Among the television ads that book-ended this year’s U.S. Super Bowl extravaganza, Audi’s Green Car commercial truly stood out, not for the beautiful car or the amazing scenery but for its apt, modern-day take on the no-littering, no-polluting, no composting, no carbon-foot printing world we all now try, as much as we can, to live in.

Some iconic snapshots: A man pulled out of his home by a squad team for not composting a rind; another man arrested for choosing plastic over paper; a cop pulling over two other cops for using Styrofoam cups; and last but not least, an Audi A3 clean diesel driver allowed to pass an “eco” road blockade for not fouling up the air with noxious fumes – all to the tune of a song entitled “The Green Police.”

It was a deprecating take on what in the developed world at least has become a fairly all-encompassing issue: collective guilt over trying to follow – and keep up with – the ever-changing rules of keeping “green.”

The investing world has certainly been no different. In fact, in many cases, the “going green” mantra has become a mandate among pensions, endowments and other institutional investors, whose constituents are mandating money be allocated to clean-technology investments – through specific types of firms, fund managers or both.

Trouble is, and continues to be, that finding such investments and managers is easier said than done. A recent paper (click at the top of the page to download the complete version) published by Janelle Knox-Hayes with Oxford University’s Centre for the Environment, focuses on carbon emissions markets emerging as governance mechanisms to reduce greenhouse gas emissions and mitigate climate change – not only at the hands of regulators but also at the hands of private organizations.

In essence, the paper analyzes how organizations develop the three pillars of the carbon market institution: regulative, normative and cultural-cognitive constructs. Since organizations build the institutional pillars of the carbon market network, the strength of the institution cannot be determined by regulation alone.

The paper also draws on inherent issues prevalent in these emerging carbon credit markets: namely the debate over whether a “credit” is a physical piece of property, and if so how it is valued, traded and eventually cashed in.

The premise of carbon trading is fairly simple: polluters – companies, governments and people – purchase credits in various markets to offset the environmental damage they inflict, and “clean” firms and people sell excess credits they stockpile for being good environmental citizens.

An on-the-ground example might be an electric utility firm, where users pay a few cents extra for every kilowatt of power they use, which then goes to paying for stuff that reduces future CO2 emissions like a new gas-fired power station, which wouldn’t have been economically viable if not for the extra capital, and for the carbon credits it will also generate that can be sold.

It is a market that in theory at least is growing by leaps and bounds. A report published last year by PricewaterhouseCoopers entitled, “Capitalizing on a Climate of Change” noted the market has surged in the past five years, jumping to more than $120 billion from just $1 billion in 2004.

Still, the reality, according to Knox-Hayes and others, is that trading carbon credits in the context of a traditional marketplace is far more complex: carbon markets themselves aren’t necessarily designed to govern behaviors which emit greenhouse gas emissions.

Further, from a trading perspective, carbon credits provide the right to emit, but the credits themselves do not become a property right until they are traded, either over the counter (matching buyer to seller) through contract, or through an exchange in partnership with a registry.

In most cases, the property right, what many lawyers refer to as ownership title, is established using legal certificates that house carbon reductions that can then be traded or sold through Emissions Reduction Purchase Agreements (ERPAs), but these can take months to negotiate and settle.

The International Emissions Trading Association (IETA) has developed a Master Agreement to trade EU allowances, which can be traded more quickly, though some exchanges still require traders to provide a statement of sole claim to ownership. For instance, for offsets that were produced through a chain of companies, each company must sign a letter that they do not claim the right of the emission reduction.

All of which is to say that, despite the ever-growing recognition of going “green”, and despite the growing interest and mandates that investors, particularly on the institutional side, are facing, carbon trading as a viable way to both invest money and help the environment is still at a nascent stage – even with estimates showing the growth potential as huge (see chart below).

Indeed, as Knox-Hayes points out, while countries and regulatory bodies can and certainly have built carbon-trading markets, it is still up to private firms and players that participate in these markets to ensure they function – kind of like having the traders, computers and telephones at the Chicago Board Options Exchange.

Perhaps Audi’s ad for next year’s Super Bowl will be a spoof on a COE pit-trader trying to sell enough carbon credits to buy a car.

Investors in alternative investments, like their mutual fund counterparts, are often accused of chasing performance. In the world of hedge funds, this means that managers are often thought to focus too much on monthly performance. And why not? Since most hedge funds are open-ended, they are always trying to impress potential investors. Positive monthly returns are music to a hedge fund marketer’s ears.

