By Cliff Stanton and Jeremy Frank
The Many Forms of Risk
Most investors tend to be familiar with risk in the context of market risk, i.e., if the stock market goes down, their equities go down with it. The same is true of bonds, commodities, etc. Funds exposed to these markets tend to move in concert with those markets. However, there are many forms of risk beyond market risk, and as the universe of investable strategies and assets has expanded for the average investor, newer risks have begun to take shape. Among these risks are liquidity, concentration and leverage.
The first two have been realized rather publicly recently; one large credit mutual fund had to suspend redemptions as liquidity dried up on its underlying holdings. And additionally, a second large and historically top performing mutual fund held a very concentrated position in Valeant Pharmaceuticals, which has lost roughly 90% of its value, leaving the fund down more than 30% since early August 2015. The other risk, leverage, is currently the focus of a new SEC rule proposal that will limit the use of derivatives within mutual funds and exchange traded funds. As we outlined in the January edition of this briefing, the proposal suggests limiting the notional exposure obtained via derivatives to 150% of net asset value. This could severely hamper the ability of many strategies (none of ours at present) to continue as currently structured. At the top of the list of strategies that may need re-engineering are managed futures and leveraged mutual and exchange traded funds. However, many widely used bond funds that gain exposure via derivatives could be affected as well. As we attempt to explain in this month’s Education section below, leverage, or the creation of economic exposure that exceeds the amount of capital invested, is a complex subject. It is not only difficult to define, but leverage doesn’t necessarily equate to risk, and investors vetting funds need to understand just that.
Equities began February with a continued sell off, as the S&P 500 Index dropped more than 5% in the first 11 days of the month and the Russell 2000 shed nearly 8% during the same timeframe. However, by the end of the month both indices recovered, finishing roughly flat. International equities had a more difficult time, as the MSCI EAFE lost about 1.8% for the month, bringing the 2016 year-to-date return to nearly -9%, and the trailing twelve month return to almost -15%. This environment has been tough for Long/Short Equity, which tends to maintain some positive exposure to the markets. The category shed about 0.6% during February and is down nearly 7% over the last year. The best performing alternative strategy was Managed Futures, adding nearly 2% for the month, which brings the year-to-date return to over 4%. Over the last 12 months all of the major strategies that we track were flat to down.
Managed Futures funds continued to see staggering inflows, gaining another $2.2 billion during February, and bringing 2016 flows to nearly $3.7 billion. While the largest fund in the category dominated flows with $700 million, several other funds saw strong growth, bringing in more than $200 million each during the month. Equity Market Neutral also benefited during the month, as a shift in recent trends led to nearly $800 million of inflows into the category. However, despite the uptick, the last 12 months has not been kind to the category, as more than $1.2 billion has exited funds in the space. We’d hazard a guess that recent market turmoil, coupled with good performance from a number of the larger funds in the space, was likely the cause of the reversal.
Bond Hedge Funds See Worst Quarter Ever
We were recently discussing the fact that many of the historically best performing fixed income hedge funds ended last year very poorly and are off to a horrendous start this year. I guess we’re not the only one noticing the pattern:
“It is probably going to be the worst quarter in history for a number of the fixed income-oriented hedge funds,” Fuss said at an event in Tokyo on Thursday. “A few are already known but there are some that were wiped out and just wound down.” Hedge funds that bet on bonds prices falling were caught off guard as individual investors poured money back into junk debt funds in February, according to Fuss. The funds that used borrowed money to short the debt found they couldn’t cover those wagers as institutional holders were unwilling to sell and there were fewer dealers at investment banks to act as market makers, he said. “The market is going, I think, to stay thin” he said. “Volatility will stay high any time you have a major change like this.” The pain suffered by hedge funds is a “side effect but an important one” of declining market liquidity, according to Fuss, who has been at Boston-based Loomis Sayles since 1976 and helps lead fixed-income strategy there. (Bloomberg)
Will SEC Crash the Liquid Alts Party?
As mentioned above and below, the SEC is looking hard at limiting the allowed leverage gained via exposure to derivatives. ThinkAdvisor offers up some thoughts on the proposal and the potential impact to alternative mutual funds generally and Managed Futures in particular.
Enormous Valeant Pharmaceuticals Drop Causes Widespread Losses
Hedge funds lost billions of dollars Tuesday, March 15 as Valeant Pharmaceuticals was down more than 50% in a single day. The stock is one of the most widely held, leading to widespread losses across some very notable names. Pershing Square, ValueAct Holdings and Paulson & Co. are all large holders of the name and have all apparently stuck by the stock despite its 90% drop since early August 2015.
2015 Was the First Time Since the Recession that More Hedge Funds Closed than Opened
It felt like closing hedge funds were highlighted nearly every month last year, and it appears that there was a reason for this. More hedge funds closed last year than any year since the 2008 financial crisis. Not only were there more closures, there were fewer hedge funds starting up, the first time since 2007 that this has happened.
As we mentioned within the intro to this month’s briefing, the use of leverage within mutual funds and ETFs is under the SEC’s microscope. And the mere mention of leverage can give investors familiar with Long Term Capital or Lehman Brothers a chill. But leverage isn’t necessarily bad, and in fact, the use of leverage can actually reduce total portfolio risk (think Risk Parity approaches). But let’s start at the beginning. What is leverage? It’s the creation of economic exposure that exceeds the amount of capital invested. In the ’40 Act space, the amount of leverage that can be utilized is limited to a maximum of 50% of unlevered assets, or 33% of total assets once leverage has been employed.
Leverage can be achieved in a number of ways. For one, investors can buy the stock of leveraged companies and/or high beta stocks to stretch their investment dollars. More conventionally, leverage can be achieved directly by: 1) borrowing money (perhaps by issuing debt, as many closed end funds do), or by borrowing stock, shorting the stock and reinvesting the proceeds. Or 2) indirectly, by purchasing futures contracts with notional exposure that exceeds the amount of investor capital. This is possible because of the low margin requirements for futures contracts. For example, the emini S&P 500 futures have an initial margin requirement of about 5%, meaning that you only have to put $5 down to gain $100 of exposure. Now to be clear, fully collateralized futures positions (e.g., where an investor holds $95 in cash or short term instruments in the prior example) are not levered, the total economic exposure to the underlying asset class ($100) equals the amount of capital invested ($100). But futures do lend themselves to levering up a position. For example, we run a strategy in a ‘40 act structure that can take notional exposure up to 150% of invested capital (we do so rarely and, when we do, it is for very short time frames).
But what does leverage, in and of itself, say about risk? Not much. If I take a 200% notional position in 3-month T-bills, clearly the risk isn’t the same as a 200% notional position in S&P 500 futures. The risk characteristics of the asset being purchased matter greatly (something that is not considered in the SEC’s current proposal). Further, a long only position that is 200% notional in S&P 500 futures has a different risk profile than a 200% long S&P 500 / 200% short Russell 2000 relative value trade. The latter has significantly more leverage in use, but the risk is basis risk, or the risk derived from the performance differential between the two assets, which pales in comparison to the risk of the long-only position.
Leverage can indeed be deadly, but as we’ve tried to articulate, leverage has many forms, and as such, varying levels of impact on risk. Investors should investigate the types of leverage embedded in portfolios, the extent to which it is employed, and the actual risk profile of the total portfolio, inclusive of leverage.
Predictable Spring Break in Denver, 70 degrees today, snow on Wednesday. #SpringWeatherVolatility