Over the past few years, it has become clear to many that raw performance-based compensation for hedge fund managers has significant flaws – from its asymmetry to its inability to distinguish between skill and luck.  Various tweaks have been proposed (as you can see in our section on fees).  But here is one idea that integrates several dimensions of risk with traditional performance metrics.  Eric Hirschberg is the CEO  of the Bermuda-based fixed income manager Orion Investment Management. He also advises on compensation, resource allocation,  portfolio structuring and risk management  issues, and is the founder of the blog KapitalMarks.com.

Special to AllAboutAlpha.com by: Eric Stanhope Hirschberg, CEO, Orion Investment Management

The term Hedge Fund has become a misnomer, as more and more alternative and not so alternative assets find their way into the space. The term Hedge Fund has really become a proxy for an incentive based fee structure more than a statement about the investment enterprise that underlies it. The market settled on a 2% management fee with a 20% profit split for the manager. Of course there are variations on this theme, but they are more or less arbitrary structures.

The growing debate about the nature of Hedge Fund returns, coupled with the notion that many Hedge Fund returns are not in fact idiosyncratic are driving more institutions to revisit the issue of compensation.

I believe that an appropriate compensation scheme should take into account the following four rules.

1. Managers should be rewarded for the volatility characteristics produced by their strategy P&L.
2. Managers should be penalized for the inherent risk they undertake to achieve those returns.
3. Investors should penalize Managers for the replicability of the return stream they generate.
4. A Manager’s base compensation for “holding” an asset over its expected return horizon should be discounted by the expected horizon.

Armed with the above mentioned notions, we shall now attempt to construct a logical and equitable compensation framework.

Rule #1: A manager should be rewarded for the volatility characteristics produced by strategy P&L

The Sharpe ratio or is a measure of the excess return (or Risk Premium) per unit of risk in an investment asset or a trading strategy.  But from the manager’s point of view, this measure is inferior to the Sortino ratio.

The Sortino ratio measures the risk-adjusted return of an investment asset, portfolio or strategy. While the Sharpe ratio penalizes both upside and downside volatility equally, the Sortino ratio penalizes only those returns falling below a user-specified target, or required rate of return.  Thus, the ratio is the actual rate of return in excess of the investor’s target rate of return, per unit of downside risk.

So let’s create a scalar that puts the 20% performance fee back in its rightful place.

In the early days of Hedge Funds (they actually did hedge back then) Sortino’s of 2 and above were the selling point. For argument’s sake, lets create a Scalar N, where N=0.1

Now let’s start to build a compensation equation, replacing 20% with C= N*S

Where N=0.1 and

Under our new compensation scheme, a manager with a Sortino of 2.0 would receive a compensation of 2.0*0.1, or 20% of performance. If on the other hand, the manager produced a return stream with a Sortino of 0.5, his compensation would be reduced to 5% of performance.

Rule #2: A manager should be penalized for the inherent risk undertaken to achieve those returns

The first flaw with “Version 1.0″ of our new compensation equation (above) is its failure to recognize the role of risk in creating a “false dawn” benchmark for the Sortino itself.

Our Sortino assumes that T = the risk free rate at a particular time. This creates the implicit assumption that T is also the appropriate rate benchmark for the Strategy return X. Holding a basket of risky debt will generally produce a return over the risk free rate as will selling a basket of out-of-the-money options. Both strategy return distributions are far from normal, yet the equation assumes a normal distribution.

The more fat-tailed and negatively skewed the underlying distribution, the more its return stream should be penalized. It is very difficult to know the underlying process distribution a priori. That said, we could use Conditional Value at Risk or CVaR.

As readers of AllAboutAlpha.com are aware from posts such as this one from Dr. William Shadwick, CVaR evaluates the value (or risk) of an investment in a conservative way -  focusing on the less profitable outcomes. For high values of q (where q is the “threshold”), it ignores the most profitable – but also unlikely – possibilities.  Unlike the discounted maximum loss even for lower values of q expected shortfall does not consider only the single most catastrophic outcome.

A value of q often used in practice is 5%.

ESq = E(x | x < ?,P(x < ?) = q)

where q is the threshold.

Now, a manager might argue that he should not be penalized for an outcome that did not occur.  But nevertheless, he should not be incentivized to create a performance option by simply ramping up tail risk.  After all he doesn’t share in the losses.

