Newsreel: Hedge fund headhunting, M&A, and scapegoats

3 July 2008

Hedge Funds Hire From Wall Street as Jobs Disappear, Pay Falls: Bloomberg reports that hedge fund recruiters may be the biggest beneficiaries of the carnage on Wall Street.

Asia to Create Thousands of Hedge Fund Jobs, Pinnacle Says: And it appears that some of those hedge fund recruiters are likely to be located in Asia. 

First Half 2008 Sets Record for Alternatives Manager M&A: Putnam Lovell predicts “In the next 12 months, we expect strong M&A activity involving battered banks and other financial institutions divesting asset management businesses to raise capital, and continued record demand for alternatives.”

Feds Cast Scapegoat Net, Snag Cioffi and Tannin: Bloomberg’s Caroline Baum, author of the book “Just What I Said”, reiterates just what we said last week about the fundamental questions raised by the recent Bear Stearns indictments.

Hedge-fund mystique: the need for transparency: The Australian reports that Morningstar VP of research says it’s time for hedge funds to come clean.

US Presidential Election May Spur Hedge Fund Regulation: Then again, hedge funds may have no choice if this guy is right.

Finding alpha with few bets: Seeking to avoid short-selling, institutions are looking to “concentrated” funds for long-only alpha.  (ed: While not technically short-selling, a concentrated portfolio has a negative weighting vs. its benchmark in a huge number of names and a positive weighting in select others - raising interesting questions about whether a long/short fund is really that different.)   

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Researchers: If index funds are a commodity, why are their fees so divergent?

2 July 2008

Last week, we told you about a paper that suggested price competition in the mutual fund industry was somewhat less than robust.  Rather than lopping all mutual funds into one pot and comparing their fees, the authors of that report examined the fees of individual funds relative to their Morningstar category average.  While not as ideal as examining the active management delivered by each fund, this approach loosely categorizes funds by their level of active management (e.g. the small cap growth category has a higher level of active management than the large cap value category).

Although not directly examined by that particular paper, one category that makes no denials about its lack of active management is the S&P Index Mutual Fund category.  These (almost) purely passive funds are the subject of another paper by the same authors available here.

In “Institutional S&P 500 Index Mutual Funds as Financial Commodities: Fact or Fiction?” John Haslem, Kent Baker and David Smith examine whether index funds are really are all the same and whether they are truly “commodities”.

They find a wide variation in the fees (and therefore the performance) of S&P index funds.  This is counter-intuitive given their common Investment strategy, but even more counterintuitive when one considers that institutional investors should be less likely than retail investors to pay unwarranted fees.

While the market for index funds isn’t homogenous, the researchers find that at least it’s a lot more competitive than other mutual fund categories.

It turns out that the price of an index fund has a lot more to do with the economics of managing a fund, not the investment strategy itself.  For example, large funds and funds with small minimum investments tend to charge larger fees.  Comment the authors:

“If institutional investors priced S&P 500 Index funds as commodities, they would be unlikely to continue to commit new money to chronically high-cost funds, while much lower cost alternatives existed. On the other hand, if these investors could not meet the minimum initial purchase of low-cost funds, their opportunity set would be restricted.”

Since the underlying investment strategy is exactly the same across this category of fund, any difference in fees should translate directly into lower returns.  Not surprisingly, this is what the authors found.

So why on earth would you want to buy a fund that was virtually guaranteed to underperform?  There are a number of reasons, say the authors:

“…investors in the institutional realm may value fund features beyond the expense ratio. For example, such investors may value the availability of a wide variety of funds including money market and other index funds offered by the family and the cost of these other funds…high-cost institutional index funds come from families that offer greater choice to investors, or that offer low cost funds elsewhere in the family…”

The growing interest in portable alpha and alpha/beta bifurcation will likely bring these funds into more direct competition with products such as index futures, swaps and ETFs.  So it will be interesting to see if fee deviations like the ones described in this paper become more closely linked to tangible attributes.  In other words, will there eventually be a base (commodity) fee and a Chinese menu of other attributes (low minimum, an option to switch to another fund in the same family etc.) 

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Cap Intro: The new emphasis for prime brokers. But how much do funds care?

1 July 2008

Last fall, after a particularly busy period on the pro-am hedge fund conference circuit, we noted that prime broker salespeople seemed to all be updating their business card to include the title “cap intro”.  Apparently, capital introduction (a.k.a. fund raising assistance) was seen as a great way to differentiate one’s self from the growing throngs of prime brokerages. 

At around the same time, eFinancial News noted…

“By strengthening their capital introduction teams – once seen as a glorified dating service – prime brokers hope to secure potentially lucrative start-up funds as clients.”

But a recent survey of hedge funds raises some questions about what really attracts and retains prime brokerage clients.  AllAboutAlpha.com media partner FINalternatives just released the results of its 2008 prime brokerage survey.  It concludes that the new focus on cap intro may not be generating a lot of fans:

“One in three hedge fund managers considers the capital introduction services they receive from their prime brokerages to be ‘poor’, the survey shows.  In fact, only one in four rate such services as ‘fair’ and just one in six say they are ‘good’.  A miniscule one in nine considers their prime broker’s capital introduction services as ‘excellent’.”

