Macro themes on one page for June

The monthly themes often stay the same but with ebbs and flows of importance. Again, we are seeing a focus on Fed action. What was on the table a week ago is now off the table, yet whether the Fed is "one and done" still remains to be seen. With a pass on June Fed action, asset markets are playing the risk-on story, but the weak global PMI shows that slow economic growth will be a growing theme as we move further into the second half of the year. 

We generally get nervous with a liquidity-driven market. While we understand investors should not fight the central bank, sustained asset levels have to be driven by earnings from growth not investor driven P/E's. The same logic applies to credit markets. Chasing yield is not a long-term strategy for growth or sustainable investor returns. Similarly, currency moves should not be a function of handicapping central bank differences. Nevertheless, investors have to live in the world given to them not the world they would like to have. 

Multi-strategy approach versus fund of funds

One of the quiet battles within the alternative industry is between those firms developing multi-strategy funds and fund of funds. For investors, the idea of one stop shopping for your portfolio of alternatives makes sense. The investor can minimize the fixed cost of learning about all the strategies and managers. You pay a fee to have others conduct the due diligence and portfolio construction. As firms get larger and want to diversify their offerings,  the multi-strategy approach also makes perfect sense to smooth their revenues. The issue is the the type of structure used to gain access to a portfolio of hedge fund strategies. 

First, some simple definitions. A fund of funds is a structure where investors pay a management fee to professionals to identify hedge funds that can be bundled into a portfolio. The portfolio managers are outsiders relative to the investment managers. The multi-strategy fund will be a bundle of hedge fund strategies that may be run by different portfolio managers who are employees or partners of the firm that structures or manages the portfolio.

A simple table comparing multi-strategy fund and fund of funds can provide details on the differences. We find that the multi-strategy approach dominates a fund of fund in almost every category except one, manager selection. The question of what approach to employ for the outsourcing of building a portfolio rests on a simple question. Can the broad search for the best managers through a fund of funds dominate the cost advantage and portfolio structuring gains from a multi-strategy approach?

A fund of funds has to dominate with finding alpha through skill and this skill identification has to offset a host of costs and structuring limitations. If the FoF's skill at finding managers is limited, it has to focus on reducing costs and offering other portfolio alternatives to beat a multi-strategy manager. This may get harder as the number of diversified hedge funds grow.

Direct costs are in favor of the multi-strategy approach. First, there is a single fee for the multi-strat approach. The fund of funds has a double layer of fees. The only way this cost advantage is eliminated is if the FoF can negotiate lower fees so the total cost is less that the multi-strat. Nevertheless, the multi-strat will dominate with lower administrative costs versus the FoF's which pay two sets, one for the manager and one for their own fund. This can be minimized through a platform.  The multi-strat will dominate because there is one inventive fee as opposed to the FOF which has to pay incentives to individual managers. The performance of one manager may be positive and another negative such that incentives are paid even though the portfolio has no return.

There is an information advantage with the multi-strat manager who is able to see all of the trades inside his firm in real time. FoF's could negotiate the amount of information provided but the best it can do is match the multi-strat manager. There is the potential for full transparency of information on the portfolio with the multi-strat manager although this information is not always broken apart for investors. Again, FoF's are only as transparent as the negotiated deals they structure with the managers they pick. It is possible that bigger more established and/or better managers may not provide the same level of information and transparency to fund of funds.

Portfolio allocations for a multi-strat can be done at anytime. Leverage can be fully controlled. Gross and net positions as well as sector and asset class constraints can be managed. FoF's will not have this level of portfolio control for the simple reason that their building block unit is the manager and not the security.

Risk management can be controlled for each portfolio manager as well as the entire portfolio by the multi-strat firm. The FoF does not have control of the individual risk taken by the fund chosen.  Risk management cannot only be done at the fund level with perhaps some overlay if desired.

