Critics of hedge funds often argue that industry growth has had two negative side-effects: firstly, that less-skilled managers have been attracted to the sector and second, that the number of alpha-generating opportunities has not kept pace with asset inflows.  Assuming these are true, then it could be argued that recent industry shrinkage may lead to new opportunities.  In our monthly guest contribution from a member of the Chartered Alternative Investment Analyst ([1] CAIA) Association, Tommaso Sanzin of Hermes BPK Partners suggests that recent headwinds have ushered in a new phase in the “hedge fund industry life cycle”.  Sanzin is Partner and Head of Quantitative Research and Risk Analysis at Hermes BPK and was previously head of quantitative research at Pioneer Alternative Investment Management in London.  Hermes BPK is a boutique fund of funds majority-owned by British pension manager [2] Hermes.

Alternative Viewpoints: Manager Capacity vs. Market Capacity: The fund of hedge fund conundrum

Special to AllAboutAlpha.com by: Tommaso Sanzin, CAIA, Partner & Head of Quantitative Research and Risk Analysis, Hermes BPK

In December, the National Bureau of Economic Research (NBER) announced that the U.S. economy entered the recession in December 2007, declaring the longest contraction since 1982. At the same time, early November reports estimated that the fund of hedge funds industry returned  negative 19% YTD, making it the worst and the longest drawdown on record, according to Chicago’s Hedge Fund Research (HFR). There is no doubt funds of funds are possibly facing the strongest headwind ever, as prices depreciate, liquidity conditions worsen and a tsunami of redemptions hits managers.

Clear and Present Danger

“Flow risk” can be defined as the risk that a manager experiences significant redemptions mostly due to industry-wide issues or a specific category of investors, rather than due to issues related to the manager itself. Among the current threats, this risk is probably the toughest to navigate. It can be exogenous to the portfolio and usually results in massive deleveraging that  impacts most managers, regardless of their performance or size, since both longs and shorts are indiscriminately squeezed and/or liquidated. This may seem obvious in the current environment but the summer ‘07 quantitative long/short managers debacle highlighted how a deleveraging event can hit hedge funds even if they run “neutral” portfolios and the equity market closes the month up (recall August 2007).

Liquidity or Objectives Mismatch?

The above mentioned flow risk is caused by a general liquidity mismatch between assets and liabilities caused by a deeper mismatch between clients and hedge fund managers objectives. The industry has always been broadly split into high net worth individuals and institutional long-term investors, with fund of hedge funds typically viewed as institutional investors. The issue has been that funds of funds raised money mostly through platforms or structured vehicles whose investors were predominantly private clients. These clients had a shorter term view than the funds of funds themselves and definitively had a much shorter one than the underlying managers (especially with regards to the less liquid strategies). Not only did they have different investment horizons but also different investment objectives. Private clients were looking for “optionality” in returns (equity like returns during bull and bond like returns during bear) while institutions generally aimed for low volatility and contained correlation against other asset classes. All this resulted in a conflict of objectives, which was very difficult to manage by funds of funds, thus creating the foundation for the current liquidity crisis.

Hedge Fund Evolution

Life below the ubiquitous “high water mark” has never been easy. Having said that, hedge fund survivors have always enjoyed periods of renaissance right after each previous crisis. It is likely that the overstretched bull environment attracted less skilled (on average) players in a very crowded (and thin) opportunity set, leading into the current crash which very few have been able to forecast. The good news is that market capacity is improving day by day and a new range of opportunities has arisen from the present dislocation. The winners will prove their skill and are likely to enjoy the panacea of rich trades and very little competition.

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Where does the new set of opportunities lie?

Even with outflows threatening to wipe out 1/3 (or more) of the industry (according to various press reports), there are some hedge fund allocators working hard to identify where the next set of opportunities will arise. I remember that once, during a sailing competition, my coach said: “Once you touch the bottom, you can only do better…or start digging”. By the end of that competition, my yacht club was in last place.  As he had predicted, we simply couldn’t do any worse.  Later that year, however, our team clawed our way back to a silver medal at the national championship. Like that sailing team, it is likely that we shall all wake up in a brave new world full of opportunities.

As an example, distressed debt is one particular opportunity that I believe will be the next wave to ride..  Why?…

• Investment Grade (IG) and High Yield (HY) spreads went through the roof;
• All but one high yield sector is trading at distressed levels;
• Leveraged loans and mortgage pools underwent a dramatic transformation as a result of excessive liquidity conditions;
• Massive dislocations took place in IG and HY capital structures, cash and derivatives market.

If the default rates eventually met spreads in 2009, the supply of new distressed debt should subside somewhat relative to demand, which probably would be good news for distressed investors. Furthermore I expect an unprecedented supply of juicy fallen angels’ paper, which typically yields higher alpha and lower tail risk than any other distressed security.

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There is little question that a gale force headwind blew the hedge fund sector off-course in 2008.  But as any sailor will tell you, headwind - like any wind - can power a boat forward as long as the sails are trimmed right.

- T. Sanzin, December 2008

(Editor’s addendum: Related news items: [5] John Paulson looking to buy distressed debt: report [Reuters, Dec. 31],[6] Yale’s Swensen Sees ‘Extraordinary’ Opportunity to Snap Up Debt [Bloomberg, Jan. 2] )

The opinions expressed in this guest posting are those of the author and not necessarily those of AllAboutAlpha.com.