Sign up for free newsletter


Raoul Pal, The Global Macro Investor

Chapter 2 – Seeking supernovae returns

There was no shortage of idea generation when it came to discussing the various ways alternative fund managers are trying to overcome the gravitational effects of market forces in a bid to boost returns.

As markets begin to normalise, fundamental-focused active fund managers are seeing more opportunities to trade both long and short, while credit markets are offering opportunities, especially for those pursuing relative value strategies to profit from tightening spread ratios between investment grade and high yield corporate bonds. 

But this is no time for managers to rest on their laurels. The alternatives industry, as a whole, remains vibrant but it faces tremendous challenges to keep pace with technological change and shifting investor habits. 

Hedge fund managers, for example, face higher competition from passive low-cost funds. Private equity and real estate managers face competition from sovereign wealth funds that are opting to invest directly into PERE projects (which in turn is increasing asset valuations and making it harder for managers to put dry powder to work). Infrastructure managers, meanwhile, face regulatory and economic uncertainty, when weighing up where and when to invest in new developments. 

Orbit 1: Hedge funds versus passive funds

Systematic funds are flavour of the month in hedge fund world. Previously, this was an industry dominated by star traders and intergalactic egos. There are still many `masters of the universe', but one cannot escape the inevitable fact that tomorrow's superstars will be less human, more machine. 

Raoul Pal (pictured), Economist, CEO and Founder, The Global Macro Investor, and CEO and Co-founder, Real Vision Group, noted that there are more hedge funds than Taco Bells. Such overcrowding means the ability to generate alpha has diminished; there are simply too many funds chasing the same trades. 

"Some of the best hedge funds can be replaced with machines. High frequency trading has replaced market making and similarly, I think most hedge fund trading will be replaced by machines. The hedge fund manager of old will be replaced by a programmer," suggested Pal.

This is already in evidence at BlackRock, which has announced it will place greater emphasis on systematic investing and plans to remove seven fundamental portfolio managers as it re-engineers the way it runs its USD275 billion active fund business.

Speaking at CAIS 2017, BlackRock's Geraldine Buckingham said that "active managers simply haven't performed". Global mutual funds, for example, experienced outflows of USD233 billion in 2016. Only 5 per cent of domestic US Equity Funds outperformed the benchmark last year, improving slightly to 8 per cent for Emerging Market Equity Funds. 

Crucially, at a time when more people are becoming their own CIO because they have no direct contribution pension plan in place and are turning to alternatives to juice returns, education on the merits of active versus passive funds is critical. 

Buckingham gave a revealing statistic that showed that for several years now, revenue growth in the global asset management industry has been slower than asset growth. This, said Buckingham, was a dynamic that is likely to be maintained.

"As people look for yield, returns and value for money we are going to see more interest in alternatives, particularly from the retail segment. The challenge is going to be fees and providing the right access to these investments, particularly illiquid assets such as real estate and infrastructure.

"The shift to passive investments is not just borne out of frustration with active managers, it is also being accelerated by things like regulation and the shift in the retail space from brokerage to advisory, and advisory frequently turning to passive. The ETF has become a far more mainstream investment product," said Buckingham. 

She added that BlackRock expects ETFs to grow at a rate of 13 per cent, citing low penetration in markets like Australia and Latin America, whose USD2 trillion in AUM is forecast to experience 5 per cent organic growth in the near term. 

She also believes that Smart Beta products offer a compelling opportunity for investors looking for alternatives to traditional active. These strategies experienced USD55 billion of inflows globally in 2016, an 83 per cent increase over the prior year.

If one assumes hedge funds are active and private equity funds are passive, said Kevin Butler, Partner, Head of Cayman Islands Office, Conyers Dill & Pearman, "We are seeing more inflows going into PE. There are a few reasons for this: primarily performance and investor demand. We see multiple closings north of USD1 billion. This is part of a trend towards passive strategies."

For equity-focused hedge funds, Emerging Markets, which are far more inefficient and therefore `alpha rich' for the skilled stock picker, there are numerous trading opportunities. One only has to look at what is happening in India. Prime Minister Modi has introduced foreign direct investment as one of his pillars of policy while the proposed Goods and Service Tax, which will unify India's tax systems into a single system, will have enormous implications for logistics. 