Why would an investor place money with a fund of funds given these advantages? The answer is simple. The FoF's have been able to use their wider net of contacts to find better managers. The multi-strat has to attract, pay, and manage talent better than the process of searching the entire marketplace.  The one factor that is most important favors the FoF. Yet, this advantage is being eroded.

As hedge funds diversify and get larger, they will better be able to attract talent. Additionally, as the cost of starting a hedge fund rises, more talent will join larger firms. The skill game will diminish. If the best firms are closed to new investors or less willing to negotiated terms, the advantage of some FoF's will also be eroded. Similarly, as the demand for portfolio management, information, and transparency increases, multi-strat may offer more advantages. On the other hand, the move to customized portfolios may prove to be helpful for FoF's. The development of platforms either inside or outside FoF may also cut costs and erode some of the advantages of multi-strat managers.

Given these clear differences, the threshold for the value of each approach may actually be measurable. If the FoF charges more, they may have a good idea of the hurdle on skill that they need to overcome. Similarly, multi-strat managers may know exactly how to compete on services, cost, and skill based on our framework. Given these potential advantages, it is not clear that multi-strat managers will always dominate. There may be conflicts of interest that make it harder to allocate away to internal managers. FoF may be better at manager portfolios, marshaling information, and providing transparency. At the least, we provide a framework for comparison. 

The three ways hedge funds make money

How do hedge funds make money? This question could be answered through describing the wide set of strategies that constitute hedge funds or it can be addressed on a much higher or general level. At this higher level, the potential for making money can be broken into three categories, exploiting: biases, risk premiums or structural flaws.

• Alpha production from behavioral biases may come in a number of forms. Investors may be slow to react to new information. They may have anchored expectations. It could be an over-reaction to news. All of the behavior biases identified may lead to deviations from true value, and the smart hedge fund manager is able to identify and exploit these biases. This may be persistent or they may ebb and flows with market conditions.
• Exploiting risk premiums could be considered managing  the wide set factor exposures identified in different asset classes. The excess returns are associated with taking on risk premium that are not measured in a benchmark. The hedge fund manager may be very good at switching between risk premiums which could be the basis for global macro and managed futures or the manager could just receive returns for taking on a unique set of risks. 
• The hedge fund manager could be good at identifying structural changes or flaws in the marketplace which could lead to return opportunities. These excess returns could be from a change in regulations or a new law that may be temporary but will allow for excess returns. The excess returns could be from a capital constraint that allows profit to accrue because there is not even capital to arbitrage away opportunities.

A simple way to better understand any hedge fund manager is to ask how he would categorize their return generation within this framework.

Boom and bust in global capital and commodity cycles

The global economy is driven by cycles. Normally, the focus is only on the business cycle, but there are also capital flow and commodity cycles that have significant impacts on sovereign risk, currencies, and asset prices. The work of Reinhart, Reinhart and Trebesch, "Global Cycles: Capital flows, Commodities, and Sovereign Defaults, 1815-2015" does the heavy lifting of measuring the ebb and flows of capital around the globe over the last 200 years.  Gross capital flows move cyclically with boom lasting on average nine years and busts averaging five years.  When there is a trough in the cycle there is a marked increase in sovereign default risk. 

The most recent data show that capital flows followed a significant growth cycle through 2011 which was longer than average. This positive flow has been in reversal over the last five years. What has placed an additional real strain on global economies and markets has been the commodity cycle which has also turned down to generate a "double bust".  

The coincidence of two cycles each falling together has been a major headwind against the global economy. Clearly, the key negative impact is on emerging markets. Emerging market equities (EEM)  peaked before the Great Recession, fell significantly only to have a slightly lower peak in April 2011. The EEM peak of 2011 has not been tested over the last five years.  

The capital cycle has been tied to a move to safe assets. It would be hard to imagine a scenario of new highs in EEM until there is a reversal in the cyclical downturn in capital flows and a broad-based turn-around in commodity prices. There has been a positive move in oil and some selected commodities but weak global demand and limited capital flows may continue to holdback emerging markets from further growth and asset appreciation.