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Hedge Fund Indices: Seeing the industry through a prism4 September 2008
We looked at July’s hedge fund index returns from Barclay Hedge Fund Indices from: CASAM, CogentHedge, Credit Suisse/Tremont, Dow Jones, Edhec, Eurekahedge, FTSE, Greenwich, HedgeFund.Net, HedgeWeb.Net, Hennessee Group, HFR, MSCI, and RBC. Specifically, we wondered if the returns reported for each strategy had different levels of dispersion. You’d think that the larger the average sample size in each database, the smaller the dispersion of returns. Further, you might guess that funds using certain strategies might tend to stick closer to the average (see Wednesday’s post). Below is a chart showing the 2 standard deviation range of the reported July returns from the various databases (with the sample sizes in brackets).
July’s returns suggest this intuition might actually be true. It turned out that the top-level indices and the funds of funds indices had the smallest range among various index providers. At the other end of the spectrum, strategies with less of a common beta driver (equity market neutral and event-driven) tended to have largest dispersions among the databases. Managed futures, a field where funds tend to agglomerate around the mean, showed a surprisingly wide dispersion however. So we wondered if July was an anomaly and set about collecting the same data on year-to-date returns. Here’s what we got:
Managed futures looks a lot different now. While July’s index results were all over the board, the YTD numbers tend to crowd together a lot more (around 9%). With most hedge funds reporting to only one or two databases, it’s no wonder the results don’t line up each month. Perhaps the best thing to do is average the averages. So today we introduce yet another hedge fund index: the AllAboutAlpha Hedge Fund Index Composite Average, an average of all publicly-reported averages. Because let’s face it, the world can always use another financial index. For the record, July’s result was -2.22% (YTD: -3.35%).
Comments »Ospraie Down3 September 2008
While it’s easy to assume that hedge funds are falling out of the sky, the news this week is actually somewhat mixed as usual. In fact, in its usual annoying way, the hedge fund industry continues to defy easy characterization. First, there’s the issue of hedge fund closures. Reuters reported last week that: “Running a hedge fund was long considered the crown jewel in finance but this summer a growing number of managers have called it quits, unable or unwilling to keep going during one of the industry’s worst-ever years.” One might easily be excused for assuming that less funds equals a shrinking industry. But as we’ve discussed several times on these pages, consolidation is a necessary stage in the maturation of any new industry - particularly one with such dramatic economies of scale. Smaller funds are being snapped up by larger players as they fail to achieve orbital velocity, and in cases where funds are simply mothballed instead, their assets are just as likely to end up in other hedge funds as they are back in traditional investments. Like previous shake-outs in the banking or telecommunications industries, this one will make the lives of suppliers (fund managers), not the customers (investors) difficult. As a result, it will not dramatically impact the underlying industry demand. Are institutions cancelling their dates with hedge fund managers? Not really. Just yesterday, the Conference Board reported that institutional demand remains healthy with plenty of room for growth: “Pension funds have been increasing the investments they make in hedge funds during the past three years. The report shows the largest 200 U.S. employee retirement plans with defined benefit assets in hedge funds. The amounts invested in hedge funds by these pension funds rose from an insignificant amount in prior years to $29.9 billion for the year ended September 30, 2005, to $50.5 billion for the year ended September 30, 2006, and then to $76.3 billion for the year ended September 30, 2007. This actually represents a fairly small percentage of total assets for these pension funds - 0.7 percent in 2005, 1.0 percent in 2006 and 1.4 percent in 2007. Thus, while increasing rapidly, hedge fund investments remain a small portion of the total defined benefit plan assets invested by these pension funds.” With the World’s top 300 pension plans now managing $12 trillion (up 14% year over year), this segment alone could carry the entire industry. Are hedge fund investors losing their collective shirts? Not really. Sure, Ospraie investors will need to visit a good haberdashery. But as Reuters pointed out last week, hedge fund returns to the end of July were about 7% ahead of the S&P 500. Early returns from August suggest the gap has narrowed somewhat, but hedge funds remain well ahead of equity markets. Put another way, the S&P 500 has seen two days in the past 2 weeks when the percentage daily loss roughly equalled the year-to-date loss in the Credit Suisse/Tremont Hedge Fund Index. And this year is generally considered to be the worst in recent memory for hedge funds. Some industry participants seem to realize that shut-downs and lay-offs don’t necessarily indicate industry shrinkage. Investment consulting firms know that hedge funds represent an alpha source not unlike the alpha sources their clients have owned for decades - only separated off into its own fund rather than being mixed with market betas in the form of traditional active mandates. As a result, they are actually entering the industry right now. Reports Pensions & Investments today (new: free registration required): “Client demand and higher fees are luring more investment consultants into money management, particularly hedge funds of funds…Consulting firms are managing at least $2.3 billion in discretionary alternatives portfolios, mostly focused on hedge funds. The total most likely is much larger, because many consultants do not report their assets under management.” Why run back into the burning building just as everyone else is stampeding out? Because the smoke is just coming from a turkey (osprey) burning in the oven - not a 5-alarm propane explosion. In fact, it turns out that some institutional investors have been hounding their investment consultants to start funds of funds. P&I reports that some consultants’ clients “…have been so persistent in asking for discretionary management that executives there were pushed into finding a way to provide it.” Sure, Ospraie copycat funds may be next to fall. But the result is more likely to be greater due diligence by investors, more regulation, more conservative funds, and the avoidance of commodity funds, not an all-out flight to passive mandates. While there’s no question that competition in the hedge fund industry is intensifying, that doesn’t mean that the amount of assets dedicated to active management and deployed in the form of “hedge funds” is destined to shrink. The hedge fund industry may indeed wax and wane. But if it does, it will be taking its cue from the active/passive management debate, not from the sickly cries of a wounded osprey.
