This time next year: 2006 and hedge funds

Dubai: "This time next year we will all be millionaires," was the frequent refrain from Del Boy to Rodders in the comedy classic Only Fools and Horses.

Sitting around a room of hedge fund managers has a similar air to Del Boys market lane environment as all of them expect their fund strategy to be the right one for this year.

Comedy needs to be near to the truth, right? Well this is the near-truth, like the market or souq, the hedge fund guys are generally tied to absolute benchmarks for performance purposes.

It means that a benchmark of, say, 8 per cent per annum needs underlying assets that will deliver. Same as the market, Del Boy can't sell tape record-ers anymore; he needs to find Lorries from which music downloading technology falls, then he simply picks them up and sells the right product into the market at the right price. Get that right and he becomes a millionaire.

The hedge fund space is an intriguing market place where strategies like fashion and taste change. It's also confusing. For help on the subject I spoke with Derek Stewart, Director and Founder of Mellon Global Alternative Investments, boasting assets in excess of $637 million.

Differentiator

Is Derek a Del Boy? The differentiator is the fact that Stewart's role is not to trade in the market but to study the market. Work on it and not in it. Got it?

Stewart's differentiators can be seen at two levels: dictating strategy, and picking a team of managers to run with that strategy. This means that The Mellon approach to the hedge world is a multi-manager approach.

Yet, the clear message from Stewart is that, "of the two, strategy or asset allocation, is the key determinant of performance". Performance against benchmarks will be influenced primarily by asset allocation and only secondly by the fund manager.

One of the biggest influences on strategy will be the performance benchmark.

"Mellon Sanctuary, the group's flagship fund, is targeting a benchmark of two or three times the risk-free rate" says Stewart.

"With the US dollar risk free rate approaching 4.5 per cent the target is rising to above 8 per cent, in addition we are looking to maintain standard deviation at around our historical average of 2.5 per cent".

In laymen speak; this is a fund targeting real absolute growth with very little volatility. Steady growth rather than spectacular performance numbers reflect the investment temperament of this fund.

So, what does Stewart see as the main drivers of asset allocation at present? The sub-title to this question would read: why will the Mellon Sanctuary Fund be in better shape this time next year? Two big trends stand out in Stewarts mind.

Trend One: described by Stewart as "shareholder activism". Shareholders are increasingly looking for value this year, a "fast food" mentality on performance.

The upshot is what Stewart and the hedge space call "special situations".

Translated it means special situations which force a change in the value of a company.

This means understanding the corporate lifecycle. Briefly, the corporate lifecycle would witness more than normal corporate defaults as interest rates rise and as debts become increasingly difficult to service; near to the top of the interest rate cycle distressed debts peak; with rising rates merger and acquisitions also drop off.

At the other end of the interest rate cycle, low rates encourage mergers and acquisitions and provide a stable environment for equity growth.

Bottom line, we are still in (but moving upward) a low rate environment, and Stewart believes that this environment will remain the same for at about a year, meaning stability for equities, and a breeding ground for shareholders to push for good results, creating "special situations" such as planned corporate reorganisation, management changes, mergers, acquisitions and so on.

It's the management of this area that creates the pricing opportunity.

Stewart describes the Mellon process as "looking for inefficient information" and describes a stock such as Citibank as "efficient", in that as soon as news of corporate restructuring emerges the news has already been seen by every trader and fund manager.

The news is easily followed and quickly dispersed. The better rewards Mellon anticipates will come from "under-followed small to mid cap stocks", says Stewart, which is where Mellon's proprietary research and analytical tools prove their worth.

Trend Two: described by Stewart as "the convergence of hedge fund managers, private equity mangers and particularly the leveraged buy out funds".

He might have meant this heading as a consequence of "shareholder activism", but it's my column, and it's an intriguing stand-alone observation.

Leveraged Buy Out firms look to for companies where they feel that a new management and financial structure is required to improve the value of the company.

To achieve the value change the leverage buy-out includes the purchase of the company at X and then selling it for a multiple of X.

Hedge funds have similar objectives in that they are looking for corporate values to change, but they take limited positions in any one company.

Mellon's position for example would not allow the weight of any investment to be too big, this provides for greater flexibility particularly in adding greater liquidity to the overall fund.

LBOs, by definition, are in there until it's all done and dusted.

Ultimately, Stewart's point and prediction is that the hedge space winners for 2006 will be those managers and investors who focus on "special situations".

Shareholder activism

The managers that execute Mellon's instructions will be researched for their ability to implement strategy.

Certainly they will all be visited and inspected, but they are only incidental to the performance drive.

With shareholder activism on the increase, with the Leveraged Buy Out firms targeting similar deals the winners will be the most nimble players exploiting the areas of greatest "inefficiency". It's not a job Del Boy would relish!

- The writer is the Managing Director of Mondial (Dubai) LLC.