The fable of The Wind and Sun tells the story of how the Wind and Sun argued over who was more powerful.  Seeing a passerby wearing a coat, the Wind blew as hard as he could to blow it off the man – to no avail.  The Sun, on the other hand, shone on the man, lifted his spirits (and his body temperature) – and basically cajoled him to remove his own coat.

As they develop ways to keep investors in their funds during times of lacklustre performance, a new study suggests that hedge fund managers might find this fable to be somewhat instructional.

One of the great ironies of 2009 was that so many investors were “locked-up” in gated hedge funds at a time when the fee levels they faced – the very fee levels that raised the ire of so many in the recent past – were at an all-time low.  In September 2008, we noted that hedge fund investors the world over were about to go on a lengthy performance fee holiday since so many of their funds were well below their high water marks.

Still, many wanted out and managers began to halt redemptions.  As the gates began to come down, many commentators decried the callousness and alleged self-interest of those hedge fund managers.

But according to a new academic paper, many of the “gated” investors actually have wanted to stick around (at least, assuming a stampede to the exits by co-investors could be averted).   George Aragon of Arizona State University and Jun Qian of Boston College describe the ubiquitous high water mark as a sort of self-imposed gate for investors.  By comparing the asset inflows and outflows of funds with and without high water mark provisions, they say that,

“Our model also predicts that HWMs provide a lock-in mechanism that serves to reduce fund outflows following poor performance…compared to funds without a HWM, investors are less likely to remove capital from HWM-funds following poor performance, as they perceive this as a better opportunity going forward.”

Further, the researchers found that actual outflows cannot be explained solely by the use or avoidance of redemption gates.  In other words, many un-gated investors actually opt to stick around in the tough times.  Writes the duo:

“Overall, our findings cannot be explained by a greater use of share redemption restrictions by HWM funds, and are consistent with the lock-in mechanism that retains investors after poor performance in HWM-funds.”

Like redemption gates themselves, HWM provisions can benefit investors by reducing the traffic heading for the exits (i.e. reducing the likelihood of what Aragon and Qian call an “inefficient liquidation” of the fund).

In fact, not only do investors seem less inclined to run from underperforming funds with HWMs, but they seem to strongly prefer well performing funds with a HWM over strongly performing funds without one.  The authors chalk this up to investors’ beliefs that the manager essentially has “asymmetric information” about their own true skill level – and their assumption that a great manager is more likely to offer a possible fee holiday since he/she probably believes they will never actually have to provide it to investors.

Overall, the study finds that funds with a HWM tend also to have a higher performance fee (to make up for the downside of the HWM we conjecture), come from younger firms, have longer redemption notices and are more likely to have a lock-up (ironically).  (See table below constructed with data from the paper).

So while commentators cry foul over redemption restrictions, we wonder how many gated investors are secretly glad that their fellow movie goers have been forced to sit in their seats, rather than run for the exits. (After all, the movie is now provided at a discount).

While funds will likely always have to use brute force to stave off investor panic, they should apparently also take a page from Aesop and consider the power of a little cajoling.

By: Andrew Saunders, Member of the Editorial Board of AllAboutAlpha.com, & Director, EFX Prime Services

In January the Wall Street Journal reported that ETF assets had crested $1 trillion. No longer is it simply another way to capture S&P 500 beta. It seems that every day there is an innovative new investment idea that is packaged in an ETF form. Joining us this month to discuss how ETFs play a role in an alternative investment portfolio is Adam Patti, CEO and Founder of IndexIQ . A lifelong entrepreneur, Adam has founded and run a number of companies in a number of business areas including marketing, technology and supply chain management. He was an early pioneer in ETFs, having led an indexing/ETF initiative involving two products while at Fortune Magazine, including the Fortune 500, the first fundamentally derived Broad-based index. His new venture brings ETFs to the alternative realm via a distinct replication methodology seeking to offer exposure to the return profiles of a number of hedge fund indices. Is this the wave of the future? Adam is here to shed light on this growing segment of ETFs.

Q1: Why does the market need another ETF product? How does your replication methodology differ from Harry Kat or Andrew Lo or other replication products?

We are acutely aware of the proliferation of ETFs and only plan to bring to market those ETFs that meet investor needs that are currently not being met by existing products. QAI is a great example of this focus as it is designed to fill a gap in the existing ETF marketplace by providing investors with hedge fund-like exposure in a liquid, transparent, cost effective vehicle.

IndexIQ uses a factor-based model, while the replication methodology put forth by Harry Kat is more of a “returns distribution matching” approach. What this means is that the process employed by Professor Kat and others is designed to generate a set of returns that, over an extended period of time, will have similar statistical properties to a target return series. The approach employed by Professor Lo, by contrast, is factor based and is more similar to the approach employed by IndexIQ, yet important differences remain. Importantly, IndexIQ attempts to provide hedge fund-like exposure at the strategy level (e.g. Emerging Markets, Long/Short, etc.) while the Lo approach focuses on replicating individual hedge funds. The IndexIQ approach further allows for an allocation process that can systematically over and under-weight strategies at different times. This allocation process has been an important contributor to the strong results seen thus far.

Meanwhile, back to the ETF industry. The mutual fund industry still dwarfs the ETF industry and we believe, given all of the structural benefits of ETFs, we are still in the early days of ETF development.

Q2: The benefit of hedge funds is that the return profile does not correlate to the market. Do IndexIQ products also deliver the benefits of non-correlation? Do you have enough data on the correlation relationships?

The correlation of IndexIQ hedge fund replication products to the broad equity market (as represented by the S&P 500) is similar to the correlation of aggregate hedge fund returns to the broad equity market.

The correlation between hedge fund indexes and the broad market depends on the hedge fund index in question, and may fluctuate over time along with hedge fund performance.

Our ETFs offer similar risk return characteristics without the structural impediments of hedge funds, which are characterized by illiquidity, high fees and a lack of transparency, and often lack of access to the best managers. In fact, the performance of (and behavior of some) hedge funds in 2008 is effectively our product positioning – we offer low-correlation return profile without gating, long lock-ups and individual manager risk.

Q3: Please fill in the blanks and explain your answer. “If I were _______, I would be worried about the launch of replication ETFs.” What markets are you targeting with the suite of ETFs?

There is a broad group of investors that do not have access to hedge funds at all because of the accredited investor rules. Having an exchange traded alternative product available to these investors is a way for them to access the positive merits of hedge fund investing.

Further, we certainly believe that there are many talented hedge fund managers in the world. However, for investors whose hedge fund managers have not been able to deliver the types of returns that their clients had hoped for,  who saddle them with high fees, a lack of transparency into the process and positions, and limited liquidity, hedge fund replication products should be viewed as a viable alternative.

Interestingly, we are seeing interest coming from hedge fund-of-funds who are using our products in a core-satellite approach or as efficient alternative beta where the core portion of the portfolio uses liquid, alternative beta products and the satellite portion employs individual hedge fund managers. This allows for greater liquidity in their portfolios and a lower overall cost structure.  Fund-of-funds are also using our ETFs to equitize their cash positions during rebalances.

In addition, we have had significant institutional interest, most recently from the City of New Haven, which desired to gain hedge fund-like exposure without the structural and headline risk issues of direct investment.

Q4: What are you hearing from clients and prospects? Is there sufficient knowledge of factor-based replication to understand these products?

The adoption of hedge fund replication, like any other new approach, can take some time. As hedge fund replication products have generated attractive risk and return profiles, investors are becoming more comfortable with them. We are starting to see an increase in the awareness and adoption of investors as our products are performing as expected.