Comments »That’s quite a “distinctive” strategy…2 September 2008
Now a new paper by researchers at the University of California takes the same general idea and applies it to hedge fund strategies themselves. The authors Lu Zheng and Ashley Wang aim to determine if manager and strategy “distinctiveness” is a predictor of positive alpha in the long run. To do this, they use a measure they call the strategy distinctiveness index. The “SDI” is simply one minus the r-squared of the manager’s return vs. those of her peer group. Once the SDIs for over 2000 hedge funds in the Lipper Tass database were calculated, Zheng and Wang grouped them into deciles. As you might have guessed, certain hedge fund strategies tended to be the home of highly idiosyncratic managers with a low average correlation to their sub-index (e.g. market neutral), and certain strategies tended to be the home of a large number of managers with a high correlation to their sub-index (e.g. CTAs). The chart below from their paper shows this clearly. The decile buckets on the left side of the graph contain funds with a low SDI (a high average correlation to their sub-index) while the decile buckets on the right side contain funds that have a low average correlation to their sub-index.
This charts confirms what is often assumed in the hedge fund industry - that convertible arbitrage funds and CTAs tend to have less idiosyncratic risk and rely more on what might be called “convertible arbitrage beta” or CTA beta while equity market neutral funds tend to have little relation to a common risk factor and therefore have a lower correlation (i.e. a higher SDI score). Also not surprisingly, emerging markets funds tend to be relatively absent from the ranks of the highly idiosyncratic (at the right). After all, these funds are obviously designed to be long-biased in emerging market beta. Global macro, fixed income and equity market neutral funds are all but absent from the low idiosyncratic risk deciles, but comprise about a third of all funds in the most “distinctive” decile at the right. And finally, long/short equity funds seem to align best with Fung & Hsieh’s original chart - with that strategy dominating the seventh decile (with an r squared roughly around 0.3 we’d guess). So do “distinctive” funds do well over the long run? Apparently yes. The authors create 5 portfolios made up of funds with common levels of distinctiveness. Their conclusion: “…we find that the SDI helps to predict future fund performance. Funds with more distinctive strategies tend to perform consistently better after adjusting for differences in their risks and styles. Specifically, with a 3-month sorting and rebalancing trading strategy, the quintile portfolio of funds with the highest lagged SDI yields an average risk adjusted return of 10.27 percent per year, whereas the quintile portfolio of funds with the lowest SDI yields an average risk adjusted return of 3.63 percent per year.” Contrary to the common assumption that hedge fund managers always try to goose their funds’ volatility just to increase the possibility of a big payday (a.k.a. “gaming”), this study finds that a couple of years of high idiosyncratic volatility often leads to a period of (more conservative) index hugging. “Moreover, SDI decreases with the idiosyncratic volatility of fund returns in the previous two years. This result is inconsistent the gaming hypothesis that the deviation captured by SDI is driven by managers making random bets and taking on excessive risk to maximize the option-like payoff. Furthermore, SDI decreases with fund age and size, and increases with incentive fees.” The bottom line is that distinctiveness is a good thing - arguably the reason we pay fees in the first place. But still, like anything, too much of it can be a bad thing.
