The Morningstar Category TM Classifications for Hedge Funds

Transcription

1 The Morningstar Category TM Classifications for Hedge Funds Morningstar Methodology Paper Effective April 30, 2012

2 Contents Introduction 4 Directional Equity Asia/Pacific Long/Short Equity Bear-Market Equities China Long/Short Equity Emerging-Markets Long/Short Equity Europe Long/Short Equity Global Long/Short Equity U.S. Long/Short Equity U.S. Long/Short Small-Cap Equity Emerging Markets Long-Only Equity Long-Only Equity 5 Directional Debt Long/Short Debt Long-only Debt Event Distressed Securities Event-Driven Merger Arbitrage Global Derivatives Currency Global Macro Systematic Futures Volatility

3 Multistrategy Multistrategy Long-Only Other Fund of Funds - Debt Fund of Funds - Equity Fund of Funds - Event Fund of Funds - Macro/Systematic Fund of Funds - Multistrategy Fund of Funds - Relative Value Relative Value Convertible Arbitrage Debt Arbitrage Diversified Arbitrage Equity Market Neutral

4 Introduction The Morningstar Category TM classifications for Hedge Funds were introduced in 2005 and revised in 2007, 2011 and 2012 to help investors understand the different types of investment strategies used by hedge funds around the world. Hedge-fund managers typically focus on specific areas of the market and/or specific trading strategies. For example, some hedge funds buy stocks based on broad economic trends, while others search for arbitrage profits by pairing long and short positions in related securities. The Morningstar categories divide the universe of hedge funds based on these different approaches. Morningstar supports 31 hedge-fund categories, which map into six broad category groupings (directional equity, relative value, directional debt, global/derivatives, event, and multistrategy). These categories and category groupings can help investors make meaningful comparisons between hedge funds. Investors can use these peer groups to identify top-performing funds, evaluate a fund s performance against its peers, and find similar funds. For example, if an investor wanted to evaluate how well a debt-arbitrage fund performed, they could compare its performance to that of the debt-arbitrage category and the broad arbitrage-category grouping. Morningstar assigns a category to each hedge fund based on a review of the hedge fund s memorandum document, manager-provided investment-strategy descriptions and supporting data, conversations with portfolio managers, cluster analysis, and portfolio statistics acquired via surveys. Currently, Morningstar does not have access to portfolio holdings for hedge funds and must instead rely on other information provided by the asset managers. We regularly review the category structure and the hedge funds within each category to ensure that the system meets the needs of investors. The driving principles behind the classification system are as follows: Individual funds within a category use similar strategies and techniques to create value. Individual funds within a category can, in general, be expected to behave more similarly to one another than to funds outside the category. Categories have enough constituents to form the basis for reasonable peer-group comparisons. The distinctions between categories are meaningful to investors and assist in their pursuit of investing goals. 4

5 Directional Equity Funds in the directional-equity category grouping primarily invest in stocks and may take long or short positions. Managers may also use options to leverage their position or to hedge. Hedge funds with more-varied degrees of short positions are likelier to have different risk parameters, beta exposures, and return streams than traditional long-only funds or indexes. These funds will usually have either net long or net short market exposure to equities, unlike arbitrage funds, which tend to balance out long and short equity-market exposures. Asia/Pacific Long/Short Equity These funds primarily take long and short positions in Asia/Pacific equities. At least 75% of the exposure of a fund in this category is invested in equities, and 75% of equity exposure is in developed greater Asia equities. These funds follow a strategy consisting of equity investments, but may also include some derivative instruments. These funds will typically have a beta exposure of greater than 0.3 to Asia/Pacific equity indexes such as the MSCI AC Asia Pacific. Bear-Market Equities These funds dedicate a majority of their assets to equities. Most of the portfolio is dedicated to short stock positions in an attempt to take advantage of anticipated market or stock declines producing a net exposure to equities of less than or equal to negative 20%. Some managers invest the proceeds from their short positions in low-risk assets, while others dedicate a portion to long stock positions in order to hedge against broad market rallies. In the event of a broad market rally, these funds will lose money on their short positions but will experience a gain on their long positions. Short positions typically account for 60% to 85% of fund assets, although some managers may be 100% short. These funds will typically have a beta of less than -0.3 to equity indexes such as the S&P 500 or MSCI World. 5

