Bridgewater Associates: Hedge Funds Levered Betas - January 2007
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Bridgewater Associates: Hedge Funds Levered Betas - January 2007

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Bridgewater Associates: Collection of Writings (1999-2012)

Bridgewater Associates: Collection of Writings (1999-2012)

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  • 1. Bridgewater® Daily Observations January 10, 2007 © 2007 Bridgewater Associates, Inc. (203) 226-3030 Greg Jensen Noah Yechiely Amit Srivastava United States Hedge Funds Levering Betas: Returns for hedge funds were decent in 2006. The CSFB/Tremont index of hedge funds showed returns of 13.6% through November. Hedge funds continued to raise assets, albeit at a slowing rate, our estimates indicate the increase in hedge funds’ AuM topped $150 billion for the year. To get these returns, in the current low volatility environment, hedge funds have levered up, increasing leverage ratios by over 70% by our calculations in the last 3 years. Hedge funds in aggregate have reached leverage levels not seen since 1998, when LTCM dominated, and assets were tiny. The chart below shows assets under management and assets controlled by hedge funds (i.e. holdings after leverage). Both assets under management and leverage ratios continue to surge. All Funds: Total Assets (Blns $) All Funds: Total Exposure (Assets x Leverage ; Blns $) 2500 2000 1500 1000 500 0 94 95 96 97 98 99 00 01 02 03 04 05 06 As you know, we generally view the move into hedge funds as part of the evolution of money management. As we have described for many years now, the investment world should, and will, evolve towards a world of separating passive investment decisions (we call them beta) from active investment decisions (alpha). Most institutional investors continue to tie together their alpha and beta decisions (i.e. an institution typically decides how much money they want in equities and then goes out and hires equity managers to manage it). This is clearly inefficient, as the two decisions need not be linked. Instead, investors should decide which asset classes they want to be in and then overlay on top of these asset classes the best alpha managers they can Bridgewater ® Daily Observations is protected by copyright. No part of the Bridgewater ® Daily Observations can be duplicated or redistributed without prior consent from Bridgewater Associates. Copying or redistribution of The Bridgewater ® Daily Observations is in violation of the U.S. Federal copyright law (T 17, U.S. code). 1 Bridgewater ® Daily Observations 2/7/2007
  • 2. find, no matter which asset class they get their alpha from. This is alpha overlay, and it is a better way to run a portfolio. Cutting-edge institutions have begun to manage their assets this way, and the rest of the world will eventually adopt this superior strategy. To the extent that investors are able to use hedge funds to get access to more and better alpha sources to overlay on their portfolio, the dive into hedge funds is worth taking. Too often, however, hedge funds are mixing alpha and beta together, blurring the picture. To be clear there are only two ways to make money in the market, and it is essential to be able to differentiate between the two. The general perception right now is that hedge funds are providing alpha. In truth, many hedge funds are packaging up beta and selling it at alpha prices. When we strip many hedge fund “strategies” from the beta that underlies them, we find that quite often, they are not wearing any clothes at all. In many cases, hedge fund betas are not hard to strip out. For instance: Fixed Income Arbitrage: One of the most popular hedge fund strategies has been fixed income arbitrage. This is a classic beta strategy. We don’t claim to be experts at what all of these guys are doing, but in aggregate, the picture is pretty clear. Simplistically, these funds are taking three systematic risks. The primary systematic risk is buying illiquid, risky securities (e.g. MBS, EMD) and shorting more liquid, less risky securities. The second strategy is positive carry trades, e.g., long-term US treasuries vs. cash. The third strategy is selling volatility. Some funds can probably sort the good securities from the bad ones, but in aggregate, fixed income arb funds have simply returned the beta of buying illiquid fixed income instruments. In aggregate they are highly correlated to the naïve strategy of being long a