Comments »Poll reveals explosive growth in LDI1 September 2008
About a month ago, consultancy Mercer wrote: “It seems like only yesterday that Liability Driven Investing (LDI) was an interesting academic idea with few “real world” proponents among pension plan sponsors. Now, LDI regularly makes the front page of pension industry publications and is widely accepted as a practical and effective risk management framework. Plan sponsors implementing LDI strategies were “mavericks” only a few years ago; now they are “cutting edge.” For such a new area, LDI seems to have more than its fair share of experts. And there is a surprising diversity of opinions on what it is and what best practices are.” The pace of change seems to be accelerating. Poll results released last Friday by SEI Global Institutional Solutions show that the simple, traditional definition of the concept, “matching the duration of assets to the duration of liabilities” is giving way to a more holistic view that LDI is ”a portfolio designed to be risk managed with respect to liabilities.” Although this sounds like the same definition delivered by a marketing person instead of an actuary, SEI says this “suggests a stronger understanding around the broader implementation of LDI”. Curious about whether LDI was having a break-out year, we requested a copy of the full report. Here’s some of what we learned… This broader definition of LDI (”risk managed…”) has taken hold in the UK and Canada, but not in the US, Netherlands or Hong Kong where pension executives still say LDI is still just about matching the duration of assets and liabilities. This isn’t' to suggest that the Dutch, for example, remain ignorant about the potential of LDI - fully 62% of pensions there use it (vs. around 40% for other countries polled). While their definitions differed, US and UK pension funds agreed on one thing though - LDI is here to stay. The percentage of plans using the approach doubled in both countries over the course of 2007. In fact, as the following chart, build with data from the report, shows, more pensions are implementing LDI while fewer are not considering it (the remainder, we assume, are considering implementation). Why all the excitement? Apparently it’s not just because recent abysmal returns have forced pension plans to revisit their strategies. In fact, “poor investment performance” ranked as only the fifth most important reason why plans have flocked to LDI. The reason, it seems, may be that investment consultants (the reformed egg-heads and actuaries) have the ear of the pension community. The following chart showing what factors are influencing changes in pension asset allocations (also created from data in the full report) suggests that consultants and their immediate clients (boards and committees) are driving the LDI agenda:
The bottom line, says SEI… “The biggest change over the past year appears to be that pension sponsors are no longer in the “understanding phase” when it to comes to LDI and are now entering the “implementation stage.“
Comments »Labor Day Newsreel31 August 2008US Managers Stem the Fall in Assets: US investors checked under the sofa cushions and found a bit of extra change - just enough that “for the first six months of this year, unlike the largest European asset managers, the largest US investment firms have been able to stem their fall in assets under management.” Low Returns Spur Big Cuts: Re-use your paperclips everyone, “…while massive layoffs are still rare in the asset management industry, headhunters report that bonuses - with some exceptions for the top echelon of talent - and other incentives have softened.” Large Cap Doldrums Drive Alternative Investment Quest: Apparently turning their backs on plain vanilla mark beta, financial advisers are looking to products with a higher proportion of alpha in their returns - in this case, real estate, commodities and small caps. JP Morgan Increases Allocations to Alternative Investments: The firm’s private bank says equity allocations in discretionary accounts have dropped 40-80% in the past five years to between a quarter and a half of the typical client portfolio. Now they’re roughly the same size as alternative allocations. Touted 130/30 Funds are New and Unproven: MarketWatch’s Chuck Jaffe rains on the 130/30 parade by setting up the following straw man: “…there’s a logical expectation that it will deliver superior performance in all market conditions.” Appeal of 130/30 funds swell: Hold the phone! Investment News says “…the market continues to move in the direction of 130/30 strategies, with growing supply meeting growing demand.” Inflows to Emerging Market Hedge Funds Fall 72%: Sure, emerging market hedge funds with a local presence in the region to better than those with no presence. But apparently, the whole category took it on the chin anyway in Q2. Who Needs a Hedge Fund Anyway?: CNBC reports that hedge funds rock - as long as you’re a big institution. Says one expert, “High net worth investors don’t get access to alpha managers.” Regulatory Paranoia Means Hedge Fund Claustrophobia: SEC xenophobia is resulting in hedge fund claustrophobia. A crack-down on sharing investment ideas threatens one of the most cherished traditions of the hedge fund industry, the “best ideas dinner”. Ivory Towers Showing Some Cracks: After “blowing the bell curve” for the rest of the class for years thanks, mainly to alternative investments, US university endowments have finally lost some money. US Seeks Delay of Civil Case vs. Bear Managers: So much for civility! Prosecutors appear to think their chances are better with a criminal case, rather than civil one.
Comments »Musical Chairs - Asset Manager Edition28 August 2008
Well, let the asset management musical chairs begin. Managers of both the long-only and hedge fund persuasion seem to be uncommonly receptive to recent overtures from potential acquirers. Investment News reports that the “time may be right for big-name asset manager acquisitions”. They cite industry observers who suggest Lehman’s Neuberger Berman and Wachovia’s Evergreen Investment Management are making their way around the circle as we speak. Apparently, the first half of 2008 saw a dearth of asset management M&A with stakes in 104 fund managers selling for a little over $10 billion - one third of the action seen in the first half of last year). So there is a backlog of managers who may be interested in cashing in a few chips - like, for example, Lehman and Wachovia. Meanwhile, potential buyers are topping up their fuel tanks. Affiliated Managers Group (AMG), the grand daddy of asset management buyout firms, recently raised $460 million to “execute the new investments component” of its strategy. Another firm that specializes in buying stakes in asset managers, Asset Management Finance Corporation (yes, “AMF”) just sold four-fifths of itself to Credit Suisse for around $400 million. According to Dow Jones, the chairman of CS’s alternative investment business says AMF “has a significant pipeline [of deals] due to the demand for capital from a significant number of high-quality managers”. Ironically, Dow Jones reports that Lehman is also reportedly planning a fund aimed at buying stakes in fund management businesses (like, um, Neuberger Berman?) To prove this ”demand for capital from high quality managers”, you needn’t look any further than the hedge fund business. Pensions & Investments reports that hedge fund managers are “hungry for a cash infusion” right now. The paper reports: “In the face of their worst collective performance in years - compounded by a 76% drop in net inflows in the first half of the year and redemptions from high-net-worth investors - hedge fund managers anxious to replenish their coffers are visiting institutional investors and their proxies, institutionally oriented fund-of-funds managers, with caps in hands, sources said.” While hedge fund managers try to top up their funds, they are surely also contemplating the precarious state of their firm’s own stock too - pushing equity sales up the corporate agenda a little. One possible exit strategy that has generated interest in the past is a reverse take-over by a special purpose acquisition corporation, a SPAC. Reuters reports that these so-called “blank check companies” raised a metric tonne of money last year and are still trying to deploy over $12 billion of it. According to Reuters, these capital pools are simply “unable to put their funds to work effectively“. Even SPACs that target asset managers are having trouble closing deals these days. Earlier this year, we told you about one particular SPAC, Tailwind Financial, that was about to eat up a hedge fund company called Asset Alliance (itself, a bit of an AMG or AMF). But in early August Tailwind pulled the plug on that deal, saying in a press release that “the decision to terminate was based on the belief that the transaction would not receive shareholder approval due to market conditions in the financial services sector.” This hasn’t deterred the rest of the pack, though, from snacking on asset managers. Just yesterday, Money Management Australia reported that a new player in this field has started buying up Aussie fund managers and has struck an alliance with US-based Skybridge Capital - yet another firm that buys stakes in hedge fund managers. And so we come around to our starting position in this circular game of musical chairs. Skybridge was co-founded in 2005 by a manager who sold his firm to, you guessed it, Neuberger Berman.