Investors want to see the products working with real money. They want to understand the methodology and most importantly want to see how to use the ETFs in their portfolio. We provide a more consultative approach and provide different sample portfolio allocations to show what dialing up or dialing down will do to expected risk and return.

Q5: The buzzwords among alternative investors this year have been transparency and liquidity and the best expression of those trends have been the growth of managed accounts. Do you see these ETF products leap-frogging managed accounts on the liquidity spectrum or are you targeting different investors?

Both product wrappers have their advantages. Importantly, both solve many of the frustrations associated with direct hedge fund investing. However, there are important differences. ETFs offer intraday liquidity while managed accounts will generally be end of day. However, managed accounts can potentially be customized to meet specific client objectives (i.e. targeting higher returns, lower risk or tax management) while ETFs do not offer customization.

Q6: ETFs from Rydex, Direxion and ProShares have attracted the scrutiny of regulators for the sales practices of the leveraged products? Do you see similar risk for IndexIQ products?

IndexIQ products do not use leveraged ETFs to implement our strategies, nor do our ETFs employ leverage of any sort. In fact our strategies are typically low volatility strategies designed for portfolio diversification. We are confident that our portfolio management and sales processes are consistent with both the intent of the underlying strategies and the regulatory requirements of the products.

However, certainly our sales model is reliant on a heavy dose of education. Investors are becoming much more sophisticated on the use of ETFs in a portfolio as evidenced by the total AUM breaking through $1 trillion. We are generally targeting sophisticated investors and not the retail audience at this time and have not run into confusion with leveraged ETFs.

Q7: The most recent product is a merger-arb ETF. Talk through the methodology of putting together the ETF products? Has there been sufficient data to determine the durability of returns?

The research underlying all of our ETFs begins with an initial discussion of the investment thesis and the merits of developing a particular strategy. Once we determine that the ETF can potentially satisfy a missing exposure for investors, we consult with our academic advisory board to fully vet the idea and to begin to compile academic support for the product. With our merger-arb ETF, we underwent a rigorous research process whereby we compiled data on 10 years of merger and acquisition transactions to determine the characteristics of deals that consistently provide the most significant ROI. From that we created an index rule-set used to create portfolios that would have existed at certain points in time with the data that was available at that time. We then test our hypothesis that the portfolio construction process we have proposed would indeed have performed in line with our a priori expectations. All of our research generally extends back at least 10 years and can go back even further if there is reliable data available. This helps us to check the return pattern across different market cycles and economic environments.

The merger-arb index has been publishing returns dating from 2007 – which provides a good starting point to assess the durability of returns. The ETF has performed as expected – it provides the exposure, importantly, in an ETF wrapper, and offers significant tax benefits.  As a result we have seen considerable interest.

American university endowments have long been held up as models of a new form of investing.  The so-called “Yale model” is standard fare at industry conferences and the recent travails faced by Harvard’s endowment have scratched a Schadenfreude itch felt by many commentators.  Way back in January 2007, The Economist raised the possibility that these beacons of alternative investing may someday have to pay the piper (see related post)…

“Simply putting 20% into hedge funds is no longer enough. The big test of their prowess will come when lax credit conditions tighten. John Griswold of Commonfund thinks that some investment committees, stuffed with alumni, may be starting to lose track of the risks their endowments are taking.”

Investment committees may indeed have been aware of the risks they were taking with alternative investments.  As a result, they under-weighted the traditional risks of long-only equity (known by previous, more cautious generations as “playing the market”) and instead invested in alternative strategies.

According to new data from The National Association of College and University Business Officers (NACUBO) and Commonfund, that move paid off handsomely in 2009.  The average return from domestic equities was -25.5% while the average return from international equities was -27.6%.  Meanwhile the average return from hedge funds was only -12%.  Thankfully, hedge funds (a.k.a. “marketable alternative strategies”) represented about a quarter of the average portfolio on a dollar-weighted basis).

Returns for alternative investments ranged from a high of 12% for hedge funds to a low of -36.7% for “commodities and managed futures” (note: we surmise that long-only commodities accounted for most of this since managed futures indexes were generally flat on the year).

Taken as a whole, these numbers reflect pretty well on university endowments.  Their equities beat the S&P 500 and their hedge funds bettered most hedge fund indexes by around 8%.

For the first time, alternatives represented over half (51%) of all endowment portfolio assets. But as usual, this number was much lower among smaller institutions.  (See table below from NACUBO – click to enlarge).  In fact, big endowments appear to invest 3 times as much of their portfolio in alternatives.

However, there is one category where smaller endowments lead their larger brethren – the proportion of their alternative investment allocation going to hedge funds (vs. private equity and other alternative investment classes).  As the following table shows, the proportion of capital allocated to hedge funds is 50% greater among small endowments than it is amongst large ones.

Data in the full version of the report shows that the equal-weighted average allocation to “marketable alternative strategies” (the closest proxy to last year’s “hedge fund” category) was 13.5%.  So hedge fund allocations seemed to actually grow last year (by virtue of losing less, rather than necessarily attracting more dollars, we’re guessing).

Marketable alternatives aside, the overall “alternative strategies” category commanded over 60% of the assets of mega-endowments (a number that was noted recently in this Reuters article by two AllAboutAlpha.com contributors – Mebane Faber, CAIA, and Michael Crook, CAIA).

Commonfund’s Bill Jarvis tells us that this year’s survey asked more detailed questions about exactly which types of alternative investment strategies were being pursued by endowments.  He explained to us that the pace of evolution of alternative investments was such that old labels such as “hedge fund” no longer suffice.

While the reorganization of the alternative investments categories does make an apples-to-apples comparison with last year’s “hedge funds” a little difficult, it does signal that previously disparate asset classes such as hedge funds, private equity, real estate and commodities are finally coming together under the “alternative investments” umbrella.  And as Jarvis points out, it also shows how dynamic this asset class has become as it grows beyond its hedge fund roots.

If 2008 was characterized by meltdown and 2009 was characterized by thaw, 2010 will be noted as the year hell finally froze over, at least when it comes to hedge fund and investment banking oversight.

For years, hedge funds have been threatened with tighter borrowing and lending practices, more scrutiny and less flexibility to hide behind the veil of being a private investment for the accredited. The gauntlet never quite came down, thanks to Goldstein, Madoff and a global financial crisis, allowing hedge funds to continue doing what they have always done.

But comments from officials at this year’s World Economic Forum in the cold, snowy mountains of Davos seem to suggest that the rhetoric may finally be snowballing into something a bit more onerous, and that banks, private equity firms and hedge funds may be looking at a new type of landscape with more stringent standards – at least if they want to remain in business.

Regulators from the world’s developed countries told bankers far and wide in Davos that greater regulation is indeed on the way – a defensive move aimed at avoiding a repeat of last year’s financial meltdown that dragged most of the world into recession. The remarks came on the back of President Barack Obama’s suggestion – dubbed the Volker rule (because it was former Federal Reserve Chairman Paul Volcker’s idea) of forcing banks to divest their private equity and hedge fund holdings as well as their prop trading desks to reduce their financial footprint and limit systemic risk.

Untangling banks, especially big ones, from proprietary trading and alternatives strategies is no small feat, judging from the prop-trading market segment chart shown below from a slideshow by the CME Group.

Of course, Davos and many other forums have heard talk like this before: After the technology bust, after the Russian debt default, the Asian financial crisis, Long Term Capital Management and even after Amarynth blew up. AllAboutAlpha wrote about how hedge funds were on the “Global Agenda” in Davos back in 2007.