But what if the marketing process only happens once every three or four years?  That’s the world faced by most private equity and real estate funds.  Due to the illiquid nature of their holdings, these alternative investments need to open, raise capital, and close to new investments often within a few months. As you can imagine, this makes the performance of previous funds critical in the marketing of new funds.

You can almost say that an extra percent return for a private equity manager has a twofold effect on her compensation. One is direct, while the other (the ability to raise additional assets for future funds) is indirect.  This is the premise behind a paper by Ji-Woong Chung, Berk Sensoy, Lea Stern, and Michael Weisbach of Ohio State University (“Incentives of Private Equity General Partners from Future Fundraising”).

According to the quartet, these indirect incentives are as large – sometimes even larger – than the much-heralded incentive fee itself (a.k.a. carried interest).  So in a way, the incentives faced by private equity managers are actually twice as large as you think – especially for younger managers who often “give up promising careers in other fields such as investment banking to manage a relatively small fund.”

Previous studies have confirmed the axiom that fundraising success is related to historical performance. But according to the authors of this paper, none has reversed this equation and examined the effect of potential future funds on the incentives faced by PE managers right now.

But posting stellar returns doesn’t always help, according to the researchers. In fact, it only helps under two conditions: One is that the fund management company must be young (i.e. new). This makes intuitive sense. Investors have very little information on new managers, so the performance of their first or second fund really sets the tone for the marketing of future offerings.

The other condition under which a stellar first-fund return can drive future asset-raising success is scalability. The paper indicates that successful scalable strategies such as buyout funds are more likely to raise a ton of assets for a second fund than a less-scalable strategy such as venture capital.

To prove the point, Chung, Sensoy, Stern, and Weisbach look at nearly 10,000 private equity funds tracked by research firm Preqin (representing “70% of all capital ever raised by the private equity industry”). They extract about 1,700 buyout, VC and real estate funds for their study.

The chart below (created with data from the paper) confirms the assumption that buyout funds are more scalable than VC or real estate – regardless of the performance (which was pegged at around 16% p.a. for all three categories).

But once you add in the effect of performance on initial and secondary attempts at starting funds, future fund raising potential can change significantly.

The chart below from the paper shows that the ratio of “indirect incentives” (future fundraising) to “direct incentives” (carried interest on current fund) can be as high as 1.2 for rookie managers who plan to stay in the game for the long haul (defined as eventually launching another 4 funds).

The horizontal axis of this chart represents the current fund (first through fifth) while “N” represents the number of future funds still to be raised. So, if a manger is on their fourth fund and plans 5 more, then there is little future benefit from hitting the lights out on the current fund. For better or for worse, investors have already developed an opinion of the manager. So there is little incremental respect the manager can earn by producing good returns in the current period.

So the bottom line is that while the private equity portfolio manager might get excited about the carried interest when returns are good, the fund’s marketer can be equally as excited about the potential to raise assets down the line a little.

It’s become practically cliché to note that the 2008 market crash was a stark reminder that hedge funds too can suffer at the hands of a series of highly improbably and unanticipated events – even after looking at their strategy, their diversification and the mean and variance of their past returns.

Yet a recent research study (free registration required) by TrimTabs and BarclayHedge entitled “Do Hedge Fund Investors Care About ‘Fat-Tails’ Risk” caught our attention for a theory put to test: Can hedge fund investors hedge themselves from unforeseen risk events – kurtosis, in economic-speak – that the hedge funds they’re writing checks to might be taking?

We  pride ourselves on being somewhat schooled in the nuances of economic and financial market phraseology, thanks in large part to the resources of CAIA and others at our disposal (shameless plug, but CAIA has this study on building a hedge fund portfolio with kurtosis and skewness available on its Web site). But we’re also grateful when someone else defines an academic term for us, which the TrimTabs study thankfully does:

“Kurtosis measures the risk of a highly implausible event coming to pass more frequently than one would expect from a normally distributed variable.”

TrimTabs and BarclayHedge analyze how the kurtosis of hedge fund returns is measured; how, if at all, it impacts hedge fund flows; and if kurtosis is in fact priced in to hedge fund returns, or if non-normal returns offer arbitrage opportunities for sophisticated investors.

The study finds that in contrast to returns on individual securities and contracts like stocks, gold, oil or bonds, individual hedge fund returns display significant excess kurtosis, for the most part thanks to hedge funds’ ability to utilize leverage. (See illustration below.)