Comments »When the absence of incentive fees can give investors an Olympic-sized headache27 August 2008
The incentive to win - whether financial or purely psychological - is arguable what separates athletes from entertainers or performers. But are incentive fees also valuable in asset management? A hedge fund incentive fee is often referred to as a “free option”. In a 2001 article for the Journal of Alternative Investments, Mark Anson described it this way:
So basically, a hedge fund investor pays a management fee that is analogous to that of a mutual fund (around 2%), plus a free option that is not dissimilar to an executive stock option. But as we all learned around the turn of the century, these options have a value. If were to similarly “expense” these options, then the overall fees paid by an investor would be, to take a hypothetical example, 2% plus another 2% depending on the volatility of the fund’s return. Hedge funds could, of course, just charge a 4% management fee. Technically, the investor should be indifferent. But they aren’t. And investors don’t demand it either. In fact, research suggests that hedge fund investors are more price sensitive when it comes to management fees than they are when it comes to incentive fees. So thankfully for those investors (many of them sophisticated institutions), the government allows them to freely negotiate fees. Mutual fund investors aren’t so lucky. As we have discussed before, US mutual funds are barred from charging asymmetric fees - fees that have an upside for the manager, but no downside. Notwithstanding certain tricks used to get around this rule, the market is not able to negotiate any alternative fee arrangements with fund managers. In a recent article on the sub-prime turmoil, Columbia University’s Charles Calomiris made the following observation about this regulation:
There is no question the aggregate fees charged by hedge funds (explicit plus option value) tend to be higher than those charged by mutual funds. But as Calomiris points out, if the market is willing to pay those higher fees, then freely allowing participants to structure their arrangements may not be such a bad idea after all.
Comments »Alternative Viewpoints: “Higher Moment Betas”26 August 2008Most investors are familiar with the concept of beta. Beta gives us an idea of how the returns of a security are likely to act in the long run given the returns of the broader market (or the returns of a narrow slice of that market). But that definition assumes that both the security in question and the market in general have bell-shaped normal returns. Hedge funds tend not to fit neatly into this model. Instead, they are positively or negatively skewed and tend to have “fat tails”. So now researchers have come up with new betas that measure how one asset’s variance, skewness and kurtosis (tail-sizes) react to the variance, skewness and kurtosis of other asset classes. In our monthly spot featuring the thoughts of a CAIA Association member, Mikael Haglund of Altevo Research tells us about how to use these “higher moment betas”.
Traditionally, the CAPM and the mean-variance asset allocation approach have been the standard ways of constructing portfolios. But implementing a similar approach is problematic when hedge funds are included. Numerous studies have shown that the returns for different hedge fund indexes display non-normal return distributions when longer time frames are studied. Therefore, working with a framework that assumes asset returns are normally distributed can over- or under-estimate downside risks and lead to suboptimal portfolio allocations. The standard deviation used as a measure of risk in traditional asset allocation techniques only measures deviations from the mean and puts equal weight to positive and negative deviations from that mean. However, usually preferences are asymmetrical. The utility derived from a positive result is often less than that derived from a negative result of equal magnitude. One way of accounting for this preference structure and for the non-normal distributions of hedge funds is to use “higher moment betas” in the portfolio construction process. Higher co-moment diversification benefits include a marginal reduction in portfolio variance, skewness and kurtosis, and can therefore help determine the appropriate hedge fund strategies to include in a portfolio. The overall aim here is to reduce not just the volatility, but the downside risk of the portfolio. To determine which of the sub indexes that is suitable to use as equity diversifier for the equity part in a traditional portfolio of stocks and bonds we calculate the higher moment betas (for details on how to calculate these measures, see our white paper on the topic available at the Altevo Research website).
