Man FRM Early View - March 2020

Arbitrage or Risk Premium?

Markets

A biological shock, an economic shock, a financial shock. It does seem as if that is the order of causality. You have to go back a long way to find a big bad event that did not have some form of finance as a prime suspect. When it’s finance, it feels like a punishment meted out to everyone in society for the excessive financialisation of the economy, and some toxic combination of the fear, greed and stupidity of a small number of rich people. We remember the villains not the heroes. But this is different. Most importantly everyone knows who the heroes are this time.

There is no need to rehearse the reasons why traditional markets performed as they did in response to a negative economic growth shock, though on this occasion it is interesting how long it took most asset managers to take the pandemic seriously. (The market consensus was, quite broadly, that we were in a reflationary upswing; the virus was barely more serious than seasonal ‘flu and dips in the equity market were there to be bought.) But we all got there in the end and no doubt this accentuated the sell off as it gathered pace into the second week.

The transmission mechanisms to the alternatives industry by contrast are superficially more mysterious: the whole point of these investment strategies is that they are supposed to be at least somewhat independent of the equity market and so too the whole growth story, in our view. Well, even if they are less exposed, there remain points of connection which speak of the financial system as a whole. Centrally, whatever the origin of the crisis, there tends to be an urgent need for cash. Cash, as we were advised by an industry luminary earlier this year, was trash. But when the economy suddenly grinds to a halt, the normal means of cash generation stop too. Cash rises quickly from bin to king.

Yesterday, a derivative was tightly (i.e. efficiently) priced to its underlying security, but now what suddenly matters is that while the cash security (‘on balance sheet’) can be sold to meet an urgent need for cash, the derivative can’t. It doesn’t take much to destroy the price relationship to the derivative if no one wants to commit fresh cash to buy the on balance sheet securities when the rest of the market turns a seller.

As a fixed income arbitrage manager – the first to be hit this time round - you can protect against the propensity of the cash instruments to fall much faster than the derivatives that hedge them by making sure that your book is not all long of on-balance-sheet instruments, all short of off-balance-sheet (this was a big lesson from cash credit and CDS protection in 2008). But if you are all long cash, short derivatives, though you may say you are trading ‘market inefficiency’, you are also probably earning a risk premium for providing liquidity and earning a return for taking the risk that something like this happens. Or should we say that it is the investor who is looking for that return in exchange for that risk?

There are a variety of ways of getting bitten at this point depending on exactly what you did. Most commonly, the ‘arbitrage’ book suddenly shows a material loss on a mark to market basis. This isn’t too much of an issue in itself if the relative value trade is a genuine arbitrage (i.e. that the longs and shorts are ultimately fungible), though it’s more challenging if it is a strategy trade simply based on a statistical generalisation about the component behaviour. But the financing of the leverage will have been predicated on the quantity and quality of your investment capital which has now shrunk on account of the mark to market losses. The critical question is whether the leverage provider still thinks there is enough capital left to support the trades you have on the book.

Now, the required levels (‘NAV triggers’) of capital, the required ratios to the assets supported and the rules around changing these numbers and the prices at which the leverage is provided should be precisely set out in the legal documentation. But the precise valuation of the book is no longer possible because the market pricing has become chaotic and liquidity has evaporated…that’s the whole reason for the problem in the first place. It’s a big deal because if the capital is deemed inadequate and you can’t shrink the gross book very quickly (because no one wants to put up the cash just now), then the leverage provider takes control of your book. At this critical point, typically no one knows quite where we are because it all hangs on the valuation levels on which the market no longer has a clear opinion. And it is critical because once the leverage provider takes the book, it’s curtains. To escape this dreadful end, all sorts of dreadful decisions can get taken in the chaos of the moment, and these may well have ramifications long after the crisis is passed, if that is, the book escapes alive.

And this is why the problem with fixed income arb strategies recur with every crisis. An efficient market leaves an excess return in these trades which is itself ultimately determined by the very cost and quantity of the leverage that is required to finance them. Or to put it another way, if you don’t take as much leverage as you can, then others won’t leave the prices at a level which affords you a competitive return on capital...so it goes elsewhere. Arbitrage traders bring efficient pricing and provide liquidity to the system, but they live their whole lives in the choppy waters between the Scylla of too much leverage and the Charybdis of too little return. Ultimately it is their ability to navigate this strait that defines their skill, and their ability to survive a whole cycle. To be clear, some do it very well indeed…but some do not.

The second group of strategies to suffer this time were the merger arbs. By trading the spreads between the shares of two companies that are intended to become one, they receive a return for committing capital to the efficient pricing of the probability of success. As with the fixed income specialists, a purist’s arbitrage book has trades both ways round (i.e. some trades, also, that say the probability of closure is currently exaggerated), so in a sudden general downturn, parts of the book benefit from a widening of the spreads. But merger ‘arb’ is, like fixed income ‘arb’, mostly a risk premium in real life with most deals long the risk of failure...or so it seems to have been this time.

