From the desk of Jeroen Bakker
Benelux Consulting Lead, Pierpoint Financial Consulting
In my recent blog, I wrote about how lenders should select borrowers and examples of trades that are typically conducted with the securities that are lent out. This week, I go deeper into this content and provide examples of trades in order to give more detailed information about the transactions behind the loans.
While I established in that blog that the suite of borrowers consists of prime brokers, investment banks, brokers and custody banks, I will primarily focus on the prime broker/hedge fund and investment banks segments.
Prime brokers / Hedge Funds
I am combining prime brokers and hedge funds into one group as, although in some instances lenders are comfortable to take on hedge fund credit risk, it is more common that prime brokers act as the credit risk intermediate between the lender and the end-user.
Below is an overview of different types of hedge fund and their strategies – the list is not exhaustive but does explain the majority of investment strategies:
Long / Short
A Long / Short Fund or Market Neutral Fund is usually a mutual fund that holds investments (LONGS) as well as positions in securities it does not hold (SHORTS), often in the same or similar market segment. For example, if the fund manager considers that Renault (RNO.FP) is overvalued compared to Peugeot (UG.FP) it will sell Renault and buy Peugeot. As the fund does not hold Renault it will need to borrow the securities to sell and deliver them. If the share price of Renault has dropped (and potentially the share price of Peugeot has risen) the fund manager will sell Peugeot and buy back Renault. Once the purchase of Renault has settled, the borrowed securities will be returned. The return is, of course, the difference between the two purchase and sell amounts minus the cost of carry (SBL fee/Financing costs). This trade as described is the plain vanilla route, often highly leveraged funds would prefer to trade this as a synthetic. Contract for Difference (CFD) is the most common route, where in that case the prime broker will execute the trades and will contractually sell the ’performance‘ of the trade to the fund. The fund will be paid the positive return if the trade works according to their analysis, if not the fund will have to pay the prime broker the negative return.
A Global Macro hedge fund is typically a mutual fund that holds its investments based on global economic and political views. Holdings may consist of fixed income, equity, currencies and or commodities. Global Macro investment strategies include analysing trends in interest rates, politics, government policies and exchange rates. For example, if the fund manager believes the UK is heading towards a recession, they may sell short UK stock or gilts or sell futures on the FTSE or sell Pound Sterling. Equally, if they think the US is heading for an upturn they may buy US stock, futures on the S&P or USD.
High Yield and Distressed
A high yield and/or distressed hedge fund is often a fund that invests in the debt of a troubled company – usually at a discount – to seek profit if the company turns around. ‘Distressed’ is commonly defined as at a significant discount to its fair value. Hedge funds that purchase large quantities of distressed debt often end up with some form of control of the company. Moreover, the distressed debt holders can achieve priority of payout in case of an event of default, ahead of equity shareholders or employees. Unlike the other strategies, this is usually a long-only strategy.
Event-driven hedge fund strategies consist of seeking to exploit price discrepancies or inefficiencies caused by corporate events such as ‘mergers and acquisitions’ or spin-offs. These funds employ corporate action specialists who analyse corporate actions from multiple angles. The stock price of a target company is likely to rise when an acquisition is announced however if the acquisition does not get completed the stock may very well suffer.
One other investment strategy is to buy the target and sell the takeover company. If the merger is being paid in stock, the target company shares will be exchanged for those in the acquiring company at a certain ratio. The fund would be looking to borrow the target company shares (preferably through a term loan) and return the takeover company shares once the corporate action has been completed. Well-known large (sometimes hostile) takeovers are Kraft / Cadbury, Anheuser-Busch / SABMiller. Of course, sometimes these deals also fall through with famous examples such as Altria/Philip Morris, BHP Billiton / Rio Tinto.