Overall, 46% of respondents said their broker’s cap intro was either “fair” or “poor”.  This put cap intro ahead of ”cost” at 44% and well ahead of “personal service” at 32%.  Why?  Survey respondents blamed things like “insufficient activity“, “inferiority of investors“, and “a tough financial environment” for fund raising.  Also, as funds grow in size their fundraising needs grow and they are more likely to be dissatisfied with existing cap intro services. 

So apparently, prime brokers aren’t hitting the lights out with their cap intro offerings quite yet.  But is cap intro actually that important?  Curious about how cap intro might play into a fund’s decision to bail on their prime broker, we asked out good friends over at FINalternatives for a bit more information.  They graciously agreed to send over the raw data and here’s what we found:

It seems that cap intro may not be a critical factor in retaining a prime broker after all.  While it may be important for winning new business, it doesn’t seem to be a top factor when a fund decides to switch prime brokers.

The chart below, constructed by us from the raw data provided, shows the results for those funds that are on the look-out for a new prime broker.  Like all respondents, these unhappy funds ranked their satisfaction with five different aspects of their prime broker’s offering.  The results are indexed to the levels of satisfaction reported by all respondents (i.e. all respondents include those looking for a new PB together with those who report that they are NOT looking for a new PB).

As you can see, the funds with the “wandering eyes” are disproportionately unhappy with the level of “personal service” they get from their prime broker.  Not surprisingly, very few of these unhappy funds rated service as ”good” or “excellent”. 

Conversely, unhappy funds weren’t that much more likely to be dissatisfied with “electronic execution”.  In fact, many unhappy funds actually said they were getting “good” electronic execution.

We placed these five dimensions in order from the largest ratio of “fair/poor” to “good/excellent” to get an idea of which dimensions seemed to be important (e.g. service) and which ones weren’t as big a deal (e.g. execution).  As you can see, cap intro came out in the middle.   

In other words, hedge funds that are looking for a new prime broker (formally or informally) were 1.5 times more likely than the overall population to report cap intro was “poor”.  A factor in their decision to look elsewhere for sure - but certainly not the biggest one.

Maybe the new “cap intro” staff at the prime brokerages should have changed their titles to “personal service specialist”.

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Sweden’s AP7 pension fund reports on progress of alpha/beta retooling

30 June 2008

With its (appropriate) focus on generating returns, the asset management industry tends not to spend inordinate amounts of time on introspection - on the way firms in the industry management and organize themselves.  As management consults are fond of saying “form follows function”.  That’s consulting-speak for “structure follows strategy”. 

A great example of an organization that realizes the holistic implications of alpha/beta separation is Sweden’s AP7, one of the country’s many so-called “buffer funds” designed to fund the retirements of its citizens.  Regular readers may recall AP7 and its forward-thinking CIO Richard Grottheim.  As we reported in January, AP7 has recently awarded what it calls “pure alpha briefs” that are essentially notional overlays applied to the fund’s passive portfolio.

A few weeks ago, Grottheim and colleagues including one from the Stockholm School of Economics, revealed how AP7 is set up to undertake this kind of innovation in a new white paper.  In this paper, Grottheim and friends propose an org. structure that they say shows “not only significant improvement in portfolio performance, but also a more transparent and cost efficient portfolio structure.”

While the authors acknowledge that alpha/beta separation has been used for return attribution for several decades, they argue that it “can evolve to a framework for portfolio management“.

Beyond the obvious benefits of focusing on alpha (flexibility for both investors and managers), the structure and business processes implemented at AP7 have other benefits according to the authors:

• Diversification: “…passive or beta management typically allow for improved diversification benefits as more securities are included in the portfolio management.”
• Fee Transparency: “…separate management of alpha and beta lets investors capture the full economies of beta management and pay active management fees that reflect a manager’s skill.”
• Lower Costs: “[Manager transition] is associated with substantial costs which reduces the efficiency in the market substantially.”

But re-writing the playbook brought new challenges.  One was the requirement for new risk measures.  As Grottheim and colleagues report:

“The standard deviation of alpha return is hardly the ultimate risk limit. Instead a risk budget was defined by using expected tracking error, the return target and the notional amount. The purpose of the risk budget is to cover potential losses and is not capital to be used for active bets in the day to day operations. In addition to the general risk budget, constraints on short selling and VaR are implemented in the day-to-day risk management.”

The paper contains one example of an active long only manager with an apparent propensity for index-hugging.  When the index was stripped from the return stream, it was found that the manager was actually producing a negative alpha (charts below).

While you’d think the market can be tracked perfectly by a passive investment, even the beta portion of the AP7 portfolio contained enough tracking error to leave an active footprint once the market was removed (right chart below), although things seem to be improving in recent years.

Grottheim says the search for alpha has been a bit tougher however.  Apparently, managers have had trouble getting their head around the lack of any physical capital.  Their longs and shorts are given life via overweighting and underweighting a separate passive portfolio - meaning they don’t actually manage any money.  Managers are asked to construction an overlay as if they managed x Swedish kronor.  That “x” is called the “notional amount”.  

Naturally, the changing the notional amount (the denominator in the return calculation) would dramatically change the return of the overlay.  So you can see how things get a little weird.  While there are technically no assets under management, compensation has ended up being a combination of both management and performance fees.