The key difference this time around is that governments, after spending billions to bail out the banking and financial services industries, are now calling the shots, and are more likely than ever to push through reforms that will make investing a much more different space in 12 months time. Even former Treasury Secretary Hank Paulson is on the hell-needs-to-freeze-over warpath, noting on CNBC in the past week that he approached his former Goldman Sachs cronies “numerous times” about the crazy casino that is Wall Street.

For their part, the banks still appear to be very, very deep in denial. They have already come out swinging, arguing everything from prop trading and hedging is only a small portion of their businesses to liquidity will all but dry up if such activities are made extracurricular.

Source: The Wall Street Journal

Elizabeth Warren, the woman in charge of the Troubled Assets Relief Program, or TARP, gave a passionate “now or never” diatribe on the “Daily Show” with Jon Stewart late last month, making plain that Wall Street is facing two choices: Either continue along the path of ever larger booms and busts that eventually turn into a financial atomic bomb, or make drastic changes that ensure the global financial system remains intact for at least the next 50 years.

Stewart called attention to a great quote she had, noting the lack of downside to the shenanigans of Wall Street in the 21st century: “Capitalism without bankruptcy is like Christianity without Hell.”

On the flip side, all the talk could actually end up being positive for hedge funds and other prop-trading shops, who presumably will find other places beyond the banks to get what they need.

Fire, or ice? The hedge fund industry, which rightly or wrongly is inexorably linked to the investment banking business, is likely in for both. One thing is for sure: Melt it, freeze it or pack it into a ball and whip it, it’s still the same thing.

With the dust still settling after World War II, British policymakers began to turn their attention to what had been called “a chronic shortage of long-term investment capital for small and medium-sized businesses.”  The result was the Industrial and Commercial Financial Corporation (ICFC), a pool of capital funded by major British banks.  Fast forward to July 1994, and the successor to the ICFC – now known as “3i” became one of the first private equity funds to be listed on an exchange.

Since then, many other private equity funds have listed themselves – most notably in the UK.  In fact, one might even say that listed private equity funds have blazed a trail for the recent wave of hedge fund ETFs.

A new study of this branch in the private equity family tree sheds light on which types of institutional investors allocate capital to these funds, and why they have grabbed the attention of investors.  The paper, by Douglas Cumming of Canada’s York University (see related post), Grant Fleming, a visit professor at the Australian National University, and Sofia Johan of the Tilburg Law and Economic Center, examines the private equity allocations of 100 European institutions and finds that 43% invest in listed PE funds – allocating an average of just over 6% of their capital to them.

As you can see from the chart below (created with data from the paper), organizations that invested in listed PE made extensive use of consultants.  In addition, they were the only PE investors to use their existing equities teams to manage the allocation.  As the authors suggest, this is likely because listed PE funds are, technically speaking, listed equities.

In addition, listed PE investors were more commonly private pension funds, rather than public ones.   According to the paper, part of this could be due to the smaller size of private funds – and therefore their smaller capacity to conduct due diligence on LP investments.

One of the problems with traditional (LP) PE investing is that capital may be deployed quite slowly as the GP searches for investment opportunities.  As a result, full PE exposure may not be reached until several years after the initial capital commitment is made.  To compound this problem the time line for ramping up this exposure is in the hands of the GP, not the LP.

As the paper points out, listed PE funds allow institutional investors to get PE exposure immediately.  And in fact, institutions seem to take advantage of this benefit.  Those that invest in listed PE are 15% more likely to adjust their allocations over time.  In addition, listed PE investors are 9% closer to their desired private equity allocation compared to institutions that invest using LPs.

In conclusion, Cumming, Fleming and Johan suggest that listed PE may be a growing asset class as defined benefit plans switch to defined contribution plans and put decision-making into the hands of unit-holders themselves.

Which makes us wonder if hedge fund ETFs may ride the same tail wind…

With the explosion of hunters searching for the same scarce alpha and the proliferation of high-frequency trading, is asset management still all about alpha?  Yes, says Jane Li, CAIA, of  FundQuest, a division of BNP Paribas.  Her research of over 10,000 mutual funds (both alive and dead) collectively managing $4  trillion shows that it depends on which category of fund you’re talking about.

Special to AllAboutAlpha.com by: Jane Li, CFA, CAIA, Manager, Investment Management & Research Team, FundQuest

Many argue that more efficient financial markets permanently reduce the potential for managers to produce bona fide alpha.  For example, the author of “Illegal Alpha,” published on AllAboutAlpha.com in November suggested that

“…nowadays talk of alpha generation and alpha-beta separation still permeates, though the search for it – and expectations of finding it – has greatly diminished.”

I disagree.  In fact, following the significant out-performance of many active managers over their passive peers in 2009, it seems logical that investors will rekindle their passion for searching for alpha.

The most important criterion for choosing between a passive or active product is whether active managers are able to add value by generating real alpha. Real alpha is the additional return truly stemming from the unique ability and skill set of the investment manager.

In early 2009, I authored the FundQuest study, What Now?Active or Passive Management? Examining Real Alpha and Exotic Beta. The study analyzed 30,435 U.S.-domiciled non-index mutual funds in 60 categories representing almost $4 trillion of US and non-US assets as of the end of 2008.  It included all live and obsolete mutual funds in the Morningstar database to minimize survivorship bias. Mutual funds were analyzed for the 15-year period from January 1, 1994 to December 31, 2008. Each fund’s behavior pattern and performance was analyzed for 13 rolling 3-year trailing periods ending December 31, 2008.

The study’s main conclusion was that we should not paint either active or passive investments with a broad stroke, as both types of investments have their strengths and weakness.

Importantly, there is very wide variation in the relative performance of either active or passive management from one style category to another. In some style categories, a high proportion of active managers consistently beat index-based investments while in others, very few active managers justified the additional management expenses.

The study also analyzed mutual fund performance patterns in different market environments. The 15-year period was divided into two groups based on market conditions: the bull markets of 1994-1999 and 2003-2007, and the bear markets of 2000-2002 and 2008. The asset-weighted average exotic beta and real alpha of each category for each market condition was also calculated.

Generally, active managers generated more real alpha in bull markets and lower real alpha in bear markets. In aggregate bull markets, the real alpha generated by the entire universe was 0.44 higher than that in bear markets. Specifically, 38 out of 60 categories generated more real alpha in bull markets, while 24 out of 60 categories held relative strength in bear markets. Many growth categories performed better in bull markets, while some value categories generated more real alpha in bear markets. Details are provided in the following chart. As shown below, eight categories generated positive real alpha (>0.5) in both bull and bear markets.

In all, 19 categories of funds generated positive real alpha in bull markets and 12 categories generated positive real alpha in bear markets.

It appears from these findings that active management (in the form of mutual funds in this study) still produces alpha – particularly in niche strategies that may rely more on exploiting informational inefficiencies.  While the “expectations of finding alpha” may be somewhat “diminished,” the reality appears to be that alpha continues to exist.

We’ll see if this hypothesis holds up.  Our next study will be published in the first half of 2010.

- Jane Li, January 2010

Two thousand and eight was all about the big drop in hedge fund returns, while 2009 was all about the big rebound.

So with the markets seemingly having righted themselves, the focus among investors this year is coming back to strategy - convertible arbitrage, distressed, global macro, technology and others that fall under various categories depending upon what their managers do and on what markets they are focused.

One strategy commanding particular attention is merger arbitrage, which still managed to produce so-so returns last year (see chart below).

Source: Barclay Hedge

Merger arb managers are licking their chops this year for a variety of reasons: the global economy apparently on the path to recovery, hoards of cash sitting on companies’ balance sheets, the U.S. dollar seemingly back on the rise – and talk of the day is that funds that invest simultaneously long and short in companies involved in a merger or acquisition are going to bring it home this year.