One suggestion would be ranking the q=0.05 across a range of strategies and creating a bucket penalty, e.g. if q(manager A) such that decile(qA) < 3 then V=.5.  So under “Version 2.0″ of our new compensation scheme, a manager with a Sortino of 2.0 and a q=0.05 decile of 3 (v-0.5), would receive a compensation of 2.0*0.1*.5, or 10% of performance.

Rule #3: An investor should penalize a manager for the replicability of the return stream generated by that manager

Common sense and Modern Portfolio Theory would dictate that, the lower the covariance of strategy returns (with positive expected return), the more attractive the overall portfolio return. Therefore, the more idiosyncratic the manager’s return stream, the more he should get compensated to generate it for you.

The problem from the manager’s point of view is that this compensation scalar has potentially more to do with his investor’s portfolio construction skills, meaning that this element is investor specific. A work around involves the definition of common benchmarks (e.g. SP500, 10yr Bond, High Yield Index) with a penalty for correlation over a threshold ). To create a scalar against multiple benchmarks, one could consider covariance measure of returns. We can also consider conditional covariance (e.g. splitting negative SP500 months from positive SP500 months).

This way, the higher the (conditional) covariance of a manager’s return stream to an investable asset, the closer the compensation structure to the investable asset investment costs.

Rule #4: A Manager’s base compensation for “holding” an asset over its expected return horizon should be discounted by the expected horizon

There is a reason I’ve left this point for last. There are two linked issues at play, which are described below, and although I am convinced that a scalar penalty function is the answer, I’m not convinced that a single formula will work.

Firstly, the longer the manager subjects capital to risk to achieve a return, the less active the management. A counter argument would go something like this “Why shouldn’t I be compensated for all the background work that allows me to make that one correct decision?” My answer goes something like this: I believe all my managers do the work to make informed decisions. You will be compensated based upon your risk adjusted performance. As for base compensation, I am happy to pay you more if weeding the garden is needed, but watching the crop grow is another story. Less activity requires less application of resources. As active management requires more human and intellectual capital than passive management, it follows that an investor should pay an increasing scale within an agreed upon fee band to adjust for higher cost of goods.

Practically speaking, the investor needs to look at the range current range of fees charged across asset managers.

F( A) = (ATO(A)*(Tfr-Bfr))+(Bfr)

Where

• F(A)= fee to manager A
• ATO = annual percentage turnover normalized (0,1)
• Tfr = Top of market fee range
• Bfr =Bottom of market fee range

Secondly the longer the manager subjects capital to risk to achieve a return, the higher the probability of the occurrence of a negative tail outcome. Ask anyone who tells you differently to predict a 1 year return and a one year low and when that low will occur. Increasing exposure to risk results in decreased risk adjusted expected returns versus the Manager’s stated return target. This is particularly true if the Manager intends to liquidate the investment upon meeting stated target return regardless of holding period.

F(A) = F(A) – [ ( ( P(L>R) for duration(p) * RT(A) ) / RT(A) ) *F(A) ]

Where

• F(A)= fee to manager A
• P(L>R) = probability of loss greater than risk free rate
• Duration(p) = the expected holding period
• RT(A) = Manager A return target for portfolio

Obviously, none of the aforementioned concepts are particularly earth shattering.  But having said that, I believe that new compensation structures need to integrate a variety of metrics, and thus reduce their reliance on simple raw returns.

- E. Hirschberg

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

There have been many studies on hedge fund manager return “persistence”.  Persistence, after all, is a necessary precondition for the existence of alpha.  Like alpha itself, you might expect that the persistence of a good Sharpe ratio may be possible in less mature (more informationally inefficient) markets.  But a new study by Siewling Lay, CAIA, finds that this intuition might be wrong.

Special to AllAboutAlpha.com by: SiewLing Lay, CAIA, senior analyst, GFIA

Many investors use the Sharpe ratio conveniently to categorize the risk-adjusted return profile of a hedge fund.  Implicit in its use is the assumption that the fund’s Sharpe ratio is somehow persistent over time – that a good fund manager will stay “good”.  As a result, many investors look to the Sharpe ratio as an indication of how a manager might perform in the future.  If investors decide to include it in their assessments of a fund’s attractiveness for investment, its persistence and reliability would clearly be important.

