Hedge Funds Q&A: Patrick Ghali, Sussex Partners

Hedge Funds Q&A: Patrick Ghali, Sussex Partners

  • Funds
  • September 5, 2022
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Getting manager selection right in hedge funds is growing ever more important, with dispersion on the rise and choppy markets providing opportunities and challenges for all strategies. AlphaWeek’s Greg Winterton spoke with Patrick Ghali, Managing Partner at hedge fund advisory firm Sussex Partners, to learn more about how his firm sees the current landscape for hedge funds.

GW: Patrick, to begin, tell us what strategies your clients are currently asking you about, and why.

PG: Given the uncertain global outlook, clients, for a while now, have been asking for diversifying, all weather strategies. It has been our contention for some time that it makes sense to avoid traditional, high net exposure equity strategies, as well as traditional fixed income strategies, and instead look for strategies that can provide low correlation, alpha and good convexity during periods of market dislocations. For that reason, we have been focusing on strategies such as macro (both global and, also with an Asia tilt for additional diversification), CTA/systematic strategies, and multi-strategy. Where we have opted to take any sort of equity risk this has been done either via market neutral managers (ideally, such that are also factor and sector neutral) or multi-pm equity funds (again market neutral). To a lesser extent we also employ convertible arbitrage but with managers that are taking little or no credit risk and where we see it more as a play on volatility. Japan and China also continue to remain of interest but for more idiosyncratic reasons, with China currently dividing opinions of clients; some see it as a great opportunity given where valuations are, and others are completely avoiding it for now.

GW: Hedge fund performance dispersion is on the rise, making manager selection more difficult. What are a couple of the things Sussex Partners looks for on the IDD side that you think leads to persistent alpha?

PG: Whenever possible, we look for strategies that take advantage of market inefficiencies. It is a lot easier to generate alpha in such markets. For this reason, we also tend to avoid overly efficient markets. A good example of a strategy we are not so constructive on, and have avoided for some time, would be US long short as it is very crowded, with lots of very smart managers with big budgets all competing against each other. As a result, crowded trades and short squeezes can be problematic, and correlation among managers can be very high. Managers also often have to resort to some sort of activist stance to add some value, which adds additional risks. It is often hard to see what added value a specific manager has in such a market versus its peers. Of course, we also look very carefully at risk management, and try and understand how flexible, or not, managers are. Some of the high-profile losses this year seem to have stemmed from managers not being able to change their point of view, and very stubbornly sticking with a world view that didn’t work in a rising rates environment. We try and understand how married to their positions managers are, and also how good they are at volatility-adjusting their risk. We have found in the past that arrogant managers tend to generate outsized losses, whereas more humble ones tend to be better at adapting when markets prove them wrong. This is a soft factor but an important one. You have to accept that you will lose money from time to time when you invest, as all investors can and will make mistakes, but how they handle these is key, and arrogant managers tend to dig in and let losses spiral out of control as they cannot stomach being wrong. Lastly, though we are not a macro firm, we do have a view of the world, and if we feel that what a manager is doing just doesn’t make sense in a given environment, we will avoid them. Having a repeatable and robust investment process is another factor we look for. It is important that we can understand how returns are generated, how sustainable the alpha that a manager purports to deliver is, and importantly in which environment we would expect them to lose money or struggle, and why. If we cannot understand that, we tend to shy away.

Patrick Ghali
Patrick Ghali

GW: You’re well-known for your bullishness on Japanese hedge funds; you’ve been building relationships in the country for many years. What are some of the current concerns and opportunities you see for Japan-based strategies and managers?

PG: I recently returned from my first trip to Tokyo in almost three years, as it was previously impossible to travel there due to ongoing Covid-19 restrictions. This gave me a chance to catch up with quite a few managers face to face for the first time in a while. The main issue I see with Japanese managers, and this applies to global managers as well, is that markets generally have not been trading on fundamentals in the recent past. A lot of Japanese managers are fundamentals-driven managers. The Japanese hedge fund market is really an equity market, and the edge many Japanese managers have had in the past is the lack of analyst coverage and the vast universe of Japanese equities where they could conduct primary research and therefore profit from that research. However, in a largely liquidity driven market, significant distortions can occur and persist for a while, and for many managers, that has been quite tough. Trading oriented managers have been able to better weather this environment, but it is often harder to understand whether a trading manager has a sustainable edge. An additional headwind has been the global rising rates environment, and just as in the US, some Japanese managers have underestimated the impact this would have on valuations. Additionally, liquidity in Japanese markets has been somewhat poor over the past 18 months, with liquidity only really available at the open and close, coupled with a lack of foreign participation which can move prices to more extreme levels in a short period than perhaps would have happened otherwise.

The other topic that is very relevant is whether the Bank of Japan can continue to keep rates where they are. A lot of global investors seems to think that the BoJ has little choice but to raise rates, and that hence the JPY is a screaming buy. Interestingly, this is not a view that seems to be shared at all by local Japanese hedge funds or large institutional investors, which by and large feel that rates will remain low for some time, and that the JPY has no real catalyst to appreciate significantly and imminently. Their view is that inflation remains low, the BoJ would be happy for some inflation to become entrenched, and that at least until there is a change of guard at the BoJ, a change in policy is unlikely (and even after that, some feel there won’t be much impetus for change). I guess time will tell, but I thought it was interesting to hear how diametrically opposed the local view was versus the global narrative on the same topic.

Having said all of this, the long term backdrop hasn’t really changed for Japanese hedge funds in a fundamental way, and hence I think opportunities will continue to present themselves. Over a medium to long term time horizon, the alpha opportunity for these managers should remain robust. The fact that markets have not been reacting to fundamentals is a global, not a local, phenomenon, but with quantitative tightening and rising rates, fundamentals should come to the fore again as we have already seen happen to some degree.

GW: Managed futures strategies have been doing well this year; most of the data companies out there show that these programs have been amongst the best performers in 2022. Any thoughts here?

PG: We have been using these strategies for a long time; however, the problem is that it is very difficult to predict performance. We therefore always create baskets of funds that have a different approach (e.g., short term, medium term, machine learning/AI, Asia, etc.). We are continuously looking for managers that can add additional diversification either by having a very different approach or using new technology (such as machine learning or AI), or by focusing on a different geography such as Asia where the return drivers for local markets differ from those of the main US and European markets. We have found that by doing this we are able to create better and less volatile outcomes. The main challenge for these strategies tends to be choppy, directionless markets, so sizing is also key as they can go through extended periods of small losses which can be a drag on performance over time. However, in the current environment, we think it makes a lot of sense to have an allocation to these types of strategies.

GW: Finally, Patrick, you also have strong views on hedge fund index data. Can you tell us why this frustrates you, and what do you think investors should be focusing on here?

PG: I think it is too simplistic to just look at an index and to come to any meaningful conclusions from this. There are some indexes which are well constructed, but we usually create our own peer groups rather than to rely on an index. Hedge funds are quite complex, and it is important for us to really understand what the return drivers are and to make sure that we are comparing apples with apples. It can be very difficult to really get a good sense for what is really going on with a strategy, let alone with the industry as a whole, simply by looking at an index. Indices are also of course skewed by assets, and with equity long/short being the largest strategy by AUM, performance by those managers has an outsized influence. However, there is a lot more to the industry than just equity long short, and strategy selection during different market regimes is important and can create very different outcomes for investors.

Patrick Ghali is Managing Partner at Sussex Partners

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