Good afternoon, dear readers! Today we want to talk about hedge fund portfolio management. We would like to introduce you Mr. Andrey Kozhokara, Director of the Department of Alternative Investments.
- Andrey, Can you tell our readers what exactly does fund portfolio management mean?
- Good afternoon! Firstly, I would like to explain what a hedge fund portfolio is.
Conceptually, we can consider investing in hedge funds like investing in any other popular asset class, such as stocks and bonds. We have capital that we invest in various hedge funds, forming a portfolio of funds of various strategies.
Hedge fund is an actively managed fund, investment mandate of which may include different strategies and methods of their implementation – hedge funds that open long and short positions in the equity market, hedge funds that enter into transactions with distressed assets, macro hedge funds that open positions based on changes in macroeconomic factors, multi-strategy hedge funds and others.
Thus, each hedge fund has a certain liquidity - the conditions under which an investor can withdraw capital from the fund. The liquidity of hedge fund in most cases depends on the strategy used. For example, funds that enter into transactions with illiquid debt or equity instruments may often have a complete ban on withdrawing funds for a certain time from the moment of investment (hard lock-up period), restrictions on capital withdrawal at the level of each investor (investor-level gate) and the entire fund (fund-level gate). On the other hand, there are funds offering increased liquidity, sometimes comparable to publicly traded instruments. This category includes equity strategy funds, funds of discretionary and systematic macro strategies (Global Macro, CTA and others) – such funds can give investors the opportunity to fully withdraw all capital within a few months, weeks or even days due to the high liquidity of traded instruments.
Another feature of hedge funds is their availability. Certain funds that are in high demand among investors may be completely or partially closed to external investors. The main reasons why hedge funds may not accept additional capital are the capacity restrictions imposed by their strategies and limited investment opportunities in a certain market environment. In the case of large investment sizes, hedge fund positions can have a significant effect on market prices, increasing transaction costs and reducing the manager's profit. Depending on the strategy and model of the fund, the manager, when growing assets under management, often needs a corresponding increase in the number of employees, mainly to generate additional investment ideas. In such cases, the volume and frequency of attracting additional funds from investors will depend on the dynamics of changes in the hedge fund's investment team. Well-known examples of closed hedge funds are Citadel, De Shaw, Tiger Global and Element Capital.
Thus, summarizing the above, hedge fund portfolio management is technically similar to managing a portfolio of traditional instruments - stocks and bonds, but has limitations on liquidity and availability of hedge funds, and also covers many different strategies and instruments.
- Andrey, what should be taken into account when managing a hedge fund portfolio?
- In most cases, hedge fund portfolios have a mandate of absolute return - making a profit under any market conditions. Guided by the portfolio's mandate, which describes investment goals and constraints, the optimal weights of various hedge fund strategies are determined, and then the best hedge funds are selected for each individual strategy.
To determine the optimal share of each strategy, market expectations, expectations for fund strategies, as well as historical results of strategies are taken into account. Given the limited liquidity of hedge funds, investors are mainly guided by medium- and long-term market expectations. Depending on the approach, investors can tactically invest in certain hedge funds. For example, during the growth of equity markets, hedge funds of equity strategies that have an increased correlation with the stock market and invest in fast-growing companies can be in high demand. In the presence of pronounced market trends, similar to those observed recently in certain commodity markets and debt instruments against the backdrop of persistent inflation, managers applying systematic strategies, including CTA (trend-followers), demonstrated strong results and experienced high demand from investors. At the peak of the sell-off of risky assets, some investors may switch to funds specializing in distressed assets (distressed debt and equity), which usually show strong results during the market recovery after the crisis. In 2021-2022, institutional investors actively invested in macro-strategy hedge funds, expecting good results against the background of significant changes in the monetary and fiscal policies of a number of countries related to macroeconomic factors. Also guided by economic, geopolitical and other differences between countries, investors may prefer hedge funds specializing in certain geographies.
Usually, the main purpose of managing a hedge fund portfolio is to select and retain funds in the portfolio that can, in combination with each other, show positive results in any market environment. Given the changing market conditions and the results of managers, investors from time to time need to rebalance the portfolio by reducing positions in certain funds and investing in other funds. Taking into account the terms of hedge funds for making redemptions on certain dates with a specified frequency, requests for partial or complete withdrawal of capital from hedge funds are sent in advance. When investing in new hedge funds by withdrawing capital from hedge funds in the portfolio, investors often have to use credit facilities to fund new investments. In the future, the return of borrowed funds is carried out with the receipt of redeemed capital from hedge funds in the portfolio.