You might expect that good managers are able to persist in less efficient markets such as emerging markets.  To explore this, my GFIA colleagues and I tested whether in fact Sharpe ratios of Asian hedge funds persisted on a multi-year time frame.  What we discovered might come as a surprise.

Firstly, to ensure that no single fund benefitted from a certain market environment, we examined hedge fund performance over a common timeframe: July 2007 to July 2009 (i.e. not since the inception of each fund).

As you can see from the table below from our report, funds that fall below the 25th percentile show little consistency on a year on year basis.  In fact, only 28% of funds in the top quartile in 2007 actually remained there in 2008: More…

AllAboutAlpha.com reader Rene Levesque of Mountjoy Capital writes:

The following article is in reference to a specific statement embedded into a featured item presented in AllAboutAlpha.com on September 23, 2009, i.e. “Alpha being airlifted out of the dying portable alpha strategies”.

The statement reads: “So it may come as no surprise to critics of hedge funds that portable alpha has lost its luster. But what may come as a surprise to them is the fact that it was traditional market beta, not the hedge funds, that led to its apparent undoing.”

This statement, with which I am in total agreement, is filled with subtleties and truths. More…

Special to AllAboutAlpha.com by: By Neil Kotecha, CAIA, Vice President, Senior Research Analyst, BNY Mellon Wealth Management

Using risk-adjusted return ratios is a necessary yet difficult task to do when analyzing investment managers. Ranjan Bhaduri points out the weaknesses of the Sharpe ratio in analyzing managed futures products in this July post at AllAboutAlpha.com. However, there are times when market anomalies make using the Sharpe and information ratios difficult even on traditional products. During these times, investors should not use the standard version of these ratios, for they can be misleading and result in ill-informed investment decisions.

Between 1970 and the end of 2008 there have been few periods of extreme losses among US and international equities. The S&P 500 Index’s rolling three-year returns have been positive in all but three periods (1972 – 1975, 1999 – 2003 & 2006 – 2008). Similarly, the MSCI EAFE Index has only had three-year declines in 1972 – 1975, 1989 – 1992, 1999 – 2003 & 2006 – 2008. During these periods, many formulas broke down.

Each of the aforementioned ratios is calculated by dividing a type of excess return by a measurement of risk. As a reminder, the Sharpe ratio uses investment returns in excess of the risk-free rate of return as its numerator, then divides that by the standard deviation of the product (its risk). Similarly, the information ratio uses investment returns in excess of the return of an assigned benchmark as its numerator and then divides that by the tracking error of the product to its benchmark (its risk).

When the investment returns are sufficiently low in both instances, the numerators become negative and the ratios break down. Consider the following examples for the Sharpe ratio, which also apply to the information ratio.

The Sharpe ratio holds when it is positive. Investment A has twice the return and the same volatility so it is preferred over Investment B. …RATIO HOLDS More…

It’s our pleasure to bring you a guest contribution today from Dr. William Shadwick, a highly-regarded mathematician who “crossed the aisle” to the world of finance a decade ago and has since made his mark on the field of investment performance analysis.  Regular readers may remember Bill from his previous guest contribution to AllAboutAlpha.com in 2008 – one of that year’s most-read articles on AAA.  Widely known as the developer of the Omega Function and Omega Metrics®, Shadwick won the 2007 Journalism Award from the Investment Management Consultants Association, jointly with Ana Cascon.   A prominent mathematician, he was responsible for establishing the Fields Institute for Research in Mathematical Sciences before entering the finance industry in 1998.  He is the founder of Omega Analysis Limited, a quantitative research firm in London.

Special to AllAboutAlpha.com by: Dr. William Shadwick, Omega Analysis Limited

The credit crisis and its impact on world markets have prompted a great deal of discussion of risk management (and its absence). Much of the forecasting by financial institutions of the risk inherent in their businesses failed to avoid extreme and, in some cases, catastrophic losses. Institutional investors and other shareholders who failed to manage risk absorbed huge losses as equity markets plummeted.

The goal of statistical analysis in financial risk management is to predict the future with reasonable accuracy over a reasonable period of time. Predictions need not be precisely correct to be of great value in managing risk.

