CHAPTER 11
Sector Funds
SECTOR STRATEGIES COMBINE core long holdings of equities with short sales of stock or sector indexes, confining their universe to a group of companies or a segment of the economy with similarities either in what is produced or who the market is. Managers combine fundamental financial analysis with industry expertise to identify the best profit opportunities in the sector. Net exposure of sector portfolios may range anywhere from net long to net short depending on market and sector-specific conditions. Managers generally increase net long exposure in bull markets for the sector and decrease net long exposure or may even be net short in bear markets for the sector. Generally, the short exposure is intended to generate an ongoing positive return in addition to acting as a hedge against a general sector decline. In a rising market for the sector, sector managers expect their long holdings to appreciate more than the sector and their short holdings to appreciate less than the sector. Similarly, in a declining market, they expect their short holdings to fall more rapidly than the sector falls and their long holdings to fall less rapidly than the sector. Profits are made when long positions appreciate and stocks sold short depreciate. Conversely, losses are incurred when long positions depreciate and/or the value of stocks sold short appreciates.
Sector funds can engage in one or more of the hedge fund strategies but limit their investment universe to a specific industry or other concentration. Although this strategy is categorized by the specific investment universe rather than investment activities and return source, most pursue equity hedge or event-driven approaches.
CORE STRATEGY
Investment managers who specialize in particular sectors or industries often invest in the sectors of the economy with long-term growth rates superior to the market in general, thus increasing their chances of identifying top-performing stocks. Many hold primarily long core positions in the companies that offer the best value in those industries. However, many sector hedge fund managers do not have such a bias toward their sector. They can profit in down markets by using their specialized knowledge, experience, and the flexibility to sell short the stocks of the worst companies, especially those also in the weakest sectors, and earn profit accordingly. In recent years, the most prominent and successful sector funds have been concentrated in the biomedical, health care, energy, information technology, media, and financial industries. Often, sector specialists are former or present participants in the industry in which they invest and can draw on industry expertise and industry contacts to which investors with a more general approach do not have access. In addition, they often count among their clients experts and current participants in the particular industry who are fluent in its processes and associated technologies. The sector fund formula is a simple one: combine fundamental financial analysis with industry expertise to create an informational advantage that allows the sector specialist to identify the best profit opportunities.
ONE MANAGER’S LOGIC OF SECTORS
Sector specialists usually look for at least two of the following three things in a sector: (1) high growth rates relative to the general market, (2) an industry in which the specialist holds a distinct informational advantage, and (3) the size and breadth to offer plentiful opportunities that are affected by a variety of factors.
Perhaps the most popular sector for hedge funds in recent times has been the energy sector. The current oil and gas situation has demand outstripping supply. Some managers believe that emerging markets demand may be underestimated and is at the very least not very well understood. Another manager has pointed out that U.S. gas reserves have recently been near all-time lows. Sixty-five percent of U.S. refined crude oil was imported by April of 2004, up from 28 percent in 1982.1 Natural gas production was 12.8 percent lower in April of 2004 than a year earlier, and 20 percent lower than two years earlier.2 Oil demand is forecasted by some sources to increase 33 percent from 2005 to 2020. Demand is on the rise at the same time the industry is coming off a long period of underinvestment. The total number of exploratory wells drilled in 2002 was less than in 1993. Thus, supply is tight in a capital-intensive industry where investment may take a number of years to yield results.
Today, sophisticated hedge funds can go both long and short, and pick from a variety of factors and companies in order to achieve significant returns. The trends detailed by managers will have an impact on different companies in different ways. The energy industry includes many subareas that will be affected in various ways, including oil, oil services, oil sands, oil transport, oil refining, gas power generation, gas transport, coal seam gas, coal bed methane, natural gas, gas pipelines, gas to liquids, coal, synthetics, and alternative energy.
INVESTMENT PROCESS
Many sector specialists try to identify GROWTH STOCKS with earnings and cash flow numbers that are selling at a significant discount to the company’s intrinsic value. They also look for a CATALYTIC EVENT, or catalyst, to heighten investor interest in the company. A catalytic event could be, among other things, a new product launch, a regulatory approval, or a corporate restructuring. The logic is reversed when sector specialists are looking for stocks to sell short. In that case, they look for overvalued stocks and a catalytic event to expose the company’s weaknesses. In addition, sector specialists remain aware of macroeconomic, monetary, and cyclical elements that affect the overall level of the equity market and the position of their particular sector relative to that market. Before making an investment, many sector specialists meet with company management to get to know the people behind the numbers and to understand their business model. To understand the company’s position in the industry, they also meet with customers, suppliers, employees, and competitors.