Source: TrimTabs Hedge Fund Flow Report

Indeed, the study’s results show that hedge fund returns display high levels of kurtosis. At the fund level, kurtosis averaged 33.1 in the past 10 years. Kurtosis is also extremely volatile, with peaks of 127.8 in 2003 (a stock market bottom) and 91.8 in 2007 (likely due to the sharp and simultaneous sell-off of quantitative strategies in the summer).

In fact, the results of the study show even higher levels of kurtosis than most academic studies because it focuses on individual fund returns rather than a composite hedge fund index.

Source: TrimTabs Hedge Fund Flow Report

So is that a good thing or a bad thing? At first blush, its not a good thing. All else equal, investors should avoid high kurtosis. A 90% loss means near ruin for investors, and a 90% gain does not offset it, the report notes. The fact that hedge fund returns display much more kurtosis than the assets in which they invest suggests that kurtosis is the result of leverage, which magnifies the likelihood of extreme outcomes, as the chart below shows.

The level of kurtosis also highly depends on the hedge fund strategy being employed. According to the study, fixed income and convertible arbitrage strategies show the most kurtosis, while equity market neutral is the only strategy for which the presence of kurtosis is not certain.

“This too, we ascribe to leverage,” the study notes. “It is not uncommon for fixed income and convertible arbitrage funds to use leverage ratios of 20:1, but strategy constraints and the volatility of stocks force much more caution from equity market neutral funds.”

Source: TrimTabs Hedge Fund Flow Report

On deeper reflection, however, the study notes that since most hedge fund investors do not seem to care about “fat-tails” risk, sophisticated investors with the ability to diversify their hedge fund portfolios should be able to diversify away kurtosis without any cost in terms of returns or variance – good news.

Conclusion: Kurtosis within hedge funds remains one of the last free lunches for sophisticated investors. Translation: If the buffet has enough different kinds of food to sample, and you know the right way to mix them, your chances of getting an unforeseen wallop of indigestion will be less.

Popular mythology often tells the tale of a disgruntled mutual fund manager who strikes out on his or her own and starts a (more lucrative) hedge fund business.  The existing hedge fund community often retorts that mutual fund managers simply don’t have the training (read “short selling”) experience to manage a hedge fund.

Is this just marketing bravado?  Or is it true that mutual fund managers are no good at managing hedge funds.

More importantly for policy makers, does a mutual fund manager do a disservice to their investors by running a hedge fund on the side?  After all, wouldn’t the much lauded “alignment of interests” inherent in hedge fund contracts give the manager an incentive to funnel their best trades and ideas to the “2 and 20″ hedge fund?

Counter-intuitively, a new study by Tom Nohel of Loyola University, Z. Jay Wang of the University of Illinois and Lu Zheng of UC Irvine actually concludes that managers of “side-by-side” hedge funds and mutual funds actually tend to deliver better mutual fund returns than those who manage only mutual funds.  In other words, the possibility of nefarious trade allocations invoked by hedge fund antagonists is not only a red herring, but the exact opposite may be true.

Regular readers may recall this 2006 study by Gjergji Cici, Scott Gibson, and Rabih Moussawi that shows that companies (not managers themselves) that provide both hedge funds and mutual funds tend to deliver lower mutual fund returns.  To explain this phenomenon, Cici et al outline 6 potential conflicts of interest faced by these companies (front running, trade allocations, soft dollars etc.)

AllAboutAlpha-philes may also remember this paper on “hedged mutual funds” by Vikas Agarwal, Nicole Boyson, and Narayan Naik.  Agarwal, Boyson and Naik found that mutual fund companies running hedge funds in mutual fund wrappers deliver sub-par returns unless they also run a bona fide hedge fund.

This new study seems to conflict with Cici et al and, to some extent, support Agarwal et al’s finding that managing a hedge fund on the side is good for mutual fund unit holders.

In any event, the authors of the new study create a portfolio of mutual funds managed by “side-by-side” managers (those managing both mutual and hedge funds) and a portfolio of mutual funds managed by individuals whose sole focus is the mutual fund.  Similarly, they create a portfolio of hedge funds managed by “side-by-side” managers and one of hedge funds managed by pure-play hedge fund managers.

