Deutsche PWM backs equity long-short

In the second of a two-part Q&A, Karen Tan of Deutsche Bank Private Wealth Management gives her outlook on hedge-fund strategies, which includes avoiding highly leveraged fixed-income arbitrage.
Deutsche PWM backs equity long-short

Having already looked back at hedge-fund performance over the past couple of years, Karen Tan of Deutsche Bank Private Wealth Management in Singapore gives her take on strategies for the coming months.

Tan is a director in the hedge fund group, having joined Deutsche Bank in April 2007. Before that, she worked for Citi Private Bank in Singapore, most recently as head of product management for the advisory range of managed products.

What are the key lessons for investors, given how events have played out for hedge funds in the past few years?
The events of 2008 carry several lessons for investors. First, manager selection was more important than strategy selection, so issues like manager experience and alignment of interest with hedge fund principals and portfolio managers are of critical importance.

Second, hedge funds must have independent risk-control functions and a list of reputable and known service providers.

Third, it is imperative for investors to know what their hedge funds are investing in and to understand the drivers of returns for different strategies and allocate assets accordingly, as this will influence hedge funds' ability to manage their asset and liability profiles. If the underlying investments are not market traded, a manager may run into valuation issues in times of liquidity constraints and thus not be able to fulfil investor redemption demands.

Finally, it is important to know broadly the investor constituent in a particular fund -- a hedge fund with significant institutional investor base would be less likely to find itself in a liquidity crunch.

What are the trends and themes investors should expect from the hedge-fund industry in 2010?
We expect 2010 to be a challenging year, with increased volatility and a need for tactical changes in asset allocation as well as within asset classes. Thus the environment can be expected to be a less supportive 'beta picture'. Therefore both top-down alpha via dynamic asset allocation as well as alpha via manager and strategy selection will be crucial for a successful investment year. 

The hedge-fund industry is starting to embrace the use of more managed accounts and even Ucits III, given the push by hedge fund investors towards liquidity, transparency and regulation rather than performance per se. Ucits -- essentially retail funds authorised by a member of the European Union with rules on investment behaviour -- promotes investor protection and disclosure by operating within a regulatory framework.

Which are the most appropriate strategies to invest in within the hedge-fund space?
Our preferred strategy currently is long-short equity as a means for controlled participation in stock-market moves. We expect stock-picking to become more important in 2010 due to expected higher dispersion of single-stock returns after two years of extremely high correlation (2008 on the way down, 2009 on the way up).

We expect emerging equity markets to outperform developed markets on both a three-and twelve-month horizon for both structural and cyclical reasons. Within a hedge-fund context, while the strategy [long-short equity] is generally recognised as more of a beta play, as many managers have long exposure, the less efficient markets also provide opportunities for alpha generators.

The strategy lost much less than long-only emerging-market equities during the crisis and was down only 9.9% as of December 31 since the stock-market peak in October 2007. This compares to current losses of -22.3% for long-only emerging-market equity investments since the peak (MSCI Emerging Markets Total Return US Dollar, up to the end of December).

Continuing the trend, the strategy limited losses to -1.1% in January and -0.7% in February (according to the HFRI Emerging Markets index), further illustrating that astute hedging techniques can mitigate the high-risk nature of emerging-market investments.

What about other strategies, including ones to avoid?
From a strategic perspective, we have always advocated the use of CTAs to stabilise hedge-fund portfolios. However, the dynamic nature of the strategy calls for a continuous analysis of return streams and trading positioning of the respective funds when managing the strategy tactically. We recommend an underweight in the strategy for the time being.

In turn, we recommend to slightly overweight discretionary macro, which leads to our current slight underweight position in the global macro strategy (CTAs/discretionary macro) overall. 2010 should provide a wealth of macro-driven trading opportunities related to the preparations of monetary exit strategies and fiscal policy developments.

While most countries have been hit hard by the crisis in a synchronised fashion, the recovery phase is likely to be characterised by a high degree of dispersion in terms of economic performance. Accordingly, regional capital markets are expected to react in more differentiated way. Skilled discretionary managers should benefit from these developments. 

We are currently neutral on the event-driven strategy as a result of a slight underweight recommendation on merger arbitrage and slight overweight recommendation in distressed debt.

However, over the course of 2010, we expect to turn more bullish on event-driven and merger arbitrage strategies in particular. This is because they tend to excel in a relatively well-behaving or even sideways stock-market environment, and very strong upward stock-market moves are not a prerequisite for robust performance.

We continue to see opportunities in outright distressed investing, after company defaults. However, such opportunities are more appropriate for investors with a higher risk appetite and illiquidity tolerance.

We currently have a slight underweight recommendation for relative-value strategies overall. Within the style, we continue to favour convertible arbitrage, which rebounded strongly over 2009. While the 'normalisation trade' is over, we continue to see good traditional arbitrage potential, with leverage below historical averages, a more diversified investor base and a decent degree of stock-market volatility -- all of which provide a supportive backdrop for convertible-arbitrage activity.

While we are underweight equity-market neutral from the perspective that such degree of defensiveness is currently unwarranted, risk-adverse investors may still be attracted to this strategy.

We continue to avoid highly leveraged fixed-income arbitrage strategies.

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