The degree of accuracy that is acceptable varies from investor to investor and across investments of different types. The common feature is the need to estimate both the likelihood and severity of unacceptably large losses. Making such estimates is as essential in building a stock portfolio or a trading position as it is in overseeing regulatory capital requirements for banks. Statistical analysis is an important and, in many cases, essential part of risk management. More…

After being beaten up along with most hedge fund strategies in 2008, emerging markets hedge funds are roaring back this year along with the fortunes of their target regions.  Hedge Funds Review reports that,  “While prone to volatility, emerging markets hedge funds have historically posted strong gains following market bottoms. In the 12 months following the trough of each of the five largest performance declines, funds have produced an average gain of 23.3%.”

And Citigroup recently told Bloomberg News, “There is going to be an outsized investment back into Asia. Some of the big pensions are going to be looking at Asia; it’s coming onto the radar screens.”

We wondered if this was just a matter of emerging markets beta, or whether emerging markets hedge funds provide added value? For a perspective on this, we turned to our resident emerging markets expert, Peter Douglas, for more. As many of you are aware, Peter is the founder of Singapore-based hedge fund consultancy GFIA, and is a regular contributor to AllAboutAlpha.com.

Special to AllAboutAlpha.com by: Peter Douglas, CAIA, Principal, GFIA pte ltd.

For long-term investors, hedge funds are the most prudent approach to access the opportunities inherent in emerging markets.

Emerging market equity investing has typically been characterized by dramatic price movements through market cycles in both directions.  In addition, the inefficient, diverse and often rapidly developing nature of emerging capital markets creates challenges which can create unexpected risks for non-specialist investors.

In a recent report, GFIA analyzed how hedge funds specializing in emerging market investing can both exploit these market inefficiencies, and protect themselves from extremes of price movements, thereby generating stronger risk adjusted returns over time.  The paper further evaluates the performance of emerging markets hedge funds against traditional investment methods, including long only funds, using various metrics. The key conclusions of the study are: More…

Back in early 2008, the Economist marveled over the gravity-defying returns of US university endowments.  In early 2009, AllAboutAlpha.com contributor professor Christian Tiu wrote on these pages that “all endowments are relatively unconstrained, tax exempt and large enough to hold different asset classes”.  But what happens when a major driver of returns for these “different asset classes” runs out of gas?  Michael W. Crook, CAIA, of Barclays Wealth examines this issue today.

Special to AllAboutAlpha.com by: Michael W. Crook, CAIA, Vice President, Alternatives Strategist, Barclays Wealth

The revelation last month of serious problems in the Harvard Management Company’s portfolio brings into question the viability of the so-called “endowment model” of asset allocation. Harvard has essentially been forced into a liquidity-driven unwinding of its portfolio, due in part to some specific recent mistakes, but also due to its adherence to the prescriptions of the endowment model.

The endowment model is associated closely with the investment philosophy of David Swensen and the management of the Yale University portfolio. It has been adopted (or imitated) by other endowments around the nation and by some foundations, family offices, and private investors. The main differences between a more traditional asset allocation and the endowment model are:

1. An overweight to equities, typically through private equity,
2. An overweight to hedge funds,
3. Allocations to “new” asset classes (e.g., timber), and
4. Elimination of low volatility liquid assets (fixed income).

These adjustments reflected two fundamental assumptions: that there are additional returns associated with illiquidity and that the returns on private equity, hedge funds, and new asset classes were very stable and, therefore, helped to increase portfolios’ risk-adjusted returns.

The recent period has, however, cast doubt on these assumptions. During periods of crisis the premium associated with liquidity becomes even larger, resulting in negative relative returns for illiquidity. The recent crisis has been unusually severe in this respect and has made it clear that these returns to illiquidity came with an unlikely but potentially devastating downside risk. Additionally, many adherents to endowment model, who didn’t pay enough attention to their actual liquidity needs, are now suffering the consequences. Finally, investors discovered that the relatively steady returns realized by some of the “alternative” asset classes concealed serious “fat-tail” risk.

Liquidity Premium

It has been well documented that liquidity impacts asset prices, and that on average a less-liquid instrument that is functionally similar to a more liquid instrument will be priced more cheaply (implying greater future returns). This can be seen in equity and fixed income markets, among others, by isolating liquidity risk from other sources of risk and then measuring the return over time associated with that risk factor.

We have created a proxy for the illiquidity factor by forming a portfolio that is long off- the-run treasury securities and short on-the-run treasury securities. This creates a liquidity mismatch because off-the-run Treasuries are slightly less liquid than on-the-run Treasuries, even though both have the same underlying credit risk. We hedged interest rate risk by matching duration within the portfolio. Figure 1 shows the cumulative return of this portfolio since 2000.

