Friday, 9 November 2018

Pro-forma vs realised hedge fund portfolio returns

Most hedge funds promise high uncorrelated returns but many dont deliver, or performance erodes over time. What impact does this have on investor returns?

When buying new managers/ maintaining existing ones you need to think about the probability of the realised return scenarios. Versus recent history, what's the probability the fund makes;
  • more
  • the same
  • less
  • blows up
Small confidence interval funds
If you buy an investment grade bond fund with say 3 years duration, then likelihood of achieving the running yield over say 3 years is very, very high, lets say 90% probability. Interest rates could rise or fall, but you also have bonds maturing and can reinvest proceeds.

In a high yield bond fund its still fairly high despite the risk of a default/ spread blow out cycle. In a normal spread widening cycle high yield bonds might see 500bps of widening, so 10-20% price drop, but you will have a much higher running yield after that and if the manager avoids defaults then you get to reinvest coupons at the higher yield. So on a longer term basis you could be confident of generating a return that is similar to the running yield but with uncertainty over the path and the potential for a 1-2 year drawdown at some point.

Hedge fund returns have a large confidence interval
Hedge funds however are unbenchmarked strategies. With the exception of stressed credit there is no anchor or 'pull to par' for returns. Equity bear markets can last years and recoveries can be even longer.

As such the confidence interval for the return for an individual hedge fund has to be large.
Anecdotally the HSBC hedge weekly report by year end often has an 80% plus spread between the top few hedge funds and bottom few. Its not uncommon for certain managers to frequent both lists in different years.

Question: What percentage of hedge funds meet their double digit return goals?

My experience with low beta/ uncorrelated institutional portfolios is that realised returns, by the time you have redeemed underperforming hedge funds, are about half of the pro-forma returns.
I.e. if you want to realise 7-8% you need to buy funds making 15% at the point in time that you buy them. This raises an issue if you buy low returning funds.

Question: What if I buy 'conservative' funds that lose less when they go wrong? Generally speaking the average return is lower in my experience and you can see that in the HFRI indices.

Let's assume we buy a portfolio of 9 funds that has an expected/ recent return of 7%, what is the expected outcome of that portfolio:

3 funds make 7%
3 funds make 2%
3 funds average 0%

What is the weighted return of that portfolio? Its 3%, or less than half of the expected 7%, before costs.

What evidence can I supply for portfolio realised returns being roughly half pro-forma expected returns? Simple look at the HFRI FOF index returns and the UCITS index returns.

The UCITS market is dominated by absolute return funds targetting 7%. What is the return for the UCITS index in an environment of QE and ZIRP that has supported asset classes?
The UCITS index has made approximately 10% or an annualised 1.1% since 2010. Meanwhile 'successful' UCITS funds make 7% annualised.

What if there is a bear market?

3 funds make 3%
3 funds make 0%
3 funds average -3%

Weighted return drop to zero. In a market crisis like 2008 the returns could be worse.
So what if we buy double digit returning funds?

3 funds make 12.5%
3 funds make 7%
3 funds average 3%

The average is 7.5%, even though all the funds bought had been making 10-20% prior to being bought. For this to work you need to avoid bad blow ups though.

To boost these returns:
  • If you can average a higher hit ratio than 1/3 that it would boost returns significantly
  • If you have one outlier high returning fund, say 25% IRR, then it would boost the portfolio return to 9%
  • If you aggressively redeem low returning funds, that would boost portfolio returns
  • If you want to take beta bets then thats a slightly separate issue but you can use that to push up the IRRs

What if there is a bear market?

3 funds make 10%
3 funds make 4%
3 funds average -3%

Portfolio still makes almost 4%. It really helps if you have some funds that can make double digit returns in a bear market like 2008, or if there are funds that can exploit opportunities like the 'Big Short' in sub-prime.

So there you have it: buying low returning funds and running them for years.

Its the answer as to why UCITS investors and consultant led institutional investors have hardly made any money from hedge funds.

Why do they keep doing it? Or are they now rotating the money into 'return free risk' in conventional private lending strategies, thereby setting up a great secondaries opportunity when defaults rise.

As for institutional interest in hedge funds I just wonder how it works if QT pushes many asset classes into synchronised grinding valuation bear markets.

The best thing for the hedge fund industry's returns would be for these institutions to exit enmasse and reduce the level of me-too competition in markets.

Tuesday, 6 November 2018

3.1% rental yield for central London real estate?

The Trust has £1.15bn in CBRE valued assets, yielding 3.1% gross rent income, £290m of debt that costs 2.1%. If debt costs went to about 6.5% then there would be no distributable income and the equity would be toast.

