Separating brilliant trades from style drift

Wed Sep 12, 2012

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Neuberger Berman’s Ian Haas on a common investor conundrum.

By Ian Haas

When it comes to hedge fund investing, the initial due diligence process is critical, but the real work begins after the investment has been made. One of the characteristics of hedge funds that make them unique and potentially attractive can also lead to headaches for investors - namely that hedge funds are often dynamic and constantly changing, free to tactically adjust gross and net exposures, to invest in new markets, new strategies and/or new instruments. The challenges associated with staying on top of these changes are often compounded by the fact that transparency varies widely by manager. How should an investor determine if their hedge fund is exhibiting the often quoted, but very open to interpretation phrase, "style drift"? And what should an investor do should they encounter a situation where what they own today is different than what they bought yesterday?

There is no simple answer to these questions, but investors can go a long way toward being able to address them if the following two criteria are met: 1) a proper set of expectations are established prior to the investment being made; and 2) the investor is able to perform a thorough analysis of any and all risk issues that are uncovered after the investment has been made.

When it comes to setting expectations, going through this exercise in advance of the investment is key because it ultimately provides the most disciplined way for the investor to evaluate the success, or lack thereof, of the investment.

Expectations can be quite varied but some important factors include:

Performance: Expectations for absolute and relative performance and correlation and beta to other managers in the portfolio as well as the equity and credit markets

Mandate: What are the manager's distinctive capabilities and activities that led to the decision to hire them? What types of strategies, trades and instruments are within the mandate and which are outside the mandate?

Transparency: How often will the investor communicate with the manager? What types of information will be collected? Is the manager providing additional transparency to other investors?

Capacity: How much money can the manager effectively deploy before diluting performance and introducing real liquidity risk?

Of course setting expectations alone isn't enough because it's likely the manager will do something which falls outside of those expectations. If a manager's performance is worse than expected, or if the manager begins to invest in a new strategy or instrument type it is up to the investor to decide what to do about it. Deciding what to do about it really means analyzing the new strategy and associated risks.

Let's look at two examples to illustrate the importance of setting expectations and then thoroughly analyzing the situation when those expectations aren't met.

Example 1: By now it is a very well known story that a relatively small number of managers faired extremely well in 2007 and 2008 by betting against the subprime mortgage market. Certain of these managers likely had little focus on analyzing non-agency mortgage backed securities, as they included long/short equity funds, corporate credit funds and event-driven funds. Did these managers exhibit style drift?

Example 2: The hedge fund world is no stranger to multistrategy funds hiring a trading team and expanding into a new strategy only to see that new strategy lead to performance issues. Examples include managers putting on concentrated long bets in the mortgage market leading up to the crash, or investing in a highly levered fashion in relative value spread trades within the commodities markets. When does a multistrategy manager's launching of new strategy constitute style drift, or a risk not worth holding onto?

Example one appears to be a pretty clear example of style drift, while example two sounds reasonable enough. What business does a long/short equity, credit or event-driven fund have shorting subprime debt? I think it's quite safe to presume that this would be outside the expectations that an investor in that hedge fund would have had pre-investment. And isn't well within the rights of a multistrategy fund to expand the mix of strategies employed? Acting on this basis alone one may presume that investors should rightfully had cause for concern when their long/short equity, credit or event-driven managers put on a short subprime trade but little cause for concern when their multistrategy funds employed new strategies to invest in a highly levered manner.

Of course we know it's not quite that simple. The short subprime trade had an incredibly positively skewed return vs. risk profile. That is, the manager was likely only risking a small fraction of fund assets (i.e. the premium paid for the short hedge) with potentially large upside. Perhaps more importantly, the position was likely viewed as a sound hedge to a manager's long equity or long credit book. So in actuality it may have been a sensible decision to hold onto that risk in 2007-2008 despite potentially it being labeled style drift. And while most multistrategy managers are prudent in the new strategies they deploy and in the leverage and liquidity risk they assume with those new strategies, we all know that many have gotten into significant trouble, and in some cases have had to shut down due to outsized losses as a result of those new strategies leading to increases in the fund's leverage, illiquidity and/or directionality.

So the question of what is and what isn't style drift is a complicated one. Furthermore, deciding what to do if and when drift does arise raises an additional layer of complexity. Having a pre-defined set of expectations for a manager prior to the investment, and then spending the time to carefully analyze any and all new risks that develop is one way for investors to minimize the chances of being faced with buyer's remorse as their hedge funds continue to do what hedge funds do best - change.

Ian Haas is an investment committee member for the fund of hedge funds group at Neuberger Berman.