Investors need to assess risk their fixed income related hedge fund investments, notes Donald Steinbrugge.
The massive dislocations in the fixed income markets in March caused huge divergence in performance among hedge fund managers with similar strategies. The first quarter selloff affected most fixed income hedge fund strategies, including structured credit, corporate credit, distressed, high yield (see Mike Larson’s story), collateralized loan obligations, convertible bonds and relative value fixed income. This divergence in hedge fund performance will drastically transform many managers’ competitive positioning.
This real life stress test of portfolios exposed those managers who subjected their clients’ portfolios to unacceptable risk through excessive use of leverage and/or holding higher risk securities in their portfolios. Many of these managers looked relatively attractive in 2019 when volatility was low and interest rates and credit spreads continued to decline. However, this reaching for yield strategy exposed their investors to unacceptable tail risk at a time when interest rates and credit spreads were near all-time lows.
Some of these managers, who have recently underperformed, incorrectly believed that diversification in their portfolios would reduce downside volatility in their performance. They forgot the lessons learned after the 2008 market crash when liquidity dried up, causing correlations to rise with broad based sell-offs across most non-Treasury fixed income securities. The hardest hit securities were those with less liquidity, longer durations, and lower credit quality.
The recent drawdowns in performance experienced by the poorest performing managers were well beyond what most of their investors expected. Such a divergence between expectations and reality will lead to a huge spike in the percentage of funds shutting down, once investors’ redemptions are met. These hedge fund closures might not happen all at once, but for those with the resources to continue operating, eventually the reality will set in that the fund is no longer marketable. For current investors in these funds it is well advised that they put in a redemption. Often hedge funds will sell their most liquid securities first, which cause a deterioration in the quality of the portfolio for the remaining investors.
The disappointing performance by some fixed income managers will likely also put pressure on many of their clients’ businesses. For example, it was reported that a large fund of funds with a substantial allocation to structured credit hedge fund managers lost 22.5% in March. One of their underlying structured credit funds contributed losses of over 50% and another over 30%. Drawdowns of this magnitude are well beyond what most investors would find acceptable and will likely make it very difficult for firms like this to survive.
There were many reasons for the selloff in the fixed income markets, which was primarily driven by potential future downgrades of securities due to deteriorating credit quality resulting from the Coronavirus pandemic. Fear and forced selling by mutual funds and other types of investors, exacerbated the sell-off. The effects of the Volker rule, which eliminated bank proprietary trading departments that historically helped provide liquidity to the markets, have also added to the decline. All of these factors created a mismatch in supply and demand that resulted in a large discount between average fixed income security prices and their intrinsic value. Because this market selloff has impacted fixed income security prices indiscriminately, large disparities in relative pricing among individual fixed income securities has arisen across the industry to end the 1st quarter of 2020.
Entering the Q2, many of the extreme discounts in average security prices have narrowed in markets the Federal Reserve has focused on bailing out through its purchasing of $2 trillion of fixed income securities. This has created two dynamics in the fixed income markets. First, it has created wide relative valuation differences of fixed income “beta” between fixed income security types that the Federal Reserve is actively buying and avoiding. Secondly, it has done less to eliminate the inefficiency of pricing among individual securities, because little fundamental analysis was used in the Federal Reserve’s security purchases. This dislocation in the fixed income markets has created one of the best environments to add value through security selection “alpha” for hedge funds since 2009. The only way these inefficiencies can be reduced is through intensive security selection, which hedge funds are the primary market participants.
As investors look to select the appropriate strategy and manager to take advantage of the current dislocations in the fixed income markets, they should focus on the following four attributes: Fund structure, return attribution, valuation policies and the manager’s behavior relative to gates and suspending redemptions to investors at the end of Q1 (in addition to the obvious factors of organization, investment team, process, risk controls, performance and service providers).
Fund structure: There have been several new fund launches to take advantage of dislocations in the fixed income markets. These structures range from the typical hedge fund liquidity provisions to private equity drawdown structures. In areas of the market to which the Fed is providing liquidity, investors should avoid long lockup structures, because the drivers of performance will be much more dependent on security selection and actively managing the portfolio. The opposite is the case for lower credit quality, less liquid areas of the markets that are not part of the Fed’s purchasing program.
Return attribution: As mentioned previously, many managers subjected their clients to excessive risk by leveraging beta in their portfolio. Investors should focus on managers who have derived a high percentage of their historical returns through security selection and active trading.
Security valuation policies: These vary widely throughout the industry and have higher relevance for managers with low turnover. Valuation policies of less liquid securities can, at times, artificially smooth out return streams. This will, in turn, reduce the standard deviation of returns, increase Sharpe ratios, distort correlations, and understate potential tail risk. All of these statistics are among those used by investors in selecting hedge funds.
Gates and suspending redemptions: Less liquid fixed income strategies should have liquidity terms that match the underlying securities in the fund. Often these will include either a fund level or investor level gate over which the manager has discretion. Investors should carefully evaluate managers that limited investor withdraws at the end of the 1st quarter and avoid managers that used gates or suspended redemptions primarily for the benefit of the managers.
In summary, changes in the competitive position of managers and a more robust environment for managers to add value should drive major changes to investors’ hedge fund portfolios during the second quarter. Managers that disappointed their investors during the Q1 have sustained a permanent mark on performance. This will not be offset by a rebound in April’s performance due to the Fed’s bailout and will see significant redemptions leading to the potential closing of their fund. Those managers that managed through the selloff in the market well are in a great position to take advantage of the dislocations in the market and grow their business.
Donald A. Steinbrugge, CFA, is Founder and CEO Agecroft Partners, LLC.
donsteinbrugge@agecroftpartners.com; www.agecroftpartners.com
