Investor Monitor Archive

Since May 1, the VIX, a measure of the volatility of the S&P 500, increased from 20.19 to 33.73—a 67 percent increase in just over one month. With such high volatility, investors are looking for ways to mitigate the inherent market risk present not only in the U.S. but also worldwide. Some investors have turned to short-biased funds, which can capitalize on recent slides in stock markets, while others feel that the path to a successful investment portfolio is through broadly diversified exposure.

During the month of May, BHA analysts gathered 126 mandates for long/short equity funds. In evaluating this data, a telling trend has emerged. In three of the four major regions in which BHA gathers investors’ preferences for country-specific and regionally focused funds, investors overwhelmingly favored regionally focused funds.

In Asia (including Australia), Latin America, and Europe, investors favored funds with a regional focus to those that concentrated on the equity markets of a single nation. In fact, only in North America were investors more interested in a country-specific fund (U.S. focused) than a regionally focused opportunity.

In the Middle East and Africa, BHA does not collect data on country-specific funds so a comparison is not possible here. However, it is worth noting that nearly 10 percent of all long/short equity mandates were for MENA or frontier market funds.

Of the mandates that specified some interest in pan-Asian investments, 56.5 percent were for funds with a broad focus across the region. The remaining 43.5 percent of investors specified an interest in country-specific funds within the region, mainly China, India, and Japan.

In Latin America, a similar trend was evident. 52.6 percent of mandates gathered for the region were interested in funds investing across Central and South America. The remaining 47.4 percent of investors were considering country-specific funds, predominantly funds focused on Brazil.

The comparison was stark when we examined preferences for managers within Europe (including the U.K.). Investors looking for funds in this part of the globe favored those investing across European equity markets 78.9 percent of the time. Only 21.1 percent of investors were interested in country-specific funds, predominantly U.K.-focused managers.

One possible explanation for this overwhelming trend towards regionally focused managers comes from the simple theory of portfolio diversification. With volatility rampant across global markets, many investors fear that funds concentrated on only one country’s stock market are exposing themselves to unnecessary risk.

Other investors may simply believe that country-specific funds are too focused and that the domestic market alone does not provide ample investment opportunity. Such investors would be driven to a regional fund as it can provide (in sheer quantity) more investment choices, as well as more complex arbitrage opportunities as fund managers are able to capitalize on pricing inefficiencies across international markets.

Furthermore, many investors believe that small domestic markets have few genuine shorting opportunities. In such markets, funds often short indexes as opposed to the stock of individual corporations. While this technique may accomplish a similar goal to shorting corporate stocks, many investors prefer funds that can generate alpha due to their unique understanding of individual listings and an ability to stock pick more effectively than their peers.

Whatever investors’ rationale, it is clear that there is a strong preference for long/short equity managers that are focused regionally as opposed to their country-specific counterparts.

Long/short equity is among the most popular investment strategies used by hedge fund managers, primarily because it is a straightforward and effective way to hedge market risk. Similar to stock picking, funds invest in equities that they believe will increase in value over time while simultaneously selling short positions they believe will decrease in value.

Traditionally, long/short equity funds average 35 to 40 percent net long, indicating a bullish outlook. Recently, however, we have seen that percentage dip well below the historical average due in large part to the guarded nature of today’s investors.1

However, many managers are doing more to protect themselves against downturns than rebalancing their portfolios. To fight against negative market trends, more and more hedge fund managers are pursuing fundamental strategies. Apparently, this is just what investors want.

In May, 45 percent of the investors we spoke to expressed a preference for fundamental mangers while 30 percent favored quantitative managers. This difference could be attributed to the fact that fundamental approaches have outperformed their quantitative counterparts during the past few years.

However, BHA’s conversations with investors point to other reasons. Many investors note that long/short strategies are easier to understand and fundamental managers provide more transparency. Investors are reluctant to invest in something they don’t understand and many feel quantitative strategies are too complicated.

Additionally, almost half of the investors we spoke to in May required at least quarterly liquidity, and an astonishing 99 percent required an experienced management team with a proven track record. Investors want access to their money and they want to work with teams they can trust. The plethora of Ponzi schemes and fund meltdowns over the past few years has diminished investor’s willingness to take risks.

Although most quantitative strategies may be difficult to understand, they can potentially provide better downside protection and characteristically have lower operational fees. Therefore, an argument can be made for combining a fundamental approach with a cheaper, more defensive model that employs sophisticated mathematical tools able to sift through copious amounts of data in seconds. The fact that there isn’t an uptick in quantitative interest during such volatile times, however, implies that current investors prefer fundamental reasoning and analysis when it comes to picking stocks.

