During the course of the subprime debt crisis that began last summer, we have heard on a number of occasions that this bank or that bank did not have exposure to subprime per se but were hurt by the resultant liquidity crisis. But when markets experience widespread turmoil, they begin to correlate.
Stonebrook Capital Management is launching a proprietary hedging program targeted to funds of funds, aiming to reduce risk and improve returns during times when diverse strategies may begin to correlate.
Jerome Abernathy, chief investment officer for Stonebrook, says, “When markets have risky episodes like the one we have just gone through, all correlations go to 1.0.” He says it is a problem of contagion, which causes otherwise non-correlated asset classes to correlate and leads to huge losses. What he was looking for was a way to, “hedge these events regardless of asset class.”
The program has produced strong pro forma results. Applied to one fund of funds last August, the strategy would have improved the funds’ performance from -0.26% to 1.6%, says Abernathy.
Abernathy recommends an allocation of 3% of a fund of funds’ assets to the program that works as a risk overlay. The strategy uses a number of measures of risk to determine when an allocation should be made, but the majority of the time that allocation will remain in cash.
The strategy is meant to handle extreme events and is usually triggered once every few years. These aren’t normal times though, and the strategy has been triggered three times in the last year. First in late July to mid-August, second in late October through November and most recently in late December through January.
When the strategy detects the markets entering risky territory it does two things: purchases “flight to quality” type instruments in the form of U.S. Treasuries and sells small cap and emerging stock indexes. “The program has demonstrated outsized returns during down months, precisely when managers need it most,” Abernathy says.
Teaming up
With the world’s regulators talking about greater cooperation, it only makes sense for professional groups representing hedge funds to work together as well. And in April, the Managed Funds Association (MFA) and Alternative Investment Management Association (AIMA) announced that they were entering an alliance to work more closely together and collaborate on key initiatives. Richard H. Baker, MFA president and CEO, says the two groups have already worked together and have a common goal of supporting principles-based regulation. “The market is a composite of investors and firms in the global markets, so the standards of AIMA and MFA should be consistent,” Baker says.
