago. How do you account for this phenomenon?
Well, for one thing there has been explosive growth, both in the number of hedge funds and hedge fund assets under management over the past three years. And on a relative basis, the growth has been even more impressive in the case of credit hedge funds.
But despite the growth in hedge fund assets, don’t hedge funds still account for a very small percentage of total assets under management?
That’s true. Despite the fact that hedge fund assets under management are approaching $1 trillion this year, by most estimates hedge funds still only account for less than 2% of all investment assets. However, the impact that hedge funds have on the securities and commodities markets they trade in is much greater than one would expect based on their asset size. While hedge funds only control a small percentage of assets, they account for a disproportionately large share of trading volume in those markets.
Why is that?
Unlike traditional money managers that are benchmarked to a specific market index, like the Lehman Agg, and therefore are reluctant to have their portfolio migrate too far away from the composition of that index, hedge fund managers have relatively few constraints and are more likely to have big concentrations in specific credits or sectors. Furthermore, they tend to have very short-term investment horizons and, unlike traditional asset managers, are likely to turn over their portfolio many times a year.
Hedge fund managers also tend to be trendsetters, being the first investors to trade when there is new information. And last but not least, there is also the multiplier effect created by the industry’s use of leverage. This means that the size of the portfolio of investments actually controlled by a hedge fund manager may be many multiples of the fund’s stated assets. As a result, hedge funds exert an inordinate amount of influence on the markets they’re involved in.
What has been the driver behind the explosive growth in hedge fund assets?
The primary reason for the growth in hedge fund assets for the industry overall is a distinct increase in the demand for alternative investments by institutional investors, such as endowments and pension funds. Prior to several years ago, individual investors accounted for the lion’s share of hedge fund investments. However, given the mediocre returns in most of the major markets over the past several years, there has been a shift away from equities and other traditional investments to alternative asset classes such as hedge funds. As a case in point, during 2003 hedge fund investments grew to account for almost 20% of the assets managed by large US endowments—those with a billion dollars or more in assets—and for the first time ever surpassed traditional fixed income as the second largest asset class in their portfolios after equities.
Earlier you mentioned that the growth in assets managed by credit hedge funds has been even more impressive than the growth in hedge fund assets overall. How do you account for the heightened interest in credit-related strategies within the hedge fund industry?
There are a number of reasons for this increased interest in the credit space. First there is the capacity problem created in the hedge fund industry over the past few years when too much new capital flowed into the industry over a relatively short period of time. Hedge fund managers are at the point where they can’t deploy any new money in traditional equity and macro-oriented hedge fund strategies without dramatically reducing their returns on those products—there is simply too much money chasing a limited number of investment opportunities.
As a result, faced with the inability to expand the scale of their old core businesses, equity and macro-oriented hedge fund managers have been forced to diversify into new trading strategies within the fixed-income space. While non-credit forms of fixed-income arbitrage, such as mortgage and interest rate arb, have been around for a while, the credit sector was relatively unexploited as recently as 2001. Given the size of the credit sector and the hedge fund industry’s historical involvement in strategies like convert arb and distressed debt, credit-related strategies were a natural progression in the expansion of trading strategies.
But why the infatuation with credit fixed income in particular?
Credit-related strategies first came into their own in 2002. The cataclysmic events in the credit markets that year really highlighted the tremendous return opportunities in the credit markets and demonstrated the important synergies created by combining the pursuit of debt and equity trading strategies. It was that year that the proprietary trading world realized the benefits of approaching trade opportunities in a specific company from a holistic perspective: taking into account not only the company’s stock, but also the publicly traded debt, bank loans and credit derivatives related to that company. This is when the term ‘capital structure arbitrage’ first became an industry catchphrase.
How does the growth of the credit derivatives market factor into all of this?
I would actually attribute much of the credit for the recent renaissance in the proprietary credit trading business to the evolution of credit derivatives markets in recent years. The rapid development of credit derivatives technology—especially the more recent developments in standardized synthetic portfolio products—has created an array of quantitatively oriented trading strategies that didn’t exist in the credit markets four or five years ago. As a result, for the first time in history, the quantitative and statistical methods that have long been used by investment banks and hedge funds in arbitrage strategies related to commodities and equities are finally being applied within the credit space.
