FORTUNE — For those of you who missed it in high-school history class, Sir Ernest Shackleton is the best-known figure in the “Heroic Age of Antarctic Exploration,” which began in 1911 after Roald Amundsen successfully reached the South Pole. Shackleton was a maverick. He wanted to one-up Amundsen. So he set forth raising funds for his journey and eventually launched the ill-fated “Imperial Trans-Antarctic Expedition” to cross the frozen continent’s tundra. Mother Nature of course had other plans. Misfortune beset Shackleton and his crew early on when an ice flow froze his ship, The Endurance. The ship was abandoned.
For the next 500 days, Shackleton and his men were stranded. They had no contact with the outside world and routinely faced temperatures below -50 degrees Celsius. Fortunately, after an almost impossible trip to a nearby whaling station, the entire crew was rescued. Even though the expedition fell short of its goal, Shackleton and his crew walked away with their lives and some harsh polar perspective.
While obviously nowhere near the difficultly endured by Shackleton, for many hedge fund managers, this has been a year to gain perspective (if not outperformance). Take a look at the Hennessee Hedge Fund Index which was up 9.9%, as of the end of October 2013 — a return that paled in comparison to the S&P 500’s (SPX) return north of 23%. While returning close to 10% on “2 and 20” hedge fund fees isn’t the worst thing in the world, for most hedge fund managers, underperforming a passive strategy by over 1,000 basis points can lead to investor ire and redemptions.
One key reason for the underperformance of hedge funds is the outperformance of heavily shorted stocks. Heavily shorted stocks are outperforming the S&P 500 by a staggering 570 basis points this year. That said, long and short equity managers aren’t the only investment managers playing catch-up with the market this year. PIMCO’s Total Return Fund (BOND) has returned a capital eroding -0.87% in the year-to-date. Clearly, PIMCO’s Bill Gross and the big bond boys are experiencing some performance issues.
The broader issue with bond managers like PIMCO is how far afield they have journeyed in search of yield. And therein lies the key question: At what cost does this hunt for yield come?
As it relates to the PIMCO Total Return Fund, prospective underperformance may even be more concerning given the fund’s holdings and where the managers have gone to find yield. According to analysis by our Financials Team here at Hedgeye, almost 34% of PIMCO Total Returns holdings are in agency Mortgage Backed Securities (MBS). Check out the chart below highlighting the spread of agency MBS to the 10-year Treasury Yield.
Prior to the financial crisis, this spread was around 126 basis points. It has now narrowed to approximately 68 basis points. In other words, the almighty chase for yield has effectively priced mortgage backed securities to one of the lowest levels of risk that we’ve seen in the asset class. Even if the spread for Agency MBS normalized by just 50 basis points, to pre-crisis levels, it would have a meaningful impact on the market. By our estimation, allowing for modified duration, a 50 basis increase (reversal of tapering for instance) in yield would lead to 5% downside in the Agency MBS market.
The issue for firms like PIMCO is that a 5% correction in one of its more significant asset class exposures is likely to lead to continued underperformance and accelerated outflows. Outflows and decreased liquidity, of course, are only likely to exacerbate any move in price in the MBS market.
The Financial Times emphasized this point further in a recent article looking at managers of collateralized loan obligations (CLOs). According to the FT, managers of CLOs have increased the proportion of risky loans that their investment vehicles are allowed to buy to the highest level on record. Currently, 55% of new leveraged loans come in the covenant-lite form, which eclipses the 29% reached shortly before the financial crisis.
In theory, when the economy is stable, covenant-lite loans are fine. But, if there is volatility in economic activity, these loans get much more difficult to repay for many corporates. A good analogy is probably Shackleton and his crew in -50 degrees Celsius weather in Antarctica. You know weather that cold is dangerous but it is survivable, until the wind starts to blow and wind chill sets in.
Given the challenges faced by large asset allocation funds that rely heavily on yield for performance, going forward it might be prudent that managers of these funds search for analysts for their investment teams with a similar advertisement to what Shackleton used to find his crew:
“Men wanted for hazardous journey. Small wages. Bitter cold. Long months of complete darkness. Constant danger. Safe return doubtful. Honour and recognition in case of success.”
Daryl Jones is the Director of Research at
Hedgeye Risk Management