Figure 1: Cumulative liquidity returns, January 1, 2000 – March 31, 2009

This illustration makes it clear why many endowments oriented their portfolios toward illiquid investments. Illiquidity appeared to provide an additional element of stable, low volatility positive returns to the portfolio. However, the recent period has made it clear that those returns came with a negative fat-tail risk, as the recent negative returns associated with illiquidity more than wiped out over 3 years of gains in less than 3 months.

The Future of the Endowment Investing

Many endowments are now confronted with the question of whether or not they should move in increase portfolio liquidity. For some this will be an easy answer. Portfolios that are either experiencing a forced unwinding of positions or that are not able to provide funding for their institutions should certainly target a higher level of liquidity going forward. For others the answer is less clear. Illiquidity, in this context, should be viewed as a source of risk and return. It simply becomes part of the asset allocation decision. In the same way that managers allocate to equity risk, credit risk, and interest rate risk, they should be consciously and deliberately managing their allocation to illiquidity risk, i.e., by considering both the upside and the downside.

Considering the new information we have regarding the risk and return associated with illiquidity, we believe many portfolio managers will decide to reduce their exposure to illiquidity risk. This likely means that equity risk will move to public equities from private equities, arbitrage hedge funds will be sold in favor of fixed income and allocations to emerging asset classes will be made more cautiously.

A recent academic article also brings into question whether the endowment model really was responsible for outperformance all along. Brown et al found that endowment outperformance should be attributed to an overweighting of their best managers rather than the increased allocations to specific asset classes. That sounds like good advice for all investors.

- M. Crook, May 2009

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

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We conclude a week covering hedge fund operations issues with a guest contribution from Abdul Sheikh, CAIA, a Vice President at State Street’s fund administration group.  Sheikh makes the case that many attendees of GAIM Ops also made: that independent fund administration may be the only way to fully address investor concerns in the post-Madoff world.

Alternative Viewpoints: The Ascendancy of Risk Management

Special to AllAboutAlpha.com by: Abdul Sheikh, State Street Fund Administration

In the past years, investors used to select fund managers based on three criteria: performance, philosophy and pedigree. But in Deutsche Bank’s annual Alternative Investment Survey released last month (see related post) , “risk management” entered the ranks of the top three selection criteria for the first time, and “pedigree” fell to fifth.

It’s clear that we are witnessing a paradigm shift in manager selection and asset allocation criteria.   Gone are the days of just looking at attributes like track records, top down vs. bottom up approaches, low correlations to markets, and manager size.  Recent events have shown that investors need transparency, independent risk analysis, and independent asset servicing.

A State Street study conducted late last year in conjunction with the 2008 Global Absolute Return Congress (see related post) reinforces this – indicating that five out of six institutions (84 percent) expect more disclosure of hedge fund positions and nearly half (49 percent) anticipate more frequent reporting from hedge fund managers. Meanwhile, only a few (19 percent) currently receive some level of consistent transparency across hedge fund holdings.  (See chart below from report) More…

Special to AllAboutAlpha.com by: James Burron, CAIA, ICICI Wealth Management Inc.

Ever heard of Peter Lynch, Warren Buffett or Benjamin Graham?  Sure.  But how about Robert Farrell, Alan Shaw or Stan Weinstein?  Chances are many investors have heard of most or all of members of the first group and none of the second.  What’s the difference?  Lynch, Buffett and Graham are fundamental (research) investors; Farrell, Shaw and Weinstein are technical adherents.

The striking part of reading The Heretics of Finance (Andrew Lo & Jasmina Hasanhodzic, Bloomberg Press, 2009) was that upon opening it up to the table of contents, I could only find one interviewee I recognized (Laszlo Birinyi Jr., if you were wondering – and only because he was often on Wall Street Week). This made me think: was I missing out on something, or was technical analysis really just a rather obscure investment style more akin to astrology?

