Opportunistic, Specialist, and Multi Manager Strategies

Opportunistic Hedge Fund Strategies

Opportunistic hedge fund strategies are a broad class of investing approaches that attempt to extract profits using a wide range of techniques in a broad range of securities. Rather than being focused on individual securities, these strategies take a top down approach to make macro investments on a global basis across regions, sectors, and asset classes.

The returns of opportunistic hedge fund strategies may be impacted by market cycles, global developments, and international interactions. The risks will depend on the particular strategy and asset classes involved.

Opportunistic hedge fund strategies can be based on a number of broad techniques. Technical analysis uses past price changes to forecast future price movements. Strategies based on fundamentals, on the other hand, attempt to analyze security prices, markets, sectors, and the relationships between markets, using economic data as the input.

Managers using a systematic implementation of their strategies employ computer algorithms and rules to determine which trades to make. Managers using a discretionary process instead use their instinct to determine when to trade.

We will consider two opportunistic strategies in detail: global macro and managed futures.

Global Macro Strategies

Managers of global macro strategy funds attempt to make correct assessments and forecasts of various global economic variables including inflation, currency exchange rates, yield curves, central bank policies, and the general economic health of different countries.

Global macro managers use a broad range of security types and global asset classes to take positions on these views.

A global macro manager that can identify a global trend early and take a position can profit.

Investment Characteristics

Global macro managers can take positions that are either directional (e.g., go long stocks that are anticipated to benefit from expected interest rate hikes, and short stocks that will be disadvantaged), or thematic (e.g., buy stocks of firms that will benefit from forthcoming free trade deals).

Unlike some hedge fund strategies, low volatility mean reverting markets are not generally favorable for global macro returns.

Because global macro managers take investment positions based on their predictions of the future, there is significant potential for unsuccessful investments when global economies do not behave as expected or if unanticipated risks emerge. As a result, the returns of global macro funds tend to be uneven and volatile.

Strategy Implementation

Global macro strategies are generally based on top down analysis, beginning with analysis of the global economy, then macro trends within economies, and so on, in order to identify potential opportunities.

Different global macro managers are likely to implement their strategies using very different techniques; for example, technical analysis vs. fundamental analysis, or discretionary implementation versus systematic implementation.

One commonality between global macro funds is that most tend to apply leverage, often representing 600% or 700% of fund assets.

A manager making directional predictions will generally use fundamental information to determine whether a particular asset is undervalued or overvalued on a historical basis. By contrast, a manager using a relative value strategy will seek out securities that are overvalued or undervalued compared to one another.

Global macro managers tend to use discretionary approaches more than do managed futures managers.

Role in a Portfolio

When added to a portfolio of traditional assets, a global macro hedge fund can add not only alpha, but also portfolio diversification.

A global macro manager will attempt to anticipate changes before other market participants and then will take a corresponding position and wait for the market to come around. For example, some global macro managers were able to anticipate the United States’ subprime mortgage crisis well before the housing bubble began to collapse in 2007.

This contrarian tendency can make an allocation to global macro strategies especially advantageous. However, due to heterogeneity amongst global macro managers, they are not consistently dependable in delivering short alpha as compared to trend following managed futures funds.

Global macro funds perform well during times of market stress and volatility by predicting trade wars and interest rate regime changes. They use a lot of leverage and hence deliver lumpier and uneven returns, as their predictions may not always pan out.

Managed Futures

Hedge funds that pursue a managed futures strategy take long and short positions in a variety of derivatives contracts including futures, forwards, options on futures, swaps, and sometimes currencies and commodities.

Managed futures strategies can be as simple as trading index futures on a particular sector, or it can involve very exotic contracts such as futures on the weather.

Investment Characteristics

Managed futures funds do not buy and sell assets; rather, they enter into derivatives contracts in order to gain the desired exposures.