For the investor, there are key judgements to make: is this or that manager running more an arbitrage strategy or more a risk premium? To the extent it is a risk premium, can I afford the (quite large) risks when they come for which I am hoping to be paid? Does the strategy in the current environment offer a good prospective return or a bad one relative to the other opportunities in the market now? In short, the same judgements as on any other investment.

But there is new bite to the questions this time round. In 2008, it was the banks who were most highly levered to these risks and the Central Banks had to step in to save them. Since then, their ownership has in some measure been transferred by regulation to both asset owners and asset managers. Whether we have done it well or badly will of course vary, but that the Fed knew all about this was pretty clear from the lightning speed with which they stepped in to become themselves the provider of the liquidity to the fixed income markets where the various arbitrage relationships had been the first to break.

You could of course say, in tones of moral outrage, that the Fed stepped in to bail out the banks last time and the hedge funds this time…albeit indirectly. That may well be true, but it’s also a bit cheap. We want efficient pricing of securities and their derivative hedges; we want returns on our savings; and we want to be able to turn them into cash at a moment’s notice – like now. Well, you can’t have your cake and eat it. There are analytic connections between these wants which mean if we are to absorb sudden changes in the need for cash or the level of risk, then someone, somewhere is going to have to provide the cash on demand from a reserve that is not as productively invested. Who should that be?

Hedge Funds

The month of March was one of the most turbulent for hedge fund returns since the global financial crisis. As the month progressed there was material stress spreading across different strategies at different times. On average, the month finished poorly for the hedge fund industry, but portfolios of hedge funds experienced widely divergent returns depending on the specific strategies and managers held. Indeed, even within strategies there was very large dispersion between the better and the worse performing managers.

As a summary, apart from Macro strategies, which performed positively during March, there was a range of losses across the majority of other strategies. It is worth recapping the timeline of the month’s events for hedge fund managers.

In the first week of March we saw a continuation of the equity market sell-off that began in the last week of February. Initial losses were driven by outright exposure to equities, particularly from longer biased Equity Long-Short managers. While some Relative Value spreads were beginning to widen in the first week and some tension was building in multi-strategy hedge funds, the predominant response was of managers adding risk to take advantage of better entry points for trades. By 6th March prime brokers were reporting managers increasing gross exposure and little sign of panic despite some losses from the hedge fund industry.

The collapse in the oil price on 9th March following the decision by Saudi Arabia to increase oil production led to a large drop in equity prices. More painful than the equity market move was the intra-market dynamics, which by the second week of March was beginning to unravel. Merger Arbitrage spreads and some Fixed Income spreads (such as bond basis trades) were starting to widen uncontrollably. Managers were forced to choose between crystallising losses at levels of opportunity not seen for over a decade, or holding on and hoping the capitulation was not too deep. For managers with stronger financing relationships, a solid investor base and not too much leverage, the latter option was very appealing. Through the middle of the month, markets exhibited a classic domino effect, with managers capitulating in turn and forcing spreads wider. By the depths of the pain in arbitrage trades, spreads had reach levels comparable to those seen in 2008.

As fixed arbitrages finally started to calm and stopped widening, there was contagion into broader equity market strategies. Statistical Arbitrage managers and other quant equity strategies had suffered some losses through the second week of the month, but the largest part of the risk reduction from quant managers took place in the third week of the month and was accompanied by large losses in these strategies.

Another phenomenon of the third week of March was the growing contagion into Credit strategies. Credit had been falling in value during the first half of March, but as with other strategies, the market reached a point of intolerable losses for enough hedge funds that managers began to cut risk aggressively, in concert, leading a negative feedback loop – particularly in less liquid markets. As credit markets became more chaotic, so too did spreads between different parts of the corporate capital structure, with losses for strategies such as Convertible Arbitrage.

In the final act of the month, other strategies started to see losses. Alternative Risk Premia strategies focused on equity factors saw the worst of their pain in the last week of the month. Defensive market neutral strategies, which had performed reasonably positive through the noise earlier in the month, suddenly became the latest area to see deleveraging and managers sought to reduce risk in the few surviving parts of their hedge fund exposures.

By month end, there was some recovery to managers who experienced losses earlier in the month, and risk taking behaviour was quickly turning back to positive, with managers who had come through the month relatively unscathed looking to capitalise on the opportunities arising from the market noise.

The one bright spot for the hedge fund industry was the performance of Macro strategies. Managed Futures generally made money, with extended themes in Commodities and FX helping performance. Discretionary Macro managers also added value, as managers were able to navigate the high levels of market volatility across all asset classes. In particular, the frequency of policy interventions from both central banks and politicians meant that there were plenty of events for Macro managers to trade.

As the dust settles on the turmoil of March, most investors in hedge fund portfolios are nursing losses. However, as with the positive returns in 2009 following the pain of 2008, many managers are looking at the significant disruption in markets as a chance to generate profits for the rest of 2020.

In positive deal news for a number of hedge fund managers, a telecommunications company $59bn takeover has moved forward decisively after a US District Court ruled against a lawsuit filed by more than a dozen states, led by New York and California. The merger agreement has also been renegotiated and the telecom parent company will likely receive a bigger ownership stake of the combined company, while the parent of the acquired firm will get a smaller share, reflecting the acquired company’s declining financials over the last two years.