In conclusion Grottheim makes the following observations about the transition at AP7:

“One important lesson is that the asset management industry has not been fully prepared to meet the new demand of separate management of alpha and beta as opposed to traditional active portfolio management…However, the market seems to adopt this new asset management framework and asset managers are increasingly interested in providing services.”

“Another important lesson of the alpha-beta-separation framework is the overall improvement in portfolio performance. Traditional active managers that were hired struggled to deliver alpha and AP7 as a whole did not obtain a positive alpha. The new setup has implied a cost efficient beta exposure and a positive and significant alpha.”

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Alternative Viewpoints: Commodities not about “buy and hold”

29 June 2008

With so much interest in commodities, we thought this might be a good time to revisit the rationale for so-called “managed futures” funds. But as Keith Black, CAIA, of consultant Ennis Knupp + Associates says, commodity investing is about a lot more than buying and holding commodities in hopes that the Chinese continue to buy new cars.

The Case for Commodities

Special to AllAboutAlpha.com by: Keith Black, CFA, CAIA, Associate, Ennis Knupp + Associates

Over the last several years, institutional investors have more than doubled their allocation (to over $200 billion), to financial products whose returns are linked to those of commodity indices. Commodities may be attractive due to: the low correlation between their returns and those of other asset classes, the high correlation of commodities returns with unexpected inflation, and the rising demand for commodities from fast-growing emerging markets countries, such as China and India.

In fact, when you look at the performance of these commodity indices during the best and worst quarters for the Wilshire 5000 (and quintiles in between), you can see that they have produced modestly positive returns in almost all quintiles. In fact, the correlation between commodity indices and other major asset classes is generally below 0.2.  

Commodity Beta via Equities

While these indices provide a simple method of gaining commodity exposure, one could always implement their views on commodity prices by investing in equity securities. The prices of these stocks may be somewhat correlated with those of commodity futures. Metals firms include Alcoa and Anglo American, while agricultural firms include Archer Daniels Midland. In the energy sector, stocks such as Exxon-Mobil, Chevron and ConocoPhillips may be used as a crude oil proxy.

But the problem is that existing exposure to equities means commodity-linked equities may not be the best way to express a view on commodity prices alone. To make matters worse, commodity stocks are likely to underperform commodity futures during times of high inflation. When inflation and commodity prices rise, stock prices typically decline, meaning an investor may not actually earn the anticipated return.

The bottom line is that commodity futures are a more direct way to earn the diversifying benefits of commodity investments (especially metals, energy and agricultural commodities) without increasing the stock market risk of the overall portfolio.  

Sources of Return

Part of the reason for this is that the total return to a commodity futures index consists of three components: spot return, roll return and yield. The spot return is the return to an investment in physical commodities. The roll return is earned in the process of passively trading (rolling) futures contracts as they mature and must be replaced. The yield is the interest earned on a short-term fixed income investment that is pledged to the futures exchange in order to maintain the collateral required to back the futures investments. As you can see from the table below, the annualized return of the S&P GSCI can be attributed to each of these three components.  

But commodity price increases have not exceeded the rate of inflation over long periods of time. As new natural resources are discovered, production technologies improve and research advances in areas such as crop engineering and alternative energy, commodity prices tend to decline in real (after-inflation) terms. So how could commodities futures have offered a total return rivalling that of equities since 1970 if the ownership of physical commodities does not offer a return that exceeds inflation? The answer is in the roll return and the collateral yield, as shown in the chart below.  

The roll return and collateral yield can only be earned when investing in commodity futures. The return to commodity futures investments has significantly exceeded that of a direct (spot) investment in commodities over the last 37 years. This is because futures contracts have a finite life. Commodity index investors normally invest in the contract nearest to expiration, which is typically less than three months. In order to maintain a consistent exposure to a given commodity, the investor must purchase a new contract at or before the time of expiration of the current contract. The roll return to a commodity futures investment is earned when the futures position is “rolled” from the current contract to a later-dated contract.

When a futures curve is in “backwardation” the investor buys a contract at a lower price, say $70 for the June contract, and sells it at a higher price of $75 when prices rise as the contract nears expiration. Should the curve retain the same shape, with the front month futures trading at a premium to later-dated contracts, the investor will earn a positive roll return as time passes and the June contract becomes the premium-priced front month contract.

Conversely, an upward-sloping futures curve is one in which later-dated contracts trade at a higher price than the current futures contract (“contango”). Contango markets are undesirable for a commodity futures investor as the return to rolling futures contracts is negative.

The secret behind commodity futures: roll return

Futures markets are likely to remain in backwardation when producers of a commodity desire to hedge the sales price of their commodity production. A positive roll return can be earned when producers view futures markets as insurance and are willing to sell futures at a low price in order to insure against a decline in the commodity price.

The market will continue to offer a positive roll return as long as the demand for producers to sell is larger than the demand from investors or speculators to purchase those contracts. However, over the last two years, investors have funnelled over $50 billion into indexed futures investments and a number of exchange traded funds (ETFs) were launched that invest in oil, gold and silver futures.