simple combo of mortgages, emerging market debt, euro dollars relative to treasuries, long- vs. short-term treasuries, long high yielding currencies, and short volatility. All of these betas are now highly squeezed. Convertible Arbitrage: Convert arb has been a popular hedge fund strategy for years, but the strategy has a large beta component to it. Convertible arbitrage funds take convertible bonds and hedge out some of the underlying pieces. A convertible bond has three components (credit, volatility, and equity). Most convertible arb players are going to do well when convertible bonds are sold at a discount to the underlying pieces, and poorly when the convertible bonds sell at a premium. That is why most convertible arb funds are so highly correlated. For much of the last decade there has been more supply of converts than demand, which has allowed converts to trade at a discount. This led to solid returns for entities able to hedge out the pieces (i.e. convertible arb hedge funds). The premiums are extremely narrow today. Emerging Market: Emerging market hedge funds are over 80% correlated to a simple 50/50 mix of emerging market equities and bonds and are failing to outperform this basic combo. Distressed: Distressed securities hedge funds match up well to a basic mix of junk bonds and high-yielding emerging market debt. You get the point, and in the past, we have discussed our hedge fund returns replication process, which closely tracks hedge fund return indices so we won’t bore you with the details; suffice to say our estimates of the betas in hedge funds are 90% correlated to the aggregate hedge fund index. This year’s returns of hedge funds were slightly below the betas we use to replicate them. The exotic betas did well in 2006, but the spreads are now all as tight as a drum. 2 Bridgewater ® Daily Observations 2/7/2007
  • 3. Hedge Fund Index Returns (Excess of Cash, Net of Fees) - Rolling 6mo Hedge Fund Index Replication Returns (BW's Replication Portfolio ; Exc. Cash) - Rolling 6mo 30% Correlation: 90% 20% 10% 0% -10% -20% 94 95 96 97 98 99 00 01 02 03 04 05 06 The following table shows many of our individual hedge fund strategy replications. Convertible Arbitrage Emerging Markets Index Replication Index Replication 30% Correlation: 52% 30% Correlation: 80% 20% 10% 10% -10% 0% -30% -10% -20% -50% 94 97 00 03 06 94 97 00 03 06 Event Driven Fixed Income Arbitrage Index Replication Index Replication 20% 15% 15% Correlation : 84% Correlation: 66% 10% 10% 5%5% 0% 0% -5% -5% -10% -10%-15% -20% -15% 94 97 00 03 06 94 97 00 03 06 3 Bridgewater ® Daily Observations 2/7/2007
  • 4. Global Macro Long/Short Equity Index Replication Index Replication 40% 40% Correlation: 83% Correlation: 81%30% 30% 20% 20% 10% 10% 0% 0% -10% -10% -20% -20% -30% -30% 94 97 00 03 06 94 97 00 03 06 In 2006, hedge funds performed well because they tend to hold risky assets relative to safe ones. Risky assets have been supported by a flood of liquidity, enough of which has poured into alternatives. The low volatility would have been a problem except for the levering up by hedge funds. The problem on a forward looking basis is that there is very little left to squeeze out of risky assets. Bridgewater’s aggregate risk spreads shows the tightest level in forty years. Market Based Risk Gauge 6% 5% 40-year lows 4% 3% 2% 1% 0% 60 63 66 69 72 75 78 81 84 87 90 93 96 99 02 05 The next chart overlaps hedge fund cumulative returns against rising risk periods using BW’s market-based risk gauge from above. Hedge funds have not proven their ability to deliver good returns at a time of rising risk, and while risk spreads can only get a little bit tighter, they could get a lot wider. The risks to hedge fund betas in our view are skewed. Rising Risk Periods Hedge Funds Excess Cumulative Return (ln) 1 0.8 0.6 0.4 0.2 0 -0.2 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 4 Bridgewater ® Daily Observations 2/7/2007
