Siddhant Jain Jaiswal
A storm is coming – reading this phrase, what are the odds that your mind painted a picture of a hurricane, or you looking for a shelter? Knowing where the shelters are, i.e., having a game plan in place, can help you survive the storm. In this scenario, the storm refers to an ‘event’, the game plan to a ‘strategy’, and when applied to the world of hedge funds, it is known as an event-driven strategy.
An EDS traditionally aims to profit from the outcome of specific corporate events. These events include, but are not limited to, corporate transactions such as mergers, acquisitions, spin-offs, and even bankruptcies.
To illustrate this concept, let’s consider a scenario of a company that is ‘in distress’ (e.g., has defaulted on debt payments or coupons, filed for Chapter 11 in the US, etc.). Often, a distressed company’s debt will trade at an overly diminished price as a result of market inefficiencies.
Traditional corporate-bond investors generally liquidate positions when they become distressed either due to the guidelines in their mandate or because of human nature – traditional managers would rather get rid of a ‘nightmare position’ in their portfolio than have it hanging around as evidence of a bad decision. As a result of this sell-off by the institutional world, the debt of distressed companies falls to irrationally low levels.
This marks an entry point for event-driven funds, that have no mandated restrictions on owning distressed debt. The EDFs have the ability to take advantage of their beliefs that the market is undervaluing the potential returns to the stakeholders as a result of a successful restructuring, sale, or liquidation of the investment target.
These EDSs are a particularly attractive set of hedge fund strategies in times of economic downturns. The global hedge fund industry’s assets under management fell below $3 trillion in the first quarter of 2020, as investors withdrew capital amid market turmoil.
The latest outflow is the fourth largest in industry history, with the three largest amounts occurring during the global financial crisis from the fourth quarter of 2008 through the second quarter of 2009. Of these withdrawals, EDFs experienced an estimated $2.4 billion outflow, reducing the overall strategy capital to approximately $740 billion.
According to Kenneth J. Heinz, president of Hedge Funds Research, investors reacted to the unprecedented surge in volatility and uncertainty driven by the global coronavirus pandemic with a historic collapse in their tolerance for risk and the largest redemption of capital from the hedge fund industry since the financial crisis.
Hedge funds used to have an almost superhuman aura about them; EDFs, for instance, generated annual average returns of more than 3% above the S&P 500 index from 1990 to 2009. It is probably not a coincidence that this timeframe included some of the financial industry’s biggest crises: the infamous Long-Term Capital Management crisis (July 1998-Aug. 1998), the GFC (Aug. 2007-June 2009) and the dot-com bubble (March 2000-Oct. 2002).
Given that, historically, EDFs have outperformed during a crisis could EDFs weather the current storm (market crisis) being caused by COVID-19? Before the crisis, between 2009 and early 2020, EDFs lagged the broader market by a fair amount. In quarter one of 2020, though, all has changed. The S&P was down 21% while EDFs were down just 15.1% (HFRIEDI Index). Investors’ fears prompted a major sell-off in February and March 2020 – this is when the defensive strategy of the EDFs outperformed the S&P 500. It is important to note that March 2020 was the most volatile month on record for the S&P 500.
Many institutional investors have been satisfied with the defensive role that the hedge fund portfolios have played during the pandemic so far. One thing is for sure, today’s hedge fund class is more resilient than during the GFC. In fact, the ferocious market conditions observed in the first quarter so far were a good test of the power of diversification hedge funds offer.
The current dislocations created by indiscriminate selling from traditional asset managers have created significant opportunities for hedge funds, especially the EDFs. The EDFs are currently training their sights on a range of event-driven opportunities stemming from the demand-supply impact as a result of the COVID-19 outbreak (i.e. to position their portfolios ahead of key catalyst events.)
It will be interesting to see a push-and-pull effect over the coming months, as capital moves from liquid strategies into longer term, illiquid strategies. The current market will require the active managers to take a page out of the distressed-credit playbook, getting involved in creditors’ committees, potentially negotiating the exchange of debt for equity etc.
Given the uncertainties around the pandemic, investors are faced with a crucial question: Continue to ride the COVID 19 storm of volatility in the traditional equity and credit markets or seek some form of shelter? If a shelter is a better option, could EDFs provide the shelter from the storm?
By the end of a storm, a shelter is meant to keep you safe, and not make you feel comfortable.
Please note: This article is not suggesting that EDFs are right for each investor. You must do your own research and be aware of the risks of each investment, but they could warrant a closer look and may serve as a useful diversification tool. As always, consult your financial professional before making any investment decision.
Siddhant Jain Jaiswal is a member of the CFA Society Cayman Islands board.