The result of this additional demand for investments in commodity futures has served to move many futures markets into contango. The potential to experience a negative roll yield during certain market conditions is one reason why EnnisKnupp does not recommend passive investment in products that track commodity futures indices for most clients. Another reason is that over time, commodity investments have been quite volatile and the returns don’t fit well into a traditional asset valuation framework, such as the Capital Asset Pricing Model (CAPM). Variables such as political strife and weather can have a significant impact on both long-run and short-run commodity prices.

Actively Managed Commodities Funds

Given the drawbacks of commodity-linked equities and commodity futures indices, where does this leave us? It turns out that active management of roll dates and index selection can add significant value in commodity futures markets. For example, in a case where the entire futures curve for a given commodity is in contango, an active manager can choose to reduce or eliminate exposure to that commodity.

In addition, managed futures funds (CTAs) allocate about 25 percent of their assets to commodity markets and 75 percent of their assets to financial markets, including currencies and futures on equity indices, interest rates and bond prices.

Flexibility and the addition of non-commodity futures results in a relatively low correlation between managed futures and (passive) futures indices. Global macro hedge funds, which often trade commodity futures also have a low correlation to futures indices as the table below shows.  

Conclusion

Commodity investing is about a lot more than simply hoping commodities will rise over time. After all, the GSCI spot index earned an annual return of only 4.0 percent since 1970, cash returned 5.8 percent and CPI increased by 4.6 percent per year over the same time period. But with so many factors influencing price movements (roll, demand/supply etc.), active commodity management can provide real alpha opportunities.

Ennis Knupp + Associates does not recommend strategic allocations to commodity futures investments. However, we do believe that commodities have a role in the portfolio of plans that value the historic tendency of commodity futures investments to have a higher correlation to inflation and a lower correlation to traditional stock and bond investments.

- Keith Black, June, 2008

The opinions expressed in this guest posting are those of the author and not necessarily those of AllAboutAlpha.com.  

Editor’s Note: Keith is the author of a more detailed paper on commodities and timberland in institutional portfolios available here at Ennis Knupp + Associates’ website.

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Hedge fund seeding: “hot” or “not”?

26 June 2008

A few years ago, before social networking was all the rage, a website called “Hot or Not” was launched to allow webs surfers to post their photo and generate, shall we say, feedback on their appearance.  Today, the site is used to canvas users on everything from American Idol candidates to political candidates (example: Obama seems to be totally smoking McCain)  

But strangely absent from the line-up is hedge fund seeding.  The strategy seems to run hot and cold and would surely have elicited some chippy debate.  (okay, maybe not).

At the beginning of this year, seeding was hot (see related posting).  Then it was not (see related posting).  And with the continuation of a difficult fundraising environment for hedge funds, seeding is hot again.  In fact, it was in the news several times last week.

eFinancial News reports on HFR data showing that new hedge fund launches are at their lowest level in 8 years.  One reason, suggests eFinancial News…

“In addition to market conditions, start-ups were hit with increased capital needs.

The costs for launching a hedge fund have increased to $250m in the past few years. Companies offering hedge fund seeding services that provide capital to start-ups in exchange for a stake in the fund or percentage of fees are finding a market for their services.”

HedgeWorld goes a step further with a piece on the same day titled “Seeding Back in Vogue” in which it observes:

“Unprecedented inflows of cash into alternative investments and easy credit conditions provided start-up hedge funds with a way around using seed investors until recently. Most new funds that set up operations during the boom got early backing from funds of hedge funds plump with new allocations from institutional investors.”

HedgeWorld was reporting from a Merrill Lynch cap intro conference where the firm’s head of capital introduction, Anita Nemes told the audience that there was a definite step-by-step process involved with raising capital.  Reports HedgeWorld:

“Start-up managers, [Nemes] said, need at least $20 million in friends and family funding in order to pick up $50 million from a seeder. “You need a credible amount of money, operationally robust infrastructure and good performance numbers,” Ms. Nemes said. “Then the other allocators will look at you.”

“Seeders are seeing quality people now,” Ms. Nemes said. “It is not just that seeding activity is up, it is that unless you are an über launch you need a seeder.”

Also last week, Euromoney Institutional Investor ran the third of a three part series called “Hedge Fund Start-ups Face a New Reality”.  It quoted one service provider as saying:

“If you don’t have the contacts and the resume to find at least the first $25 million in assets on your own, you shouldn’t even start a fund.”

Yikes.  Things are getting worse.  What about the tried and true “third-party marketer”?  But the official quoted by Euromoney continues:

“Placing huge confidence in a third-party marketer as a saviour for your fund is a big mistake.”

If you’re a small or start-up hedge fund, you’re probably crying “uncle!” by now.  At least one manager did last week.  According to FINalternatives, Quasi-seeding operation Fairfield Greenwich Group pulled $100 million from one of its seedlings, leaving the fund with only $65 million in assets.  The seedling’s managers promptly announced they would be shutting down the fund at the end of June.  

Although officials with Fairfield Greenwich said “it would be incorrect to state that FGG had caused Manhasset’s current or future decisions”, we have a sneaking suspicion that the two events are somehow related. 

A survey published in May by hedge fund database manager Prequin Hedge found that outright seeding isn’t actually that popular among institutional investors.  The survey found acceptance for “emerging” managers and “spin-outs”, but only 8% of respondents expressed a desire to be the first to jump into a new, unknown manager.  Worse, only 12% would even “consider” such an investment (chart below).

