The latest JP Morgan Institutional study* underscored some of the key concerns facing investors. As gravity weighs on beta directionality in an uncertain environment, investors are upping exposure to event-driven arbitrage and market neutral strategies to unearth new sources of uncorrelated returns.
But are all uncorrelated returns truly uncorrelated? The investors interviewed in the study appear to think not. The report cited ‘crowding' as the primary concern for investors when allocating to hedge funds, underlining fears it is getting more difficult to provide impactful layers of diversification.
Hedge fund managers consider themselves foremost alpha generators. However, as the industry becomes bigger and assets under management grow, it has become harder and harder to deliver consistency. Moreover, investors are seeking out new routes to alpha as they lose faith in bloated strategies' ability to deliver. According to the study, 27% of investors were considering allocating to new launches, highlighting a willingness to look beyond flagship names.
The issue of alpha is not the only concern. While correlation theory appears sensible on paper, it held a lot more weight when asset classes were generally less positively correlated. Markets are not as stable, and correlations are not as easy to predict post-financial crisis. The problem for modern investors is portfolio theory requires one to estimate risk, return, and correlation from a rear-view mirror. This leaves a lot of room for ‘unknown unknowns' amid the sea of market data.
The reality is hedge funds operate in a type of market Darwinism - where information and trading advantages tend not to last long if a manager fails to adapt. Furthermore, the diminishing set of opportunities is getting harder to access as large funds lack the nimbleness to execute truly uncorrelated trades. Fortunately, there are opportunities for investors prepared to adapt to evolving capital markets.
For example, the rise of the machines, combined with the decline of investment banking trading, has led to an unprecedented level of event-driven arbitrage opportunities. This retrenchment has destroyed the culture of arbitrage within investment banking and fractured dialogue within existing market players. Whether due to unsuitable automated analysis, or lack of experienced traders at the bank, mis-pricing is on the rise.
Banks are simply not undertaking anywhere near the same depth of analysis. Some are trying to plug the gaps with machines, but systems and generalists can fail to spot opportunities hidden deep in a security's documentation. Decades of experience in fundamental research has taught us the dollars are in the details. Machines are great at analysing vanilla instruments with standard structures and large datasets, but struggle with the products we trade, which can be idiosyncratic. AI applications should be embraced, but it's not yet fit for purpose in this arena.
Moreover, there is no replacement for an extensive professional network, including originators and their agents in major financial centres, maintained over a period of many years. In event-driven arbitrage, it is also vital to have a holistic understanding of securities and any complex tax accounting and regulatory implications. In this brave new world, there has never been more fertile ground to unearth sources of uncorrelated alpha - from mispricing around new capital raises to regulatory change, shareholder buybacks, security issuance and capital restructuring. By understanding the catalysts that may trigger price corrections in these products, a strategy can generate alpha from trading the ensuing changes in price.
Reasons to invest
The top three reasons to invest in a hedge fund are well-worn: alpha generation; access to select/niche opportunities; and returns uncorrelated to equity and credit markets. But the checklist now needs to be more nuanced.
Does the portfolio manager take a market neutral approach, offering high alpha and low beta? Is the strategy nimble with high barriers to entry? Is the strategy truly uncorrelated to S&P indexes? Is the strategy's manager a specialist with a demonstrable history of capturing arbitrage opportunities?
Pinning your hopes on the analysis of retrospective events fails to grasp the myriad complexities of our world. The rise of the robots makes this self-evident. If hedge funds want to continue to deliver alpha and uncorrelated returns to investors, a good place to start is by understanding the complexities around them.
Oliver Dobbs is CIO at Credere Capital