"This has yet to be translated into an upturn in Indian equities. Hopefully this will pay dividends in the future," remarked Joe Bryant, Investment Director, UCLA Investment Company. She added: "Some consumer-facing stocks in India are attractive but too highly valued. We like domestic players deeply entrenched in the supply chain, such as Imperial Tobacco Company Limited." 

Others are more bullish on China. Faisal Nawaz, CEO of Asiya Investments, an Emerging Asia specialist investment firm, said the Chinese tech sector was especially appealing given the number of Chinese unicorns. "That area will be our focus for the next two or three years," he confirmed. For San Francisco-based active manager, Quantum Capital Management, Chinese firms such as Ctrip, one of the country's largest travel agencies, present compelling opportunities as China's growing middle class looks to travel overseas.

Geopolitical shocks such as Brexit proved to be highly profitable for systematic hedge funds last year as induced volatility levels leading up to the event, and directly after the event, presented strong signals. 

"The directionality was massive after Brexit. For us, and the CTA/managed futures industry at large, the month following Brexit was the best of the year," remarked Karsten Schroeder, Chairman and CEO of Amplitude Capital, a Swiss-based futures fund. 

As more systematic funds come to market, utilising the smartest algorithms and machine learning techniques to manage money, this could, as Pal alluded to above, represent the next stage in active management, stripping away human emotion. A Brave New World perhaps?

One of the benefits of machine-based strategies, albeit with a human discretionary overlay, is their ability to react at light speed to changing market dynamics. This is the difference between active and passive strategies, and is likely to become a key battleground for investor dollars. 

Active funds that trade systematically might further lead to a reduction in fees and make them appealing to an increasing retail audience, but as one institutional allocator said at CAIS 2017: 

"Skill set, opportunity, conviction: that's what comprises active management and it hasn't changed. Hedge funds will continue to outperform. We don't get caught up in the passive versus active debate."

Orbit 2: Credit – The next frontier

Some of the biggest moves in years were seen across the credit spectrum last year, not just in high yield bonds, but leveraged loans, asset-backed securities and collateralised loan obligations. In 2016, CLO sales totalled EUR16.81 billion, with analysts at JP Morgan Chase & Co and Morgan Stanley predicting roughly EUR20 billion in sales for 2017 as spreads continue to tighten.

Spreads have been tightening in other areas of credit but the inherent risk to corporate bonds is what will happen when central banks finally start tapering. As Bloomberg reported, when the Fed finished QE2 in June 2011, the spread (to US Treasuries) more than doubled to 3.59 per cent by the end of September that year. 

Of course, volatility is precisely what active portfolio managers welcome.

"Our view is credit looks to be overshooting a bit, things are looking fairly rich," commented Denise Crowley, Head of Securitised Product, ZAIS Group, which focuses on specialist credit strategies. "We remain cautious but that is not to say there is no upside potential. Almost universally across the board we are at post-crisis tights but can we get to pre-crisis tights?"

"We are short on both interest rate duration and credit spread duration and trying to play things a bit more defensive. There are some great opportunities in CLO equity tranches if you do your homework and know how the deals were structured." 

Direct lending funds: The next death star?

Opinions differed at CAIS over the prospects of credit in 2017. Some worry that within private credit markets, hedge fund structures used to run direct lending strategies could be an accident waiting to happen. 

Asset liability is critical, said Clark Cheng, CIO of Merrimac Corp, a single family office investor. 

"When you start lending with tier terms and offer quarterly liquidity terms, that is going to create problems. If enough people redeem at the same time, it could end badly for a lot of private debt funds. That's a big problem for me in the credit space," remarked Cheng.

This bearish sentiment on private credit was shared by Andrew Ross, Associate Director, PAAMCO, a USD10 billion FoHF manager. Private credit carries a lot of illiquidity such that if a market shock occurred, and the bottom fell out of the market, a lot of questions would need to be given to investment committees and boards.

"That said, we think it is a good shorting environment in credit markets because a lot of spreads are very tight," confirmed Ross. He added that the rise of passive money into high yield ETFs, should work very much to the advantage of active credit managers; the inference being that retail money is less informed, less sophisticated. 

