A Managed Alternative… The Case for Alternative Equity Strategies Using Hedge Funds
By: Keith Summers, CFA
Few investors have a portfolio that consists of only Exempt Market investments, and most people working in the Exempt Market recognize the diversification and typically low correlation of Exempt Market strategies to traditional equity portfolios. Clients get this too - whether it’s mining, oil & gas or real estate, the daily gyrations of the stock exchanges in Toronto, New York and elsewhere have a negligible impact compared with the risks of drilling dry holes, relying on erroneous ore estimates, or optimistic vacancy rates.
But still, for many investment professionals working in the Exempt Market industry, seeing clients leave substantial amounts of their portfolios in stocks is frustrating.
Typically, clients who hold equities do so either through retail mutual funds or exchange-traded funds. Both retail mutual funds and exchange traded funds are managed against a benchmark, a specific equity market index or industry sector benchmark which is usually published by an index firm like Standard & Poor’s, Russell, or MSCI. Retail mutual funds try to beat the index, whereas the ETF attempts to match it. A lot has been written about the relative merits of each approach which basically comes down to this:
If you were to suggest to a client that they consider alternative equity strategies, a few of them might ask you, ‘alternative to what?’ And this is where it can get interesting. Alternative equity strategies differ from passive exchange-traded funds and actively managed retail mutual funds in a number of key ways:
- The investment strategies are not constrained by mutual fund regulations (which limit the degree to which a retail mutual fund can go short, restrict their ability to participate in IPO’s, limit how much cash they can hold or limit how much they can invest in their best idea).
- The managers typically have a significant equity ownership in their own fund and firm. Clients tend to like to do business with people who have a lot on the line.
- Performance fees usually make up the majority of the managers compensation.
- They sometimes use leverage.
- The managers usually have better-than-average track records and more experience.
That last point is, not surprisingly, the one that clients focus on. Alternative equity strategies have been around for over 60 years, and originated in the United States in the post-war period where enterprising managers formed limited partnerships and then actively bought and sold stocks – going long and short – with the stated objective to ‘make money’ in all types of markets. One of America’s most successful investors, Warren Buffet, managed such a partnership for several years before it morphed into Berkshire Hathaway, Inc. in a reverse merger in the late 1960’s.
The More Common Alternative Equity Strategies Are:
Global Macro Equity
Equity Long/Short is a strategy where a manager will be long stocks he expects to rise and short those he expects to fall. Sounds straightforward, enough doesn’t it? The most common example would be the manager who looks for ‘stars’ and ‘dogs’ in the same industry – Buy ABC Bank and short XYZ bank, which would be profitable if the return on ABC (whether positive or negative) is greater than the return on XYZ.
The competitive advantage of an Equity Long/Short strategy will usually be that they are run by equity research analysts who specialize in a specific industry. In either case, whether the broad index goes up or down doesn’t matter to the equity long/short manager.
High-Frequency Trading is a new approach to equity markets that profits by monitoring the bid-ask spread and order flow of specific (usually very liquid large-cap stocks or ETF’s) that trade on multiple exchanges or alternative trading systems. They will buy (or sometimes just bid) on one exchange and sell (or sometimes just offer to sell) on another exchange. They are paid by the exchanges for “providing liquidity” as well as sometimes profiting from the change in security prices too. Successful HFT firms require extremely fast (and expensive) computers, high-speed telecommunications (they frequently try to locate next door to stock exchanges to take advantage of the shorter telecommunication transmission times) as well as a staff of computer engineers. Successful firms in this strategy spend millions of dollars per year on their computer and telecommunication infrastructure. That is their competitive advantage. They are also able to be profitable in both rising and falling markets.
Statistical Arbitrage is somewhat similar to equity long/short in that stocks are bought and sold, but unlike the fundamental research approach of an equity long/short manager, a statistical arbitrage manager will find his opportunities by using computers to mine databases for hundreds of thousands of hypothetical trades. Stat Arb (as they like to call themselves), can generate returns in rising and falling markets. Their competitive advantage is usually the strength of their computer models (which is also sometimes their Achilles heel).
Global Macro is a broad category that includes managers who speculate on currencies, interest rates, commodities as well as stocks. Global Macro Equity managers are those who focus on buying and selling stocks in different markets around the world based upon macro trends like foreign economic conditions, industry trends, changes in sector fundamentals, earnings or price momentum, or exchange rates. Their competitive advantage is political risk management and a global ‘big-picture’ analysis that looks for winners without a bias to any one market. Global Macro Equity can generate returns whether or not the rest of the client’s equity portfolio is rising or falling.
One of the biggest criticisms of all alternative strategies is that the net returns (after paying management and performance fees), don’t beat the index. Like most mutual fund managers, most alternative strategy managers struggle to beat their benchmark. However, good alternative investment managers outperform good mutual fund managers.
Of the nearly 12,000 retail equity mutual funds listed in the Lipper database, the 80th percentile threshold for 5 year returns was 2.19%. (80% of funds earned less than 2.19% per annum over the last five years). Contrast that with the 80th percentile threshold for some alternative strategies:
Most alternative equity strategies are relatively small funds. Half of all alternative funds have less than $25 million in assets under management. Frequently, they close themselves to new investments once their assets under management reach a point where capital becomes difficult to deploy. Finding one that is well run, and still accepting new capital is not always easy. But they’re out there.