Tag Archives: ideas

Making The Case For Liquid Alternative Strategies

Hedge funds may make sense for some investors, especially when the opportunities are unique and the allocation is small. Because of their typically high fee structure, lack of transparency, illiquidity, capacity limits, and challenging due diligence process, hedge funds may not be the best choice for institutional investors. That accounts for the growing popularity of liquid alternative investments (LAIs), systematic investment strategies that employ similar return sources as traditional hedge funds. By Wei Ge, Senior Researcher Hedge funds may make sense for some investors, especially when the opportunities are unique and the allocation is small. Hedge funds also offer great potential alpha opportunities for accredited investors or investors with access to information, opportunities, and investment acumen who can extract favorable fee terms from hedge fund managers. Hedge funds are historically organized as limited partnerships, limited liability companies, or similar vehicles that are sold through private channels, allow only a limited number of accredited investors, and typically have minimum investment thresholds in the millions of dollars. Because of their typically high fee structure, lack of transparency, illiquidity, capacity limits, and challenging due diligence process, hedge funds may not be the best choice to be used en masse by the majority of institutional investors. As our understanding of investment returns grows, however, hedge fund returns that were traditionally attributed as manager alpha can now be explained by exposure to alternative beta, and it is increasingly common for analyses of hedge fund returns to be divided into: traditional beta, alternative beta, and finally, “true manager alpha.” True manager alpha is usually elusive, temporary, limited in capacity, expensive, and hard to capture for most investors. In response to these challenges, liquid alternative investments (LAIs) have been growing in popularity and variety. LAIs are systematic investment strategies that employ similar return sources as traditional hedge funds, including: managed futures, event driven trading, carry, liquidity, momentum, value and volatility selling, and others. Because many LAI funds are designed to help investors capture the unique risk-return characteristics of hedge funds, it is not surprising then that such investments are experiencing rapid growth with an increasing array of choices being offered. Today, LAIs come in the form of separate account portfolios, mutual funds, closed-end funds, or ETFs. LAIs have some limitations, too, many of which caused by their shorter and less familiar histories in the market. Because the underlying investments of LAIs need to remain liquid and scalable, they cannot take advantage of the same limited, illiquid, transitory, or more elusive opportunities exploited by hedge funds. Similarly, LAIs cannot replicate many of the highly leveraged strategies used by hedge funds. Nonetheless, investors who are dissatisfied with hedge funds may find LAIs more attractive in terms of reasonable cost, greater transparency, liquidity, a more user-friendly format, and simpler due diligence. Lower Fees – LAI funds usually charge a flat fee, which is much lower than the sliding fee structure of hedge funds. Lower fees leaves a greater share of the return in the investor account, and can represent a significant saving over time compared to hedge fund fees. Higher Transparency – In contrast to hedge funds that have undisclosed strategies and often focus shifts in search of investment opportunities, LAIs typically attempt to monetize on defined strategies and risk premiums, and is fully transparent with its investment objective. A clearly defined investment focus may help investors to construct a portfolio that includes different potential sources of return. Improved Liquidity – LAIs can also be much more liquid than hedge funds, many of which have limits on withdrawals or redemptions. Since LAIs predominantly invest in exchange-traded instruments, they are by design easier to liquidate than hedge fund investments, and can provide reliable daily pricing information. Easier Accessibility – There are several features that make it potentially easier for investors to use LAIs. Because of no limits on the timing or size of withdrawals, and less stringent limits on the number of investors, LAIs may provide more investors access to the alternative asset class. The straight forward construction of LAIs may also create a more even playing field by providing liquid and standardized formats, with a large enough capacity to be available to more investors. Within a diversified portfolio, investors may utilize the core-satellite framework to make asset allocation decisions for the alternative asset segment. They can invest a large portion of the alternative allocation to a core set of LAI funds, utilizing different investment styles, risk exposures, and hedge fund betas as return sources, with generally lower costs and the benefit of transparency and liquidity. The rest of the alternative assets may be invested in high-conviction traditional hedge funds (satellites) that may supply true after-cost alpha and give investors a chance to enhance returns. The core-satellite framework is flexible and comprehensive, easily adjusted to suit the needs of different investors under a wide range of circumstances, especially with the complex decisions regarding liquid alternative investments versus hedge funds.

