July-August 2011

ALTERNATIVE INVESTING: How macro is your event?

Chess-piecesEvent-driven strategies are popular with investors looking for alternatives. But Anne-Gaelle Pouille of Paamco says that the state of the world means these funds are taking on more macro risk, and not all managers are equipped to have strong views.
Many investors allocating to event-driven strategies are getting more macro exposure than they may think. Of course, the world has been rather macro-driven lately, which is a contributing factor. However, the trend is also due to substantial style-drift, particularly at larger hedge funds (and in the long-only world). Should investors care? Let’s take hedge funds as an example. Event-driven is an important component of most investment programmes: about 25% of hedge fund industry assets are consistently allocated to the style, according to data from Hedge Fund Research (HFR). This consistency in allocations reflects the strategy’s ability to create alpha at multiple points in the economic cycle. In its pure form, event-driven investing aims to isolate idiosyncratic events happening to companies. Examples of events include mergers, acquisitions, bankruptcies, recapitalisations, spin-offs, asset sales, leadership transitions, litigation or regulatory changes. These events cause dislocations in the price of securities that can be exploited regardless of what happens in the broader markets.  This independence from most market risk factors is a key selling point and event-driven funds should therefore focus on getting the microeconomic fundamentals right. In other words, bottom-up thinking should drive the P&L [profit and loss] of an event-driven fund, not top-down macro management. While event-driven funds can never afford to ignore macro-drivers of markets, the historical norm has generally been to be “macro aware”, not “macro obsessed”. Similarly, while some may have stretched the definition of an “event” to include almost any macro or micro occurrence, traditionally the search for market diversification has required that events be confined to idiosyncratic corporate changes. In other words, most managers appreciated how macro could affect their holdings, but did not expect the majority of their P&L to come from macro. This has shifted in the past three or so years, with more event-driven funds placing increasingly large macro-driven bets. In fact, the average 24-month rolling correlations between the Credit Suisse Macro and Event-Driven indices has risen from about 0.4 in the years up to 2007 to about 0.6 more recently. It is important to look closely at what is going on inside these funds. Using public regulator filings for the quarter ending 31 March, 2011 and focusing on a basket of larger event-driven funds (represented here by the Credit Suisse Event-Driven index), the largest long position held in aggregate is gold (via gold SPDRs). Other top positions among event funds include several energy (linked to oil), mining (more gold) and financial (macro crisis related) stocks. A few quarters ago, buying outsized protection against European sovereign defaults through credit default swaps was a favourite trade. Event-driven indices may not be perfectly representative of the event-driven strategy, but as many investors use such indices as benchmarks for their event-driven investments it is likely that some of these macro trades are in investor portfolios. Why it’s happening
With the integration of global economies and various political and resource tussles, the role of macro is ever expanding. Clearly, the level of interest rates affects companies’ ability to seek financing which in turn impacts distress or expansion rates. High demand for commodities and precious metals has knock-on effects on the value chain for companies operating in those sectors and beyond. The currency intervention that governments (both developed and emerging) engage in will create winners and losers in the corporate landscape, as will political shifts such as the Basel III negotiations for banks, or the recent regional elections in Spain. There are also two somewhat less palatable reasons behind this shift. First, as hedge fund managers get larger (in 2010 over 80% of net inflows into hedge funds were into funds above $5bn (€3.5bn) of assets under management, according to HFR), they struggle to find trades with sufficient capacity to meet their investment needs. Many of the juiciest corporate event trades are in limited supply: unlike with very deep macro markets, there are only so many dollars outstanding in a particular company’s capital structure to go around. Second, many hedge fund portfolio managers have a substantial amount of their liquid high net worth invested. To the extent they feel the need for inflation protection (gold, commodities) or simply have strong conviction in a macro trade, they may be tempted to shift the event-driven fund’s focus to be more macro-driven than would otherwise be the case. Should you care?
Investors should question what the manager’s edge is in placing macro bets. Most are ill-equipped to have strong macro views. Few can capitalise on macro trends promptly, due to the amount of one-off research that event-driven managers must perform on each company prior to investment. Take for example the recent tragedy in Japan: while some macro managers may have been equipped to trade quickly, event-driven managers generally missed the drawdown and rebound (unless they happened to be already researching Japanese companies). For this reason many managers (especially smaller ones) choose to execute macro ideas exclusively in a hedging context. Macro trends do frequently provide opportunities, for example, when massive macro dislocations (2008) render many corporate cash flows very cheap, but the true and replicable edge is generally in the fundamentals-based selection of the right securities at the right companies to capitalize on these macro trends. From a risk management standpoint, monitoring a macro-heavy portfolio will be different from monitoring a pure event-driven one. A portfolio with several large macro trades may be more liquid, more levered and more volatile than an aggregation of bottom-up idiosyncratic trades on corporates. Investors need to understand all of these characteristic differences and in order to best measure them, there is no substitute for knowing the actual positions in the portfolio. Fees are also an important consideration. On a per dollar basis (per investment), macro research appears much cheaper than event-driven research, given that larger amounts of capital can be applied to macro ideas compared with event-driven trades. Does it make sense to pay an event-driven hedge fund manager their full fee to put on a long gold position when a gold exchange-traded funds would suffice? In other words, what are you paying for and how much is any macro timing skill worth? There are important differences between assessing event-driven and macro money managers (skill set, research process, risk management, fees, and so on) and there is undeniably value in both. If investors can understand the nuances between the two and the overlap with the rest of their portfolio, then they will be better equipped to answer “how macro is my event” and avoid surprises such as macro-related drawdowns. Anne-Gaelle Pouille is an associate director at Pacific Alternative Asset Management Company ©2011 funds europe

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