The survey did not include hedge funds of funds - which are much more likely to invest in start-up managers.  Indeed, just last week, AIG announced its entry into hedge fund seeding with a joint venture with Larch Lane, a subsidiary of Old Mutual.  Reports MarketWatch:

“While institutional investors still seem willing to put money into large, established hedge funds, smaller and start-up managers are struggling to attract investors.

“Talented investors are leaving large hedge funds to start their own businesses, but many of them have not been able to reach their capital targets,” Mark Jurish, Larch Lane’s chief executive, said in a statement. “The current supply/demand imbalance for start-up hedge fund capital represents the best seeding opportunity I’ve ever seen.”  

So the attractiveness of seeding seems to depend on who you ask.  The recent turmoil in Hedgistan is either an unprecedented buying opportunity or a relentless march toward industry consolidation that will leave thousands of hedge fund casualties.

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Is the mutual fund industry competitive enough?

25 June 2008

Industries dominated by fixed costs tend to experience a lot of price competition.  You don’t have to look any further than the airline industry to find evidence of this economic axiom.  In fact, price competition is often even more fierce in growth industries where price cuts are enabled by economies of scale.  For example, the Model T Ford had a price tag of $850 when it was launched - blowing away most rivals priced in the $2000-$3000 range.  Within a few years, the Model T MSRP was around $300 - illustrating to the world the new economics of scale.

But price competition seems to have bypassed one particular fixed-cost business - the money management business.  This, according to an article in the Journal of Investing that was made available for free recently.  The paper by John Haslem of the University of Maryland, Kent Baker of the American University and David Smith of SUNY at Albany has the benign-sounding title “Identification and Performance of Equity Mutual Funds with High Management Fees and Expense Ratios”.  But don’t be fooled.  The authors rail against what they see as a lack of price competition in the US (and by extension the global-) mutual fund industry before examining the relationship between fees and performance.  They even name names - highlighting the US mutual funds with the highest relative fees in the land.  

In their words:

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Alpha Magazine’s New Hall of Fame

24 June 2008

The AllAboutAlpha.com “Hall of Fame” contains a who’s who of academics, entrepreneurs and researchers in the field of investment management and hedge funds.  But one group we have not included in the Hall are hedge fund managers themselves - the ones who actually make money from the ideas and theories espoused by financial innovators and thinkers. 

Thankfully, our good friends at Alpha Magazine have just launched their own hall of fame, appropriately called the “Alpha’s Hedge Fund Hall of Fame“.  It will contain several great write-ups on hedge fund legends such as:

• Louis Bacon, Moore Capital Management
• Steven Cohen, SAC Capital Advisors
• Kenneth Griffin, Citadel Investment Group
• Alfred Winslow Jones, A.W. Jones & Co. (posthumous)
• Paul Tudor Jones II, Tudor Investment Corp.
• Seth Klarman, Baupost Group
• Bruce Kovner, Caxton Associates
• Leon Levy, Odyssey Partners (posthumous)
• Jack Nash, Odyssey Partners
• Julian Robertson Jr., Tiger Management Corp.
• James Simons, Renaissance Technologies Corp.
• George Soros, Soros Fund Management
• Michael Steinhardt, Steinhardt Partners
• David Swensen, Yale University  

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130/30 bull run still has some legs: S&P

24 June 2008

Hedge Funds Review reports that S&P is telling clients that 130/30 is “strategy to watch in 2009” (no word on what to watch now or for the next six months - but it’s an ugly year anyway). 

Taking a page from Andrew Lo, co-author of the recent academic paper “130/30: The New Long-only“, S&P’s Srikant Dash told a London audience earlier this week that “Asset managers are moving into this area and eventually these funds will take a significant share from traditional active funds”.   

This year may not be a bust though.  Referring to one particularly aggressive market estimate, another S&P official apparently said 2008 could also be shaping up to be a barn-burner:

“I know of one analyst who predicted there would be $1.6 trillion by the end of 2008 linked to 130/30 funds”.

According to Hedge Funds Review, S&P is launching two new 130/30 indices later this year.  This, after an S&P-authored research paper recently argued that the best benchmark for 130/30 funds is probably a long-only index (see related posting, read report).  Maybe that was a different “S&P” (?)

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Virtual private equity a step closer to reality

23 June 2008

A lot has been written over the past few years about hedge fund/private equity “hybrids” where a so-called “side-pocket” is created to hold a particularly illiquid investment.  But while these funds may indeed contain both asset classes, they are long and short in public equities and long-only in private equities.  In other words, it is difficult to actually hedge private equity.

Of course, you could always short comparable public equities (or even an index) against a long position in private equity.  In fact, given the high correlation between private equity and public equity, that might not be a bad idea.  There has been some research showing that a leveraged public equity position could actually trump private equity on a risk adjusted basis (see related posting). 

But insofar as private equity has its own return characteristics that are uncorrelated with public equity beta, it can’t truly be hedged.

This may be changing soon.  State Street is reportedly working on a “private equity replication” model that will complement its existing hedge fund replication model (see recent posting on that one). 