Many have questioned the very rationale for the strategy in recent years – wondering if the opportunities have all been arbitraged away.  Since we ran a post about that possibility back in March, it appears the extinction of merger arb was greatly exaggerated.  The strategy has since posted a string of nine consecutive up-months.   At the very least, merger arb seems poised to continue its recent propensity to track the S&P 500 (see related post).  But will merger arb produce alpha in 2010?

GLG, one of the world’s biggest hedge funds with more than $20 billion under management, told the Telegraph earlier this week that Kraft’s recent successful bid for Cadbury was a sign of a new cycle of M&A activity. GLG believes conditions are similar to the late 1980s and early 1990s when conglomerates and large companies spun off operations that were not reflected in their valuation.

Indeed, analysts are predicting an M&A revival in 2010, with companies leading the way as private equity firms continue to be dogged by tough credit market conditions. According to KPMG, the M&A market is set for growth after revisions of over-optimistic earnings expectations in 2009, which it blames for skewing market activity last year.

David Simpson, global M&A head for KPMG, said in the firm’s annual Global M&A Predictor released last week that analysts had overestimated corporate earnings in 2009 by some 20%, which had skewed a clear view of the market.

So are merger arbitrage funds poised to pounce on this new era of M&A activity? Do they have their short lists of acquirers and targets ready to go, stop losses and all? After mediocre performance over the past two years, one would expect the M&A guys are more than ready to see some deals by the dozens emerge, and to profit from them.

The question, as with any hedge fund strategy these days, is whether investors are willing to put their chips on the table on their behalf. Not many are, based on the flow of assets going back into the space, which can be seen from the chart below from Barclayhedge.

Source: Barclay Hedge

Then again, if President Obama’s recently declared intention to limit banks’ involvement with hedge funds holds true, a flurry of M&A activity could quickly unfold, leading to some lucrative profits for merger arb managers – at least those betting on the right divestitures, the right acquirers and the right timing – and maybe some flows back into merger arb managers’ coffers.

Let the M&A games begin.  But will merger arb managers come home with any medals?

Usually when I walk into a room full of hedge fund managers, the average IQ drops precipitously.  Today, as I walked into the annual New York edition of “Battle of the Quants”, there was a palpable sense that a mortal had just infiltrated the rarefied world of math Ph.D.’s, think tank researchers and finance professors.   Today, your humble scribe was an “embedded reporter” with the troops fighting a battle between robots and humans and between robots and themselves.

What follows are field notes taken – and published – during the fighting.

“I’m very interested in gambling”

There are worries about the amount of snow in Vancouver for the Winter Olympics.  So the first speaker today, William Ziemba, Professor Emeritus at Vancouver’s University of British Columbia was likely a little surprised to see a blanket of the white stuff on the ground here in New York.  (Ziemba is actually teaching at Oxford right now.)

He told the audience that he’s “very interested in gambling”, which means that he “gets calls from some very interesting people.”  One of his clients is a trend follower in the Bahamas who is so good at Black Jack that he is banned from playing the game in over 40 countries – a badge of honor we surmise.  (”Once you’re banned in one country, you get banned in them all”, he points out).  Ziemba has also co-authored a book on horse racing.

Using “gambling” (a.k.a. “quant”) strategies, he says that he has “worked with several people who have begun with zero and ended up billionaires.” He referred to one of them several times during his talk, referring to him as “a client that is so secret, I can’t even mention his name.”

Little-known power brokers

Ziemba is currently working on a book about the Kelly Criterion – an approach that he says he once taught to Jim Simons – the hedge fund manager Ziemba describes as the “greatest trader in history” (an assertion that he later proves mathematically).  To describe the Kelly Criterion, he uses a parable very similar to the one described on these pages by Ranjan Bhaduri.  The bottom line: The Kelly Criterion can help manage Black Swans.

Ziemba weaves a fascinating tale of mega quant traders and hedge fund managers that included Brian Hunter, Victor Niederhoffer, Simons, and others.

Secret billionaires?  Giant market bets?  Swans?  It’s enough to fuel conspiracy theorists.  Here’s a theory for you:  Ziemba’s homepage logo (above right) is eerily reminiscent of another mysterious organization – The Dharma Initiative in TV’s Lost (below – right).  Note to US readers, watch Lost’s season premiere next week to see if Ziemba makes a cameo.

The “battle” begins

AllAboutAlpha.com friend (and quant manager himself) Giovanni Beliossi of FGS Capital introduced the annual “machine vs. human intelligence” debate.  The panel was moderated by Karsten Schroeder, CEO of Amplitude Capital and was judged by The Wall Street Journal’s Scott Patterson, Tarek Ritz of CSFB and Kevin Kribs of Lighthouse Partners.  Combatants from Tradeworx, Rand Labs and Quantitative Asset Management argued on behalf of machines (who, being machines, weren’t able to make it here today).  Representatives from Starmine, Catalpa Capital and AllAboutAlpha.com contributor Denise Shull argued for the poor old humans.

Regular readers will recall this recent post about a research study comparing “quants” and “quals”.  Schroeder referenced similar research on systematic traders vs. discretionary.

The main argument raised by the humans: things change.  Only human discretion can adequately address these unforeseen changes. The main argument made by the robots:  you can’t find the trends without us!  On behalf of humans, Shull retorted out that the selection and dedication to a particular quant model is itself a human foible that requires flexibility to manage properly.  She argued in favour of both sides by saying the debate is somewhat artificial since humans are required to develop, operate, and tweak quant models.  Argued Shull emphatically:

“The idea of taking emotion out of it is a complete farce.  No one here would be able to choose what to wear this morning if they lacked the ability to have emotion!  There is emotion at play when quants choose factors of their models.”

Although here pleas were met with scattered applause, the outcome of this particular “battle” was less certain.  The final verdict from the judges: systematic scores a narrow victory.

Kudos go out to Swiss moderator Karsten Schroeder for keeping Swiss-time as he lobbed the panel nearly 2 dozen questions in 45 minutes and for highlighting some interesting parallels to quantitative management (e.g. online dating websites as quant managers, and weather forecasters as systematic traders and major league baseball coaches as discretionary managers).  Not surprisingly, these allegories elicited the most violent clashes in this particular battle.

Humans as sore losers

After listening to quants themselves for 2 hours, next up were three quant investors.  At most conferences, a hush falls over the audience as attendees (often marketing professionals of some form) listen intently for anything that would help them argue in favour of their particular fund.  The choice of many here to use this opportunity to convene informal discussions in the hallways during this panel was actually a bit of a refreshing change.  Clearly, many of the quants in this audience really do just want to talk about quant investing rather than market their funds.

Unfortunately, they missed some interesting comments on quant management from an investor’s perspective.  Although research shows that quants tend to be much larger than discretionary managers, two of the panelists, a family office and a small fund of funds both focus on emerging funds (and, by extension emerging quants).  However, Brian Chung from SSARIS, State Street’s fund of hedge funds disagrees – pointing to back-fill bias as the reason for the out performance of emerging managers.

Chung also notes one special challenges faced by human beings in high frequency trading.  He said it’s psychologically difficult to be a discretionary CTA “when you know that 60% of your trades are going to be loser.”  However, he said, computers are better at losing like this.  Succinctly stated, computers aren’t sore losers.

Panelists, Terri Chernick, CIO of The Koffler Group Family Office has a degree in neuroscience.  That came in handy as she explained that there was no “direct pathway” from your sensory organs to the higher-order portions of your brain.  All sensory information must first go through the more primitive segments of your brain.  Ergo (as Denise Shull would surely agree), there is no such thing as a purely “logical” trade.