An equity hedge style sector specialist’s portfolio usually has two components: CORE POSITIONS and trading and hedging positions. Core positions are long-term positions that are rarely turned over and are a key source of investment returns. The rest of the portfolio is composed of TRADING POSITIONS, short positions in overvalued companies, and HEDGING positions. These account for most of the portfolio turnover and allow sector hedge fund managers to make profits in both up and down markets. They may sell long positions when a company changes management or they cease to understand its business model. If they invest in a company because of a specific economic event, they will usually sell after that event has taken place. In sum, long positions will be reconsidered if there is a change in the original investment rationale.
MANAGER EXAMPLE
Energy infrastructure master limited partnerships (MLPs) are publicly traded limited partnerships that trade primarily on the NYSE. MLPs do not pay a corporate level tax, do pay out most of the available cash on an annual basis, and issue a Form K-1 versus a 1099. Due to their pass-through nature, depreciation, depletion, and other expenses are included within the K-1 and have the effect of reducing the taxability of distributions received from MLPs. As a result, most of an MLP’s distributions would be treated as a return of capital or a reduction of cost basis for most investors. The downside is that the K-1 adds complexity to tax reporting, and MLPs have the ability to pass through unrelated business taxable income (UBTI), which can be a concern for many tax-exempt investors.
Kaneb Pipeline Partners, L.P. (KPP) is a publicly traded MLP that was formed in 1989. KPP owns two refined-products pipelines consisting of the 2,075 mile-long East Pipeline, which primarily services Kansas and Nebraska, and the West Pipeline, which services Wyoming and Montana into Colorado. Since 2000, KPP has completed three major pipeline and terminal acquisitions totaling $600 million, including an ammonia pipeline from Tessoro, a refined-products pipeline from Koch, and crude terminals in Nova Scotia, Canada, and Netherlands Antilles.
Organic growth on KPP’s existing pipelines, the increases in cash flows expected from recent acquisitions, and a relatively high yield, have made KPP an attractive investment over the last several years. Annual distributions have increased over 20 percent during the last five years.
In September 2001, Kaneb Inc., a diversified company that owned the general partner of KPP, 5.1 million common units of KPP, and a refined products trading business, spun out these assets as a new company, Kaneb Services, LLC (KSL). The value of the KPP units owned by KSL represented more than $13.00 per share of KSL, which was trading for $11.69 at the time of the spin-out. In the opinion of Kayne Anderson Capital Advisors, the general partner interest was one of the more valuable assets of the company and was thus undervalued.
General partners of MLPs are interesting assets. The general partner of an MLP is incentivized to grow the distributions on the common units through the existence of incentive distribution rights. These rights offer the general partner the opportunity to participate in the increases in common unit distributions by receiving greater percentages of the incremental cash flows necessary to pay the higher distributions to common unit holders. For example, a general partner may receive 2 percent of the cash flows at a $2.00/unit distribution level, but may receive 25 percent or 50 percent of the incremental cash flows above $2.50/unit and $3.00/unit, respectively. In the case of KPP, the general partner’s maximum incentive distribution was 30 percent, and it was quickly approaching that level at the time KSL was spun out.
Before the spin-out of KSL, Kayne Anderson Capital Advisors began modeling the valuations of KSL’s three main assets relative to the public value of KPP, other MLPs, and other publicly traded general partners. The thesis was that KSL was inherently undervalued at the time, and that due to the incentive distribution received from KSL’s general partner interest in KPP, it would experience significantly greater cash flow distribution growth, and therefore an investment in KSL would be more fruitful than would a direct investment in KPP. The latter has proven true, as KSL has grown its distributions (KSL is also formed as an MLP, and therefore, “distributions” is more appropriate than “dividends”) at roughly double the rate of KPP.
Following the spin-out of KSL, Kayne Anderson Capital Advisors continued to model the relative value of KSL versus KPP, generally choosing to be long KSL, but at times long KSL and short KPP, and in some instances long both when Kayne Anderson Capital Advisors felt they were cheap versus other similar MLPs.
