Event-Driven in 2012: Rich Opportunity Set, but Beware of Macro and Crowds

Mar 13 2012 | 8:39am ET

By Anne-Gaelle Pouille, Associate Director, Pacific Alternative Asset Management Company -- 2011 was a disappointing year for many event-driven hedge funds, as illustrated by the Dow Jones Credit Suisse Event-Driven Hedge Fund Index and the HFRI Event-Driven Index (-9.1% and -3.0%, respectively). Yet despite frustrating recent performance, the longer-term track record of the strategy remains compelling (over a ten year time period, from 2002—2011, the Dow Jones Credit Suisse Event-Driven Hedge Fund Index ranks as the third top performing strategy of the ten strategies ranked in the index). So has something fundamentally changed the attractiveness of the event-driven strategy or is this a “poor run” that will revert? Is the event-driven alpha engine broken or just in need of a tweak?

Event-Driven Environment in 2011 and Outlook for 2012

In 2011, event-driven faced a “Bermuda Triangle” of external factors:

  • Most impactful was the macro-economic volatility that created a series of “risk on/risk off“ reversals globally; this caught many event-driven managers wrong-footed and caused event realization to be delayed.
  • Markets for the most part did not trade with fundamentals. Given the value bias inherent to the event-driven strategy, this disconnect meant that not all the value was crystallized even when events did happen.
  • The risk-free rate remained low, which lowered absolute return expectations from spread trades such as mergers and acquisitions.

For 2012, we believe the third factor—the low level of the risk-free rate—is very likely to persist. However, the first two factors may be less important drivers this year. We are already seeing a pick-up in dispersion indicating higher expected rewards from security selection. In addition, volatility across markets has declined. While we remain uncertain about the specifics of the macro outlook, recent events do point toward at least a softening of macro-driven risk reversals. In brief, the environment in which event-driven hedge funds operate seems to be improving into 2012. Let’s now turn to the pipeline of event trades.
 
Robust Pipeline

There is a well-documented, structural bull case for the event-driven strategy based on the continued existence of functioning capital markets and on the strategic imperatives companies around the world face to engage in corporate actions. Currently, many of these companies are sitting on high cash levels. Below are a number of the more prominent themes PAAMCO sees for 2012.

Implementation Considerations—Suggested Tweaks to Keep the Alpha Engine Running

From where we stand today there are considerable potential return-generating opportunities in event-driven for 2012. This would indicate that the key challenge for investors for 2012 is not the event-driven opportunity set, but rather adequate downside risk management and appropriate investment structuring. With this in mind, we believe that event-driven managers in institutional portfolios should preferably be:

  • Early into mostly original trades. By definition event trades tend to get crowded because they act as “focal points” for capital. Strategy draw-downs in 2008 painfully highlighted how vulnerable event-driven investors are to what other hedge funds and their investors are doing. Our preferred control approach for this risk is to favor smaller managers with AUM levels that should allow them to be nimble and to look for exposures outside of the more common event trades. There is no substitute for position-level transparency to monitor the size and nature of trades.
  • Macro-aware, not macro-obsessed. Clearly the world has become more macro-focused in recent years and event-driven managers are increasingly macro-orientated. Certain managers may actually be skilled at trading macro themes; for example, in our experience, managers with prop desk backgrounds tend to be particularly adept. In general, however, ask yourself what the manager’s core skill set is. Because of the risk of style drift and our view that macro trading requires a very specific skill set, we tend to favor event-driven managers who are macro-aware, but who don’t try to be macro traders.
  • Managing concentrated “high-conviction” portfolios. Each event trade requires a heavy investment in research. Therefore, it may be beneficial to ask your event-driven manager to focus on fewer trades in more depth. In addition, more often than not, your risk tolerance as a holder of a diversified hedge fund portfolio may be higher than that of an underlying manager. The use of separate accounts with transparency enables the construction and monitoring of higher concentration portfolios (relative to the commingled equivalent) that are designed to harness the manager’s best ideas.

Anne-Gaelle Pouille, CFA, CQF is a Portfolio Manager responsible for hedge fund selection and portfolio construction in PAAMCO’s Event-Driven strategies. She is also the Portfolio Manager for the firm’s Pacific Corporate Opportunities (U.S. Dollar), Ltd. commingled fund. Anne-Gaelle received her MBA from Harvard Business School, her MS (Distinction) from the London School of Economics, and her BS (First Class) from Imperial College London.

 


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