I tried to keep an open mind as I readied myself for talk of head & shoulders (not the shampoo), double and triple tops, pennants (whatever those are) and breakouts.  I’ll admit to being a somewhat of a skeptic of technical analysis.  But as I read Heretics, I gained an appreciation for what drives these highly intelligent – if not quirky – individuals. More…

Special to AllAboutAlpha.com by: Konstantin Danilov, CAIA

Looking at several excerpts from chapter 25 of Machiavelli’s letter to Lorenzo de’ Medici written in 1513, it is interesting to note that a large portion of this particular chapter is particularly relevant to the hedge fund industry. It seems that ideas that were once known and respected have since been forgotten or largely ignored; modern day investors would be wise to revisit Machiavelli’s prescient observations on the topic of luck and randomness and the implications for hedge fund investing.  (As you will see, you might even say that best-selling author Nassim Nicholas Taleb is somewhat of a latter-day Niccolo Machiavelli.)

Chapter 25 begins with the idea one must understand the overwhelming effect of luck on life events, and by extension, the financial markets:

“Nevertheless, since our free will must not be denied, I estimate that even if fortune is the arbiter of half our actions, she still allows us to control the other half, or thereabouts. I compare fortune to one of those torrential rivers which, when enraged, inundates the lowlands, tears down trees and buildings, and washes out the land on one bank to deposit it on the other. Everyone flees before it; everyone yields to its assaults without being able to offer any resistance.”

Machiavelli’s observations are even more relevant today, as the complex world of finance is highly influenced by randomness, yet few people realize the impact of luck on hedge fund performance. Because of the overwhelmingly large sample size (number of fund managers or investors), it is inevitable, based on randomness alone, that during our lifetime we will encounter a fund manager like Michael Steinhardt. With that in mind, it is easy to see that, as Nassim Taleb points out in Fooled By Randomness: More…

Hedge fund transparency was in the news again last week as EU Commissioner Charlie McCreevy told a conference audience that hedge funds need “to provide effective due diligence of the funds’ liquidity and risk management, valuation process as well as on the basic investment proposition.”

Note that McCreevy stops short of calling for position-level transparency.  Indeed, there can often be little value in knowing the positions in a fund whose purpose is to produce alpha through a dynamic trading strategy.  But some hedge funds do pursue a buy-and-hold strategy.  And for those funds, position level transparency can potentially provide useful insights.

In the latest installment of our monthly contribution from a member of the Chartered Alternative Investment Analyst (CAIA) Association, Mebane Faber, CAIA, proposes a way to exploit position level transparency that currently exists for US equity hedge funds.  Many of you may know Mebane through his popular blog World Beta, where he writes about many of the ideas below.  He is also the co-founder of AlphaClone and co-author of “The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets.“

Alternative Viewpoints – powered by CAIA: Let the Top Hedge Funds Manage Your Portfolio

Special to AllAboutAlpha.com by: Mebane Faber, CAIA, CMT, Portfolio Manager, Cambria Investment Management

Picking stocks is hard. Academic research has shown that most individuals and professionals under perform their benchmark indexes. That is not surprising given new research from Blackstar Funds that shows that roughly two thirds of all stocks under perform their index over their lifetime, 40% are unprofitable investments, and nearly a fifth lose at least 75% of their value.

That being said, would anyone deny that there are some managers who are very good at stock picking? Warren Buffett is certainly good at it; so are David Einhorn, Seth Klarman David Tepper, and David Dreman – all elite money managers that have proven they can pick winning stocks consistently.

By reviewing the publicly-available SEC form “13F”, you can see the holdings of these and any other professional money manager with assets under management of over $100 million.

This information is interesting.  But since it is backward looking, can it be of any value to investors?   It turns out the answer is “yes”, as long as you use a structured and quantified process. I recently co-founded a software tool called “AlphaClone” to harvest these ideas from 13F filings and test them.  In fact, you can use 13Fs from top managers as both an “idea farm” for new stock ideas as well as an alpha generator in the long only equity space. More…

A couple of months ago, the U.S. Congress summonsed some of the world’s hedge fund titans to Capitol Hill.  Sensing that these managers – all of whom made over US$1 billion in 2007 – might be biased in favor of their industry, Congress also asked several noted academics to brief them on various aspects of the hedge fund business beforehand.  We interviewed one of the academics called to Hill that day, Houman Shadab of George Mason University, immediately after his testimony (see post).

Shadab is a senior research fellow in the Regulatory Studies Program at the Mercatus Center at George Mason  His work focuses primarily on financial regulation, in particular such areas as hedge funds, corporate governance, and derivatives.  He regularly publishes in journals such as the Berkeley Business Law Journal and the New York University Journal of Legislation and Public Policy and is a frequent commentator in the media.