Because of the mechanics of futures contracts (requiring only a small amount of upfront collateral), managed futures funds can easily apply great amounts of leverage. Typically, a fund will use perhaps 1⁄8 of its capital as collateral on futures contracts. The rest of its capital will be invested in some highly liquid security (such as short term government bonds) that can also serve as collateral for the futures clearinghouse.

Managed futures funds are extremely liquid, because futures contracts themselves are highly liquid: they trade globally and continuously. Taking long or short futures positions allows a hedge fund manager easy access to exposures across a range of asset classes.

One downside of the popularity of managed futures strategies is that crowding has occurred: many market participants pursue the same trades and use similar signals, resulting in a “herding effect” and execution slippage.

Strategy Implementation

There are a number of ways to implement managed futures strategies.

In perhaps the most popular method, time series momentum (TSM) strategies, portfolio managers simply follow the trend: they buy securities that have been rising in price and sell securities that have been trending downward.

Another similar methodology is cross sectional momentum (CSM) strategies, which is carried out within a particular asset class (a cross section of assets). Again, the securities rising fastest are purchased while falling securities are shorted.

The high liquidity of futures contracts allows hedge fund managers to pursue a wide selection of trading strategies. Generally, portfolio managers will rely on a signal trigger , most often based on volatility or momentum, to prompt a trade.

In addition to using trade signals, portfolio managers will also have rules for closing a position. Exit methodologies can be based on:

Price targets.

Momentum reversal.

Time.

Trailing stop loss.

Or, some combination of these approaches.

Managed futures investors seek to develop rules and signals that are profitable not only using historical data but also in real world use. However, the more portfolio managers that use similar signals, the less effective these signals will become.

The size of positions taken are usually based on factors such as correlation and volatility.

Role in a Portfolio

Perhaps the most appealing feature of managed futures is their interaction with other investments. Overall, managed futures have very little correlation with traditional equity and fixed income assets. The result is that when added to a portfolio, managed futures will generally improve the total risk adjusted return.

This diversifying characteristic has proven its worth during times of market stress. While other strategies exhibit negative asymmetry during such periods, the right skewed return distribution of managed futures provides a significant advantage.

Specialist Strategies

Portfolio managers for specialist hedge fund strategies use their knowledge of a particular market to pursue niche investment opportunities. The goal of specialist strategies is to generate high risk adjusted returns that are uncorrelated with those of traditional assets. The risks of such strategies are often unique to the particular niche securities being invested in.

Two such strategies that we will consider in detail are volatility trading and reinsurance/life settlements.

Volatility Trading

Once an esoteric pursuit, volatility trading has evolved over recent years to become a recognized investment strategy.

Volatility trading hedge fund managers trade volatility related assets globally, across countries and across asset classes, in order to exploit perceived differences in volatility prices. The overall goal is to purchase underpriced volatility and sell overpriced volatility.

For example, even though the Tokyo Stock Exchange (東京証券取引所) traditionally has higher volatility than the New York Stock Exchange, implied volatility is usually cheaper in Tokyo (東京) than it is in New York. In general, the price of volatility in Asian markets has traditionally been lower than in other regions.

Another volatility trade involves acting as the counterparty to market participants that consistently seek long volatility. Because the negative correlation between stock market returns and equity volatility is high, equity investors seek to buy volatility as a hedge. A hedge fund that is willing to sell volatility will earn an insurance like premium as compensation for taking on this risk; however, an upturn in volatility can cause such a strategy to unravel in a dramatic fashion.

In the U.S. markets, the most common volatility futures are contracts on the VIX index, which tracks the 30 day implied volatility of the S&P 500 index. VIX contracts tend to be mean reverting because high volatility naturally tends to dissipate over time.

Strategy Implementation

Hedge fund managers wishing to pursue volatility trading have several options.

One possibility is to construct various option strategies, such as straddles, calendar spreads, bull spreads, or bear spreads, using basic exchange traded options.

A second possibility is to make use of over the counter (OTC) options, which are customized to meet the portfolio manager’s specific needs. A drawback of this method, however, is that it introduces counterparty risk, plus potential liquidity issues.