Why have the returns for credit hedge funds, though better than the returns of some of the more traditional hedge fund strategies, been so poor this year?
The problem is twofold. First, the revenues generated by hedge funds and the proprietary trading arms of investment banks have suffered for two main reasons: the secular decline in volatility that usually occurs at this stage of an economic recovery and the reduction of arbitrage profit margins created by the entry of too many new participants. This has negatively affected the return on equity (ROE) calculation for the overall industry by reducing the numerator.
Second, the capital base for the industry has grown way too quickly as a result of the tremendous inflows from a new base of institutional investors. This further dilutes the ROE calculation for the industry by inflating the denominator. Ironically, the incredibly attractive performance of hedge funds relative to equity investments over the past several years has created a situation where new capital continues to flow into the industry even as the return prospects continue to deteriorate.
How can credit hedge funds adjust their approaches to cope effectively in this type of low-volatility market environment?
Unfortunately, there is no easy answer to that question. The types of trading strategies that work best in this type of low-volatility market environment are very different from those that were successful last year which, in turn, were very different from the strategies that worked well in 2002. Whereas concentrated market, sector and credit-directional bets were the key to performance last year, the trading strategies that work in this market environment tend to be arbitrage strategies which take advantage of opportunities and inefficiencies that are much more subtle.
Can you give me some concrete examples?
Sure. When most people think of proprietary credit trading, sector or credit relative-value trades come to mind. In reality the concept of relative-value trading can encompass any aspect of valuation in the credit markets. For example, one can take advantage of relative-value opportunities along specific points of the credit spread curve for a credit or a sector, eg ‘spread curve arbitrage’ or ‘corporate yield curve roll-down arbitrage’. There can be opportunities arising from temporary mispricings of complicated or illiquid bond structures. This could involve any type of structural idiosyncrasy: embedded options, sinking funds, special debt covenants, unusual subordination, etc.
This is also a market environment where some of the best profit opportunities come from developing a superior knowledge or information advantage in an off-the-run sector that has a substantial degree of complexity and a low to medium level of liquidity. Once you’ve established an information advantage, it is relatively easy to outmaneuver other market participants and generate extraordinary profits even when the sector is a loss leader for others. Long-dated insurance, REITs (real-estate investment trusts), electric utilities and EETCs (enhanced equipment trust certificates) are all examples of credit sectors that have at one time or another presented tremendous profit opportunities for the handful of market participants with superior sector knowledge.
However, as is always the case, executing some of these trading strategies is sometimes easier said than done. A hedge fund’s ability to implement these types of trading approaches effectively is a direct function of the breadth of experience of its trading and research team and their past exposure to a range of market environments over the course of many economic cycles.
Taking into account the deterioration in the credit trading environment in 2004 and factoring in the continued rapid growth in the number of hedge funds as well as further expansion of proprietary trading activities among investment banks, how does this affect the outlook for credit hedge funds in 2005?
Unfortunately, it doesn’t bode well. In fact, the current state of affairs in the hedge fund industry—credit hedge funds included—is in many ways reminiscent of the internet bubble, though less extreme. Because the inflow of new capital has outstripped the industry’s capacity in terms of the availability of profitable trading opportunities and experienced fund managers, we are in a situation where there are a lot of managers out there that probably shouldn’t be managing hedge fund money. And there is a decent portion of the industry’s institutional investor base, like some of the endowments and pension funds, that really shouldn’t have invested in hedge funds in the first place.
So, at some point, whether it’s three months or two years from now, there is going to be some sort of a shakeout in the industry precipitated by mediocre performance. The only question is how severe it’ll be and what sectors will get hit the hardest. While many inexperienced fund managers will be forced out during this period, I don’t believe that the industry overall should experience large net outflows of capital. Instead, the better managers will either maintain their capital bases or might even gain at the expense of weaker managers, many of whom will go out of business.