The managers of the fund are paid on AuM so are benefited by as low a valuation yield as possible.
Investors want out of this Trust, with one blaming Brexit for making the UK 'particularly risky' etc.
That just shows how wrong headed most of these people are. They have held on to what are now vastly over-valued generic assets. 

The truth is Brexit should be good for the UK but London is uneconomic and the medium term outlook for real rents is poor, so the valuation of these assets should fall a lot over the next few years. A BoE rake hiking cycle will also reset valuations and funding costs.

Thursday, 1 November 2018

European perfect storm on the horizon?

Could European financial markets be hit by a perfect storm next year?

Fed hikes in H1 but the economy runs hot and markets start looking for higher terminal rates which pressures discount rates and duration

UK has a hard Brexit with WTO rules. UK economy is doing OK and BoE hints at rate hiking cycle in Q2, investors shift assets from EZ to UK

As part of WTO rules the UK will have a 10% tariff plus VAT on car imports. Luxury car sector has been hit by Dieselgate and lack a full PHEV/ EV model line up. The EZ economy is already near recession. Germany product dumps into France, France into Italy and Spain. China facing US tariffs dumps at the low end into Europe. This guarantees deflation/ slow down

ECB is tapering/ ending purchases. TARGET2 imbalances are over €1Tn already. As the Italian confrontation with the European Commission escalates, financial conditions tighten which is then compounded by financial markets pricing the chance of a crisis which tightens conditions further. The 'doom loop' is back

What can the way out be? A weakened Germany post-Merkel or lame duck Merkel could be pressured into a pro-growth framework with a €500bn-1Tn EIB infrastructure/ export support/ a Mid-East and African Marshall plan

But we need the crisis first...

Wednesday, 31 October 2018

Is Bitcoin being jammed up by a whale?

Since May as volume has slumped, has a whale(s) been propping Bitcoin up? 

The buy the dip, sell the rally strategy is not seeing rallies to get out of.

Looks like someone jammed it up today after it sold off but volume evaporated after.

Main question is which of the whales defending it folds first?

The volume over the last week has been on price weakness as well, so large or multiple small steady sellers.

Thursday, 25 October 2018

JPY - Is BoJ QT the new Plaza Accord?

The Yen has rarely been as cheap as now at about 112 to USD Last time it was this cheap was 1982-1985 and followed by the September 1985 Plaza Accord it then rallied approximately 50% in 3 years
Could BoJ QT deliver the same this time? Ending ZIRP/ QT has so far rallied the USD to rarely seen high levels

We also have a similar 3-4 year topping process as last time - since 2012 BoJ QE sank the Yen from late 2012 to 2015 and since 2015 its been range bound/ slightly strengthened

BoJ QT will rally it

If it goes to an all time high then say 55-65 USDJPY in 30-36 months is in play

What happens to JPYCNH? first stop 7.5c/ 2012 levels, then what?

Tuesday, 16 October 2018

Trump's floating rate liability

Trump has at least $180m in floating rate liabilities and with three >$50m loans potentially quite a lot more than that

The loans are against the better properties while others are known to lose money

But higher rates over time will squeeze NOIs, FCF and asset values lower

Much of the debt is from Deutsche, who are known to sometimes sell off credit risk, for example they could sell it to a bank like Alfa Bank

With the whole empire resting on the ability of the profitable properties to prop up the debt, the losing assets and the family's living costs, no wonder he doesnt like Powell's rate hikes

It will be interesting to watch the personalities and psychology play out as so far Powell seems more hawkish than Yellen

Wednesday, 10 October 2018

US real interest rates

10 year real returns went over 1% last week while forward inflation expectations remain anchored (at ~2.25%). 

As such it seems its being mainly driven by the Fed, mirroring how low real returns were engineered by ZIRP/ QE. 

Longer term I deducted a CPI measure from Fed funds to give a real interest rate indicator. Real interest rates have not uncommonly been +4 or 5% and are often in the 2.4-3% range mid to late cycle. 

Adding both together gets a potential neutral rate for the Fed for the real economy of 4.65-5.25%. 

A notable exception was the late 70s where the Fed struggled to keep up with inflation until Volcker hiked Fed funds into the teens to finally kill off inflation. 

But the Fed, given the credit and asset bubble that has been blown up, currently looks like it will try and taper out rate hikes next year with a 3-3.5% range. 

The problem they will have it that might be tight for financial assets, but it will still be loose for the real economy. 

The Yellen Fed wouldn't want to hike enough and risk an asset market crash and the Whitehouse won't want neutral rates for the real economy. 

Powell so far seems more hawkish and the whole set up looks similar to the early 70s.