A more straightforward method of trading volatility is to use futures on the VIX index. An advantage of this approach is that it is a very direct way to express a view on volatility, without the need for hedging. There are some limitations.

First, the VIX Index tends to be mean reverting, which means that trend following trades tend to be unprofitable. Second, many traders and investors crowd into the VIX futures in order to sell volatility and capture the associated premiums, making it difficult to profit from that strategy.

A fourth method of implementing a volatility trading strategy is to enter into an OTC volatility swap, or alternatively a variance swap. These derivatives provide a relatively pure exposure to volatility. (Note that the name “swap” here is somewhat misleading.

Volatility swaps and variance swaps are actually forward contracts with a payoff based on the difference between observed variance and the expected variance specified in the contract, multiplied by some notional amount.)

Investment Characteristics

The investment characteristics of a volatility trading strategy will vary depending on the securities invested in and the positions taken.

Investors that take a short position in volatility will collect premiums and generally earn stable returns under average market conditions. A long position in volatility will exhibit positive convexity, which can be valuable as a hedge.

The liquidity of a volatility trading strategy will depend on the instruments used. Futures and options based on VIX tend to be extremely liquid, as are exchange traded volatility options (especially when the tenor is short). On the other hand, OTC contracts are generally less liquid.

The use of futures contracts makes it easy to apply leverage to a volatility trading strategy. The convexity of volatility derivatives means that sometimes large gains can be made from long volatility strategies while taking little risk.

Because of their unique nature, benchmarking of volatility trading strategy performance can be difficult.

Role in a Portfolio

In a portfolio, a long volatility strategy can be a potent diversifier, because stock market volatility is highly negatively correlated with market returns. The disadvantage of maintaining a long volatility position, however, is that a premium must be paid to the volatility seller.

Reinsurance/Life Settlements

In recent years, some hedge funds have sought to take advantage of attractive investment opportunities related to insurance policies. In a typical life settlement transaction, an insured person will sell (generally through a broker) their insurance policy to a hedge fund. The hedge fund then will be liable for the premium payments, and will also receive the death benefit upon the passing of the insured.

Individuals sell their life insurance contracts when they feel that they no longer benefit from the agreements. Individuals who purchased life insurance policies may choose to sell their policies to third party brokers, because those firms will oftentimes pay more for the policy than the issuing insurance company will pay for a surrendered policy.

Catastrophe risk reinsurance is another area where hedge funds are increasingly active. Catastrophe insurance covers the policy holder against earthquakes, tornadoes, hurricanes, floods, and the like. In order to diversify and decrease risk, insurance companies in their normal course of business will sell off some of their risk to reinsurance companies, who may then resell these risks to hedge funds.

Reinsurance can be a rewarding investment for a hedge fund if sufficient diversity can be obtained (i.e., the risks should vary by geography and types of insurance), if the insurance company provides sufficient loan loss reserves, and if the policy premiums are adequate.

When considering an investment in catastrophic insurance, a hedge fund evaluates both typical and worst case outcomes against the insurance premiums to be received. Geographic diversity is important, because a specific catastrophic event will tend to affect only a particular part of the world.

Investment Characteristics

Strategies that involve investments in insurance contracts are illiquid, because insurance policies are somewhat difficult to sell after initiation.

Strategy Implementation

The term “life settlement” refers to a secondary market transaction on an insurance policy. A hedge fund that invests in life settlements will analyze various pools of life insurance contracts that brokers offer, and invest in the ones that they expect to produce an attractive return. After investing, the hedge fund then becomes the beneficiary of these contracts.

The investment is successful if the present value of the future insurance payout exceeds the present value of the payments made by the hedge fund.

In selecting which insurance policies to invest in, a hedge fund will seek out policies with the following characteristics:

The purchase price of the policy is low.

The ongoing premium payments are low.

The insured person is likely to die relatively soon.

One major prerequisite to profiting from life settlements is an accurate alternative estimate of life expectancies. Appraising a life settlement requires a significant amount of skill and knowledge and requires comparing individual policyholders’ outlooks to actuarial averages.