6 Directional Equity (continued) China Long/Short Equity These funds invest solely in equities of companies based in China. Funds in this category include funds domiciled in China that are subject to investment restrictions that may significantly limit the flexibility of the manager. Some of these restrictions include limitations on short sales and limitations on investing in shares outside of China. Funds focusing on China but not subject to investment limitations will be assigned to emerging markets long/short equity at the discretion of Morningstar analysts. Emerging-Markets Long/Short Equity These funds take long and short positions in emerging-market equities. At least 75% of the gross exposure of a fund in this category is in equities and 75% of equities exposure is invested in emerging-markets equities. These funds follow a strategy consisting of equity investments, but may also include some derivative instruments. An explanation of Morningstar's emerging- versus developed-markets methodology is available in the Morningstar Regions methodology. These funds will typically have a beta exposure of greater than 0.3 to emerging-markets equity indexes such as MSCI EM. Europe Long/Short Equity These funds primarily take long and short positions in European equities. At least 75% of the gross exposure of a fund in this category is in equities and 75% of equities exposure is in developed greater Europe equities. These funds follow a strategy consisting of equities investments, but may also include some derivative instruments. These funds will typically have a beta exposure of greater than 0.3 to European equity indexes such as MSCI Europe. Global Long/Short Equity These funds primarily take long and short positions in equity securities, but do not fit into any of the other regional categories because they do not have a primary regional focus. At least 75% of the fund's gross exposure is invested in equities. These funds will typically have a beta exposure of greater than 0.3 to a global stock index such as the MSCI World. 6

7 Directional Equity (continued) U.S. Long/Short Equity These funds primarily take long and short positions in U.S. equities. These funds follow a strategy in which at least 75% of the fund's gross exposure is in equities, and 75% of equities exposure is in U.S. equities. The fund may also include some derivative instruments. These funds tend to have betas of 0.3 and higher relative to broad U.S. indexes like the S&P 500 and DJ Wilshire U.S. Long/Short Small-Cap Equity These funds primarily take long and short positions in U.S. small-cap equities. These funds follow a strategy consisting of equity investments, but may also include some derivative instruments. Portfolios should have at least 60% exposure to small-capitalization U.S., Canada, and developed Americas equities, and the funds should not maintain regular exposure to larger-capitalization U.S., Canada, and developed Americas equities. The fund maintains at least a 20% net exposure to small-capitalization U.S. equities and does not maintain a regular exposure of greater than 20% to large-capitalization U.S. equities. These funds tend to have betas of 0.3 and higher relative to small-cap U.S. market indexes like the Russell Emerging Markets Long-Only Equity This category includes emerging and frontier market funds that do not engage in any short sales or derivative based hedging. Many of these funds focus on a specific region. At least 75% of the exposure of a fund in this category is in equities and 75% of equities exposure is invested in emerging or frontier-markets equities. An explanation of Morningstar's emerging- versus developed-markets methodology is available in the Morningstar Regions methodology. Long-Only Equity These funds make long-only investments in developed markets equities and do not materially hedge through derivatives. Many of these funds use a concentrated approach on a deep-value portfolio. Some of these funds focus on micro-caps and takes significant positions that may be accompanied by trading restrictions. 7

8 Directional Debt Funds in the directional-debt category study broad-based changes and prices in fixedincome products. In many cases, the manager will select various fixed-income products such as high-yield or emerging-markets debt to provide a fixed investment stream. Many debt funds leverage their returns to provide larger returns. Unlike debt arbitrage funds, these types of funds tend to have a net long market exposure. Long/Short Debt These funds primarily take directional positions in global debt. Long and short positions are typically independent of each other. Positions do not fully offset each other, and result in net exposures less than -20% or greater than 20% in a majority of periods. The majority of the funds assets are invested in debt investments, but the fund manager may also include other instruments. These funds may invest in emerging markets debt, U.S. debt, and global debt, along with credit default swaps. At least 75% of the exposure is tied to fixed-income investments, and short exposure is greater than 20%. Long-Only Debt This category includes long-only debt strategies in performing debt instruments. Included strategies are DIP financing, mezzanine financing, private debt, high yield debt, leveraged debt strategies and other specialty finance funds. At least 75% of the exposure is tied to fixed income, and there is no material short exposure. 8

