HSBC hedges its bets by staying agile

With increased market volatility, private investors have significantly brought down their investment horizons and their interest in illiquid instruments, such as hedge funds, has reduced too.

“In Europe and Asia, people have bad memories of side pockets,” says Arnaud de Servigny, global head of discretionary portfolio management and investment strategy at Deutsche Bank PWM. “People have lower expectations in terms of returns, but higher expectations in terms of transparency and liquidity.” As a result, he says, demand for liquid Ucits III structures has grown, even if these regulated vehicles may generate lower returns than their offshore counterparts.

But in the current environment, the trade off between liquidity and returns may not necessarily hold true. “In general, if you are willing to lock up your money for long periods of time, you should be rewarded by extra returns, but some of the funds that have done best for us are the trading type of funds, which are very much at the liquid end,” says Peter Rigg, global head of HSBC Alternative Investment Group, which rests within the bank’s private client division. The firm manages nearly $30bn (€23bn) of hedge fund assets worldwide, of which just less than five per cent are in Ucits III funds.

The risk on, risk off environment that characterised much of last year had a bad impact on hedge fund strategies. The HFRI Fund Weighted Composite Index declined by -5.0 per cent. The risk on, risk off (RORO) index developed by HSBC Global Research measuring the correlation between different asset classes clearly shows that the fortunes of hedge funds are inversely related to the index (see chart). For some strategies, like equity long short, it was particularly tough.

“When asset classes move in lockstep, it is very difficult for the fundamental type of stock-pickers to make money through relative value trades,” states Mr Rigg. “It has been easier for managers having a short-term orientation and a real focus on risk management.”

WHAT HAPPENS NEXT?

Thanks to improving sentiment, in January, virtually all hedge fund strategies posted strong gains, with the HFRI Index gaining 2.63 per cent. But it is uncertain whether the risk on, risk off environment will persist or there will be a return to fundamentals. “We want to keep very liquid, with low leverage and are favouring short-term strategies, so we can move very quickly when things unfold.”

In HSBC’s flagship multi-strategy hedge fund, GH, allocation to long short strategies has decreased to 30 per cent from 50 per cent five years ago, to the benefit of trading type of strategies like macro, directional strategies and managed futures.

Even in long short, the emphasis is on nimble, trading type of funds, and some sector specialists, such as TMT, healthcare and energy and shopping, which did well in 2011.

But looking ahead, some of the best opportunities that can come out in the most likely of future scenarios – where there will be an improvement in or a perceived resolution of the eurozone crisis, lower cross-asset correlations and recognition of price discrepancies across risk assets and regions – will be of a longer-term nature. Investors will have to be prepared to lock-up their money for three to six months, and many of these developments can take several years to play out, says Mr Rigg.

Allocation to long-short strategies will grow and allocation to macro strategies will reduce. On the credit side, interesting opportunities will arise in Europe in corporate credit and asset-backed securities. HSBC is looking to add a few more managers to the five that currently has in this space.

High hopes are placed in the recently launched programme of start up or “next generation” hedge funds, which are seeded by HSBC with a maximum investment of $50m in each. Until they are graduated to be included in other products, this handful of managers is running their assets in a separate fund of funds.

Although the firm applies the same standards of due diligence to identify emerging managers, mainly spin-outs from hedge fund firms, operational risk is higher. Also, as the investment process is held in fewer hands, their investment strategy is more focused, which leads to increased volatility. That their investment strategy does not translate into a multi-strategy type of fund, as it happens in many big hedge fund firms, is quite positive, says Mr Rigg. “We will know exactly what we are buying and how to blend them.”

Assets in the next generation fund are expected to grow this year from the current $100m to $500m, while the number of managers will likely increase to ten, each managing $50m. “We are hoping to find the future Steve Cohens, the future legends of the industry. We believe we can pick up very decent returns as early stage investors.”