Ferd External Managers - 2009 summarized
- 2009 was a year of high activity and sound results
- The hedge fund portfolio outperformed its benchmark in a strong hedge fund market
- Advantage was taken of attractive opportunities in the secondary market for hedge fund units, with good results
- The newly-established Special Opportunities portfolio has so far achieved a high return
Ferd External Managers has approximately NOK 3.5 billion of funds under management, allocated between the four portfolios of Hedge Funds (42%), Special Opportunities (22%), Equity Funds (21%) and Private Equity (15%)
Hedge Funds. Ferd’s objective for the management of its hedge fund investments is to achieve a satisfactory risk-adjusted return over the longer term, both relative to the market and in absolute terms. In addition, the hedge fund investments are intended to represent a risk-reducing factor in the group's overall portfolio.
The portfolio comprises investments in funds that are judged to have good investment managers and that represent a range of hedge fund strategies. A key factor in the analysis carried out to select investment managers is differentiating between return created by general market movements and return created by the manager's performance.
In order to achieve good risk diversification, it is important that the composition of the portfolio features a range of funds which generate returns that are not dependent on the same factors. In addition, the hedge fund portfolio will normally have a relatively small weighting in funds that are heavily exposed to the stock market, since a large proportion of the group's other investments are exposed to stock market factors.
The portfolio is invested in USD denominated investments, and the investment return generated is measured in the same currency.
After a difficult year in 2008, the hedge fund market recovered strongly in 2009. Ferd’s hedge fund portfolio generated a return of almost 16% for 2009, while the portfolio's benchmark index gained just over 13%. This represents in simple terms outperformance of 2 percentage points. However, our portfolio has shown consistently lower risk (volatility) than the hedge fund market as a whole. In order to even out this difference in risk, the portfolio has been financed in part by external borrowing. The return on the portfolio's equity was 24%, which represents a risk-adjusted outperformance of 10 percentage points for 2009.
Ferd has now invested in hedge funds for four years, and its experience over this period has been very pleasing. NOK 100 invested in the portfolio at the start of 2006 was worth NOK 128 at the end of 2009. This represents an annual return of 6.3%. The equivalent amount invested in accordance with the benchmark would have grown to NOK 103. The total out-performance by the NOK 100 investment is accordingly NOK 25, showing that Ferd's portfolio has outperformed the reference index by 5.5 percentage points. By way of comparison, investments of NOK 100 in the global equities index and in the Oslo stock exchange would have grown to NOK 101 and NOK 112 respectively. If the comparison also takes into account that Ferd's portfolio has shown lower volatility than the hedge fund market, and markedly lower volatility than the stock market, the risk-adjusted outperformance is seen to be even greater.
Secondary market for hedge fund units. A major feature of the global financial crisis was that most types of investment suffered a sharp decline in liquidity. This had a significant adverse effect on the hedge fund market. Many investors unexpectedly needed to release much more liquidity than they had anticipated, while at the same time many hedge funds found that their underlying investments could not be traded as readily as they had expected, and this meant that some funds were not able to release funds to meet their investors’ demands. This led to a sharp increase in the level of activity in the secondary market for hedge fund units. A combination of many sellers and few purchasers meant that fund units were traded at big discounts to their underlying value.
Ferd External Managers was active in this market, and purchased units in 2009 in eight hedge funds that we consider to be good-quality funds. The average discount achieved on these purchases was around 20%. The first of these investments was allocated to the Hedge Funds portfolio, while the subsequent investments were allocated to the Special Opportunities portfolio.
In aggregate, the funds in question have produced a 48% return since these investments took place, and if the purchase discount is taken into account this represents a 66% return. In addition, the units purchased carry the benefit of lower management fees, since we also acquired the sellers' benefit that money lost in 2008 must be earned back before the investment manager is entitled to profit-sharing.
Special Opportunities. Ferd External Managers won approval to establish a new portfolio to take advantage of the many attractive investment opportunities that became available in the wake of the financial crisis, particularly in the areas of high-yielding Norwegian bonds, subordinate bonds issued by banks and financial institutions and hedge fund units in the secondary market. The investment mandate for the Special Opportunities fund was approved in April 2009 with an investment limit of NOK 500 million. A further NOK 100 million was allocated to this portfolio in November 2009.
The Special Opportunities portfolio is managed with a focus on risk-adjusted return, and it is subject to a high expected potential return in relation to its risk exposure. Potential investments are analysed on the basis of protection against downside risk by evaluating the security margin the investments offer in the event of adverse developments. The security in question may take the form of asset collateral associated with a bond issue, or hedge fund units purchased in the secondary market at a price that represents a discount to the underlying value of the units.
The objective is to make the total value of the portfolio less dependent on movements in the equity and bond markets, and more closely linked to concrete events through each investment choice that is made.