Role in a Portfolio

An appealing feature of insurance investments in a portfolio is that the risk inherent in these strategies is almost entirely uncorrelated with market risks and business cycles. For example, floods and earthquakes usually have little correlation to financial markets.

Thus, hedge funds that invest in such instruments may be able to increase portfolio alpha, while simultaneously adding return diversification.

Multi Manager Hedge Fund Strategies

Up to this point in the topic review, we have been considering various individual hedge fund strategies. In reality, most investors put money into not just a single hedge fund category, but into a diverse set of strategies.

The notion behind multi manager hedge funds is to assemble in a deliberate way a portfolio of diverse hedge fund strategies and to adjust the holdings strategically over time.

The most common styles of multi manager hedge funds are funds of funds and multi strategy funds.

Fund Of Funds

A fund of funds (FoF) takes capital from various individual investors and invests in a number of different hedge funds, generally each pursuing a different strategy.

FoF can provide investors with a number of benefits:

Diversification across many hedge fund strategies.

Expertise in individual manager selection.

Strategic allocation and style allocation.

Due diligence.

Occasional value added tactical decisions.

Currency hedging.

Leverage at the portfolio level.

Better liquidity relative to individual hedge funds.

Access to certain closed hedge funds.

Economies of scale in fund monitoring.

Research expertise.

Potentially valuable concessions from the underlying funds.

FoF also have the following disadvantages:

A second layer of fees for the investor.

Lack of transparency into individual hedge funds.

No netting of performance fees.

Additional principal and agent issues.

Investment Characteristics

Individual hedge funds have traditionally employed a “2 and 20” fee structure, indicating management fees of 2%, plus performance incentive fees of 20%. On top of these individual fund fees, funds of funds have historically added a 1% management fee, plus a further 20% incentive fee on the total FoF portfolio. (Though over time, these FoF fees have become negotiable and generally smaller.)

One important benefit that FoF offer is making an investment in hedge funds practical for smaller investors, such as small institutions or moderately wealthy individuals. Individual hedge funds almost always require a significant initial investment; typically $1 million. Achieving a diversified exposure to a number of individual funds poses a difficulty for smaller investors, because an investment in 20 such hedge funds might require a cumulative minimum investment on the order of $20 million.

Furthermore, performing due diligence on 20 different hedge funds would require far more resources than most individual investors could muster. (Not to mention complications such as tax reporting on 20 investments.) Using a FoF, on the other hand, a smaller investor can typically access a diversified hedge fund exposure with an investment as small as $100,000.

In this way, FoF can serve as an entry point into hedge fund investing.

Aside from providing a straightforward path into hedge funds, FoF provide a number of other advantages. For example, FoF may provide access to high profile managers whose funds are otherwise closed to new investors. Also, the larger size of an FoF may allow the fund to obtain valuable concessions from the underlying funds’ management.

Liquidity can be a challenge for portfolio managers of funds of funds. Typically, a FoF will require a one year initial lock up for investors, and then will allow somewhat greater liquidity afterwards (e.g., monthly or quarterly). However, the underlying funds may have stricter limits on liquidity, potentially putting an FoF manager in a squeeze.

Another drawback of funds of funds relates to netting risk: investors could be required to make substantial incentive payments to a small number of successful underlying funds, even if the overall performance of an FoF is poor.

Strategy Implementation

A fund of funds strategy is normally implemented as follows:

1. Use fund databases plus personal introductions to become familiar with hedge funds available for investment.

2. Choose an appropriate strategic allocation to different hedge fund strategies.

3. Initiate the manager selection process, applying both top down and bottom up techniques.

4. For each hedge fund strategy, consider a number of candidates following that strategy.

5. Interview the candidate hedge fund managers.

6. Review relevant materials such as audit reports.

7. Examine the funds’ personnel, operational processes, and risk management.

8. Negotiate with the individual fund managers for lower fees, improved liquidity, or other terms.

9. After the various funds are approved and included in the FoF, an ongoing monitoring process begins, intended to detect major personnel changes, style drift, etc.

