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Equity or debt – as long as it’s distressed
Distressed securities look like providing the best return, both in absolute and risk-adjusted terms, again this calendar year of the 12 categories of hedge fund investment styles measured by the EDHEC – Risk Institute.
According to the research organization’s figures for periods ending October 31, the distressed securities category is a clear leader with 10.0 per cent in the first 10 months of the year, followed by convertible arbitrage and fixed income arbitrage, both with 7.5 per cent.
This should not surprise given the financial turmoil of the past five years, however, distressed securities have outperformed all others over the past 11 years. And they have done so with one of the lowest average levels of volatility – 6.2 per cent annual – giving the highest sharpe ratio of the 13 categories – 1.01 – since January 2001.
By comparison, more traditional styles such as long/short equity and relative value have been much less consistent. Long/short is up 5.5 per cent this year and relative value up 7.5 per cent, but their long-term results are a bit lower.
Long-only emerging markets, many of which have largely escaped the financial crisis, have the second-highest 11-year track record, returning 9.9 per cent, but their volatility knocks their sharpe ratio down to 0.56.
Attendees at next year’s Conference of Major Superannuation Funds in Australia will get a first-hand explanation from one of the masters of distressed securities, George Siguler. He is the CIO of Siguler Guff, an American-based alternatives manager, who is probably better known as one of the creators of “endowment envy”.
Except for a coupe of years after the onslaught of the financial crisis, America’s big endowment funds, such as those of Harvard and Yale, have been the envy of the institutional investment world. Siguler, who had been associate treasurer at Harvard, was a founding partner of the Harvard Management Company in the 1970s, which was spun out of the august body’s organisation in order to help staff retention. Senior staff of the former funds management department were amply rewarded thereafter.
However, there are a couple of issues with the endowment style of long-term investing when the universities have come to rely on their income for shorter-term requirements. The main one is liquidity. Time tends to work against any sort of value investing and distressed situations are, by definition, risky.
In recent years this has led to a move towards distressed debt rather than equity, as a way to better protect the downside risk. Distressed debt will usually provide a coupon return when the company cannot pay a dividend and then may convert to equity when the situation improves.
George Siguler prefers distressed debt to equity and even in venture capital and other growth-orientated asset classes will prefer a debt exposure to traditional venture or other private equity backing.
(The author is a non-executive director of Pyne Gould Corporation, a NZX-listed company which also specialises in distressed investments.)