As always, long/short equity strategies will remain a popular choice among hedge fund investors for the foreseeable future. However, BHA expects more management teams will combine both fundamental and quantitative models in order to maximize upside potential while mitigating risk.

1 Market Folly, “Long/Short Equity Hedge Funds: Net Long Exposure Below Average,” April 21, 2010.

With the overall popularity of long/short equity funds, it is not surprising that in May the BHA research team identified 126 accredited investors that were focused on evaluating new long/short managers. Also not entirely surprising is the preference for the strategy from funds of funds, wealth advisors, and family offices, which combined made up more than 70 percent of the total number of investors interested in long/short equity funds.

It is a bit unexpected, however, that private banks made up 12 percent of total long/short interest last month.

Apparently, private banks have become more positive on hedge funds as of late. According to an article in Reuters, private banks think that “ …hedge funds were no riskier than forex or equities, and should be included in portfolios for reasons such as diversification and their ability to make money in falling markets.”1

Specifically, some private banks are favoring long/short equity strategies. As noted in the Reuter’s article, “Barclays Wealth suggests clients shift part of their equity holdings into long-short funds that are better able to take advantage of choppy stock markets.”1

Although not every private bank active in the hedge fund space thinks long/short equity is the best or most attractive strategy, there are two underlying consistencies among those that do.

First, there is a strong preference for UCITS III-structured long/short funds. Eighty-five percent of the European-based private banks contacted by BHA will evaluate only UCITS-structured hedge funds.

Second, even though private banks as a whole are more positive on hedge funds, many of the investors BHA analysts spoke with are still being cautious. By and large, they still prefer managers with a significant track record and do not want their allocation to account for more than 10 percent of a fund’s total assets.

As we move into the second half of 2010, it is clear that long/short equity funds will maintain the popularity that presently surrounds them. If the market continues to be as turbulent as it has been of late, that popularity should increase, as more investors look for market downside protection. Private banks will then be just one category of accredited investors evaluating managers more closely in the long/short space over the next six months.

1 Reuters.com, “Asia private banks favour event-driven hedge funds,” May 25, 2010.

May was a difficult month for investors, to say the least. While hedge funds again outperformed the dismal equity market, the majority trimmed any year-to-date gains. The European debt crisis combined with the ever-increasing environmental disaster in the Gulf of Mexico, contributed to an 8.2 percent drop in the S&P 500, while the HFRX Global Hedge Fund Index reported an average decline of 2.7 percent.1

BHA analysts have heard grumblings from investors for some time about a dip in equity markets, so it comes as no surprise that a number of investors are presently evaluating short-bias managers. Sophisticated investors, in a constant search for the elusive alpha, commonly look to a manager’s short positions to assess skill.

The director of investments at a $1 billion U.S. tax-exempt organization, which has been very active in its foray into alternative investments, is particularly interested in sourcing successful short-bias equity managers. Allocations are not expected until at least the third or fourth quarter, however, they may range from $5 million to $15 million.

The chief investment officer of a U.S. family foundation is actively researching short-bias funds for its planned addition of two to three new managers over the next several quarters.

And across the pond, at a $3 billion, London-based asset management firm with over $400 million dedicated to hedge funds, an investment manager expects short-bias funds to profit substantially over the remainder of 2010. He is focusing on highly skilled managers with a track record of at least three years.

Dedicated short-bias funds undoubtedly took advantage of the falling markets in May. If investor sentiment is any indicator, they may be poised to produce significant gains in the near future.

1 FINalternatives, “Most Hedge Funds Hurt in May,” June 1, 2010.

Asia-based hedge fund managers may receive $8 billion this year from inflows, a number that is expected to double by 2013.1 BHA mandate data also show a steady increase in interest in Asia-focused funds.

In the last month, BHA analysts received a total of 43 mandates from investors seeking Asia-focused funds, an average of about 10 per week. While discussing their searches, investors mentioned several preferences that are worth noting. Many institutions were interested in Asia-focused funds that are on the ground and trading in Asian markets. Others were researching emerging managers in addition to established managers. And still others were looking at funds that are both region-specific and country-specific. A wealth advisor in the U.K. expressed an interest in Japan-focused funds.

The main driver for this interest in Asia is lingering concerns about a double-dip recession in the United States and soverign-debt issues in Europe. In addition, Asian countries are the most obvious source for growth. According to the research by the Asian Development Bank, developing Asia’s GDP should rise approximately 7.5 percent this year.2

BHA expects this trend to continue, and it will closely monitor investors’ appetite for Asia-focused funds in the coming quarters.