Revenge of the Nodes

Last year’s keynote speaker at this event was Ray Kurzweil, Director of the Singularity Institute for Artificial Intelligence (see our coverage).  This year Kurzweil’s colleague Ben Goertzel addressed the gathering on the topic of “using artificial intelligence, complex systems, and sentiment to identify stress points in the global financial system.”

Goertzel is the only person in this room with a ponytail – but that shouldn’t fool anyone.  He’s used some of his automated news gathering/analysis algorithms to gauge things like market sentiment for some of the world’s largest hedge funds.

He describes “scale-free” networks as ones where a few nodes have a lot of connections, but most nodes have only a few connections (think Facebook).  It doesn’t take a Ph.D. to see the implications for financial markets.  Attendees at Global ARC in Boston last fall will remember this concept from a fascinating panel involving the same topic (see article on this topic by co-panelists George Sugihara and Lord Robert May in the journal Nature.)

Instead of exploring the implications for financial regulators, Goertzel turns his attention to the search for the news that drives financial markets (”networks of news and sentiment rather than networks of money” as he describes it).  Just as regulators look for possible “cascades” of bank failures, Goertzel thinks you could examine “cascades of negative sentiment”.  He figures it will be about five years before we’re able to analyze sentiment in this way.

Goertzel also touches on the raison d’etre of the Singularity Institute – to explore the possibility that technology will improve so quickly by around 2045 that it will eclipse our ability to manage it.  He defines “Narrow AI” as artificial intelligence systems designed for a single purpose.  “Artificial General Intelligence” (AGI) solve problems that simply did not exist when the system was developed.

Early forms of this kind of AI are being applied to video games.  But Goertzel says that it will eventually be applied to quantitative investing.  In fact, he concludes…

“Whoever cracks this first is going to make a heck of a lot of money.”

A flash in the pan?

Irene Aldridge wrote the book on high frequency trading (literally – “High Frequency Trading: A Practical Guide to Algorithmic Strategies and Trading Systems“).  She joined co-panelists Richard Brown, head of “machine readable news” at Thomson Reuters, Mark O’Friel of MOF Capital and Scott Ignall of Lightspeed Financial in a discussion of whether high frequency trading was here to stay.

Aldridge points out that the definition of “high frequency trading” is amorphous.  She says that anyone can be a market-maker now.  Some, such as Professor Harry Kat, have suggested on these pages that many major hedge funds are just market makers in drag.

Brown warned that regulation may stymie the growth of high frequency trading in places like Brazil.  On the other hand, Aldridge said she was getting lots of emails from Silicon Valley rocket scientists who were developing trading algorithm in their garages.  LightSpeed’s Ignall is also seeing a lot of newly minted Ph.D.’s entering the field.  “That sort of innovation”, he says, “will allow for a lot of growth in the future”.

“Growth” in high frequency trading volumes, for sure.  But the hedge fund industry knows that less liquid investments usually lead to high returns.  So does greater liquidity resulting from the proliferation of high frequency trading mean less opportunity for alpha-generation?  Aldridge pointed to one Canadian firm in the news today that often accounts for more daily volume than Canada’s big 5 banks.  But the question remains:  How many more arbitrage opportunities are there?

Managed Futures.  Managed Accounts.

AllAboutAlpha.com Editorial Board member and frequent contributor Ranjan Bhaduri, CAIA appeared today along with CAIA Curriculum Committee member Ernest Jaffarian, CAIA and others to discuss why managed futures investors have always flocked to managed accounts.

For more on managed accounts, see:

• Do managed accounts reduce asymmetries or enhance them? It may depend on who you ask.
• HF Managed Accounts: A tool for change or tilting the playing field?
• Managed Accounts: Not just for breakfast any more

The home stretch…

Hedge fund leaders from Innocap (part of the National Bank of Canada), CSFB, Merrill and IKOS were then handed the impossible complex question of what was learned over the past 2 years.  Was tail-risk under-appreciated?  Did quant managers ignore warning signs?

Innocap’s Martin Bernier said that the financial crisis proved that manager – and strategy - due diligence was the critical success factor for the firm’s managed account platform.  He says that growing interest in managed accounts is definitely another outcome of the calamity.  In fact, he cites 2 surveys in the past year (one by Albourne and the other by DB) showing that his firm is  certainly not alone in attracting interest from institutional investors.

The final panel of the day tried to answer the question of which quant/CTA strategies work best in which type of environments.  As usual, the stage was stacked with Ph.D.’s in mathematics and professors of finance.  One of the panelists was a founder of a French quant hedge fund called, simply “Numbers” (website here – tough to Google that one btw).

As you might guess, most managers said CTAs proved their mettle during the 2008 market drawdown – even if they took a breather last year.  So which strategies will work this year?  Without exception, panelists adeptly sidestepped the question – with one saying that CTAs “are reactive, but not predictive” and another saying that “managers that will do well are those that are committed to getting an informational advantage”.

And with that, the “battle” died down and combatants began quenching their thirsts with the first in a series of 4 consecutive social events culminating in an official “after-party”.  Quants like to party (”Think hard, play hard”, right?).   Hopefully, the attendees will knock a few points off their IQ’s tonight and bring them a notch closer to that of your humble scribe…

For year, researchers have been telling us that one of the biggest determinants of mutual fund alpha (or lack thereof) is a fund’s expense ratio.  What little raw alpha is generated, the argument goes, is eaten up by management fees.

On the surface, a new study of “the dynamics of average mutual fund alphas” seems to suggest the same thing.  But under the surface, the paper makes an interesting observation about the changing structure of markets themselves.

The paper is by Diana Budiono, Martin Martens, and Marno Verbeek of Erasmus University in the Netherlands.  The trio says that many studies have explored mutual fund alpha itself, but most,

“…focus on the average alpha, (and) few say anything about how average alphas change over time, and what drives average alphas.”

In a bit of an anti-climax, they find that rather pedestrian variables such as portfolio turnover and cost are key determinants of mutual fund alpha over time.  They also find that the ratio of “skilled to unskilled” funds (think ratio of high-tracking error funds to index huggers) determines the level of alpha produced by mutual funds over time.  As any of these variables change, they conclude, so does the average alpha.

In fact, the following chart shows the variables examined by the trio (click to enlarge):

One of the variables examined by the trio is a little different however: the “nonprofessional AUM” ratio.  This is the ratio of equity owned directly by “households and non-profit organizations”.  As you can see, it has been falling steadily since the early 90’s and now sits at around 8%.  Although the study finds that this variable isn’t critical in determining mutual fund alpha, many suggest that the zero-sum game of alpha-generation means someone’s lunch has to be eaten for mutual funds to produce alpha at all.

At the same time, the researchers find that the ratio of hedge funds to mutual funds has been rising steadily.  You don’t see this in chart because the variable only exists from 1992 to 2006.  Still, the trio writes that,

“…the number of mutual funds and hedge funds has a large explanatory power.”

Curious, we tried to reconstruct this data by comparing the number of hedge funds at the end of each year (according to HFR) to the number of mutual funds (according to the Investment Company Institute).   Here’s what we found:

Both mutual funds and hedge funds grew in number from 1995 to 2000.  But starting at around the year 2000, the ratio of hedge funds to mutual funds started to grow.  The number of hedge funds surpassed the number of mutual funds in the middle of the last decade (the exact year depending on whether you count only single funds or every hedge fund – including funds of funds).

Also beginning around 2000, there was an accelerating drop in the number ratio of “non-professional” money in equity markets.