- Can you tell our readers how the choice of hedge funds is carried out?
- When we invest in a hedge fund, we do not buy a certain portfolio of assets, but first of all we pay for the investment skills of managers. When choosing hedge funds, it is important to analyze the consistence and content of strategies used by the manager, the effectiveness of investment decision-making and portfolio construction processes, the experience of investment and operational teams, including staff turnover and employees compensation structure, historical results and their sustainability, the dynamics of assets under management, the risk management system, the manager's infrastructure and many other factors.
Additional attention should be paid to existing hedge fund investors - what type of investors prevails in a particular fund, whether the fund depends on several large investors, what are the conditions for the withdrawal of capital for the main investors of the fund and what is the share of the manager's own investments in the fund.
It is necessary to conduct a comparative analysis of a hedge fund with peer funds. View their results in different time periods, compare the conditions for investors (liquidity and fees) and highlight the strengths and weaknesses of the fund in question in comparison with competitors.
- How important is it to monitor the hedge fund after the investment?
- A good question, yes, constant monitoring of funds and the portfolio as a whole is an integral part of active management of hedge funds portfolio.
In the process of monitoring each hedge fund, it is important to pay attention to the dynamics of assets under management, stability of manager's team, changes in the distribution of assets by the strategies and by the geographies, as well as any other changes that may affect the results of the hedge fund. If there are illiquid positions, they should be recorded. On a regular basis, it is necessary to assess the positioning of the fund – long positions, short positions, gross and net exposures for various types of instruments and sectors. A detailed positioning analysis should also be carried out at the level of the entire portfolio of hedge funds, taking into account the correlation between the funds and their cumulative exposure to various market factors.
- Please tell us how you can characterize hedge funds in comparison with other asset classes?
- For most asset classes, investment results depend on the market environment and the investment horizon. For example, portfolios consisting of private equity funds and publicly traded stocks can show strong results, but with a rising stock markets. Bonds may have inflation protection, a floating interest rate and provide a certain return, but their final profitability will always be subject to changes in inflation and interest rates. Any asset can rise or fall in price depending on market conditions. Hedge funds can open both long and short positions in different assets and dynamically change their positioning, thereby capturing both the rise and fall in the value of instruments. With this model, successful hedge funds have the opportunity to regularly make a profit.
- Could you comment on the latest results in the hedge fund market? What forecasts should be taken into account for 2023?
- According to Hedge Fund Research, macro-strategy hedge funds showed strong results in 2022. Negative results were demonstrated by hedge funds of equity market strategies, event-driven strategies and funds focusing on emerging markets. There was a high dispersion in the results of managers for each individual strategy. In general, we can say that in 2022, hedge funds holding long positions in risky assets, which had an increased sensitivity to the interest rates rise, suffered the most.
In 2023, increased market volatility is expected to persist and changes in monetary and fiscal policy in different countries are expected to continue, which will provide many opportunities for macro hedge funds.
Hedge funds of equity strategies that suffered significant losses in 2022 may improve results in 2023 against the backdrop of high dispersion in the results of companies. At the same time, in order to protect portfolios, managers will need to minimize their exposure to macroeconomic factors by hedging, focusing on the idiosyncratic risks of individual issuers.
It is expected that new opportunities will appear for distressed managers. The growth of operating expenses against the backdrop of persistent inflation and high financing costs for companies with a significant debt burden should contribute to the increase in default rates and restructurings of bonds and loans, creating opportunities for hedge funds.
In the breakdown by geography, assets in emerging markets currently have an attractive valuation. However, the persistence of high interest rates in the United States, local inflation and geopolitical risks, in particular the confrontation between Russia and Ukraine, currently limit the potential of increase in the value of these assets. Structural drivers of growth remain in the Asian region. An increase in economic activity is expected in China due to the lifting of restrictions related to COVID-19. Government-supported sectors have a significant growth potential. Given the disruption of global supply chains, India has the opportunity to increase its production base with a transfer of some production capacity from China. The consumer sector also has significant growth potential in India. Japan presents a number of attractive investment opportunities for active managers due to the resilient economy and the government policies directed to revitalization of the corporate sector. In the USA and Europe, given the multidirectional dynamics of economic indicators and the likelihood of a recession with subsequent recovery, active managers see opportunities to open both long and short positions.
In general, taking into account the increase in interest rates in 2022, many hedge fund managers expect continued pressure on the global economy in the 1st half of 2023 and its subsequent gradual recovery. At the same time, a number of managers admit the possibility of sell-off of risky assets amid persistently high inflation in the medium term.
- Andrey, thank you for your time and informative article! We wish you success in your activities!