1 Bloomberg, “Hedge-Fund Inflows to Asian Managers Will Surge, Barclays Says,“ May 27,2010.

2 Reuters.com, “Developing Asia GDP to grow this year: UN,” June 6, 2010, http://www.reuters.com/…

Hedge fund investors have expressed a consistent interest in event-driven strategies given the turbulence in the market. Recently, however, investors who were previously looking at merger arbitrage or distressed funds have shifted their attention away from these focused subsets of the event-driven space to more broad-based, multi-strategy event-driven funds.

As the economic landscape continues to change, investors have begun to look for managers that can take advantage of mispricings between securities whose issuers are involved in a variety of corporate events.

A merger arbitrage fund, for example, can take advantage of only merger opportunities. Instead, investors want to move into funds that can adjust their exposure as events happen, whether they are restructurings, mergers, divestitures, or other types of activity. During the past two weeks, BHA data show that more than 20 percent of investors are searching for diversified event-driven funds.

An example of an investor that has taken this approach is a private bank headquartered in Switzerland. When BHA previously spoke with the bank in January, it was seeking European distressed-debt funds with a focus on bank loans. This past week, this investor shifted its focus away from such a granular search in favor of more diversified funds with exposure not only to distressed debt but also special situations, credit, and merger arbitrage. Although the investor still believes European distressed-debt funds present significant opportunities, it expects diversity across all underlying event-driven strategies will give it the same amount of upside while mitigating some of the risk of more niche funds.

In a month where global market activity has been undoubtedly turbulent, there has been a bright spot that may shift the focus of many investors. According to Hedge Fund Research’s month-to-date data, the HFRX Equity Market Neutral Index is the only index with positive performance in May. As of May 28, performance was at 1.61 percent, compared with the Global Hedge Fund Index at -3.00 percent, the Equity Hedge Index at

-4.37 percent, and the Macro Index at -0.81 percent.

Since April 1, 2010, the BHA research team has spoken to 81 investors that are actively researching and allocating to market-neutral funds. Those 81 investors account for more than 20 percent of the total number of firms that the research team identified during the past two months.

Although these numbers are not overwhelming, we expect to see more investors change their focus to equity market-neutral funds. The recent market dip during the past few weeks is causing investors to reevaluate their current investment preferences. But for some, investing in market-neutral funds is unfamiliar territory. According to a fund manager running a large market-neutral fund, this type of investment should be a part of every portfolio; market-neutral funds allow for stable, low-risk returns regardless of the current market activity.1

An analyst at a large wealth advisor based in Geneva told BHA analysts that his firm has plans to allocate upwards of $20 million to at least three market-neutral funds by year’s end. The firm is more interested in equity market-neutral funds than it was last quarter, due in large part to the recent activity in the market. It is most interested in funds offering a UCITS III structure, which when combined with its interest in market-neutral funds, will ensure the firm is lessening its risk.

A small family office based in Florida is also predominately interested in equity market-neutral funds; it has plans to invest $2 million to $5 million during the next few months. The firm is evaluating this strategy simply because of the ratio of positions. In the past, the firm has found that many funds that claimed they were long/short held too many long positions, which is exactly what the firm does not want. Market-neutral funds allow it to feel more comfortable toward future commitments.

While market-neutral funds have the potential to provide diversified returns and improve portfolio performance, individual fund performance is largely the result of the fund’s design and construction, and the portfolio manager’s skill. This means that it is critical for investors to analyze past performance. Noting that caveat, investors are still actively researching equity market-neutral funds in order to truly find the best places to put their money.

1 The Wall Street Journal, “Sometimes It Pays to Be ‘Neutral’,” May 26, 2010.

Since October 2009, BHA analysts have spoken with over 40 endowments. Of those, 26 have recently decided to begin investing in or make larger allocations to single-manager hedge funds.

The investment staffs of the endowments cited various reasons for the shift. Some emphasized interest in single-manager funds that were uncorrelated to equity market indices. Other endowments who had traditionally invested in funds of funds noted the cost-effectiveness of these funds when compared with fund of funds for their increased allocation to single-manager hedge funds.

Since the financial crises, an increasing number of endowments have been asking their investment committees to conduct more stringent due diligence and secure access to more information, such as reports on portfolio holdings and exposure. In response, the committees have augmented their staffs, hiring sophisticated analysts. Therefore, today, many committees have the staff necessary to research and evaluate single-manager funds.

A $500 million endowment based in the U.S. recently decided to invest in single-manager funds. The institution has typically gained hedge fund exposure through funds of funds; however, it believes that single-manager funds will provide more information about their strategies and more access to their portfolio managers than funds of funds. The endowment has decided to divest itself of its long-only portfolio and reallocate that money to single-manager hedge funds. It is seeking emerging managers, which it believes can access less saturated segments of the market and provide returns that a much larger fund may not be able to offer.