Due to the negative skewness seen in MSCI World, we would want to look for a value below 1 in all the higher moment betas presented in this chart. This would indicate higher moment diversification benefits. As you can see in the chart, Managed Futures, Fixed Income Arbitrage, Equity Market Neutral and Convertible Arbitrage demonstrate the best values of higher moment diversification benefits. So we use these sub-indices to construct the optimal diversifier for our long-only (MSCI World) portfolio. When we add progressively more of the diversifier to the long-only portfolio, the result is marked improvement not only in volatility, but also in “Modified Value at Risk”, a measure that also takes into account skewness and kurtosis. As we all know, hedge funds have had a tough time during the current credit crisis and Convertible Arbitrage is one of the strategies that suffered the most. So we thought it would be useful to examine how the higher moment diversification benefits of Convertible Arbitrage have developed during the recent crisis. As you can see in the chart below, the diversification benefits on extreme risks of including CSFB/Tremont Convertible Arbitrage hedge fund index in an equity portfolio have indeed decreased somewhat (the higher moment betas have risen) but the strategy still demonstrates significant positive diversification effects (higher moment betas remain well below 1.0).
As you can see, accounting for non-normal return distributions in the portfolio construction process can create more stable portfolios and limit the large drawdowns often seen in traditional equity portfolios during bear market periods. This is especially appealing for investors with defined liabilities, e.g. pension funds, where it can result in a better match between assets and liabilities and thereby limit the risk of the pension plan being under-funded due to decreasing asset values. - M. Haglund, August 25, 2008 The opinions expressed in this guest posting are those of the author and not necessarily those of AllAboutAlpha.com.
Comments »Hedge fund marketers remain stuck between a rock and a hard place25 August 2008
An article in this month’s Journal of Financial Transformation illustrates why this is. The piece, titled ”Hedge fund marketing in an era of regulatory uncertainty” covers many of the issues faced by those trying to raise money in the US. It’s a great update on the ebb and flow of SEC edicts over the past year and was co-authored by hedge fund personality James Hedges. The article describes Congress’ response to the SE having the rug pulled out from under them on hedge fund registration back in 2004. Sensing an opportunity after manager Phil Goldstein successfully challenged the SEC’s registration rule, Congress stepped into create a “legislative override”. While leaving the registration issue in Congress’ capable hands, the SEC embarked on an anti-fraud rule that makes it illegal to break the law (see related posting). So where does this leave hedge fund marketers today? Unfortunately, not much better off than in the past. Here’s some of what Hedges, who is also the principal of a firm that provides hedge funds with market advice, and his co-authors suggest:
But probably the most important lesson for hedge fund marketers in this article is that a prospectus “does not satisfy the duty to provide balanced sales materials and oral presentations.“ In other words, since hedge fund buyers cannot rely on the rigorous standards of disclosure and reporting required by mutual funds, the sales pitch itself becomes a more critical element of the contractual relationship. Sales people from other fields often find it odd that it’s actually against the law to give an “unbalanced” presentation of the fund. In other words, if you’re a hedge fund marketer, for goodness sake, don’t sell. As someone who spends a good portion of my day trolling the world’s media to keep on top of this industry, I find that most hedge funds are forced to push the envelope on some of these issues - particularly the ban on talking to the media. The truth is that investment ideas, like all ideas, deserve to be freely discussed. Without the free flow of these ideas, there would be no AllAboutAlpha.com. Banning the discussion of hedge fund ideas not only bumps into first amendment issues, but it also raises questions about academic freedom. After all, many of today’s hedge fund managers are part-time academics (or is it the other way around?) In any case, small non-institutional funds better keep praying that the SEC doesn’t raise the wealth threshold for investing in hedge funds. Because if they do, there won’t be anyone left to mail to, present to, or even call up on the phone.
Comments »Are financial advisors serving your lunch to hedge funds?24 August 2008
Here’s another weird market anomaly that seems to be in no hurry to arbitrage itself out of existence. Individual investors who invest in mutual funds via financial advisors do markedly worse than those who don’t. This begs the obvious question “why do mutual fund investors even employ financial advisors?” Professor John Haslem (see previous postings), the author of an article on this question in the upcoming edition of the Journal of Investing, doesn’t mince words. In an earlier version of his article he writes:
We’re always interested in “behavioral biases” because when you boil it right down, they represent one of the few logical explanations for the continued existence of recurring alpha in hedge funds or traditional active funds. So we posed a few questions to Haslem, who is the author of dozens of other interesting papers on mutual funds and Professor Emeritus at the University of Maryland. AllAboutAlpha: Professor, the hedge fund community is always interested in the “supply” of alpha. Is it finite? Is it decreasing? Is it a “renewable resource”? Could investor “inertia” (and other factors enabling the perpetuation of underperforming mutual funds) represent a continually replenishing source of alpha for the active management community (of which hedge funds represent a disproportionate share)?
AllAboutAlpha: Pensions are often viewed as deriving non-economic utility from their investments (like farmers or other types of hedgers). In other words, their investment strategies are relatively constrained. If retail investors are constrained by the list of funds available in their DC plans, then are those retail investors also giving up their lunch to the less constrained alpha hunters?
AllAboutAlpha: How to you define “irrational”? In other words, how can the value created by the ancillary services (e.g. life event planning) and value propositions (e.g. convenience) of a financial advisor be delineated from the fee structure? Is there a way to count the soft value created by the “handholding”?
AllAboutAlpha: And a related question: Does the satiation of purely behavioral biases actually have a value as well? For example, marketers might refer to your notion of “framing” as just “branding” and say that it is a legitimate part of the product’s value and therefore represents x% of the price people are willing to pay.