The Risk Impact Of Valeant Pharmaceuticals Intl Inc On Sequoia Fund

The Risk Impact Of Valeant Pharmaceuticals Intl Inc (NYSE: VRX ) On Sequoia Fund by AlphaBetaWorks Insights “This is your fund on drugs” The Sequoia Fund’s (MUTF: SEQUX ) hefty sizing of Valeant Pharmaceuticals ( VRX ) dramatically changed the fund’s risk profile from historical norms. With the proper tools, allocators would have noticed this style drift back in Q2 2015 when Sequoia’s key factor exposures moved two to three times beyond historical averages. What’s more, allocators would have noticed a predicted volatility increase of 25% and a tracking-error increased 70%. Though this analysis would not have anticipated Valeant’s subsequent decline, it would have warned fund investors that Sequoia’s risk was out of the ordinary. Sequoia Fund’s Risk Profile Below is a chart of Sequoia’s major factor exposures , spanning a ten year history through June 2015: (click to enlarge) Sequoia Fund – Historical Factor Exposures (Note that this analysis and our model do not include Valeant’s recent heightened volatility: we are using the AlphaBetaWorks Statistical Equity Risk Model as of 8/31/15 and SEQUX’s positions as of 6/30/2015. In short, we are looking at the world prior to Valeant’s subsequent downside volatility.) Sequoia’s stock selection and allocation decisions result in certain factor bets such as market beta (“US and Canada”, above), other factors (Value, Size), and sectors (Consumer, Health). The red dots above represent factor exposures in a particular month, the red boxes represent two quartile deviations, and the diamonds denote current (i.e. 6/30/15) exposures. Several sectors/factors are circled for emphasis: they are current exposures as well as outliers versus history. More importantly, these outlying factor bets are the direct result of Sequoia’s large percentage ownership of Valeant. The Impact of Valeant on Sequoia Fund’s Factor Exposures We examined Sequoia Fund’s factor exposures with and without Valeant. We assumed that the pro forma Sequoia Fund without Valeant would have increased all other positions proportionally to make up for the void. For example, we increase Sequoia’s next-largest position in TJX Companies Inc. (NYSE: TJX ) from 7.3% to 10.9%, and so on for all longs for the pro forma non-Valeant Sequoia portfolio. Below is a chart comparing the most salient factor exposures of Sequoia Fund, with and without Valeant: (click to enlarge) Sequoia Fund – Factor Exposures With and Without Valeant Valeant has had a significant impact on Sequoia’s factor exposures. The factors with the highest delta are the same as those highlighted as outliers on the first chart above. This is significant in several ways. First, the large Valeant holding increases Sequoia Fund’s overall volatility by 25%. Second, Sequoia’s tracking error is increased by its Valeant holding by 70%. Sequoia Fund volatility estimates with and without Valeant are below: (click to enlarge) Sequoia Fund with Valeant – Absolute and Relative (to S&P 500) Estimated Risk (click to enlarge) Sequoia Fund without Valeant – Absolute and Relative (to S&P 500) Estimated Risk Valeant increases Sequoia’s overall predicted volatility (tracking error) by 26% (from 9.73% to 12.31%, annualized – gold boxes). Likewise, Valeant increases Sequoia’s tracking error by 69% (from 5.19% to 8.76% – brown boxes). Increases in both Absolute and Relative volatility are due to the incremental Residual Risk contribution of Sequoia’s large Valeant holding (graphically shown by the larger blue boxes in the “with VRX” charts, in contrast to smaller blue boxes in the “without VRX” charts). Conclusions In the end, this analysis is not about Sequoia or VRX. It is a single example of decisions that could have been avoided by a portfolio manager or questions that would have arisen to an allocator with the proper risk toolkit. Sequoia’s decision to make Valeant an outsized position did not go unnoticed from a risk standpoint. Increases in factor exposures of two to three times outside historical bounds were an early warning. The impact of this was increased predicted volatility – both on an absolute basis and relative to the S&P 500. A framework that warns of a fund taking large factor and idiosyncratic bets aids greatly in avoiding negative surprises. Disclosure : None.