9 Event Funds in the broad event category grouping attempt to profit when stock or bond prices change in response to certain corporate actions, such as bankruptcy, mergers, or acquisitions. Managers will typically use short positions or derivatives to hedge their market exposure. These positions help the fund capture the price change related to the event itself and insulate the fund from broad market changes. Distressed Securities These funds specialize in financially troubled companies that may face bankruptcies, distressed sales, corporate restructurings, or financial reorganizations. A fund might take long positions only in the company stock or debt, or it might exploit pricing discrepancies between different parts of the company s capital structure, for example by buying senior debt and shorting preferred stock. The hedge fund may try to accumulate a controlling stake in the company in order to influence the outcome. During bankruptcy proceedings, debt-holders often exchange their debt for an equity stake in the post-bankrupt entity. Event-Driven These funds attempt to profit from price changes related to a variety of corporate actions, including bankruptcy, emergence from bankruptcy, divestitures, stock buybacks, dividend issuance, major shifts in corporate strategy, and other atypical events. Many of these funds undertake activist techniques to spur further corporate changes at the underlying companies. Merger Arbitrage These funds attempt to profit from price changes related to mergers, acquisitions, and divestitures of the underlying companies. These strategies typically involve the purchase of stock of an acquisition target and sell the shares of the acquiring company. 9

10 Global Derivatives Funds in the global-derivatives category group study broad-based changes and prices in global markets. Often, these funds make tactical decisions about an optimal global assetallocation mix, and they use equities, bonds, currencies, derivatives, and commodities in their portfolios. Many managers look for emerging trends in countries, industries, and geopolitical institutions. Some managers will also attempt to profit from general market volatility during times of uncertainty. Currency Currency portfolios invest in multiple currencies through the use of short-term money market instruments; derivative instruments, including and not limited to, forward currency contracts, index swaps and options; and cash deposits. These funds include both systematic currency traders and discretionary traders. Global Macro These funds base investment decisions on an assessment of the broad macroeconomic environment. They look for investment opportunities by studying such factors as the global economy, government policies, interest rates, inflation, and market trends. As opportunists, these funds are not restricted by asset class and may invest across such disparate assets as global equities, bonds, currencies, derivatives, and commodities. These funds primarily invest through derivatives markets. They typically make discretionary trading decisions rather than using a systematic strategy. At least 60% of the funds' exposure is obtained through derivatives. 10

11 Global Derivatives (continued) Systematic Futures These funds trade liquid global futures, options, and foreign-exchange contracts largely according to trend-following strategies (such as linking greater than 50% of fund's exposure to such strategies). These strategies are price-driven (technical), and systematic (automated) rather than fundamental or discretionary. Trendfollowers typically trade in diversified global markets, including commodities, currencies, government bonds, interest rates, and equity indexes. However, some trend followers may concentrate in certain markets, such as interest rates. These strategies prosper when markets demonstrate sustained directional trends, either bullish or bearish. Some systematic futures strategies involve mean-reversion or counter-trend strategies rather than momentum or trend-following strategies. At least 60% of the funds' exposure is obtained through derivatives. Volatility Volatility strategies trade volatility as an asset class. Directional volatility strategies aim to profit from the trend in the implied volatility embedded in derivatives referencing other asset classes. Volatility arbitrage seeks to profit from the implied volatility discrepancies between related securities. 11

12 Multistrategy The multistrategy broad asset class contains the hedge funds that merge multiple techniques into one single fund. Multistrategy These funds offer investors exposure to several different hedge fund investment tactics. In most of these cases, all of the assets are managed in-house at the hedge fund, but the assets may be divided between multiple portfolio managers, each of whom focuses on a different strategy. This is not to be confused with a fund of funds, which uses external portfolio managers and strategies, as well as second layer of management and performance fees. An investor s exposure to different tactics may change slightly over time in response to market movements. Long-Other Funds in this category include long-only commodity and long-only macro strategies. Additionally, funds investing long-only in private assets such as collectibles, life settlements, and other esoteric long-only strategies. Fund of Funds - Debt Debt funds have statistically significant betas to at least one debt index or to a credit or duration spread. These funds primarily (50% or greater) derive their directionality from debt-related hedge fund strategies. Debt funds can diversify across geography or can concentrate in a particular region. These funds can invest in strategies other than directional debt strategies, but the systematic risk is dominated by correlations to fixedincome investments. Fund of Funds - Equity These funds have statistically significant betas to at least one equity index, and primarily (50% or greater) derive their directionality from equity-related hedge fund strategies. Equity funds can diversify across geography or concentrate in a particular region. 12

