Diamonds in the rough?

Many investors will remember the first three months of 2008 as one of the worst quarters experienced in financial markets.

Despite several initiatives by central banks — including the rescue of Bear Stearns in the US backed by the Fed and the ‘special liquidity scheme’ introduced by the Bank of England — significant drawdowns were seen in virtually all major stock markets and economic indicators also deteriorated.

Australia has not been immune to the turbulence, with the stock market having lost up to 15 per cent from its October 2007 peak and several high-profile collapses thrown in to underscore the situation.

In this climate, what of absolute return funds — those whose returns are intended to have low correlation to the performance of traditional investments such as stocks and bonds? The theory is that by taking a more flexible approach to investing than traditional long only managers — for example, accumulating both long and short positions — absolute return funds have the ability to perform in the current environment.

And indeed, some absolute return funds have performed spectacularly: two US-based funds made some US$15 billion in 2007 by betting that the US sub-prime housing market would fall in value.

Closer to home, other absolute return funds have also performed amid the gloom.

However, this is only half the story.

Absolute return funds pursue a wide range of investment strategies — techniques include using short selling, futures, options, derivatives, arbitrage, leverage and unconventional assets.

All of these investment strategies will not be equally successful at each point in the economic cycle. Indeed, at times, some absolute return strategies have suffered in the current environment.

For example, the relative value strategy, which typically takes highly leveraged positions in order to exploit mis-pricings between two related assets, struggled because asset prices did not move as expected in normal circumstances, especially in the lead up to the rescue of Bear Stearns.

So the smart question is: in the current economic climate, which absolute return strategies might give investors the best opportunity to profit? Two to consider are managed futures and opportunities in distressed securities.

Managed futures

The first quarter of 2008 was characterised by strong trends in many asset classes, continuing a theme that developed towards the end of 2007.

Some of these trends are well known, such as the sharp increase in gold and oil prices beyond US$1,000/oz (see graph 1) and US$100 a barrel respectively.

In addition, many other strong trends have also emerged in equity, bond, currency and commodity markets. For example:

> Agricultural prices surged at the beginning of 2008, with prices supported by increased demand from China, a weakening US dollar and increased demand for bio-fuel.

For example, the price of soybean futures rose by more than 70 per cent between August 2007 and March 2008 (see graph 2).

> The US dollar fell to an all-time low against the Euro in April 2008, with over US$1.60 required to buy Euro 1. Weakness was driven by credit-market losses, a deteriorating housing market, aggressive rate cuts by the Fed and a sharp increase in the price of oil.

> Short duration government bonds prices increased, due to the combined effect of the Fed’s rate cuts and investors seeking to reduce the risk in their portfolio (the so-called ‘flight to quality’). For example, the yield on two-year US Treasuries fell from over 4 per cent in October 2007 to under 1.4 per cent in March 2008.

> Equity markets fell across the board amid the credit crunch, fears of a US recession, slowing global growth and several other factors. Futures contracts based on equity market indices also fell — the S&P 500 Index futures for example fell as much as 20 per cent between October 2007 and March 2008.

Absolute return managers can use futures, forwards, options and other derivative contracts to benefit from such trends — in industry parlance, their funds are called managed futures funds. These funds use complex and proprietary trading models to analyse market trends, generate trading signals and, importantly, quantify and manage risk.

The funds are able to take both long and short trading positions across a diverse range of markets and sectors, which means they can benefit not only from, say, the increase in oil and gold prices, but also from the decrease in the relative value of the US dollar.

In other words, they are able to profit in both rising and falling markets.

Managed futures funds have been making hay while the sun shines of late. Many are off to their best start in seven years.

Overall, the Credit Suisse/Tremont Investable Managed Futures Index gained 9.28 per cent in the first quarter of 2008, comparing favourably against the performance of local and global stock markets, which have mostly lost between 10 per cent and 20 per cent from previous highs.

This highlights another advantage of managed futures: they can have a low correlation with the performance of traditional investments, including stocks, and can therefore provide valuable diversification to an investor.

Managed futures are not the exclusive preserve of institutional investors either. Quality managed futures funds accepting private and retail clients already exist in the marketplace. Moreover, given that these funds tend to trade extremely liquid instruments (eg. exchange-traded futures contracts), the liquidity on managed futures funds is often attractive. Some funds even allow investors to buy and sell their shares on a weekly basis.

Distressed securities

Is it too early to call the current crisis in remission? There are some encouraging signs. Stock markets appear to have stabilised over the past few weeks, the price of gold has dropped below US$1,000/oz, rate cuts by the Fed may have bottomed out and some have suggested that the worst write-offs among banks and financial institutions have already taken place.

On the other hand, the US appears to be in or close to a recession, banks remain wary of lending to each other and concerns linger regarding the credit derivatives market.

More than anything, uncertainty seems to be the theme for the immediate future.

But is it too early to plant some ‘investment seeds’ that can bear fruit down the track?

In this context, absolute return strategies that focus on distressed securities present an interesting option.

‘Distressed securities’ tend to be either corporate bonds or loans that are trading at a deep discount: at a yield-to-maturity that implies a spread of more than 10 per cent above the risk-free rate, or at a value that is less than 80 cents in the dollar.

Distressed opportunities in today’s environment are appealing because, generally, managers will be able to purchase corporate debt (bonds and loans) at a substantial discount to the prices that were seen prior to the credit crisis and the subsequent fallout. This is the case even for fundamentally sound companies, or companies whose bonds or loans are undervalued compared to the value of their assets.

The reasons for this are interrelated and include:

> the fallout from the sub-prime situation and its effects on the financial system — this has led to a general re-pricing of risk, pushing spreads up across the board and often to a distressed level (ie. 10 per cent or more above the risk free rate);

> The market pricing in an increased expectation of corporate defaults, even though actual levels remain rather low; and

> A ‘spiral’ of forced selling — as prices fell, some investors were forced to sell their assets into an illiquid and stressed market. This in turn drove down prices, which led other investors to sell their positions.

What this also means is that there are more distressed securities in the market today then there were a year ago or, to put it another way, there are more investment opportunities for managers focusing on distressed securities.

The Moody’s Distressed Index shows over 24 per cent of companies trading at distressed levels, the highest since November 2002.

As the economic cycle turns and company fundamentals improve, some formerly distressed securities will begin to increase in value, realising profits for those who had the insight to invest early.

In addition, managers can also take a more active approach to a company’s affairs in order to positively influence the value of that company’s securities, providing another source of potential profits for investors.

Of course, not every security that is currently distressed will recover its value.

Default rates are estimated to be between 5 per cent and 10 per cent for 2009.

It is therefore critical to find an experienced manager that can pick the right distressed securities.

In other words, a manager that has sufficient industry knowledge, company-specific securities selection expertise and the correct identification of and/or diversification of risk associated with trading in distressed securities.

In a nutshell

Traditional investments, such as stocks, have suffered a shaky start to 2008, and most market observers do not see an immediate improvement in sight.

However, it is not all doom and gloom. Non-traditional investments, such as absolute return funds, can provide diversification and the potential to profit even in today’s financial climate.

Two strategies to consider are managed futures and opportunities in the distressed securities sector. For investors looking to make investments in the current climate, they may well be diamonds in the rough.

Hersh Gandhi is the head of product development at Man Investments Australia.