Acquisitions and, in particular, the related equity offering used to finance the acquisition would often have the effect of dampening the unit prices of KPP, but would also have the pro forma impact of increasing general partner cash flows. Therefore a common strategy around these times was to continue to own KSL and reduce exposure to KPP.
Most MLPs maintain investment-grade credit profiles. Acquisitions are typically financed 50 percent debt and 50 percent equity, a ratio that seems to please both Moody’s and S&P. However, many MLPs initially finance acquisitions with shorter-term revolvers, preferring to announce a deal, let the markets determine the accretion of the acquisition, and then follow with an equity offering. This strategy may expose an MLP to a downgrade or placement on credit watch, as the MLP’s credit ratios would temporarily deteriorate. Therefore, depending on circumstances, the advisor might choose to short the debt issued by KPP in anticipation of a credit downgrade, and also as a form of interest-rate hedge against the long positions in KSL and sometimes KPP. These debt shorts tended to be more opportunistic, impacted by the current yield and credit spread environment.
All good stories have to come to an end. On November 1, 2004, Valero Energy Partners, LP another publicly traded MLP, announced its intention to acquire KPP and KSL. The premiums to be paid over the prior day closing price by Valero for KPP and KSL are 21 percent and 38 percent, respectively. Since KSL’s spin-out in September 2001, its unit price has appreciated approximately 270 percent, from $11.69 to $43.31, and it has paid distributions of nearly $6 per unit. During the same period of time, KPP’s unit price has appreciated 101 percent from $30.57 to $61.50 (based on the currently anticipated exchange ratio between Valero and KPP at the closing of the merger), and it has paid distributions of nearly $10 per unit.3
RISK CONTROL
Sector specialists control risk by maintaining a balance between diversification and concentration in meaningful positions. If there are a variety of factors driving the sector that are independent of each other, the specialist will make investments that represent his understanding of the different factors so that different positions are not subject to the same fluctuations. Some sector specialists will also hedge their long positions with offsetting short positions or hedge the market by using index options. Another important risk consideration for sector specialists is investment time horizons. They try to align properly with the time horizons of companies in which they invest. If the manager invests in a company and the preferred investment horizon is shorter than that company’s business plan warrants, the result is unintended volatility risks in the short term.
ADVANTAGES/DISADVANTAGES
Sector funds can be attractive investments because most sector fund candidate companies benefit from being in a fast-growing industry or sector. Top-performing companies can produce extremely high returns, and even mediocre ones may generate desirable returns. In addition, sector specialists usually bring a great deal of experience and expertise to the process of unlocking the best profit opportunities on both the long and short sides in a sector.
The sector portfolio allows investors to do their own diversification. If investors use sector funds as a component of a larger portfolio, they can decide how much to allocate to any given sector. More important, they can choose the manager for each sector who best matches their risk-reward requirements. Although generalists can be very successful, for many sectors a specialist may be better able to navigate the often complex businesses and available investment opportunities in that sector. Because they have a finite list of investment options, sector specialists have more time to examine industry details and build relationships with industry contacts and company management.
The limited focus of a sector fund can be seen as both an advantage and a disadvantage. A small sector provides relatively few investment options. In addition, because companies within a sector may be affected by related events, their investment returns may be highly correlated. If the entire sector takes a downturn, the sector specialist will often fall with it. The fortunes of a sector specialist often depend on technology life cycles and the caprices of product development. As a result, sector specialists must accept short-term portfolio volatility and sometimes find it difficult to sufficiently diversify their holdings. However, the limited universe of stocks in which they navigate means they can gain a more intimate knowledge of the industry. In larger sectors, managers can diversify across the many subsectors. The preponderance of subsectors makes it somewhat difficult to compare sector hedge fund managers in the traditional ways, so merely comparing the results of managers dealing in the same broad group of stocks is not always enough. A good comparison also takes into account the investment style of the managers and the use of leverage and hedging positions.