A multibillion dollar endowment in Canada has also decided to allocate to single-manager hedge funds, chiefly global macro or global technical asset allocation (GTAA) funds. To date, the institution has only invested in fund of funds. However, funds of funds’ double layering of fees and limited access to underlying managers makes increasing its single-manager exposure a more cost-effective and more transparent way of investing. Unlike the U.S. endowment, this fund is seeking highly experience managers and much larger funds for its foray into direct investing.

Endowments rely heavily on alternative investments, mainly hedge funds, to be able to support the operational and accrued costs of running their institutions. Now that the economic environment has improved and endowments are recovering, they are beginning to actively invest again and placing more emphasis on their ability to seek out, evaluate, and monitor investment opportunities internally. This shift in strategy has increased the investment activity in single-manager funds over the past two quarters and most likely will throughout the remainder of 2010.

A benefit of being a BHA research analyst is hearing the countless views and opinions of hedge fund, private equity, and real estate investors. From call to call and day to day, BHA analysts hear a wide variety of interpretations of alternative strategies. An area that generates a lot of debate is commodities and managed futures investing. Many investors have a preference for how these managers approach their trading day

The BHA Quarterly Research Report | Q1 2010 noted a recent rise in investor interest in the high-frequency, algorithmic trading strategies that are often associated with commodities and managed futures funds. Trading-oriented investors are conducting more research of these sophisticated—and at times controversial—short-term trading operations.

Although these high-frequency trading programs have attracted many investors, there are still many that prefer near to longer-term, discretionary strategies. And for every manager that seeks market momentum and quick gains, there are many others that remain focused on steady, long-term growth.

This past week, a BHA analyst spoke with a portfolio manager overseeing research and fund selection at a wealth advisory firm. He was searching for commodities and managed futures funds, preferably funds of funds. The firm is focused on true discretionary managers that have longer-term holding periods. It knows that very short-term, systematic and algorithmic funds are an attractive and new niche. However, it also finds that it is difficult to understand the many facets of high-frequency trading and interpret them for clients.

Many investors also want the ability to speak with a portfolio manager who is able to clearly articulate why he or she decided to buy or sell a certain commodity or futures contract at a certain time. This is preferable to being told that such decisions are incorporated into an efficient and automated trading model. They want old-school traders that use their own market knowledge and experience to make trading decisions rather than a systematic or black-box trading model.

The portfolio manager who spoke with a BHA analyst last week recognized that many of these algorithmic trading platforms are able to prove their worth at times with high, attractive returns. However, he also stated that there are times when such models can hurt a portfolio because they don’t have the ability or foresight to change their view or position on the market as a whole.

Many who fall in line with this opinion point to the drop in performance among many systematic commodities and managed futures funds from 2008 and 2009. During 2008, short-term trading commodities and managed futures funds were able to outperform the vast majority of other hedge funds and caught the attention of many investors. However, this was followed by very mediocre performance at best during 2009, when many shorter-term commodities and managed futures managers struggled to profit.

Although there are many investors that pursue commodities and managed futures traders to add volatility and great short-term returns to a portfolio, these funds can serve a different purpose. Many investors incorporate this asset class into a portfolio that is designed for long-term growth and preservation of capital over a span of quarters and years as opposed to days and weeks.

The number of investors looking to gain more exposure to the natural resources sector has increased over the past five months. During the fourth quarter of 2009, there was little to no interest in natural resources from private equity and hedge fund investors. This has changed dramatically. From January through May, the number of private equity mandates for natural resources increased from 6 to 38; hedge fund mandates rose from 11 to 64.

A family office in London whose clients are based in India, is making investments in this sector because it expects high demand by emerging-market countries to lead to shortages. Water, oil, gas, and precious metals were deemed by this investor to be among the most important resources to watch. In the firm’s view, the increasing demand from emerging-market countries is partly due to their efforts to compete globally.

A wealth advisor in the Netherlands also foresees a possible increase in demand for natural resources. The firm anticipates demand to begin rising in early 2011 and then surge over the next five years, especially in emerging-market regions. The high demand will cause shortages and drive up prices, increasing profits for managers with exposure to the sector.

Some fund managers have already begun tapping into the natural resources sector in emerging-market regions. In an effort to take advantage of the commodities boom, a New York-based hedge fund recently made investments in Africa, which it called “the last untouched resource frontier on earth.”1 The firm invested in a mining company and a minerals company, and expects to make more investments.

The natural resources sector has become a hot topic among alternative investors. Managers and investors alike have begun to see the opportunities for profit. It is no surprise that emerging markets are, once again, the focal point for many alternative investment interests, since these regions are expanding rapidly.

1 The Wall Street Journal, “Sometimes It Pays to Be ‘Neutral’,” May 26, 2010, http://online.wsj.com/article/SB10001424052748704032704575268673137384154.

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