We are pleased to invite Houman Shadab to this particular media outlet with this exclusive look at the convergence of private equity and hedge funds (a topic he covers in greater detail in this recent paper) .

Coming Together After The Crisis: The global convergence of private equity and hedge funds

Special to AllAboutAlpha.com by: Houman Shadab, George Mason University

Two of the most significant types of alternative investment funds worldwide are hedge funds and private equity funds. For years, these two alternative investment strategies have been converging.  Although the financial crisis may slow this convergence, the trend will ultimately continue and strengthen – albeit with some important variations across countries.

In part because private equity funds and hedge funds both seek returns that are uncorrelated with overall markets, there is a natural synergy between the funds that has already helped fuel their convergence. Indeed, institutional investors often view their allocations to each type of fund as relatively interchangeable components of their overall allocation to alternative investments. More…

A recent members-lunch hosted by the Chartered Alternative Investment Analyst (CAIA) Association featured a presentation by the managing director of one of India’s largest private equity and real estate investment firms.  That got us wondering about the state of the alternative investment industry in the world’s largest democracy.  So we invited James Burron, CAIA of ICICI Wealth Management to give us the scoop on hedge funds, private equity and real estate in India as part of our monthly guest column by a member of the CAIA Association.

James works with a full spectrum of alternative investments for ICICI Bank – India’s second largest bank.  A Canadian, James was Director of Alternative Investments with a Seoul, Korea-based investment firm before moving to Toronto to work in structured products.  He is currently a product manager for the firm’s Canadian operation – its second largest after the UK.

Alternative Viewpoints: Alternative Investments in India

Special to AllAboutAlpha.com by: James Burron, CAIA, Product Manager, ICICI Wealth Management

For many investors, India evokes images from Kim, Gandhi or, more recently, Slumdog Millionaire and Bombay Calling. India is all at once a country of extraordinary poverty (with an estimated 41% of the world’s poor) and highly concentrated wealth (Mukesh Ambani, worth an estimated $50 billion, is completing work on his $1 billion home in Mumbai).  Seen by some as a step behind China, the lowest existing estimate for FY 2009 growth is about 6.5%, a far cry from the zero to negative growth expected in many other countries. India has a history of British-rule and central government control, but is populated by brash, young entrepreneurs working either in call centres, IT firms or Small and Medium-sized Enterprises (SMEs).

As far as alternatives go, the market for (and of) alternative investments is growing slowly as the Securities and Exchange Board of India (SEBI, regulating securities) and the Reserve Bank of India (RBI, regulating banking) are starting to allow various new products into India.

Hedge Fund Regulation

To know India is to know regulation.  And regulation is a good thing, because before hedge funds were regulated, they were simply excluded from the country.  Both major regulators are ill-at-ease with hedge funds in general.  As a result, hedge funds have gone through 4 distinct phases in India: prohibition, More…

Special to AllAboutAlpha.com by: Dr. Lars Jaeger, Partner, Partners Group…

For a long time, many investors have regarded hedge funds as an investment class that generates absolute returns by means of managers’ sophistication in extracting inefficiencies from the complexity of the global capital markets.  However, the current financial crisis has forced investors to reconsider this belief.  Even before 2008, the hedge fund battlefield had been littered with the bodies of secretive funds such as LTCM, Quantum, Tiger, Niederhoffer, and Beacon Hill, all of which failed spectacularly in comparably much less severe market environments. More…

Critics of hedge funds often argue that industry growth has had two negative side-effects: firstly, that less-skilled managers have been attracted to the sector and second, that the number of alpha-generating opportunities has not kept pace with asset inflows.  Assuming these are true, then it could be argued that recent industry shrinkage may lead to new opportunities.  In our monthly guest contribution from a member of the Chartered Alternative Investment Analyst (CAIA) Association, Tommaso Sanzin of Hermes BPK Partners suggests that recent headwinds have ushered in a new phase in the “hedge fund industry life cycle”.  Sanzin is Partner and Head of Quantitative Research and Risk Analysis at Hermes BPK and was previously head of quantitative research at Pioneer Alternative Investment Management in London.  Hermes BPK is a boutique fund of funds majority-owned by British pension manager Hermes.