AllAboutAlpha: If funds flows are positively related to the size of the complex since larger complexes = more free media (in database listings or otherwise), then do you think deregulation of hedge funds down the road might give rise to a dramatic increase in the number of funds offered by each firm? Have we seen any such development as a result of brands such as Morningstar and others getting into the hedge fund database game.
Unlike many academics, Haslem offers some pretty specific advice for retail investors: use fee-based financial advisors. We would definitely concur since fee-based advisors are essentially free of the “behavioral biases” that prevent them from offering bifurcated alpha/beta solutions – biases caused by the absence of 12b-1 fees and other incentives to sell ETFs (beta) and hedge funds (alpha). By making decisions that are less influenced by behavioral biases, fee-based advisors might be less likely to feed their lunch to the alpha-hungry hedge fund community.
Comments »The Origin of Species21 August 2008
And indeed, they may be different species - in a sense. Back in 2004, MIT’s Andrew Lo, the author of a huge library of refreshingly easy-to-read papers and articles, proposed a successor to the EMH that actually defined different groups of investors (pensions, individuals, traders etc.) as different “species” of investors and expanding on the biological analogy. His resulting Adaptive Markets Hypothesis (AMH) explains the apparent irrationality of markets as a rational reaction to a change in environmental conditions. His Journal of Portfolio Management paper can be downloaded here (academic version available here). Drawing from behavioural finance, Lo says that investors make decisions using heuristics drawn from trial and error, not from concrete analytical models. Drawing a page from Darwin, he says that without adequate trials and errors, there is no adaptation. He supports Joseph Stiglitz’ famous conclusion that perfectly informationally efficient markets are technically impossible since someone somewhere has to exploit some kind of arbitrage opportunity in order for an equilibrium to be reached. Lo adds:
There’s little doubt that smaller markets (e.g. in Asia) are less efficient than larger, more mature markets like the US. So you’d expect investors to be willing to expend a lot in order to uncover investment opportunities. And indeed, you do. As Teo found in his study, investors are essentially willing to “pay” foreign funds a premium (via sub-optimal returns) in order to exploit the inefficiencies inherent in these markets. However, unlike Lo’s version of events (where investors are willing to “expend” their own efforts), they are doing it vicariously through their non-local fund manager. Whether the fund manager re-deploys this expenditure in the form of greater research effort is another question altogether. As for why the anomaly identified by Teo doesn’t arbitrage itself into oblivion, it appears that the sheer size of the irrational beliefs of US and UK investors may be enough to trump the otherwise ubiquitous effect of market forces. As Lo said in his seminal 2004 article:
Perhaps as anomalies like Teo’s propagates through the hedge fund community it will disappear. But for now, it would appear that there hasn’t been quite enough “trial and error” for investors to discard their heuristic that you can manage an Asian hedge fund from Mayfair or Midtown.
Comments »Like real estate, hedge funds all about location, location and location20 August 2008
But when oil passed $100, guess what happened. Canada’s hedge fund alpha story suddenly resonated with investors – even though long-only energy beta was what those investors were really seeking. Last fall, the head of the Canadian Chapter of AIMA acknowledged this situation but essentially said Canadians would take the additional dollars anyway and worry about investors’ specific motivations later (see related posting). This scenario was undoubtedly played out around the world as geographically-dispersed hedge funds tried to convince investors that local presence was actually really important. Now, they may be vindicated. A new paper due to be published in the Review of Financial Studies finds that Asian hedge funds with a local address actual do perform better than those without one. And guess what; they perform substantially better in less developed, informationally-inefficient markets (surprise, surprise). The chart below from the paper shows how a portfolio of locally-based hedge funds (solid line) has produced more cumulative alpha than a portfolio of non-locally-based funds. [Click to enlarge]
But despite this outperformance, author Melvyn Teo finds that foreign funds (mainly from the US and UK) are still more able to charge higher fees and establish longer lock-ups than their predominently smaller, locally-based cousins. Teo puts it bluntly:
Teo examined Asian funds partly because the distance and time zone changes to the US and UK were substantial. Perhaps to the chagrin of the Canucks, he suggests that proximity may in fact mitigate this disparity. This is music to the ears of funds of funds that invest in Asian managers, says Teo. The outperformance of these local managers is more than enough to justify the extra layer of fees. In addition, he warns:
So maybe geography counts for something after all. With the legions of institutional investors flocking to a smaller and smaller number of US and UK-based mega-funds, this is a fact that probably shouldn’t be overlooked. Late-breaking related article: “Emerging-market hedge funds gaining traction” (August 20, 2008, Investment News)
Comments »Confusion and the confusing things that cause it19 August 2008