When they compared the 4-factor alphas of the mutual fund portfolios and 7-factor alphas of the hedge fund portfolios, here’s what they found:

Ironically, the mutual funds managed by those individuals who also managed a hedge fund produced better returns than those managed by mutual fund managers who did not also manage a hedge fund.  So much for conflicts of interest, we suppose.

In fact, regulators might take note that it’s the high net worth hedge fund investors, not the mom and pop mutual fund investors that are worse off when mutual fund managers stray into Hedgistan.

So why would a mutual managed by the same person simultaneously managing a hedge fund do better than their more focused industry colleagues?  Nohel, Wang and Zheng have a few theories…

First and foremost, they suggest that the theory that the hedge fund industry attracts high talent may have some legs.  Writes the trio:

“Our evidence supports the idea that the privilege of running a hedge fund is primarily granted to the most skilled mutual fund managers, especially given that the superior performance we document is driven by managers whose careers began in the mutual fund industry.”

In other words, an opportunity to manage a hedge fund is being used as “means of retention” by mutual fund companies.

They also hypothesize that when mutual fund managers start managing hedge funds on the side, any incentive to funnel trades and ideas to the higher-fee hedge fund is mitigates by the concern for losing their reputations as stellar mutual fund managers.

But rest assured, hedge fund marketers, this study found that “side-by-side” hedge fund managers that came from the mutual fund world delivered lower hedge fund returns than those managers who cut their teeth on hedge funds…

“…those that began as hedge fund managers had insignificant alphas of 0.081% per month relative to their peers, while those that began as mutual fund managers significantly underperformed their peers by -0.282%.”

But wait.  It also turns out that mutual funds managed by “side-by-side” managers from the mutual fund industry performed better than mutual funds managed by managers from the hedge fund industry…

“…side-by-side managers that began as mutual fund managers generated alphas of 0.094% per month or about 1.13% per year and highly significant, while side-by-side managers who began their careers as hedge fund managers generated insignificant alphas of 0.01% per month.”

So the somewhat anti-climatic conclusion is sure to please both camps:  Mutual fund managers deliver better mutual fund returns, and hedge fund managers deliver better hedge fund returns.

A final note:  Check out table 2 of the paper, comparing the characteristics of side-by-side and pure play mutual funds.  The side-by-side funds are: smaller, more expensive, and have a higher turn-over than the pure play funds.  That makes intuitive sense if you believe the “hedge fund culture” might work its way into mutual fund terms.

But what is somewhat surprising is that side-by-side hedge funds have a higher performance fee and a longer lock-up than pure play hedge funds. (Although as you might guess, they have a lower management fee than pure play hedge funds.)

To say that hedge funds were implicated in the 2008 financial calamity is an understatement.  Many commentators placed the blame squarely on the shoulders of these “unregulated and secretive” asset managers.  Such is life, some hedge funds acknowledged, when you happen to be at the scene of a crime.

A few studies have since debunked the notion that hedge fund selling was the primary driver behind the market downturn of 2008 (see one of them here).  But few have been as exhaustive as a new one by Itzhak Ben-David of Ohio State, Francesco Franzoni of the Swiss Finance Institute, and Rabih Moussawi of Wharton.  The Behavior of Hedge Funds during Liquidity Crises addresses a raft of questions that are surely top of mind for the world’s regulators.  Specifically,

• Did hedge funds actually run for the exits along with everyone else?
• If so, how much and was it enough to actually affect equity prices?
• What kinds of hedge funds were selling?
• What kinds of equities did they sell?
• What motivated them to sell?
• Who bought their positions? and,
• How was performance impacted?

Did hedge funds run for the exits and if so, did they trample anyone?

The trio found that hedge fund (long) equity ownership as a percentage of overall equity markets fell precipitously during the crisis – dispelling the notion that hedge funds bought up what other investors were dumping.

Some might point out that a drop in long positions might be accompanied by an off-setting drop in short positions.  By covering shorts, hedge funds would be buying, not selling.  But the trio finds that overall short interest didn’t seem to move nearly as much as longs – suggesting that the net effect of hedge funds reducing gross exposure was to amplify the market drawdown.

What kinds of hedge funds ran fastest?

It appears as though a sub-set of the biggest hedge funds was mainly to blame for the selling.  These funds were first to the exit door, while many other hedge funds filed out in a relatively calm and orderly manner.  The chart below from the paper shows the typical increase or decrease of equity allocations in a one month period.  As you might guess the typical distribution has a mean of around zero.  But during the 2008 crisis, the mean dropped significantly.  In fact, the number of funds that dumped more than 70% of their equity holdings in Q3 and Q4 2008 rose by over 10-fold.