Eric Brandhorst, head of the research and structured products group at SSgA told Thomson last week:

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Goldman’s new “A.R.T.” HF-Replication-Mutual-Fund

22 June 2008

As we reported in our weekly newsreel on Monday, Goldman Sachs just launched a mutual fund based on its recently-launched hedge fund replication index called the “Absolute Return Tracker” (ART).  As the FT reports, the fund aims to highlight how a large proportion of hedge fund returns are just “exotic beta” not true alpha. 

“The underlying theory makes sense. Some of hedge funds’ performance is down to alpha, or fund managers’ skill. For that, for now, you will continue to have to pay fees.

But a large amount of it is beta. In other words, it is predictably correlated with various markets. Absolute return managers will tend to cluster around similar asset allocations; it is possible to model this behaviour; and hence it is possible passively to capture a large chunk of the value that absolute return managers deliver, and pay much less for it.”

The nuts and bolts behind “ART” are a state secret, but the fund’s prospectus describes it this way:

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A closer look at the CSX/TCI and Bear Stearns cases

21 June 2008

“In the Criminal Justice System the people are represented by two separate, yet equally important groups. The police who investigate crime and the District Attorneys who prosecute the offenders. These are their stories.”

Two recent court cases have captured the attention of hedge funds.  One pits a corporate raider cum philanthropist (TCI) against the increasingly desperate management of a old-line 100,000-car railroad (CSX).  The other accuses two average-Joe hedge fund managers as the ones who originally infected patient zero in the global credit pandemic (Bear Stearns’ High Grade Structured Credit Strategies Enhanced Leverage Fund or “BSHGSCSELF” for short)

Many of the facts surrounding each case have been obfuscated by sensational reporting.  CNN’s Lou Dobb’s demanded, for example, that US legislators block the hostile take-over of CSX by London-based activist hedge fund TCI on national security grounds.  Likewise, many mass media outlets seem to have bought into prosecutors’ arguments that the duo who ran Bear Stearns’ now infamous CDO fund were personally responsible for the entire global credit crunch.

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Hedge funds starting to get “voted off the island”

19 June 2008

As the hedge fund industry matures, assets are flowing disproportionately to the larger players in what some have called a “shakeout”.  Taking a page from TV’s “Survivor”, investors are apparently starting to vote smaller players off the (Manhattan) island. 

Usually, the term “shakeout” refers to the culling of weaker, smaller players in an industry in favour of the larger and more dominant competitors.  So it’s striking that Business Week this week suggests that the “parade of cave-ins” in Hedgistan included funds managed by major financial institutions (e.g. Citi, UBS, and parade-marshal Bear Stearns). 

The ones doing the culling?  Pure play asset managers such as Bridgewater and BGI.  In fairness, JP Morgan (which bought and subsequently grew Highbridge) and Goldman (which today announced its hide was saved in Q2 by its asset management business), buck the trend.  But 8 of the top 10 largest hedge fund managers in Alpha magazine’s listing of the largest US hedge funds last month were NOT run by investment banks or other large financial services firms (we’d say that #9 BGI runs pretty independently of Barclays).  So the question remains, what’s up with the bank-run hedge funds?

Despite a rocky road for some bank-owned hedge funds, size continues to be an advantage.  Reports BusinessWeek:

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When it comes to hedge fund compensation, “social usefulness” is a red-herring

18 June 2008

After the release of Alpha Magazine’s rankings of the highest-paid hedge fund managers (e.g. John Paulson of Paulson & Co.), we questioned the uproar over the compensation of some managers.  Although astronomical, their compensation fell short of gains logged by entrepreneurs in other sectors (e.g. by Gates, Buffett, Bloomberg, and several lesser-known rich guys).

We proposed a number of hypotheses to explain this apparent double-standard.  One was that traditional entrepreneurs created a product or service of tangible value.  However, the value created by hedge fund managers (provision of liquidity etc.) is intangible at best.  As a result, hedge fund managers are often accused of simply “re-arranging the chairs”, not building them.

But a letter in last Thuraday’s New York Times by John Berlau of the Competitive Enterprise Institute reminded us how traditional entrepreneurs shouldn’t be given a free ride since they create something tangible.

Berlau was responding to a June 10 Times Op-Ed (IHT reprint here) that said:

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Non-market-cap indices dissed in Europe this week

18 June 2008

Rob Arnott, the outspoken proponent of “fundamental indexation” might want monitor what’s being said in Paris this week.  Arnott is the owner of the patent for “non-cap-weighted indices” (see related posting).  But IPE reports that Alain Dubois, the head of Lyxor Asset Management a SocGen subsidiary, told a conference audience:

“It could create a market phenomenon, like reduction of very high market caps, and could lead to performance of these indices just because everybody invests in them…It is an interesting trend, but should be arbitraged as soon as possible.”

Piling on was Tomas Franzen, head of AP2, one Sweden’s national pension funds who apparently added:

“…it is the market-cap-indices that are flawed and not necessarily the alternatives that are, per se, intelligent.”

Arnott might not actually disagree with this assessment since he has often referred to fundamental indexation as simple common sense (see related posting).  In either case, the value of his patents is probably doing just fine.

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Lending stock to yourself: nifty idea, but effectively just active long-only management?

17 June 2008

Since May 2002, a Hong Kong based enhanced index fund manager has been essentially lending stock to itself to create short positions in its long/short equity fund.  The result has been a portfolio architecture that one usually finds only at the largest, most sophisticated institutions.

