Getting the managers right in hedge funds is increasingly important, with increasing dispersion and choppy markets providing opportunities and challenges for all strategies. AlphaWeek’s Greg Winterton spoke with Patrick Ghali, managing partner of hedge fund advisory firm Sussex Partners, to learn more about how his firm views the current hedge fund landscape.
GW: Patrick, to start, tell us what strategies your clients are currently asking you for, and why.
PG: Given the uncertain global outlook, clients have been asking for diversified, all-weather strategies for some time. We’ve argued for some time that it makes sense to avoid traditional equity strategies with high net exposure, as well as traditional fixed income strategies, and instead seek strategies that can provide low correlation, alpha and good convexity during periods of market dislocation. . For this reason, we have focused on strategies such as macro (both global and, also with an Asian tilt for additional diversification), CTA/systematic and multi-strategy strategies. Where we have chosen to take any type of equity risk, this has been done either through market neutral managers (ideally, as they are also factor and sector neutral) or funds of multi-pm equities (again market neutral). To a lesser extent, we also use convertible arbitrage, but with managers who take little or no credit risk and where we see it more as a game of volatility. Japan and China also continue to attract interest, but for more idiosyncratic reasons, with China currently dividing customer opinions; some see it as a big opportunity given valuations, and others are avoiding it altogether for now.
GW: The dispersion of hedge fund performance is on the rise, making manager selection more difficult. What are some of the things Sussex Partners is looking for on the IDD side that you think leads to persistent alpha?
PG: Whenever possible, we look for strategies that take advantage of market inefficiencies. It is much easier to generate alpha in such markets. For this reason, we also tend to avoid overly efficient markets. A good example of a strategy that we’re not so constructive on and have avoided for a while would be the United States, because it’s very crowded, with a lot of very smart managers with big budgets, all in competition with each other. As a result, crowded trades and short squeezes can be problematic, and the correlation between managers can be very high. Managers also often have to resort to some sort of militant stance to add value, which adds additional risk. It is often difficult to see what added value a specific manager has in such a market compared to his peers. Of course, we also look very carefully at risk management and try to understand how flexible or inflexible managers are. Some of the most high-profile losses this year appear to be due to managers not being able to change their perspective and stubbornly sticking to a worldview that didn’t work in an environment of rate hike. We try to understand how committed managers are to their positions, and also how good they are at adjusting their risk to volatility. We’ve seen in the past that arrogant managers tend to generate outsized losses, while humble ones tend to adapt better when the markets prove them wrong. This is a mild but important factor. You have to accept that you will lose money from time to time when investing, because all investors can and will make mistakes, but how they handle them is key, and pushy managers tend to dig in and let the losses spiral out of control. can’t stand being wrong. Finally, even though we are not a macro company, we have a worldview and if we feel that what a manager is doing just doesn’t make sense in a given environment, we will avoid it. Having a repeatable and robust investment process is another factor we look for. It’s important that we can understand how returns are generated, how sustainable the alpha a manager claims to be generating, and most importantly, in what environment we would expect them to lose money or he struggles, and why. If we cannot understand this, we tend to hesitate.
GW: You are well known for your optimism about Japanese hedge funds; you have been building relationships in the country for many years. What are some of the current concerns and opportunities you see for Japan-based strategies and managers?
PG: I recently returned from my first trip to Tokyo in nearly three years, as it was previously impossible to get there due to ongoing Covid-19 restrictions. It gave me the opportunity to meet several managers face to face for the first time in a long time. The main problem I see with Japanese managers, and this applies to global managers as well, is that markets have generally not traded on fundamentals in the recent past. Many Japanese managers are fundamental managers. The Japanese hedge fund market is very much a stock market, and the advantage that many Japanese managers have had in the past is the lack of analyst coverage and the vast universe of Japanese stocks where they could research. primary schools and therefore benefit from this research. However, in a largely liquidity driven market, significant distortions can occur and persist for some time, and for many managers this has been quite difficult. Trading-focused managers have weathered this environment better, but it’s often more difficult to understand whether a trading manager has a lasting advantage. An additional hurdle was the global rising rate environment and, as in the US, some Japanese managers underestimated the impact this would have on valuations. Additionally, liquidity in Japanese markets has been somewhat poor over the past 18 months, with liquidity only really available at the open and close, coupled with a lack of foreign participation which can drive up prices to more extreme levels in a short period of time than might have been the case. happened otherwise.
The other topic that is very relevant is whether the Bank of Japan can continue to keep rates where they are. Many global investors seem to think that the BoJ has no choice but to raise rates, and therefore the JPY is a strong buy. Interestingly, this view does not seem to be shared at all by local Japanese hedge funds or large institutional investors, who generally believe that rates will remain low for some time and that the yen has no real catalyst to s to appreciate significantly and imminently. Their view is that inflation remains low, the BoJ would be happy for some inflation to take hold, and that at least until there is a change of guard at the BoJ, a change of policy is unlikely (and even after that, some believe there won’t be much momentum for change). I guess time will tell, but I thought it was interesting to hear how diametrically opposed the local perspective was to the global narrative on the same topic.
That said, the long-term backdrop hasn’t really changed for Japanese hedge funds fundamentally, so I think opportunities will continue to present themselves. Over a medium to long-term time horizon, the alpha opportunity for these managers should remain robust. The failure of markets to react to fundamentals is a global, not a local phenomenon, but with quantitative tightening and rising rates, fundamentals should come back to the fore, as we have already seen to some extent .
GW: Managed Futures strategies have performed well this year; most data companies show that these programs were among the top performers in 2022. Any thoughts here?
PG: We have been using these strategies for a long time; however, the problem is that it is very difficult to predict performance. We therefore always create baskets of funds that have a different approach (eg: short term, medium term, machine learning/AI, Asia, etc.). We are constantly looking for managers who can add additional diversification either by having a very different approach or by using new technologies (such as machine learning or AI) or by focusing on a different geography such as Asia where the performance drivers for local markets differ from those of major US and European markets. We have found that by doing this we are able to create better and less volatile results. The main challenge for these strategies tends to be choppy, directionless markets, so size is also key as they can go through long stretches of small losses which can hurt performance over time. However, in the current environment, we believe it makes perfect sense to have an allocation to these types of strategies.
GW: Finally, Patrick, you also have a strong opinion on hedge fund index data. Can you tell us why this frustrates you and what do you think investors should focus on here?
PG: I think it’s too simplistic to just look at an index and draw meaningful conclusions. Some indexes are well constructed, but we generally create our own peer groups rather than relying on an index. Hedge funds are quite complex, and it’s important for us to really understand what the drivers of performance are and make sure we’re comparing apples to apples. It can be very difficult to get a good idea of what is really going on with a strategy, let alone the industry as a whole, just by looking at an index. Indices are also asset-biased, and with long/short equities being the most important strategy by AUM, the performance of these managers has an outsized influence. However, there is more to the industry than long-short equities, and the selection of strategies in different market regimes is important and can create very different outcomes for investors.
Patrick Ghali is managing partner at Sussex Partners