The study suggests that just as well-paid professional money managers may be able to eat the lunches of “unprofessional” money managers, exorbitantly-paid (hedge fund) professionals may also be able to eat the lunches of the merely highly-paid (mutual fund) professionals.

So it appears as though the mutual fund industry may face pressures from both ends.  After arguing that money management should be left to well-paid professionals, there are fewer DIY players from which to harvest alpha.  But as hedge funds make the same case to investors, mutual funds may find themselves in the same, somewhat awkward position as the lunch-server, not the lunch-eater.

A cynic might just say, “What goes around comes around”.  Thankfully, though, we’re not cynics.

Time and again the US Securities and Exchange Commission has looked to impose additional oversight on hedge funds, and time again their efforts have either failed, been thwarted or taken a back seat to more pressing issues, such as the potential end of the financial system as we know it.

Assuming the world is indeed back on its financial axis, the SEC in 2010 is going to be getting back to its focus on regulating hedge funds and other private investment vehicles that it believes need to be more transparent and accountable. Indeed, the SEC’s 2009 annual report notes a significant increase in examinations, with more to come this year.

Of course, many both within and outside the alternatives industry have heard this song and dance before. And many have watched in bemusement as the SEC’s bark has proved once and again to be much worse than its bite.

So what’s going to be different this time around?

For one, money – lots of government money that the agency plans to use to hire key talent to conduct examinations and troll for evil doers in the non-public investment world. A recent study by Heidrich and Struggles found that the SEC is focused on nabbing veteran hedge fund and markets professionals as it seeks to beef up its new Division of Risk, Strategy, and Financial Innovation, as well gear up for increased government enforcement.

Funds particularly vulnerable to poaching are those with less than $1 billion under management, according to the report, which surveyed more than 400 portfolio managers and studied more than 100 hedge fund firms.

One of the key issues the SEC has faced for many years has been its lacking ability to hire the quantity and quality of professionals it needs to conduct routine blitzes of managers. For long, the biggest complaint among hedge funds that did fall under the cross-hairs of the SEC wasn’t so much that they were being examined, but that the examiners were young, inexperienced and didn’t know what they were looking for.

That appears to be about to change. Already Washington D.C. is being described as the new place to be for young, educated investment professionals either pining to get into the alternatives space, or unceremoniously booted out thanks to the events of 2008.

And judging by the both the SEC’s mandate and budget, it appears that this year will finally be the year it is able to do what it finally wants to do: create an army of sophisticated examiners and bright minds who know what to look for when it comes to smoking bad hedge fund managers, broker dealers and anyone in between up to no good out of their respective foxholes – before the press does.

A quick look at some numbers in the SEC’s 2009 annual report confirm that the agency is ramping up its focus on market oversight, with enforcement management and examinations at the top of the to-do list.

Sorry Goldstein. It was a valiant effort, and much appreciated, but the days of pushing back on the SEC are over, as are the days of not being completely and utterly transparent and compliant. A new era indeed.

By: Dr. Bob Swarup, AllAboutAlpha.com Editorial Board.

Over the last year, the hedge fund industry has witnessed a development of truly Olympic proportions.  After a multi-year run-up, gold has finally become the belle du jour of the hedge fund community.  For example, John Paulson recently announced he was launching a gold fund and plugging $250mn of his own money into it; Paul Tudor Jones revealed that he had become the latest recruit to the gold bug movement; and Stanley Fink’s new shop is planning to join the party with a gold fund – the latest in a series of funds focused on the sector.

The sudden love affair caps a remarkable comeback for a commodity that has spent much of the last three decades as an anachronism. Unloved for most of the 1980s and 1990s, its supporters have only recently begun to shrug off the disparaging mantle of ‘gold bugs’ – a transition aided by the fact that gold has outperformed most other asset classes over the decade. (see chart below from Bloomberg).

But that is only the proverbial tip of the iceberg.

The recent meteoric rise past the psychological barrier of $1000 is also symptomatic of the fear lurking beneath the surface amongst a growing body of investors – including the hedge fund community – over the murky economic outlook.  Some, such as Greenlight Capital, have eschewed shares, options and ETFs, preferring to store physical gold instead. There is even a hint that for many there is a paradigm shift in the making with several funds (including Paulson) now offering shares priced in gold rather than the more standard currencies of everyday life.

The mania – for there is no other word – is remarkable. But before we dismiss this as the latest bubble of our times, it’s worth examining the evidence. Bubbles have three key characteristics: a catalyst event, a convincing story and a perceived paradigm shift that renders normal valuation metrics meaningless. The dotcom crash with its new virtual worlds and notions of hypergrowth in a globalised community fulfilled all of these. Unfortunately, few considered how hypergrowth in users might be translated into hypergrowth in revenues. The realization that this might not be the easy or fast-track Mecca envisaged filtered through and the rest became a case study for future MBA students.

Gold has a catalyst – the credit crunch and its aftermath. As regards the story, proponents maintain that it was oversold by the end of the 1990s and there are fundamentals underpinning its rise since. Among the reasons trotted out are the commodity supercycle, emerging market demand, a growing appreciation amongst investors of its portfolio diversification properties and most common, that it reflects the devaluation of the US Dollar against almost everything else since the turn of the century. As the dollar declined in recent years thanks to a growing government deficit and an accommodative Federal Reserve’s low interest rates, gold edged upwards and found a new lease of life with fears over the future of the Western financial system during the credit crunch and the subsequent turning on of the taps by central banks worldwide. The inevitable inflation at the end of the quantitative easing road is the paradigm shift and explains why increasing numbers of investors have jumped on the bandwagon (see chart, right from Andrew Butter at SeekingAlpha).

There is some truth to the inflation argument. Given the sheer scale of fiscal stimulus pumped by governments into the global economy, inflation is a near certainty eventually and precisely what many central banks are aiming for.

However, the jury is still out on the precise timing and the paradigm shift may be a while in coming. For most, deflation has been the more familiar sensation over the last couple of years – hardly surprising, given the extent of deleveraging that has taken place across the global economy.

Many bulls (and central banks, though that is another post) also ignore the problem of velocity. The Fed, ECB and others can have a direct impact on the quantity of money in the system, but not the velocity of money in the system – they have no control over this. You can pump as much money into the system as you want but for it to actually have an effect and turn things around not to mention generate that dreaded future inflation, the velocity of money needs to increase.

In other words, where we end up on the inflation/deflation seesaw depends not just on the quantity of money in the system, but also how fast that money is moving through the system. That is determined by the entities that buy and borrow and lend, i.e. banks, businesses and ordinary consumers. In order to have an effect on the economy, the money needs to move through the system and that can only be determined by their willingness to borrow and lend, rather than hoard and save. When banks hesitate to lend, businesses begin to conserve cash and consumers stop buying and borrowing, monetary velocity goes down – even as the money in the system piles up.

The hope of both gold bugs and central banks is that quantitative easing will succeed in lowering borrowing costs, reviving economic demand and stoking inflation. But history offers only limited guidance. The only central bank to have tried quantitative easing policy measures in the recent past was the Bank of Japan between 2001 and 2006, with ambiguous results. Lending did not accelerate after the BoJ started its asset-purchasing scheme, credit lending actually declined and one lost decade soon became two.

Much as the hypergrowth of Google and Apple came too late to save the dotcom boom, inflation may arrive only long after the party has ended and the gold carriage has turned back into a pumpkin. The deleveraging by consumers and businesses is a powerful headwind and deflation may persist longer than we would like. Moreover, the inflation thereafter may well be greeted by relief at an incipient recovery – a poor omen for gold – and we shouldn’t forget gold failed to sparkle during the inflation of the 1980s.