The firm (”Enhanced Index Products Company” or “EIP”) was the subject earlier this week of a Reuters article that said the firm “is looking to triple its assets through a rare marriage of passive and alternative investing, creating market tracking index funds it can use to source stock for complex trades.”

Essentially, EIP uses its much larger index funds as a source for the stock borrow required by the relatively puny long/short fund - a strategy to short-selling that the firm says is “ideal solution for markets where hedge funds can’t easily or cheaply borrow stock they need for their often sophisticated trading strategies”.

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French fries active management

16 June 2008

In March, we wrote about a yet to be published paper by Kenneth French called “The Cost of Active Management”.  In this paper, French concludes that the total cost of the “futile search for superior returns” is 67 bps or about 10% of annual returns (resulting from management fees and trading costs).  At the time, all we had to go on was a New York Times article about the paper by well-known financial commentator Marc Hulbert.  A recent interview with French by the online newsletter Advisor Perspectives brought this paper back to our attention.  The full study is now available online and we felt was worthy of a second, more detailed, examination. 

Immediate benefits of active management 

Institutions have increased their allocation to passive investing significantly over the past 20 years, prompting Advisor Perspectives to wonder if institutions wising up to high active management fees.  Interestingly, French points to increasing institutional hedge fund allocations as evidence that they are not, in fact, becoming more passive after all:

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Busy week on the alpha-centric news beat

15 June 2008

State Street world’s largest again: According to Pensions & Investments, State Street Global Advisors is the world’s largest institutional manager for the 7th year in a row ($1.8 trillion AUM).   

“Best Blogs”: Speaking of P&I, we think they are one of the best.  Coincidentally, that’s exactly what they said about us in their recent ranking of “best blogs” (where they ranked us #9). 

Increased regs not in the cards for hedge funds: Morningstar says their database is “the closest hedge funds are going to come to oversight” in the near future. 

Seed capital providers now vital for funds: The FT reports that as assets get harder to raise, some are saying “seeders” are just about the only way to go for hedge fund start-ups.

Value Partners Says Smaller Hedge Funds Face Takeover: …and if smaller funds don’t have access to a sugar-daddy ”seeder”, guess what… 

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Buffett’s horse race

12 June 2008

A lot has been written in the past few days about Warren Buffett’s bet with hedge fund firm Protege Partners that the firm couldn’t beat the S&P 500 over 10 years.  We’ve taken an interest in this story because it hits at the heart of the active/passive (alpha/beta) debate.  After reading various media interpretations of the bet and the resulting comments from readers at several websites, we offer the following observations:

1. Buffett is not really against active management.  Think about it.  He is one of the most active long-only managers around.  The result: he beats the market regularly, thus proving active management actually works.
2. His selection of the S&P 500 is curious since a) it is highly constrained vs. hedge funds and b) it is a long-bet, an active bet, in favour of large cap US stocks. 
3. Comparisons to the ”Rabbit and the Hare” parable where the S&P 500 is the rabbit and the hedge funds are the hare is totally backward (as the charts to follow indicate).
4. Even if hedge fund managers have no skill in the long run, they still may exploit “alternative betas” (i.e. risk premia other than large cap US stocks).  So this bet isn’t necessarily about the presence of hedge fund skill as much as it is about new markets and their associated risk premia.  In other words, even if Protege wins, we won’t really know whether it was the result of skill.
5. Buffett’s argument that the average active manager produces the market average before fees is valid.  But the average investor can also run a mile in 9 minutes.  Yet many persistently run 5 minute miles.  In capital markets, such persistence is supposed to be arbitraged away by more firms exploiting the same investment strategies, or by more assets flowing to the firms that can exploit them.  Yet non-economic motivations (such as investor inertia, or investment constraints) can conspire to maintain this disequilibrium long enough for some managers to actually out-perform the average.  (Whether they outperform long enough or by a large enough amount to overcome fees is another question.) 
6. Protege Partners is a fund of funds with a so-called “double fee layer” - one for the underlying hedge fund managers and one for Protege itself.  Importantly, as we will see below, Buffett has bet against a group of funds of funds, not a group of (single fee) single managers.
7. According to its website, Protege Partners specializes in emerging hedge fund managers - a group that has been found to offer higher returns than their more seasoned brethren.  So they may not be truly representative of the “average” fund of hedge funds.

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Investors pull $6b from hedge funds. So what’s the alternative “alternative”?

11 June 2008

There are reports this week that US investors yanked nearly $6 billion out of hedge funds in April.  Is this the beginning of a trend?  Who knows?  But there seems to be at least one corner of the alternative investment industry that is poised for growth in the coming years - so called “alternative alternatives”.

If you are a member of the Chartered Alternative Investment Analyst (CAIA) Association, you are probably familiar with the on-going polling conducted by the association each month.  Survey topics are primarily focused on those areas for which market knowledge is currently fragmented or quickly evolving. 

In May, the CAIA curriculum survey focused on the growing area of “alternative alternative” or “alt-alt” investments. While there is no settled consensus on the boundaries of the alt-alt universe, the alt-alt universe is usually taken to include investments outside of traditional securities markets. Examples of alt-alts include weather derivatives, carbon credits, niche assets such as wine and art, litigation claims, insurance claims, and intellectual property rights such as patents.