PERFORMANCE
As shown in FIGURE 11.1, from January 1990 through December 2004, the HFRI Sector (Total) Index recorded an average annualized return of 19.29 percent, the highest average annualized return of any of the hedge fund strategies over the same period. Furthermore, the annual standard deviation of 13.63 was 1 percent lower than that of the S&P 500 index. However, it is no more useful to evaluate all sector funds as a group than it is to combine the diverse hedge funds strategies. An overview of funds that are operating in some of the more prominent sectors provides a breakdown of the performance figures. From January 1992 through December 2004, hedge funds specializing in the financial sector averaged 19.60 percent returns, with an annual standard deviation of 11.52. After reporting back-to-back losing years in 1998 and 1999, they recorded an annualized return of 17.53 percent from 2000 to 2004. From January 1993 to December 2004, hedge funds specializing in health care and biotechnology averaged 17.66 percent returns, with an annual standard deviation of 22.67. This included a 20.45 percent loss in 2002 and 39.28 percent gain in 2003. From January 1991 to December 2004, hedge funds specializing in technology averaged 18.71 percent, with an annual standard deviation of 19.37. These returns included a 124.26 percent gain in the dot-com boom of 1999, but the funds lost an annual average of 14.89 percent the next three years before rebounding with a 25.41 percent gain in 2003. The figures for these different sectors expose some of the problems with defining the general principles of a sector strategy. Two points, mentioned earlier, must be emphasized: the logic changes from sector to sector, and these performance figures tell the story of sectors in only the most general way.
FIGURE 11.2 shows the total strategy assets and net asset flows per year from 1990 to 2004 for sector-specific funds. Driven mainly by the tech-sector explosion of the late 1990s and the stability of the financial sector during the early 2000s, the strategy’s total asset size has boomed to over $42 billion as of the end of 2004.
FIGURE 11.3 on the following page shows the return distribution for sector compared to the overall hedge fund industry, stocks, and bonds. Sector funds represent one of only three hedge fund strategies that actually produced more monthly percentage gains between 2 and 4 percent than 0 and 2 percent since 1990.
FIGURE 11.4 shows the average upside and downside capture since 1990 for sector funds. Although the strategy outperforms the hedge fund industry as a whole during up months, sector funds tend to average a loss of 1.13 percent during down months, compared to the hedge fund industry’s average 0.45 percent loss. In defense of sector-specific funds, they produce virtually the same positive performance as the stock market during up months, but suffer only a quarter of the loss during down months.
SUMMARY POINTS
PROFIT OPPORTUNITY
• Sector specialists look for at least two of the following three things in a sector: high growth rates relative to the general market, an industry in which the specialist holds a distinct informational advantage, and the size and breadth to offer plentiful opportunities that are independently affected by a variety of factors.
• By investing in a sector that is outgrowing other sectors, managers can increase their chances of identifying top-performing stocks. Most companies benefit from being in a fast-growing industry. The top-performing companies can produce extremely
high returns, whereas even mediocre ones may generate desirable returns.
• Sector specialists may sell short to hedge or profit in down markets.
• The sector portfolio allows investors to handle their own diversification.
• A sector fund’s limited focus can be seen as an advantage and a disadvantage. A small sector provides relatively few investment options, but the specialist gains an intimate knowledge of that universe of stocks.
SOURCE OF RETURN
• The sector fund formula is a simple one: combine fundamental financial analysis with industry expertise to create an informational advantage that allows the sector specialist to identify the best profit opportunities in the sector.
• An equity hedge style sector specialist’s portfolio usually has two components: core positions and trading and hedging positions. Core positions are long-term positions that are rarely turned over and are a key source of investment returns. The rest of the portfolio will be made up of trading positions: short positions in overvalued companies and hedging positions that account for most of the portfolio’s turnover and allow sector hedge fund managers to make profits in both up and down markets.
INVESTMENT PROCESS
• Sector specialists use earnings and cash flow numbers to identify stocks within their area of expertise that are selling at a significant discount to the company’s intrinsic value.
• Sector specialists also look for a catalytic event that will heighten investor interest in the company, and thus reduce the current discount to intrinsic value.
KEY TERMS
Catalytic event. A near-term event, such as a new product launch, that heightens investor interest in a company.
Core positions. Long-term positions in growth stocks from which managers derive the majority of their profits.
Growth stock. A stock that an investor believes will appreciate because the company’s output and earnings will grow.
Hedging. The taking of positions to offset changes in economic conditions falling outside the core investment idea, such as the purchase of index options to offset changes in the overall level of the equity market.
Sector. A group of companies or segment of the economy that is similar in either its product or its market, for example, health care, biotechnology, financial services, or information technologies.
Trading positions. Opportunistic positions designed to take advantage of short-term market mispricings and inefficiencies.
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