But hidden in the detail above is another potential paradigm shift. This one is linked also to quantitative easing and hinges on whether you believe this is a ‘normal’ recession or something worse. It also explains much of the hoarding seen by hedge funds in recent months and some of the more unusual steps taken, such as storing physical gold and issuing shares priced in gold.

Gold is an oddity. It has no yield and its uses are limited beyond the decorative, unlike other precious metals such as platinum and silver. Its sole value comes from the fact that for centuries, we have all rather liked the lustre of the metal and it happens to be increasingly rare. Since 2001, annual worldwide mine production has decreased by 9.3%, despite the near quadrupling in prices, and the two previous decades of neglect have meant little new exploration was done. It has become ingrained in our psyche as a store of value.  (see chart, right from Barrick Gold).

Recent events have only reinforced this perception. We live in an era of fiat currencies – all only as strong as the faith put in them. Economics 101 tells us that as governments pile on debt, the value of their currency is debased relative to others. It explains why gold rose in the first part of this decade against the dollar. However, what happens when everyone plays the same game and every government begins to spend indiscriminately?  (see chart below from dollardaze.org via Casey Research).

That they are doing so is of little surprise. There may be faint signs of recovery in the world economy recently but this is unlikely to be a standard recession. We are still in a process of deep deleveraging because the developed world has too much debt and excess capacity. To cope, central banks have invoked their last line of defence – quantitative easing: fight the tide of deflation by drowning it in an ocean of new money, as the below chart of the US money supply demonstrates.

In such a scenario, it is better to own what governments and central banks cannot make a lot more of. Gold is not going up, rather everything around it is going down. It is a response to our new era of competitive devaluation, with everyone jostling to see who can fall fastest. Inflation – as and when it occurs – is only an enhancer.

The bubble has yet to fully mature. For now, hedge funds are simply buying their puts against the central bankers of the world.

- Dr. Amarendra (Bob) Swarup

The hedge fund industry’s insatiable thirst for market research will be temporarily quenched this week by an interesting new report from SEI and Greenwich Associates.  The document, called “The Era of the Investor” contains results from the firms’ second annual survey of institutional investors (conducted in November 2009) and is sure to generate a lot of press in the next few days.

Since this thing is destined to be well covered by the mainstream media, we thought we’d try to look a little deeper into the results and focus on some findings that aren’t immediately obvious or covered in the executive summary.

But first, the headlines…

• The good news continues to roll for hedge funds, as 95% of the 96 institutional investors surveyed this year said they would either increase or maintain their hedge fund allocations over the next year.
• “Diversification” remains the #1 reason to invest in hedge funds – followed closely by “absolute returns.”
• During 2009, transparency rose in importance with over 70% of respondents said they now request “more detailed information from managers than they did a year ago.”
• Since last year, “poor performance” has been overtaken by transparency and liquidity as the main sources of “concerns” about investing in hedge funds.
• The report says that “fee pressures have intensified” as 20% of respondents reported having “negotiated fee arrangements different that the standard ‘2/20′ for single-manager funds and ‘1/10′ for funds of hedge funds.”

Now here are some of our observations…

Why hedge funds?

While “diversification” remains the #1 reason to invest in hedge funds, fewer respondents cited it this year (31%) than last year (62%).  This year, “absolute returns” ranked only a couple of percentage points behind.  According to last year’s edition of the survey (conducted in August 2008 – available here – covered by AAA here), absolute returns were a distant second – more than 20 percentage points behind.

November 2009 survey…

August ‘08 survey…

Still, while “diversification tanked from 62% to 31%, more than 10 percentage points more respondents rated “non-correlated investment strategies” (a euphemism for diversification) as a primary objective.

Perhaps in response to their experience, respondents also seem to be less concerned about volatility.  Last year, 20% said “decreased volatility” was an objective.  This year,that number dropped to below 10%.

Transparency

A call for greater “transparency” makes for great headlines.  But as SEI and Greenwich point out, “participants described their transparency expectations in various ways.”  It seems that some investors wanted traditional position-level transparency while others wanted to have a better understanding of the strategy itself.  (This makes a lot of sense.  If your hedge fund manager traded only S&P 500 futures, but did so using some kind of market timing algorithm, then knowing whether or not you had an S&P position at a given point in time would likely not be particularly insightful.)

Nearly 85% said they were now seeking more information on “valuation methodology.”  Since a majority of hedge funds trade in publicly-listed securities, this could just mean that investors wanted to confirm, say, how the manager valued securities that were untraded on the last day of the month.  It does not necessarily suggest that investors have begun vetting some kind of complex valuation procedure for exotic derivatives.

Returns

As the report contends, “poor past (2-3) year performance” has all but dropped off the manager-selection checklist of institutional investors.  In August 2008, 40% said it was “very important.”  By November 2009 – perhaps in recognition that a lot of their favorite funds totally sucked eggs in the preceding 12 months – only 20% said immediate part performance was very important (see chart below from this year’s report – click to enlarge).

Despite calls for greater transparency, it appears that “quality of reporting and communications” is also less important now than it was in August 2008.  Back then approximately 40% ranked it as “very important” in the selection process.  Today, that number is down to 25%.

What keeps investors up at night?

There were also some dramatic changes in some of the respondents’ “biggest worries” about hedge fund investing.  “Failing to achieve primary objective” was cited by over half of institutions as a “biggest worry” this year.  However, in the heady pre-Madoff days of August 2008, “not accomplishing stated goal” only kept 20% of respondents up at night.  Even in November 2008, after the market fell off a cliff, only 40% of respondents said this was a “biggest worry.”  (See chart below from report.)

Looking forward

While corporate, public and government pensions had not yet reached their “target” hedge fund allocations, foundations and endowments’ “actual” allocations to hedge funds was already higher than they have targeted.  This suggests that foundations and endowments may actually pare back a little over the coming years.

The authors are a little cynical when they write that some hedge funds have accommodated managed accounts “perhaps with an eye to resetting high watermarks.”  In our opinion, investors more likely used the negative incentive of walking away, rather than the positive incentive of forgiving past performance sins.

We are accustomed to judging the value-added of investment funds in somewhat of a vacuum.  That is to say, we do so without regard to our own judgments about where markets will go in the future.   All that seems to really matter is the risk adjusted performance of a fund vs. its benchmark.  If that benchmark goes up by, say, 10%, we hope our managers beat it by, say, 3%.  If it goes down by 10%, we still hope to beat it by 3%.  Despite the “absolute return” moniker conferred upon hedge funds, they too aim to simply beat their appropriate index, whether it be the HFRI convert arb index in the short term or the S&P 500 over the long run.

But a paper released last month by Brian Jacobsen (of Wells Fargo Funds Management – although the views expressed are Jacobsen’s) proposes a different way to looking at the value of active management.  Instead of looking to traditional measures such as alphas and information ratios, Jacobsen looks at the up-capture and down-capture ratios of mutual funds to determine value-add.

He argues that investors buy mutual funds based on a given set of expectations about markets.  If the investor thinks markets are going to rise significantly, she might seek out a fund with an out-sized up-capture ratio.  Conversely, if she thinks markets will fall or remain flat, she might seek out a fund with a small down-capture ratio, regardless of the up-capture potential.  In other words, the relative importance of historical up-capture and down-capture ratios will change depending on the investor’s expectations.  As a result, writes Jacobsen,

“Depending on the investor’s expectations, a manager may be more or less valuable.   Active management is, thus, context and investor dependent.”