American baseball player and patron saint of confusion had an obvious knack for making ironic, contradictory and logically self-referential observations about daily life. Had he been in the hedge fund industry, he might have really enjoyed this week. Several recent hedge fund stories seem strangely inconsistent with each other. First Euromoney’s EMII.com website ran a story called “FoF Assets Lead Hedge Fund Growth“. And at the same time, Investment News ran a story titled ”Funds of hedge funds losing their luster“. So which is it, the best of times or the worst of times? A closer read of both articles reveals that both stories are more similar than the headline writers have let on. EMII was referring to a Finalternatives piece that acknowledges the recently-acquired taste for single-manager funds displayed by investors:
Investment News seems to agree, with the caveat that this trend is actually coming to an end rather quickly. They cite data from Morningstar that indicates single manager hedge funds had a net inflow of over US$10 billion in June while fund of funds said sianora to $9.7 billion. Says Investment News:
For better or worse, larger investors are essentially “rolling their own” fund of funds using single manager funds. But keep this in mind: Funds of funds must eventually allocate all their capital to single-managers. Imagine a world where funds of funds manage, say $100 billion and single funds manage $500 billion. Let’s say investors put a further $200 billion into hedge funds overall - allocating half to funds of funds and half to directly to single managers. The funds of funds would double in size and the single managers would increase by only 40%. Even if investors placed all of the money in funds of funds, then the funds of funds would triple and the single managers would still grow by only 40%. So comparing growth rates is a red herring. At the end of the day, all the money goes to single managers. Funds of funds are more akin to financial advisers than they are to single-manager hedge funds. Here’s another couple of stories this week that seem to conflict with each other. Bloomberg reported earlier in the week that “States Double Down on Hedge Funds as Returns Slide“, while Pensions & Investments said yesterday that Middle Eastern and European hedge fund investors were “Jumping off the bandwagon“. Bloomberg cites data showing that the average allocation to alternative investments by state pensions doubled from 2003 to 2007 and now sites at around 5.7%. Meanwhile, P&I quotes Casey Quirk’s David Bauer and Ennis Knupp’s Keith Black (see guest posting) as reminding us that alpha decay and industry concentration are starting to make some investors take pause. In fact, in “Managers hungry for cash infusion” P&I also reports that:
So what are we to make of all these seemingly contradictory developments? Yogi Berra, hedge fund commentator, summed it up better than we have ever done so. Said Berra:
Comments »Hedge funds changing tack18 August 2008
Since the beginning of the last bull market, questions have been raised about the high correlation between hedge funds and equity markets. Arguably, this relationship gave birth to the field of hedge fund “replication” (a field that now involves a wide variety of “alternative” betas as well). But all along, hedge funds have said that when markets rise, why shouldn’t they try to capture all this upside - and then some? The value in alternative investments comes not necessarily from their consistent absolute outperformance, but in the option-like behaviour of their returns. In other words, your “2 and 20″ buys you a market put. Long-only managers, hedgies are apt to say, simply don’t have the ability to make dramatic adjustments to net exposure in response to market gyrations. July’s negative performance for hedge funds has shown that they too seem unable to spin on a dime. However, two reports released last week show that hedge funds are actually able to adjust their aggregate market exposure pretty quickly. The Hennessee Group, a hedge fund database company, examined the net and gross exposure of long/short equity funds in their database over the past few years and found that net exposure peaked at 52% in Q2 2007 - about the same time the S&P 500 maxed-out (see chart below).
As you can see from this chart, long exposure went from 78% to 114% between 2003 and 2007. Then, just as the market was topping out, net exposure was reduced by nearly 10%. By the end of Q2 ‘08, it was 17% below its 2007 peak. This is a bottom-up view based on actual holdings. But is this exposure change reflected in the rolling return correlation of hedge funds with equity markets? Another report last week provided us with an answer. Credit Suisse released this study on the correlation between its broad-based index of hedge funds and the MSCI World Index. As you can see in the chart below from the report, the 12-month rolling correlation was over 0.95 in June 2007, but fell dramatically to around 0.60 by June 2008 (ignore the red circle - that’s something else).
Bear in mind that this report examined the correlation of a broad index of hedge funds, not just the long/short equity category. But the message is the same; hedge funds are charting a new course as the winds of change hit equity markets. Instead of simply sailing downwind on a dead run, they are beginning to turn into the wind. Like sailing upwind, that also requires skill - and it’s slower. As a result, their absolute returns have taken a hit, but if hedge funds can emerge from 2008 with only modest losses, then history may remember this year as the year when hedge funds proved their seaworthiness.