An Emerging Market hedge fund refers to a mutual fund that invests primarily in securities from countries with economies that are considered to be emerging. Often these funds are ETFs investing in countries such as Brazil, India, Russia and China. Not all of these markets have fully established plain vanilla securities lending markets. In Brazil for example, you have to lend through an exchange, in China you need to trade via a qualified local intermediary, in India short selling for non-residents is not allowed (yet) so investors will have to trade via a synthetic of some type (swap/p-note/LEPO).
In the last two weeks, there has been a boom in new distressed and emerging market debt funds as funds are looking to take advantage of the high premium on bonds as well as the overestimated default probabilities and underestimated recovery values.
Absolute return funds are measured on the percentage return of the fund compared to its invested capital over a specified period of time. The objective of these funds is to generate consistent returns irrespective of general market conditions and can take long and short positions in order to generate returns. ‘Absolute return’ differs from ‘relative return’ because it is concerned with the actual return of a particular asset (and the entire portfolio) and does not compare it to any other measure or benchmark which is the standard for most investment management mandates.
Fund of Hedge Funds
As the name suggests, a fund of hedge funds (or multi-manager investment) invests in other hedge funds. The aim is to achieve broad diversification and reduced risk.
For the investment banks I will focus on some of the trading strategies of the Delta One desks.
Index arbitrage – This is a strategy that attempts to profit from price differences between two indices or between the index and its composites. This could be long the future and short the underlying or the other way around. One well-known example of index arbitrage strategies is to attempt to capture the difference between the S&P 500 futures and the published price of the S&P 500 stocks themselves. Technically the price of the S&P 500 should be equal to the fully capitalisation-weighted calculation of all of the 500 stocks. Any difference between that number and the futures price provides an opportunity to arbitrage. If the total of the components is cheaper than the price of the future, a buy order for the stocks with the simultaneous sale of an equal amount of futures would generate a risk-free yield.
Single Stock Futures
SSF is a type of futures contract between two counterparties to exchange a specific quantity of securities for a price agreed today with delivery at a specified future date. Demand is stock-specific and often a lender that has high withholding tax obligations is preferred as any substitute dividend requirement will be less expensive than other alternatives. The futures markets offer the ability to use very high leverage relative to cash or spot markets. Traders use futures to hedge or speculate on the price movement of the underlying asset.
Scrip dividend arbitrage
This arbitrage tries to benefit where an issuing company declares a dividend for which investors have a choice of stock or cash. For example, HSBC Holdings pays $0.10 dividend per share with a reinvestment ratio of 1:77.13 and therefore a reinvestment price of $7.7133. If the HSBC share price is higher then $7.7133 (say in this example, $8), you can sell the number of shares equal to the number of shares you are entitled to in the conversion and net $ 0.2867 ($8 - /- $7.7133) per share. This example does not take into account the fee for borrowing the scrips in the first place and potential share price movements between dividend ex-date and election date.
Convertible bond arbitrage
This trading strategy aims to monetise the optionality premium in convertible bonds versus the equity from the same issuer. The trader will buy the bond and sell the underlying equity in a close-to-perfect hedge (‘Delta 1’) and at maturity convert the bond to equity and redeem the borrow. For example, a stock is trading at €110 and also has a convertible issued with a face value of €100 and is convertible into 1 share at the conversion price of €100. If you simultaneously sell 1 share, buy 1 convertible bond and convert the bond into shares you would gain €10. This is a very simplified example as you would have to take conversion costs into account as well as the restrictions around the conversion. As a side-note, companies issuing convertible bonds typically pay lower interest rates to investors due to the optionality and it is expected that buyers will hedge with short sales. The recent short-selling bans in some markets have disadvantaged companies looking to raise money through convertible bonds.
The examples described above are just a few of the securities finance trading strategies that are conducted in the market. A lender can never be certain as to the borrower’s motivation in borrowing stocks but we believe it is important for beneficial owners and other lenders of securities to understand more about what happens with your securities. Your securities lending provider can assist you with these questions. Still not sure or want to speak to an independent advisor? Book a free call with one of our Pierpoint consultants.