The value of the Special Opportunities portfolio at the close of 2009 was NOK 770 million. The appreciation of NOK 170 million is equivalent to an annualised return of 78%. This performance is very sound, particularly by comparison with the results that might have been achieved from alternative types of investment. The same amount invested in the Oslo stock exchange would have produced an annualised return of 62%, while the equivalent return for investing in hedge funds and high-yield bonds would have been 13% and 33% respectively.
Equity Funds. The assets of the Equity Funds portfolio are invested in index funds that offer exposure to global stock markets. This type of fund offers exposure to the markets in a liquid and cost-effective manner. This form of investment has been used since Ferd's units in actively managed equity funds were sold in autumn 2008.
The value of the portfolio at the close of 2009 was NOK 735 million. This represents a gain of NOK 53 million for the year, while the underlying markets produced an investment return of 26% in 2009. The Norwegian currency strengthened appreciably over the course of the year, and this reduced the return in NOK terms to 8%
Private Equity. The portfolio comprises investments in six funds, and was built up over the period from 2005 to 2008. Ferd's total commitment to these funds is NOK 1.23 billion. By the close of 2009, NOK 610 million of the total commitment was invested in funds, and the reported estimated value of these investments was NOK 500 million. The unrealised loss of NOK 110 million was due partly to falls in the value of the funds, and partly to currency effects when translating the value of fund investments to NOK.
Ferd External Managers does not currently have any plans to invest in further private equity funds.
Ferd External Managers received NOK 458 million from the group in 2009. Of this capital, NOK 300 million was allocated to the Hedge Funds portfolio, NOK 100 million was allocated to the Special Opportunities portfolio, and the remainder was used to meet investment commitments in respect of private equity funds. The balance of the total investment limit for the Special Opportunities portfolio was financed by selling units in equity funds and hedge funds, and NOK 250 million was released from each of these portfolios.
MARKET CONDITIONS AND FUTURE PROSPECTS
Global financial markets enjoyed a sharp upward correction in 2009 following the dramatic falls the previous year, with the equity and bond markets leading the upturn.
When looking at the extraordinary period that started in 2008, it is helpful to distinguish between developments in the financial economy and in the real economy. The financial crisis was triggered by a sudden loss of confidence in the banking sector, and the collapse of Lehman Brothers served to accelerate this crisis of confidence. As a result, the market for lending between banks ceased to function, and investment banks in particular were forced to demand repayment of loans to customers wherever possible rather than renewing loans in the normal manner. Hedge funds represented a significant proportion of the customer base that was affected by this policy, and many hedge funds found themselves in a very difficult situation. They were forced to sell investments in order to repay bank borrowing, while at the same time experiencing heavy demands from investors seeking to withdraw their investments. This created a sharp imbalance between buyers and sellers, and prices had to fall sharply to attract buyers. In many cases, funds found that there was no market at all for their investments.
The policy measures implemented by central banks and the authorities, combined with rescues of a number of major financial institutions, gradually restored some confidence that the financial system was not about to collapse in its entirety. This established a bottom to the market. Following this, attention shifted relatively quickly to the attractive returns available on various types of investment. Markets saw a return of investor interest, while at the same time the participants who had been forced to sell assets were nearing the end of the process of reducing their portfolios. The result was that asset values started to increase again. One way of describing this period is to say that the first phase of the financial crisis was very largely due to a sharp increase in the liquidity premium for investments, with a subsequent reduction in liquidity premium over the course of 2009.
Assuming that conditions in the banking and finance market are in the process of returning to normal, it seems likely that future prospects will be dominated by the outlook for the real economy. The markets will take their direction from the regular announcements of macroeconomic indicators, while microeconomic factors will determine the performance of individual investments. While it was crucial to be invested in the markets in 2009 in order to take advantage of the general recovery, in 2010 the most important factor will be holding the right investments.
There is much to suggest that the most important area of risk in 2010 will be sovereign risk, in other words the political and financial risks associated with specific countries. The extensive policy packages implemented around the world have so far prevented a serious economic depression in the wake of the financial crisis, but these policies have been financed mainly by increasing public sector deficits. Most countries will find the challenge of restoring their economies to a more normal situation in 2010 extremely challenging, both in political and economic terms. Where there is a lack of political resolution to deal with this situation, the result may well be accelerating inflation and problems for the country in the financial markets. There is also a genuine risk that certain hard-pressed countries will no longer be able or willing to service their borrowings, while other countries may try to protect their domestic industries through protectionist policies. It is extremely difficult to predict what consequences such developments might have for international trade, the currency markets, interest rates, oil prices and a long list of other factors.
The investment management carried out by Ferd External Managers is not based on an overall market view to any great extent, but we do take the view that 2010 offers particularly favourable prospects for the Hedge Funds portfolio and the Special Opportunities portfolio. Both of these portfolios involve active asset management with a controlled exposure to market developments, combined with thorough analysis of downside risk.