The FoF’s strategic allocation determines the percentage of total capital that will be invested in each hedge fund style. In addition to this strategic allocation, there may also be a tactical allocation, whereby the FoF manager will at various times underweight or overweight the various hedge fund strategies to reflect the FoF manager’s perception of a changing market environment.

Role in a Portfolio

When an FoF manager takes a number of relatively uncorrelated hedge funds and combines them together in the same portfolio, the resulting FoF should produce a number of advantages: greater diversification, steady returns, less concentrated exposure to risks, less volatility, and less exposure to the downside risk of any individual fund manager.

Multi Strategy Hedge Funds

Like an FoF, multi strategy hedge funds are funds that hold a number of other hedge funds where these various funds are pursuing diverse strategies. Also similar to an FoF, multi strategy hedge funds are intended to use this diversification of strategy to produce steady, low volatility returns.

Unlike an FoF, the sub funds in multi strategy hedge funds are run by the same organization, rather than being managed by different hedge fund firms.

Investment Characteristics

The diversification within multi strategy funds is intended to produce steady returns and low volatility.

Multi strategy funds share some investment characteristics with funds of funds, but there are also significant differences. For example, the operational risks of a multi strategy fund are not well diversified as they are with an FoF, because all of the operational processes of multi strategy funds are performed under the same roof.

Furthermore, the diversity of strategies represented by the different funds in multi strategy funds are often somewhat limited, because the managers employed by a specific multi strategy fund tend to have similar investment viewpoints and methods.

A major advantage of multi strategy funds over an FoF is the speed and relative ease with which tactical allocations can be made. Because each of the multi strategy funds are managed in house, it is relatively easy for the multi strategy manager to reallocate capital from one strategy to another. The high internal transparency and fast response time makes tactical reallocations of multi strategy funds practical, which could explain why multi strategy funds have historically been perceived as superior to funds of funds for protecting investments.

Investor fees for a multi strategy fund are often more attractive than those of an FoF. While FoF investors are subject to netting risk (where hefty performance fees can be paid to some successful sub fund managers, despite overall poor FoF performance), multi strategy funds are more likely to absorb this netting risk internally. In this arrangement, the investor only pays an incentive fee on the total fund performance.

(Though some multi strategy funds do use an FoF like “pass through” fee model, which will expose investors to netting risk.)

Like an FoF, multi strategy funds generally limit investor liquidity using redemption periods and initial lock ups. Multi strategy funds often additionally enforce limits on the amount of redemption each quarter.

Strategy Implementation

Multi strategy funds carry out their approach by making investments in a number of varying hedge fund strategies.

One key advantage of multi strategy funds is their ability to make tactical reallocations, in addition to the funds’ strategic allocation. Furthermore, the multi strategy fund’s internal teams are likely to be well informed about why and when capital and leverage should be reallocated, versus a FoF manager for whom the various funds are more opaque.

Risk management can be more effective with a multi strategy fund because (unlike FoF managers) multi strategy managers should have a solid understanding of correlations and common risks between the various funds.

Multi strategy funds also enjoy efficiencies that come from several hedge fund teams sharing the same administrative resources.

Multi strategy funds often make greater use of leverage than does the average FoF. Normally, leverage in multi strategy funds does not pose much of a hazard; however, during periods of market stress, small sources of danger can become significant left tail risks that threaten the survival of the fund. (This kind of scenario led to the demise of Ritchie Capital in 2005 and Amaranth Advisors in 2006.)

Multi strategy funds generally have more varied performance than does an FoF.

Role in a Portfolio

Multi strategy funds are intended to improve an investment portfolio by adding diversification and steady, low volatility returns.

Historically, multi strategy funds have generally performed better than have funds of funds, due to a superior fee structure and greater ability to execute on tactical asset allocation. However, the leveraged nature of multi strategy funds can sometimes lead to a left tail blow up during times of stress.