Hedge fund managers are rummaging through the world's vast debt opportunities, looking for undiscovered sources of alpha in an overheated market plagued by high volatility and correlations that are much too close for comfort.
Managers are meticulously combing through odd, obscure, complicated, often tainted securities. Also, those hedge fund firms with the sophisticated skills needed to exploit these opportunities are taking their ideas to institutional hedge funds-of-funds managers.
Hedge fund performance has been challenged so far this year, with the July 31 year-to-date return of the HFRI Fund Weighted Composite index return at just 1.55% and the HFRI Fund of Funds Composite index flat at 0.37%.
“The bad news is that it's very dangerous to be invested in traditional asset classes in a market like this that's drowning in liquidity. The good news is that because there's so much funky debt around, skilled hedge fund managers can find deals that will yield hundreds of basis points of return in excess of traditional securities,” said David Ben-Ur, co-chief investment officer, Corbin Capital Partners LLC, New York.
Corbin Capital managed $2.7 billion in hedge funds of funds mostly for institutional investors as of July 31.
Most of the creative alpha sources that hedge funds managers seek are in the debt arena, observers said. They range from troubled asset-backed securities to ways to short European sovereign debt to potential deals between hedge fund managers and European banks that are looking to trim their balance sheets by offloading structured credit portfolios.
The common characteristics of these vastly different kinds of debt deals include extreme complexity, opacity, illiquidity and fairly small investment outlays. These deals frequently involve a stressed seller who has to get rid of debt securities quickly at bargain prices.
“These forced sales tend to create a pawn-shop dynamic,” said a hedge funds-of-funds CEO who asked not to be identified. “The buyer gets to set the price, because there usually aren't a lot of buyers looking for these kinds of very complex securities. And the price usually is well below what these assets are worth,” the CEO added.