  • 5. It is clear that many hedge funds have a significant beta component, and with so much levered money chasing a limited number of illiquid betas, it is not surprising that risk premiums have collapsed. Some of this risk premium compression was reasonable, but now it seems pretty indiscriminate. While a lot more than hedge funds have caused risk spreads to be so tight, the increasingly leveraged money in hedge funds means that a stumble in the spread area could easily turn into a stampede. We are extremely wary of these betas. Other Industrialized Countries Mixed UK Surveys: UK surveys give us an up-to-date picture of what is going on with the economy. The overall picture is mixed, with the service sector showing strong gains while retail and manufacturing surveys are on the weaker side. Consumer confidence has been slipping as well. This picture is largely consistent with what one should expect at this stage of the cycle where monetary conditions are already tight and growth will continue to moderate. Current outright short rate pricing is consistent with our outlook, but pricing relative to Euroland doesn’t make much sense because fundamentals have converged while the level of forward short rates is expected to remain disparate. The following chart shows the PMI surveys for the manufacturing and service sectors. Expectations have been slipping in the manufacturing sector, while service sector expectations are making new highs. UK PMI Surveys Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Consumers are not feeling enthusiastic about future prospects either. 40 45 50 55 60 65 Manufacturing Services Services are making new highs, but manufacturing grow th is slow ing. 5 Bridgewater ® Daily Observations 2/7/2007
  • 6. Real retail sales grow th (YoY, 3mma) Consumer Confidence (3mma) 10% 20 8% 10 6% 0 4% -10 2% -20 0% Consumer Confidence has -30-2% been trending dow n. -4% -40 Jan-84 Jan-87 Jan-90 Jan-93 Jan-96 Jan-99 Jan-02 Jan-05 The strength in retail consumption also is expected to moderate. Nominal retail sales (YoY) BRC survey 11% 9% 7% 5% 3% 1% -1% Jan-95 Jan-97 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Economic activity is more likely to slow down further as monetary conditions have tightened due to a combination of a stronger currency and some rise in rates. Our monetary condition index is now indicating that growth will slow to the 2% range in the next few months. Coincident grow th (YoY) Monetary condition Index (Advanced. by 12m, Inverted) 6% -14 Monetary conditions are already tight, and -12 5% economic activity w ill follow w ith normal lag. -10 4% -8 3% -6 -42% -2 1% 0 0% 2 -1% 4 Mar-92 Mar-94 Mar-96 Mar-98 Mar-00 Mar-02 Mar-04 Mar-06 Mar-08 6 Bridgewater ® Daily Observations 2/7/2007
  • 7. Overall, we expect UK growth to continue to moderate as monetary conditions are already tight. While outright short rate pricing is roughly in line with our views, the difference in forward short rate levels between the UK and Euroland is out of sync with converging economic conditions. Conclusions Credit Markets N. America US Canadian US Bonds Bonds Euro$ Moderately Moderately Moderately Bearish Bullish Bearish Europe UK Euroland UK Euroland Gilts Bonds Euro£ Short rates Moderately Moderately Moderately Bearish Bearish Neutral Bearish Asia Japanese Bonds Australian Bonds Japanese Euro¥ Australian Bank Bills Moderately Moderately Neutral Bearish Bearish Neutral Currency Markets CAD v USD EUR v USD JPY v USD AUD v USD Neutral Moderately Bullish Neutral Moderately Bullish Equity Markets US Equities Japanese Equities German Equities UK Equities French Equities Canadian Equities Australian Equities Neutral Neutral Neutral Neutral Neutral Moderately Bearish Neutral Note: Bridgewater Daily Observations is prepared by and is the property of Bridgewater Associates, Inc. and is circulated for informational and educational purposes only. There is no consideration given to the specific investment needs, objectives or tolerances of any of the recipients. Recipients should consult their own advisors, including tax advisors, before making any investment decision. This report is not an offer to sell or the solicitation of an offer to buy the securities or other instruments mentioned. Bridgewater research is based primarily upon proprietary analysis of current public information from sources that Bridgewater considers reliable, but it does not assume responsibility for the accuracy of the data. The views expressed herein are solely those of Bridgewater as of the date of this report and are subject to change without notice. The views represent Bridgewater's outright views in these specific markets, but not all markets that Bridgewater trades. Bridgewater may have a significant financial interest in one or more of the positions and/or securities or derivatives discussed. Those responsible for preparing this report receive compensation based upon various factors, including, among other things, the quality of their work and firm revenues. 7 Bridgewater ® Daily Observations 2/7/2007