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Phil Goldstein Update

11 June 2008

Fortune released a great piece on hedge fund “iconoclast” Phil Goldstein this morning.  Like a big box store, the Goldstein saga has something for everyone.  Just when you thought he was done causing headaches for regulators and government officials, he emerges to launch new attacks on the institutions and regulations that he sees as both archaic and illegal. 

The latest battle is over his First Amendment right to communicate with the public (see previous posting).  Current US regulations prevent investors under a certain wealth threshold from investing in unregulated investment funds (collectively “hedge funds” - although that’s a misnomer).  Goldstein contends that he has the right to free speech however, even if that speech is about his hedge fund.  Further, this right to free speech, argues Goldstein, is not in conflict with the SEC’s rules barring any particular group from actually investing in hedge funds.  Reports Fortune:

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ECB touches on some hedge fund myths in new report

10 June 2008

Every 6 months, the European Central Bank issues a state of the union report on the financial system called the “Financial Stability Review” (see posting on the last edition). 

The stated purpose of the report is:

“…to promote awareness in the financial industry and among the public at large of issues that are relevant for safeguarding the stability of the euro area financial system. By providing an overview of sources of risk and vulnerability for financial stability, the review also seeks to play a role in preventing financial crises.”

As usual, June’s edition (released on Monday) makes some interesting observations about hedge funds and their potential role in “financial crises”…  

Hedge funds use relatively little leverage 

According to Merrill Lynch data cited by the ECB (chart, right), hedge funds use markedly less leverage than is often assumed in the media.  In fact, only a small portion of hedge funds reported having a gross exposure of more than 200%.  Commented the ECB:

“The use of leverage is also an important feature that distinguishes hedge funds from traditional investment funds and makes them substantially similar to banks. However, the leverage of a hedge fund is rarely comparable to or as high as that of a bank.”

“…A large part of forced or voluntary deleveraging has probably already occurred, so the risk of further selling pressure may have declined since the finalisation of the December 2007 financial stability review.”

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PwC Survey finds hedgies report more frequently than most other alternative asset managers

9 June 2008

Think hedge funds are secretive?  Think they do their best to communicate with investors as little as possible and get visibly upset when investors call?  You’re not alone.  Stereotypes of the super-secret hedge fund abound.  But in the absence of specific regulation, how much transparency is enough?  As the Journal of Wealth Management once wrote:

“Hedge fund transparency is like pornography–it is hard to describe, but you know it when you see it. A great debate currently rages over the extent to which hedge funds should disclose their investment portfolios. Advocates of transparency argue that hedge fund managers should be held to the same standard of disclosure as their other investments.” 

So are hedge fund managers “held to the same standard of disclosure as other investments”?  According to an extensive survey of hedge, private equity, real estate, infrastructure and commodity funds released last month by PwC, they may actually be.  In fact, the survey finds that hedge fund managers report more frequently than managers of other alternative assets.

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130/30 rationale, value, and “myths” covered in newly released slideware

8 June 2008

Earlier this month, Pensions & Investments held a tri-city 130/30 dog-and-pony show in San Francisco, Chicago and New York.  And this week, they released several presentations given at the event.  So if you happened to have missed the show when it came through town, you might be interested in seeing the slideware available here at P&I.  Below we give you our take.

John Power of Pyramis gave a succinct overview of the rationale, costs and benefits of 130/30 that also included what has probably become the most popular slide in any 130/30 presentation:

The key message, of course, is that you simply can’t bet against most names in the index in a significant manner.  In our view, the difference between underweighting a 0.5% position by 0.5% and underweighting it by, say, 0.6% isn’t significant from an investment standpoint (some might argue the requisite introduction of short-selling brings with it some new operational issues). 

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60″ plasma newsreel

7 June 2008

New York Life 130/30 Webcast (video): New York Life Investment Management 130/30 video is now online.  Enjoy on your 60″ plasma screen with some popcorn.   

Institutional Investment Managers Predicted to Increase Hedge Fund Allocations by 25 to 50 Percent Over the Next Two Years: Wharton prof. says “You’d expect a certain proportion of failures — including some spectacular failures — in a universe that now includes roughly 15,000 funds. But hedge funds are not necessarily riskier as a group just because some fail.” 

New LDI tools evoke ‘false sense of security’: A UBS study questions the suitability of new liability-driven investing (LDI) techniques.

AP3 restructures for alpha-beta separation: Our favourite Swedish pension plan confirms organizational changes that will pave the way for the separation of alpha and beta.

No Shortcuts Here: 130/30 Funds Require A Long, Hard Look: Poor performance from the early 130/30 mutual funds has convinced at least one major business newspaper that, “individuals are better off sticking to plain-vanilla funds.”

Back in Black: After a relatively good May, hedge funds are back in the black for 2008 - prompting the CEO of one major hedge fund firm to report in a recent telephone interview with AllAboutAlpha.com:  “We’re back in black, I hit the sack.  I’ve been too long, I’m glad to be back.” 

After a brief pause, the executive continued, ”Yes, I’m let loose from the noose that’s kept me hangin’ about.  I’ve been livin’ like a star ’cause it’s gettin’ me high.  Forget the hearse, ’cause I never die.  I’ve got nine lives, cat’s eyes, abusing every one of them and running wild.” 

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