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Structured Credit Hedge Fund Strategies

There are two categories of entities responsible for structured credit hedge fund strategies. These are beta managers and alpha generators.

Many believe that opportunities in the beta strategy are already nearing their end.  They also hold the opinion that risk adjusted returns from structured credit beta managers are not appealing. On the other hand, inefficiencies in structured credit markets work as an opportunity for alpha generators. It provides the chance to create strong alpha-driven risk adjusted returns relative to alternative hedge fund strategies.

Beta Managers

Beta managers are basically long-biased managers with a degree of leverage. They usually experience a net exposure of 75 to 200 percent. Managers add value through security selection with a low rate of turnover. Many beta founders had their start after the financial crisis in 2008. The crisis led to managers taking advantage of depressed securities prices and double digit spreads above that of treasuries.

There was a decline on interest rates and credit spreads in the period between 2009 and 2014. The decline resulted in added risk and control on a major amount of assets in structured credit hedge funds. Furthermore, structured credit underwent a major change. It  evolved from an unconventional niche strategy to a long term core item in investment portfolios.

Presently, housing recovery and the potential bottoming out of interest rates and credit spreads lead to the end of the trade. Beta managers have been suffering a decline since 2014. Moreover, they are also exposed to the risk of widening credit spreads.

Alpha Generators

The alpha generating types focus on gaps in the inefficiency of structured credit markets. They do this to take advantage of mispriced relative values. Alpha generators typically have lower net exposure and their portfolios’ tail risks are hedged. Turnovers are more frequent and returns are independent from leverage or directional bets.

Junior tranches of non-agency residential mortgage backed strategies is a common illustration. Entities find that shortening the involved market is extremely difficult. Thus, credit index default swaps are used in hedging. It offsets market risk and allows investors to benefit from mismatches. This applies in the mismatch between demand from protection buyers/sellers in varying maturities.

Evolution of Structured Credit and Market Efficiencies

The financial crisis had the consequence of the effect of the Volcker Rule implementation. This resulted to the severe decrease in dealer capital support on market making of securities. It also led to closing of proprietary trading desks. As an effect, the system moved the expertise on pricing to hedge funds instead. Dealers do not actively facilitate two-way markets in many securities.

The central clearing for credit default swap indices was introduced. Its introduction greatly reduced counterparty risk involved in such similar contracts. It also improved liquidity in index products. The indices have provided an effective means in hedging credit spreads and have low exposure to market direction.

Credit default swap index markets are deep and allow trading with a significantly tight bid-offer spread. They are an effective way to hedge credit spreads due to low costs and efficient use of capital.

Potential risks

Liquidity risk is present in both alpha and beta managers in securities portfolios. Liquidity mismatch can occur in periods of market distress because of lack of dealer capital. Dealer capital usually smoothens capital flows. Having the appropriate liquidity terms and gates help prevent force selling and provides benefits in sell-offs.

Beta funds face risk from outright market exposure. Meanwhile, alpha generating funds are exposed to basis risk. Entities cannot short a majority of structured credit bonds. CDs on high yield, investment grade, buy equity options for hedging, and commercial real estate indices are some exceptions.

Lags between different credit markets can lead to long asset and associate hedges not moving together. The basis risk is smaller than targeting unhedged long-only exposure because markets tend to be more correlated in distressed situations.

Managers should be attentive on tail risk present in fixed income securities. Credit default swap markets provide ways to hedge credit spreads and use positive convexity positions. These provide good downside tail protection.

Conclusion

Alpha generating funds possess a lot of potential because of the opportunities to take advantage of price inefficiencies. Beta-driven strategies are more risky due to leverage on low-carry return stream strategies to reach return targets.

The industry expects great distressed long-only beta trades sometime on the next credit cycle. In the meantime, it is best to invest in hedge funds with low market exposure.

 

 

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