Heading Into Winter, Propane Sales Look To Repeat 2014 Results

Summary Propane distributors like Suburban Propane and AmeriGas Partners count on the next few months for substantially all their income. With propane supply near all-time highs, wholesale prices have fallen through the floor. Consumers look to benefit this year, but pricing spreads indicate a repeat of 2014 results. The early indicative data for propane distributors such as Suburban Propane (NYSE: SPH ) and AmeriGas Partners (NYSE: APU ) is a mixed bag heading into the incredibly important winter season. This period running from November-March of each year is an incredibly stressful time for these propane distributors, who derive substantially all of their operating income during the winter heating season. The first hurdle for these companies is the weather. The chance of a deep winter chill currently looks decent for some areas of the United States and mediocre for the rest . Most meteorologists forecast above average temperatures for the Northeast, with below average temperatures for much of the Southeast and East Coast. As the South and Midwest form the largest markets for propane, these forecasts end up being a mixed bag and are hard to call as solidly favorable in one direction or another. (click to enlarge) * Source: EIA.gov From a market perspective, available supply of propane continues to peak well above long-term historical averages, due to the significant bounce in production of the commodity from ever-increasing domestic production. Shortages that were widespread in many markets in 2014 seem unlikely to repeat themselves this time around. This excessive supply has brought wholesale and residential propane prices down, yielding what should be solidly lower prices going into this year’s heating season for consumers. This is a bright spot for those that count on propane to heat their homes, but what does it mean for propane distributors? Fixed Margin Pressures Usually, low propane prices provide a boost for propane distributors like Suburban Propane and AmeriGas Partners. All else equal, low propane costs increase the demand for their products and protects against customers switching to alternatives, such as heating oil or electricity. With propane and other alternative heating fuels more commonly used among rural homes with lower annual incomes, these consumers are much more cost sensitive to price changes than the heating markets served by traditional utilities. Propane distributors, while keeping that fact in mind, still try to maintain a fixed spread between the wholesale and residential cost of propane. This is where they can derive their profit, and we can see the results of that in a comparison from 2014 to 2015 below. (click to enlarge) Trying to protect this fixed margin per gallon is why we see the current market situation in propane today with resiliently high residential propane prices. While wholesale propane prices are down 46% from a year ago according to EIA data, skirting along at $0.50/gallon in 2015 from $0.93 gallon in 2014. Residential prices have remained stubbornly high in the meantime, and are only down 19% year/year. In my opinion, wholesale prices in the U.S. cannot fall much further, so this year will be as good as it can get for propane consumers. At these prices, it is barely worth it for producers to ship, store, and market it for sale. Look for propane exports to increase, as unlike natural gas, propane is more easily shipped abroad for sale, and these price declines make exporting increasingly attractive. (click to enlarge) Heating oil, a chief competitor of propane, looks more profitable going into the winter of 2015/2016. The profit spread is up, but heating oil is primarily used in the Northeast , where it heats nearly 30% of all households. If we remember our 2015 weather forecast data, this area is at this point expected to be a little warmer than usual. The demand may not simply be there for the product compared to 2014. Conclusion With margin spreads down and supply up, propane producers are counting on a chilly winter to drive some additional demand to make up the difference. Without old man winter swirling up some unexpected cold, investors should expect operating income flat to slightly down from 2014 levels. Suburban Propane has the most opportunity for surprise earnings upside over 2014 due to its heating oil exposure, but only if the Northeast comes in much colder than expected. Heating oil is set up to be better currently year/year, and with supply running at long-term averages, a cold shock in the Northeast could drive significant demand for the company.