Hedge fund managers crossing their fingers for volatility

Far from fearing volatility, hedge fund managers are looking forward to a rockier investment climate this year, one that will allow them to do what they do best: make money on both the long and short sides.

The hedge fund managers who reviewed 2013 and previewed 2014 for Pensions & Investments were universally optimistic about investment opportunities, despite the specter of U.S. Federal Reserve Bank tapering, rising interest rates and ceaseless regulation coming from all corners of the world.

2013 was a year in which “anything with a hint of equity beta did well (particularly equity long/short, event-driven and special situations strategies), as a strong tailwind continued throughout the year,” said Warren A. Wright, co-founder and chief investment officer, Diversified Global Asset Management Corp., Toronto.

“The beta call meant everything in 2013. Strategies that had it did well, and those without equity beta mostly did not,” agreed Jim Vos, CEO of specialist hedge fund consultant Aksia LLC, New York.

Suppressed volatility and low return dispersion plagued global markets throughout 2013, which were “predominantly driven by macro influences and policy changes rather than fundamentals,” Mr. Wright said.

Those sweeping macro factors in 2013 made it much harder to find differentiated investment opportunities, especially for managers offering strategies that were long volatility, flat to short equity beta, relative value-oriented, systematic macro and commodities-focused, Mr. Wright said.

2014 promises much better return dispersion and higher volatility for both equity- and credit-oriented strategies, Mr. Wright said, but “hedge fund managers will have to manage money the old-fashioned way, using skill to generate alpha. They won't be able to rely solely on equity beta.”

“I'm not sounding an alarm bell, but with asset prices where they are now, it's not a no-brainer to deal with the increased volatility that's coming. Managers will have to short, and real hedges will have to be in place,” agreed Alec Litowitz, founder and CEO, Magnetar Capital LLC, Evanston, Ill.

Fundamental, bottom-up long/short equity managers are “poised for good performance” as global markets become less influenced by macro factors, said Lee S. Ainslie III, Maverick Capital Ltd.'s managing partner, based in the company's New York office.

Mr. Ainslie said the factors that kept interstock correlations higher than average and dispersion much lower for the past six years have reversed.

“Market stability is much better, mostly due to improved clarity over regulatory and fiscal issues, which will give fundamental hedge fund strategies a (new) tailwind. I am optimistic that shorting will be much easier in 2014 than it was last year,” said Mr. Ainslie.

Maverick managed $9 billion as of Nov. 30.

Long/short manager Passport Capital LLC, San Francisco, remains in hot pursuit of growth stock opportunities, said John Burbank III, founder, CIO and lead portfolio manager of the firm's global strategies fund. Because he believes the U.S. dollar will strengthen, the Standard & Poor's 500 index will rise and U.S. economic growth will be stronger than most other countries in 2014,

Mr. Burbank now is long U.S. equity and strong companies that lead their sectors. Mr. Burbank said he is short emerging market equities, with the exception of China and Saudi Arabia, “average” companies and commodities.

“2014 is going to be a great time for long/short strategies, with ample opportunities to protect yourself from macro trends,” Mr. Burbank said, stressing that the impacts of “macro trends and policymakers are overrated. The market has already discounted the effect of tapering and other regulations.”

Passport Capital managed $3.1 billion as of Nov. 30.

Aksia's Mr. Vos said event-driven approaches top the consultant's list of most-favored strategies for institutional investors going into 2014. But Aksia's consultants “continue pounding the table” — as they have for the past year — about combining event-driven hedge funds with complex credit and equity strategies, which “should be pulling in high returns in 2014,” Mr. Vos said.

Hedge fund managers interviewed for this story said they are focused on ferreting out the most idiosyncratic, entangled, complicated deals around the world, a strategy that helped many to generate alpha in 2013's low volatility market.

“There has been a steeper risk-return curve in recent years, with much higher returns for complicated deals,” avowed Andrew J.M. Spokes, managing partner, Farallon Capital Management LLC, San Francisco.

“As happened fleetingly in 2013, in 2014, periods of interest rate anxiety will (result in) better merger arbitrage investment opportunities,” Mr. Spokes said.

In addition to merger arbitrage, Farallon's 2014 areas of focus likely will include complicated European illiquid credit opportunities; event-driven value equity; and U.S. commercial real estate.

Mr. Spokes said the latter category of complex deals offers Farallon the chance to “make our own event” from buying foreclosed U.S. under-leased properties from banks, cleaning them up, finding renters, and then selling the properties to entities looking for stable cash flows.

Farallon managed $19 billion in hedge funds as of Nov. 30.

Credit specialist DW Investment Management LP, New York, diversifies its hedge fund portfolios by investing in sophisticated debt instruments, said David R. Warren, CEO and CIO.

In 2013, for example, the funds were invested in single corporate credit securities, structured corporate credit, residential mortgage-backed securities, commercial MBS, asset-backed instruments and student loan-backed securities.

The last category was particularly complex because of embedded interest rate exposure, which required portfolio managers to hedge the risk.

DWIM doesn't plan big changes this year because, Mr. Warren said, “there is a lot of alpha still to be found in very deep value credit deals. The (return) premium comes from being able to manage the complexity of the security.”

DWIM managed $5.5 billion as of Nov. 30.

Magnetar is avoiding or hedging strategies with embedded systematic volatility strategies as it positions for 2014, but continues to invest in idiosyncratic, convoluted investment niches where its portfolio managers believe they have a competitive advantage.

For example, Magnetar will continue to exploit the “innovation volatility” of the energy sector, specifically hydraulic fracturing, which Mr. Litowitz said has created an “energy renaissance ... and has opened up a new frontier.”

That new frontier will require about $1 trillion of financing to build out the U.S.'s fracking infrastructure by the end of 2020.

The “multiyear tailwind” can be tapped in multiple ways — transactions, financing mergers and acquisition, or restructuring — Mr. Litowitz said.

Regulatory changes such as the Volcker rule and Basel III have required banks globally to shed many of the loan and financing services they once offered. Magnetar now is filling the lost niches as an outsourcer to banks, according to Mr. Litowitz.

The company's partnerships with banks include financing for construction of a new hospital in Kent in southeastern England and assuming loan assessment for a joint venture with the Spanish bank Bankinter S.A. to invest in loans to Spanish companies.

Magnetar Capital managed $10 billion as of Nov. 30.