Comments »HedgeWorld Through the Ages17 August 2008Nearly 10 years ago, two Tremont executives and a new media manager for a Thomson Financial publication had an idea - a website that would “be the first independent Internet community and e-commerce platform which will be the catalyst for reinventing the way the industry communicates and transacts its business“. They called it “HedgeWorld” and it quickly became a leading Internet brand in the burgeoning hedge fund industry. Said the firm’s December 8, 1998 press release:
It was an audacious goal, but one that attracted a lot of users, sponsors and eventually acquirers. However, after changing hands a number of times, HedgeWorld’s new owners (somewhat ironically, Thomson Reuters) laid off the majority of staff this weekend, ending a storied history and releasing a team of excellent financial journalists into the waiting arms of the hedge fund community (see Friday’s posting). Reports suggest the brand may live on (as MAR Hedge did after it met its maker in 2006), but there seems to be little question that this marks an end to the franchise as an independent entity. In deference to the grande dame of hedge fund websites, we have assembled a gallery of HedgeWorld screen shots from throughout the firm’s history (thanks to archive.org). For online publishers like us, it’s interesting to see how each site reflects the prevailing web design conventions of the day. But even if you don’t care about these kinds of things, you will find this walk down memory lane may at least remind you of better days for the industry… (late breaking addendum: for a little extra walking down memory lane, check out HedgeWorld’s own tribute to its departing crew here)
Comments »Media Insana-ty?14 August 2008
It’s almost as if financial journalists don’t get paid enough or something. All of a sudden, hedge funds seem to want to hire people who have huge networks, are intelligent and have a great understanding of the hedge fund and financial service industry. But the trend, if it is one, began some time ago. This is just the latest chapter in an ongoing dance between hedge funds and media people. About a year ago, I was having lunch with a business journalist friend who was being courted by a major hedge fund company to join them to help with marketing. At around that time, someone emailed me a job description for an opening at a hedge fund that specifically included “journalism” as a prerequisite. Even today, you see more and more job listings popping up with the words “investigative” and “journalism” in them. Here’s one I picked off such a job board earlier today:
The question is: are asset managers suddenly realizing how to exploit the skills of (underpaid) financial journalists, or are the journalists trying to escape before they are taken to the firing line along with thousands of their colleagues in the media industry? Who knows? But financial journalists and hedge fund managers may have a lot more in common than first meets the eye. As Tim Price, himself an (excellent) part-time financial columnist said way back in 2006:
Comments »All Creatures Great and Small14 August 2008Despite all of our attempts to inject humour into some pretty dry subjects, there’s really nothing funnier than a monkey wearing glasses, right? Indeed, it all boils down the bespectacled primates. Not to be out-done, however, are the legions of other goofy-looking mammals that collectively help us to decode the often intimidating world of asset management. So today, in our summer retrospective series, we pay homage to the animals that have graced these pages over the past few years. Scroll over and click on each furry little critter to learn how they became AAA-certified. | |||||||||||||||||||||||||||||||||||||||||||||
With the proliferation of hedge fund indices these days, it can be tough to figure out which provider to trust sometimes. Around a dozen managers of hedge fund databases pump out returns across various hedge fund strategies each month. But invariably, the numbers seem to differ. Curious about these differences, we did a little back of the envelope study today that we share with you below. 
I had the pleasure of attending a breakfast meeting this morning during which several hedge fund luminaries (and myself, the token non-luminary) were tasked with selecting the recipients of one of the industry’s many annual awards. With the announcement of 
By design, hedge funds have a much lower correlation to equity market indices than mutual funds. Regular readers may remember a presentation given by Bill Fung and David Hsieh to the Atlanta Fed 
While liability-driven investing (LDI) has achieved some measure of celebrity over the past year, the concept still has a reputation for being of interest only to egg-heads and actuaries (apologies to egg-heads…okay, and actuaries).
One sport that is still seeking Olympic recognition is musical chairs - the sport where competitors dance around in a circle until the music stops. Then, in the ensuing melee, they grab a seat anywhere they possibly can. 
Although the Olympics is an “amateur” athletic event, many athletes get one time bonuses from their government or corporate sponsors if they do well. In part, such incentives are designed to ensure the athlete doesn’t just go the games to have a good time. While the Olympic festivities are an experience in their own right, many other athletes with such incentives often forgo competitions if winning seems out of reach or a pyrrhic victory is likely (take, for example, tennis players who skip tournaments to rest a nagging injury or recuperate after weeks of competition).
Special to AllAboutAlpha.com by: Mikael Haglund, CAIA, Founder, 
There are few products in the world with as many confusing and contradictory marketing constraints as hedge funds in the US (and, in fairness, many other jurisdictions). Hedge fund marketers out there know what I’m talking about. Last month, we told you about 
Last week we told you about a curious market inefficiency - the fact that Asian-focused hedge funds with local offices performed significantly better than Asian-focused hedge funds with no local offices in the region. It was curious not necessarily because you’d expect otherwise, but rather because the anomaly seems to be ongoing. In other words, the invisible hand of the market has not arbitraged it away with its usual gusto. We drew on Andrew Lo’s Adaptive Markets Hypothesis to account for part of this phenomenon. 
Melvyn Teo’s paper on the relative merits of locally-based Asian hedge funds vs. those with no local presence (see yesterday’s posting) amounts to a significant indictment the Efficient Market’s Hypothesis. After all, why would one group of managers (i.e., those without a local office) be willing to forgo higher returns? And why wouldn’t investors just stop investing in sub-optimizing, apparently irrational funds? It’s as if these two groups were totally different species or something.
One of the frustrations experienced by hedge fund managers in out-of the-way locales is that global investors seem to ignore their alpha-generating potential until there is a big move in some kind of underlying beta. Take Canada, for example. Managers in that country have long argued that you need “feet on the ground” to fully exploit most opportunities. American managers, they are apt to say, can’t just fly in for one day meetings and expect to know the lay of the land. These foreign invaders are only attracted to the largest domestic investment opportunities, the argument went, not the mid-cap “sweet spot”. But for the most part, global investors stayed away anyway.
“The future ain’t what it used to be.”
Sailors out there will know that boats can sail down with the wind - like a leaf being blown across the water - or into the wind at an angle, zigzagging back and forth along the way. Sailing downwind is easier and since it offers a direct path from A to B, and is therefore faster. Zigzagging directly upwind, on the other hand, requires more skill and is much slower. But who would want a boat that could only sail along with the direction of the wind? This is where sailing can offer a useful lesson for hedge fund investors. 
After two years at the helm of the eponymously named Insana Capital, former CNBC anchor Ron Insana has 