"Within credit there is so much money flowing into passive ETFs that provide daily liquidity, such that if there's ever a run on this stuff there will be a huge collapse. In five years' time, we might be talking about the time when we started to see the warning signs of that collapse," warned Cheng. 

On the bullish end of the credit spectrum, managers like Dallas-based Highland Capital Management, who oversee USD14.8 billion in assets, see opportunities long and short and therefore do not fixate on concerns over whether spreads are too wide or too tight. As an active manager, they just look for the right opportunities to buy. 

"We've had eight years of banks deleveraging and being overregulated; we may, with Trump, have change for the good," said Highland's Co-Founder and CIO, Mark Okada. "If things start trading more, it will become easier to express your views as a portfolio manager, which will be a positive for managers in the credit space. We're positioning ourselves to be nimble with our credit picks. 2016 was a great year for credit and it's continued into 2017."

In Okada's view, there is too much sand in the gears with respect to the US banking system because of all the regulation. "I could see regulations changing, taking some of that sand out of the gears to make capital more efficient. And that's an exciting opportunity," said Okada.

As global monetary policy diverges, it should create an environment of more winners and losers and present more opportunities for active managers, especially if inflation rises. 

Orbit 3: Building a bigger industry: real assets & infrastructure

Real estate is expected to become the largest alternative asset class in the next few years and offers significant growth potential. Technology will play an increasingly important role in terms of giving investors access to such assets, particularly retail investors. 

As more PERE and infrastructure funds launch, such is their growing appeal that one of the challenges for General Partners is to guard against these funds getting too large, from an AUM perspective. 

To overcome this over-subscription problem, co-investment opportunities are being increasingly offered: both to new investors looking to gain exposure to a particular manager, and to the fund's Limited Partners who wish to increase their allocations.

"We see co-investing as a great way to lower our overall costs," said Tim Runnalls, Senior Director, Real Assets, Ascension Investment Management, which manages assets in accordance with Catholic-based SRI guidelines. "Typically, we will look to do one-off co-investments. It is a tool for GPs to use and something that we look for. We're not fully staffed to be able to make our own PERE or infrastructure investments." 

With respect to infrastructure, this asset class has become flavour of the month for a lot of institutional investors because it provides inflation protection and a link to GDP. 

Pure infrastructure assets such as essential public services are a base portfolio play. As one moves up through the infrastructure stack, it is possible to build exposure to enterprise companies; i.e. companies that service the assets such as airports but are more enterprise-driven than asset-driven. 

"On the very far end of the infrastructure spectrum is `core plus plus'. My favourite example of this asset was Ontario Teachers' Pension Fund, who bought a chain of funeral homes. 

"Overall, we see a huge amount of money chasing these assets," confirmed Laurie Mahon, Managing Director & Co-Head, Global Infrastructure & Power, CIBC Capital Markets. 

Indeed, it is estimated that there is currently USD820 billion in unlevered dry powder chasing a finite number of infrastructure deals. 

This is great news for institutions. Private markets like PERE and infrastructure are illiquid and less efficient, and less efficiency means a greater chance of capturing alpha in private markets. 

"I see a lot of opportunities within real assets. For investors, giving up some liquidity over the short- or mid-term is no bad thing if these assets offer a greater source of alpha," said William J. Kelly, CEO of CAIA. 

However, while the volume of dry powder clearly demonstrates the extent of investor demand, it also presents a challenge for managers to put that capital to work. Runnalls confirmed that energy infrastructure was one specific area that looked appealing, particularly on the distressed side, where there is less capital flowing in.

"I would worry about the valuations for some infrastructure assets based on the amount of dry power. It is a competitive space," he remarked. 

Whereas previously it typically took five years to raise capital for an infrastructure fund, now it takes, on average, 18 months, according to Melanie Cohen, Global Head Private Equity Fund Services, Deutsche Bank. "This is just the start of the trend, I think it will continue. We have seen a pick up in the number of funds being offered by infrastructure managers as they broaden their investment capabilities," commented Cohen.

other gfm publications