13 Multistrategy (continued) Fund of Funds - Event Event funds invest primarily in event-driven strategies, with 50% or more of the portfolio in one or more of the following event-driven strategies: merger arbitrage, distressed securities, and event-driven. Event funds tend to show high betas to the single-strategy Morningstar Index of the same name. If an event fund could also qualify for the equity, debt, or multistrategy categories, it shall be placed in the category with which its returns are most strongly related, considering cluster analysis and regression betas. Fund of Funds - Macro/Systematic These funds invest primarily (50% or greater) in the Morningstar global derivatives categories, which include systematic futures, global macro, volatility, and currency. Global Derivatives funds predominantly invest in highly liquid instruments such as futures and options, and use various instruments to trade currencies. The underlying funds strategies can be systematic or discretionary, technical or fundamental, or any combination of the four. These funds tend to be diversified across global derivative strategies. Fund of Funds - Multistrategy Multistrategy funds generally have statistically significant betas to multiple asset classes (such as debt, equity, event driven, and global derivatives), without enough asset-class concentration to belong to another hedge fund of fund category. That is, no one asset class drives a majority of the funds directionality. Fund of Funds - Relative Value These funds produce returns that cannot be explained well by directional hedge fund factors. These funds generally show r-squared results of less than 30% in multifactor regressions using common factors of hedge fund returns. The underlying funds in which these funds invest generally include a majority allocation to relative value/arbitrage strategies. In some cases, if other information proves more valuable than the regression results, Morningstar s hedge fund analysts will have the discretion to make slight exceptions to the r-squared rule. 13

14 Relative Value Funds in the relative-value category grouping study the pricing relationship between pairs of related securities. Managers take a long position in the security that appears to be underpriced and a short position in the security that appears to be overpriced. The manager will hold the positions until the pricing discrepancy disappears. These strategies are usually market-neutral. Because markets are generally efficient, pricing discrepancies are typically very small and short-lived. Therefore, these funds are frequently highly leveraged, using borrowed money to increase the size of possible gains. Convertible Arbitrage These funds study the relationship between a company s stock and its convertible bonds. Convertible bonds contain an option that allows the bondholder to trade the bond for common stock at a certain price and under certain conditions. Usually, the bond is undervalued, so managers buy the bond and short the stock to hedge equity risk. These funds craft strategies to manage their exposure to interest-rate risk, default risk, and illiquidity in the convertible-bond market, and pricing volatility in both the stock and bond markets. Because the pricing discrepancies are usually very small, many of these funds employ leverage to maximize return. Debt Arbitrage These funds seek out pricing discrepancies between various private and public fixed-income instruments, usually looking for global opportunities. Portfolio managers in this category primarily invest in fixed-income derivative instruments. These funds tend to have low beta exposures (less than 0.3 in absolute value) to bond-market indexes such as the Barclay's Capital Aggregate Bond index. This is in contrast to other debt categories, which have higher net market exposures. Diversified Arbitrage These funds seek out pricing discrepancies between pairs or combinations of securities regardless of the asset class. These funds often employ combinations of the debt arbitrage, equity arbitrage, and convertible arbitrage among other relative-value strategies. These funds exhibit little market directionality. These funds tend to have low beta exposures to all risky indexes. 14

15 Relative Value (continued) Equity-Market Neutral These funds attempt to reduce systematic risk created by factors such as exposures to sectors, market-cap ranges, investment styles, currencies, and/or countries. They try to achieve this by matching short positions within each area against long positions. These strategies are often managed as beta-neutral, dollarneutral, or sector-neutral. A distinguishing feature of funds in this category is that they typically have low beta exposures (less than 0.3 in absolute value) to equitymarket indexes such as the MSCI World. In attempting to reduce systematic risk, these funds put the emphasis on issue selection, with profits dependent on their ability to sell short and buy long the correct securities. 15