Basis Trades – Ardea vs. Hedge Funds
Basis trades and the investors that employ this strategy have received a lot of attention in recent months. This is largely due to concerns raised by regulators in the United States and United Kingdom.
The basis trade is a strategy common amongst relative value investors, particularly those that operate in the rarefied world of hedge funds. Basis trades seek to exploit price differences between government bonds, most commonly US Treasury bonds and the associated government bond futures (a form of fixed income derivative whose price is linked to the Treasury market).
Due to market inefficiencies, government bond futures will often trade at a premium to the associated government bonds, making the bonds appear cheap on a relative basis. This mispricing can be driven by a multitude of variables; institutional investors will buy large volumes of futures to hedge liabilities, while other investors may simply prefer to buy the future as it requires less cash to be paid upfront.
Buy the cheap bond, sell the expensive future. Easy.
The challenge for hedge fund investors is that these mispricing’s are typically small – fractions of cents on the dollar – so for a basis trade to be worthwhile it needs to be executed in very large size. Please recall that hedge funds typically charge higher fees than mainstream investment vehicles and often have lofty performance targets. This is where the concept of leverage comes into play and why the regulators are concerned.
In this context, leverage refers to borrowing money to invest and this is most commonly done in the repo market where banks, money-market funds and other investors lend capital for short periods of time. When a hedge fund enters a repo transaction, it sells a security that it already owns (for cash) and promises to repurchase the same security at an agreed price at some date in the future. This enables the hedge fund to maintain exposure to the position while providing cash for new investments. In the case of basis trades, this cash is often used to purchase more bonds, which are then sold via another repo transaction to raise more cash which is used to purchase yet more bonds (and so on).
Regulators such as the SEC are worried by the scale of these transactions, with some relative value hedge funds employing 50 times leverage ($50 of borrowing for every $1 of capital invested) and the hedge fund community’s heavy reliance on short-term borrowing.
Specifically, with such heavy reliance on short-term borrowing, an unexpected rise in the repo rate could force the hedge fund community to rapidly unwind potentially hundreds of billions of dollars’ worth of basis trades, placing huge pressure on the Treasury market as bonds are sold to repay loans. Rapidly falling Treasury prices would make it harder to find buyers for these bonds, leading to a potential liquidity crisis in what is considered by many to be the safest and most liquid asset class.
Interest rates, including repo rates are at their most volatile when the market is anticipating a change in central bank policy. Should those expectations change, the impact on short term funding rates can be massive.
As a manager of fixed income relative value portfolios, it is not uncommon for Ardea to be compared with hedge funds employing similar investment strategies, but the differences between our approach and those of the hedge funds are very significant.
Leverage is perhaps the key differentiator between relative value hedge funds and regulated strategies such as the Ardea Global Alpha Fund (UCITS), which does not employ any form of explicit leverage. This means it does not borrow money via the repo market or any other means to invest.
As a sophisticated investment strategy, the Ardea Global Alpha Fund employs derivatives for efficient portfolio management and risk management, which create a form of leverage sometimes referred to as implicit leverage, but the lack of hedge fund style borrowing means the Ardea fund is not directly exposed to changes in funding rates and unlike hedge funds that employ explicit leverage, cannot invest more than 100% of investor capital in physical bonds.
Interestingly, derivatives can be employed to replicate repo style exposures. These ‘synthetic’ bond positions are just another type of derivative exposure and are most often used as a way to efficiently implement relative value strategies that involve a long (short) bond exposure versus an offsetting short (long) futures position. The risk / return profile is similar to that of a futures contract, however unlike futures contracts, the synthetic bond positions can be customised.
The regulatory environment certainly plays a part in the use of leverage. The UCITS directive, for example, allows borrowing up to 10% of a regulated fund’s NAV, under the condition that the funds are not used for investment purposes. Hedge funds are unregulated and therefore have no limit on leverage outside of those they place on themselves – typically meaning none.
Perhaps more important than the regulatory controls placed on regulated funds are the objectives of individual investment products. The Ardea Global Alpha Fund targets a return above cash of 2% and a volatility of between 2% and 3% per annum (measured over a rolling 2-year period), but more importantly the Ardea fund aims to be uncorrelated with traditional bond and equity investments, delivering positive returns when these markets are under stress.
As such, the Ardea fund’s objective is to provide defensive diversification. This is in stark contrast to the majority (not all) hedge funds whose sole focus is profit maximisation. That in itself is an interesting point given the original hedge funds – hedged funds – were designed to minimise market exposure by hedging risks whereas todays hedge funds are synonymous with strategies that maximise market exposure via the use of leverage.
Trade sizing is another important difference between the Ardea Global Alpha Fund and relative value hedge funds. To deliver on our objective of reliable, uncorrelated performance the Ardea fund places a great deal of importance on diversification and risk balance. Diversification simply means that our portfolio contains a large number of small trades (400- to 500- line items) seeking to exploit relative value opportunities in a wide variety of markets. Risk balance, which is arguably more important, reflects our desire to construct a portfolio that will perform well regardless of the market environment. The latter is achieved by constantly subjecting our portfolio to stress testing and scenario analysis to identify points of weakness and building downside protection into our relative value framework.
Hedge funds, which typically have high fees and lofty performance targets, tend to employ a smaller number of ‘high conviction’ strategies that have the potential to deliver massive gains or horrendous losses. That is not to say that hedge fund investors do not have their own sophisticated and often successful risk mitigation strategies. There are many examples of hedge funds that have delivered strong and consistent performance in a variety of market environments.
Finally, the Ardea Global Alpha Fund only invests in the most liquid government bond and interest rate markets and constantly tests the liquidity of these assets. This differs from hedge fund strategies that seek to exploit the more esoteric segments of the bond market or are looking to harvest a liquidity premium. Ardea attempts neither.
The purpose of this article is not to criticise hedge funds or the many excellent professionals operating in that market, rather our aim is to demystify the often-discussed basis trading strategy and highlight some of the key differences between Ardea’s regulated fixed income strategy and relative value hedge funds.
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