He examines the up-capture and down-capture ratios of nearly 800 US equity mutual funds with a benchmark of the S&P500.  Since no one knows the future direction of markets (or it would be priced in already), you’d expect investors to expect a 100% up-capture if they are expected to bear the burden of 100% down-capture (ignoring the effect of Prospect Theory for a moment).  In fact, such a security would be the S&P 500.

But what if a fund had a zero down-capture ratio.  In other words, what if the manager was really really good – like Madoff-good – at truncating their return distribution at zero and never losing money.  What kind of up-capture ratio would an investor want in that case?  Zero?  That wouldn’t be much of an investment.

Using some basic assumptions made by Jacobsen, investors should – in theory – demand roughly a 25% up-capture ratio even in the presence of no apparent downside (red dots below – what he calls the “fair value” of the mutual fund as an “option”).  But the 787 mutual funds he studied seem to have up-capture ratios that slightly exceed “fair value” (blue dots in chart below from paper).

By eschewing low downside for higher upside, investors are kind of saying “Security of low down-capture be damned!  I want to ride this market up!”  It’s as if greed trumps fear (could it be?)

This makes intuitive sense when you think about.  Why assume any risk unless the upside is bigger than the downside.

Jacobsen calls the amount by which funds deliver greater than fair value up-captures an “investor surplus” (similar to the “consumer surplus” in economics).  As of December 26, 2009, the average investor surplus, based on three year trailing data, was 0.026991 (i.e. the up-capture ratio delivered by mutual funds was, on average 2.7 percentage points higher than “fair value”).

The bottom line, according to Jacobsen, is one in which Wells Fargo – or any fund manager – may find solace:

“A manager can add value to a portfolio in ways besides just picking winning stocks—it is valuable to avoid holding a losing stock…Even if a manager does not beat a particular benchmark—which is a retrospective assessment—that does not mean that it was not—prospectively—valuable to invest with the manager.”

According to a June 2009 research note on “How Institutional Investors Think About Real Estate” by the Harvard Business School, institutions invest in real estate,”…because of its returns, the high cash flow component of its returns, the dampening of the volatility in a portfolio and as an inflation hedge.”  The note concludes that real estate is, “…an increasingly important component in the portfolios of institutional investors.”

Despite the bath taken by some real estate investors in 2009, a recent survey of institutional investors seems to corroborate this conclusion.  bFinance, the UK-based consultancy surveyed European and North American institutions in December 2009 to see how their views had changed since May of that year.

The firm asked investors if their target asset allocation had changed since May 2009.  It then measured the difference between the “increased” and “decreased” responses (sort of like the political pollster’s ubiquitous “favorable/unfavorable” rating).  Guess who’s the popular kid this year?

“Property” was the winner with nearly 20% more investors saying they had increased target allocations than had decreased it.

As you can see from the chart, private equity rated quite highly, but it will probably come as no surprise to regular readers of this website that “hedge funds” and “funds of hedge funds” sucked eggs, with more investors saying they had decreased their target allocations, than had increased them.

Then again, this could be seen as good news for beaten down hedge funds.  Despite a decrease in allocations in December (that some argue is a seasonal blip), the industry seems to be on the mend.  The new, lower target allocations could portend a ceiling in asset growth – or it could show that even with lower target allocations,  there is still plenty of room for growth.  Time will tell.

In any case, institutional investors may be bottom fishing for real estate opportunities this year.  bFinance quotes the head of the $130 billion California State Teachers’ Retirement System (CalSTRS) as saying:

“We may be able to see the light at the end of the tunnel, but it is really far away right now. There is a lot of commercial real estate debt that will come due in 2010. It will be interesting to see if any of the banks or traditional debt providers will step into this market. There is a lot of uncertainty that they will.”

Looking forward, bFinance also asked investors if the planned to increase or decrease their allocations to various assets over the next year.  Again, real estate won out – with 15% more respondents saying that planned to increase investment levels than decrease it.

But curiously, the bottom feeding had its limits.  Looking out over the next three years, respondents seemed more interested in fishing for infrastructure and commodities investments.

(Note the good news, by the way, for hedge funds in general and for the much maligned portable alpha strategies in particular.)

This interest may be well timed since other research shows that real estate fund fees may become more investor friendly over the coming years.  The European Association for Investors in Non-listed Real Estate Vehicles (INREV) reports that fees based on gross (leveraged) assets and on unrealised gains will become less common (see article in IPE).

In conclusion, bFinance reports that institutional investors will continue to fish for alternative investments of all species:

“The main catalyst in favour of alternatives remains diversification, a staple of the hedge fund industry which has had the misfortune of being marred by a number of high profile scandals. Indeed, pension funds remain more committed than ever to diversifying across asset classes and geography.”

The rush is on this year for alternative investment firms to set up and launch both offshore and onshore versions of Undertakings for Collective Investments in Transferable Securities, or UCITS- and NEWCITS-based funds.

According to a late-December report by London-based KdK Asset Management, some 80% of hedge funds, and in particular funds of funds surveyed by the firm expect to launch a UCITS-based this year (see graph by KdK below) as a way to ensure they are on a regulatory par with more traditional, and accessible, European vehicles.

At the same time, many alternative investment shops have been rushing to create what are called “NEWCITS:” onshore, regulated UCITS funds.

Why the rush to UCITS and NEWCITS? For starters, UCITS funds are already regulated, they offer the comfort of a trustee or depo bank as holder of the assets while some of the counterparty risk concerns raised by the role of the prime broker in a typical hedge fund can be mitigated with a custody agreement.

For NEWCITS in particular, the survey noted than 90% of fund of funds believe they will have lower returns than their equivalent offshore versions, with a quarter expecting the shortfall to be greater than 3 percentage points a year.

Beyond that, many see the move as mainly being motivated by the ambition to gather more assets from sources that are no longer accessible through offshore funds or managed accounts, thanks to either new or pending regulations.

According to various media reports, including this one, the reasons are somewhat different than the survey suggests – that managers are setting up UCITS and NEWCITS funds because of uncertainty surrounding the Alternative Investment Fund Managers (AIFM) Directive from the EU. (You can read all about the directive and the industry’s response to it here.)

Why else would a firm establish a fund with higher costs and more limited investment parameters?

Either way, the funds have their work cut out for them in terms of delivering performance. Among other things, they are:

• Prohibited from directly investing in commodities and physical shorting, which can limit a hedge fund manager’s ability to deliver its investment strategy in full.
• A UCITS is not allowed to borrow for investment purposes. It can only obtain (limited) leverage through derivatives.
• The maximum redemption period for a UCITS is 14 days and redemptions must be made in principle at the fund’s net asset value, limiting the ability of managers to take positions in illiquid assets or illiquid strategies.

UCITS funds have a formal market risk management process which must be in place due to restrictions on the way value at risk is calculated and there must be regular stress testing. Additionally, they must offer, as they Brits say, fortnightly liquidity, at the very least.

Among the firms to have taken this approach include: Brevan Howard, GLG Partners, Man Group and Odey Asset Management – four large London-based managers. And more are expected to follow.

Three quarter of the survey respondents confirmed there is demand for such funds from retail networks and fund platforms or fund distributors. Interestingly, more than two thirds also had demand coming directly or indirectly from high-net-worth individuals, which is significantly more than the demand coming from institutional investors. And many aren’t convinced that they do any better a job of allaying investors’ concerns than managed accounts do, as the chart below shows.

Whether part of a bid among larger hedge fund firms to get ahead of the EU directive or just another way to offer a regulatory compliant fund with that fits with the new era of risk management, it remains to be seen how many of these funds survive and thrive. We’ll be interested to read the results of KdK’s survey in December 2010.