If gyrations in the US Treasury market settle the ongoing bull versus bear battle to determine the long term interest rate, then this year’s substantial rally in bond prices suggests the bears have the upper hand. Investors now require substantially less yield today to part with their cash, though the current 1-year yield of 0.1% still makes 2.2% on the 10-year look quite generous.

The notion of risk-on and risk-off, that investors are broadly moving between risky and (notionally or nominally) riskless assets en masse, also suggests an unusual convergence of opinion since ultra-loose monetary policies commenced, following the 2008 financial crisis.  Clearly at the time of writing we are risk-off.

Economist John Maynard Keynes described aptly how interest rates are determined by the bond market: ‘Best of all that we should know the future.  But, if not, then, if we are to control the economic system by changing the quantity of money, it is important that opinions should differ.’(1)

So, is there sufficient diversity of opinion in today’s markets?  We took a look at the recent CalPERS decision to exit their hedge fund investments and what this says about taking active decisions.  Hedge funds as liquid alternative investments are often the most active.

COST AND COMPLEXITY

CalPERS CIO, Ted Eliopoulos, said of exiting hedge funds “It is not about the performance of the hedge fund program or about the industry in general. For us, it’s ending the program because it doesn’t serve CalPERS’ purposes.”

Specific issues cited by CalPERS included “cost and complexity”, and the small size of the program relative to CalPERS’ assets.  Though importantly other alternative investment strategies, such as private equity, remain (Chart).

Calpers

Taking the last point first, it is self-evident that the $4bn allocation, making up scarcely more than 1% of the $300bn of assets, is hardly going to move the needle in terms of returns.

The Harvard Endowment has about $5.8bn in hedge funds, but this represents 16% of its $36.4bn of assets as of June 2014. Harvard’s allocation increased to 16% from 15%, and there are plenty of other endowments and foundations with similar sized allocations.

It is probably true that a fund as big as CalPERS could have trouble making meaningful allocations to some of the less scalable hedge fund strategies, which might involve small cap equities, emerging markets equities, some parts of distressed debt and some niche areas of non-agency mortgage securities, for instance. However, there are plenty of more liquid hedge fund strategies such as long short equity, global macro, and liquid high yield where many billions can be put to work.

Indeed, with a secure capital base and very long time horizon, a large pension would seem ideally placed as a liquidity provider, generally speaking, particularly as banks have retreated from certain kinds of trading and lending.

WHAT ARE THE COSTS?

A wide variety of fee structures are on offer in the hedge fund industry. We look closely at total expenses, since the inception of the hedge fund, to get a feel for whether we are getting enough bang for our buck. The classic 2 and 20 does not always apply by any means.

Many of our managers are charging 1%, 1.25% or 1.5% on the management fee side and some levy performance fees of 15%. At current levels of interest rates the concept of a hurdle rate under performance fees seems largely theoretical, but as a matter of principle we do welcome hurdle rates so that managers of cash-rich strategies are not collecting performance fees on the risk free rate.

In our experience, management and performance fees are less than half of total expenses.  Operating costs are reasonably steady over time at around 5% of total expenses.  It is often the case that dividend and interest expense is the largest single cost, depending on the strategy.  The good news is that this is coming down with the advent of better organized derivatives markets.

Several of our funds are sitting on cash of 80-90% of the fund, net of margin posted to counterparties, so when interest rates do rise we will expect to get the interest on this without a performance fee applied.  Indeed, the short-interest rebate has been completely missing in this era of zero short term rates.

In our view, a well-run hedge fund is able to isolate the value of a security, for example, due to a merger or being linked to another security, and thus create a unique return stream.  The total expense of doing so is going to be closely related to the size of the team and the nature of the portfolio.  And in any case, these costs have been falling over the past 10 years based on our analysis.

AVOID UNQUANTIFIABLE RISKS

Complexity is also a valid concern in some cases but is not unique to hedge funds.  Investors in bank or insurance company stocks are exposed to similar risks.  Of course it is precisely the complexity of certain strategies and asset classes that gives rise to the opportunity set allowing hedge funds with an informational edge to generate alpha! For instance distressed debt managers can identify anomalies in complex capital structures and in complicated legal processes.

However there are good and bad types of complexity. With 10,000 hedge funds out there trading every conceivable financial market and instrument, some hedge fund portfolios can be difficult to value and price, and hard to comprehend. For this reason we pay close attention to the proportion of portfolios classified as hard to value.  These so-called “level 3” assets are often valued with respect to some unobservable input.

The level 3 category, first introduced by FAS 157 under US GAAP – and later adopted in IAS – closely dovetails with the valuation hierarchy under the Global Investment Performance Standards (GIPS) of the CFA Institute. Level 3 encompasses a broad spectrum of assets.

At one extreme private equity that might never be monetized is level 3, and this is something we would seldom expect to see. At the same time, if a 6 week currency forward is valued by interpolating between 1 month and 2 month dealer quotes, that, too, can be classified as level 3 because the act of interpolation is deemed to be an unobservable input.

In between these extremes, some auditors will also put assets that only have one broker making markets in them, into the level 3 bucket, whereas other auditors might keep these as level 2. We feel confident that excessive or unnecessary complexity can be avoided through carrying out good due diligence and ongoing monitoring.

Other fundamental risks, such as leverage and directional exposure to a particular asset, are generally quantifiable with industry standard reports.  Highly concentrated portfolios are a specific category of hedge fund and these should not be levered or contain hard to value assets, in our view.  It is unlikely that investors today can completely avoid complexity, but they can certainly say no to unquantifiable risks.

TO FAIL CONVENTIONALLY OR SUCCEED UNCONVENTIONALLY

Convention is generally the better choice in business development or career terms.  There is nothing very new about hedge funds or the current ultra-loose monetary policy, which is having a depressive effect on these very strategies. Hedge funds, or hedging and arbitrage operations as Benjamin Graham and David Dodd termed them more than 80 years ago, are essentially an extension of security analysis where the security can be valued much more accurately.

More importantly, today’s very low interest rates and QE seem to have fundamentally affected hedge fund returns.  Keynes warned of investor behaviour in exactly this environment: ‘For a large increase in the quantity of money may cause so much uncertainty about the future that liquidity-preferences due to the security motive may be strengthened; whilst opinion about the future of the rate of interest may be so unanimous that a small change in present rates may cause a mass movement into cash.’(2)

The current risk-on/off environment can easily overwhelm careful security selection.  But hedge fund investors should stay the course as the long-term risk adjusted return is worth the wait.

Hamlin Lovell, CFA & Keith Tomlinson, CFA

(1) Keynes, JM (1936). The General Theory of Employment, Interest and Money. London: Macmillan. 97

(2)  Keynes. 97

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