Alternative Viewpoints: Manager Capacity vs. Market Capacity: The fund of hedge fund conundrum

Special to AllAboutAlpha.com by: Tommaso Sanzin, CAIA, Partner & Head of Quantitative Research and Risk Analysis, Hermes BPK

In December, the National Bureau of Economic Research (NBER) announced that the U.S. economy entered the recession in December 2007, declaring the longest contraction since 1982. At the same time, early November reports estimated that the fund of hedge funds industry returned  negative 19% YTD, making it the worst and the longest drawdown on record, according to Chicago’s Hedge Fund Research (HFR). There is no doubt funds of funds are possibly facing the strongest headwind ever, as prices depreciate, liquidity conditions worsen and a tsunami of redemptions hits managers.

Clear and Present Danger

“Flow risk” can be defined as the risk that a manager experiences significant redemptions mostly due to industry-wide issues or a specific category of investors, rather than due to issues related to the manager itself. Among the current threats, this risk is probably the toughest to navigate. It can be exogenous to the portfolio and usually results in massive deleveraging that  impacts most managers, regardless of their performance or size, since both longs and shorts are indiscriminately squeezed and/or liquidated. This may seem obvious in the current environment but the summer ‘07 quantitative long/short managers debacle highlighted how a deleveraging event can hit hedge funds even if they run “neutral” portfolios and the equity market closes the month up (recall August 2007).

Liquidity or Objectives Mismatch?

The above mentioned flow risk is caused by a general liquidity mismatch between assets and liabilities caused by a deeper mismatch between clients and hedge fund managers objectives. The industry has always been broadly split into high net worth individuals and institutional long-term investors, with fund of hedge funds typically viewed as institutional investors. The issue has been that funds of funds raised money mostly through platforms or structured vehicles whose investors were predominantly private clients. These clients had a shorter term view than the funds of funds themselves and definitively had a much shorter one than the underlying managers (especially with regards to the less liquid strategies). Not only did they have different investment horizons but also different investment objectives. Private clients were looking for “optionality” in returns (equity like returns during bull and bond like returns during bear) while institutions generally aimed for low volatility and contained correlation against other asset classes. All this resulted in a conflict of objectives, which was very difficult to manage by funds of funds, thus creating the foundation for the current liquidity crisis.

Hedge Fund Evolution

Life below the ubiquitous “high water mark” has never been easy. Having said that, hedge fund survivors have always enjoyed periods of renaissance right after each previous crisis. It is likely that the overstretched bull environment attracted less skilled (on average) players in a very crowded (and thin) opportunity set, leading into the current crash which very few have been able to forecast. The good news is that market capacity is improving day by day and a new range of opportunities has arisen from the present dislocation. The winners will prove their skill and are likely to enjoy the panacea of rich trades and very little competition.

Where does the new set of opportunities lie?

Even with outflows threatening to wipe out 1/3 (or more) of the industry (according to various press reports), there are some hedge fund allocators working hard to identify where the next set of opportunities will arise. I remember that once, during a sailing competition, my coach said: “Once you touch the bottom, you can only do better…or start digging”. By the end of that competition, my yacht club was in last place.  As he had predicted, we simply couldn’t do any worse.  Later that year, however, our team clawed our way back to a silver medal at the national championship. Like that sailing team, it is likely that we shall all wake up in a brave new world full of opportunities.

As an example, distressed debt is one particular opportunity that I believe will be the next wave to ride..  Why?…

• Investment Grade (IG) and High Yield (HY) spreads went through the roof;
• All but one high yield sector is trading at distressed levels;
• Leveraged loans and mortgage pools underwent a dramatic transformation as a result of excessive liquidity conditions;
• Massive dislocations took place in IG and HY capital structures, cash and derivatives market.

If the default rates eventually met spreads in 2009, the supply of new distressed debt should subside somewhat relative to demand, which probably would be good news for distressed investors. Furthermore I expect an unprecedented supply of juicy fallen angels’ paper, which typically yields higher alpha and lower tail risk than any other distressed security.

There is little question that a gale force headwind blew the hedge fund sector off-course in 2008.  But as any sailor will tell you, headwind – like any wind – can power a boat forward as long as the sails are trimmed right.

- T. Sanzin, December 2008

(Editor’s addendum: Related news items: John Paulson looking to buy distressed debt: report [Reuters, Dec. 31], Yale’s Swensen Sees ‘Extraordinary’ Opportunity to Snap Up Debt [Bloomberg, Jan. 2] )

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