Apart from a concentration of selling among the biggest sellers, there were a few other interesting trends according to the study.  Event-driven, fixed income arb, global macro, and managed futures reduced their equity holdings the most.  Meanwhile, market neutral strategies actually increased their equity holdings.

What did they sell?

The paper shows that these panicked hedge fund managers tended to dump high volatility stocks during the calamity.  While this may seem like a no-brainer, note that hedge funds tended not to dump high vol stocks during times of overall market volatility (high VIX), but apparently only when liquidity dried up as it did at the end of 2008.

Why did they sell?

It’s easy to blame fund managers for simply being nervous nellies and wanting to retreat to cash when the global markets started to fall out of bed.  But hedge fund investors and prime brokerages apparently deserve some of the blame.

Regular readers may recall a paper by John Dai and Suresh Sundaresan of Capula Investment Management that explicitly modeled investors’ “redemption” option and lenders’ “funding” option.  Ben-David, Franzoni, and Moussawi’s calculations suggest that around half of the hedge fund selling in the second half of 2008 was precipitated by the exercising of these two options (in roughly equal proportions).

Who bought their positions?

Okay.  So if hedge funds were net sellers during the downdraft, then who actually provided the much-heralded liquidity?  This question is apparently a bit tougher to answer.  The paper suggests that company management and retail investors may have filled the void, but this conclusion is not statistically significant.

How was performance impacted?

However, it seems that hedge funds that ran for the exits did better than those that did not.  This may be because the cash generated from equity sales was immediately redeployed in other asset classes.  Write the authors,

“Overall, we view these results as additional support to the hypothesis that multi-asset hedge funds that are familiar with alternative markets (e.g., global macro and futures hedge funds) reallocate equity sales proceeds to those other markets as investment opportunities arise.”

Bottom Line?

Those hoping to pin the blame for 2008 on hedge funds will have to keep looking.  As Ben-David, Franzoni and Moussawi point out…

“The magnitude of the effect [of hedge fund sales] is large: during the worst liquidity crisis in our sample, the crisis of 2008, hedge funds reduce their positions by 18% per quarter, over two quarters. The economic magnitude is smaller when computed as a fraction of market capitalization (about 0.5% per quarter). Although these declines in holdings are material, it is not clear whether they could cause a market-wide liquidity dry-up, at least in the equity market at large.”

Given the market disaster that was 2008, one would expect that any alternative investment firm that dipped its toe into the equity offering market is worse the wear for becoming publicly held.

From London-based and London Stock Exchange-listed Marshall Wace on down to the many littler guys who lined up to list on the Irish exchange and others, both for permanent capital raising and for getting the rubber-stamp approval of being listed, it’s been a kind of given that in hindsight the efforts of going public weren’t really worth it.

Not so, according to a recent paper by Greg Gregoriou, Francois-Serge Lhabitant and Fabrice Rouah entitled “The Survival of Exchange-Listed Hedge Funds.” The paper argues that it was – and still is – more than worth it, if survival and longevity amount to anything. According to their research, the survival rates of exchange-listed alternative investment firms versus non-listed entities are significantly better.

Call it Survivor, hedge-fund style – the ones not voted off the island.

Their reasoning makes sense: Publicly traded firms are required to be more transparent, report information more frequently and most of all, adhere to regulations of exchanges. So while their stock price may make it seem like going public was far from worthwhile, their survival rate is much better than their non-public counterparts because they are following standards, guidelines and practices that private funds, for the most part, aren’t.

Another element: the concept of permanent capital, which we at AllAboutAlpha.com have focused on about from a private equity standpoint, in that a fund manager can put assets to work in long-term strategies without being hampered by cash inflows and outflows.

“This turns the famous dream of ‘permanent capital’ into reality,” according to the report’s authors.

Even after considering factors known to affect survival, such as size and performance, the paper’s conclusion – based on various estimators and models – indicates that listed hedge funds by nature tend to be larger and in turn more adoptive to conservative investment strategies than non-listed funds. Most importantly, the paper finds that the failure rate of listed funds is substantially lower than that of non-listed funds, though only during the first five years of life.

The chart below, which utilizes the Kaplan Meier curve for listed and non-listed funds, illustrates how the survival rate for publicly traded funds is significantly better two to six years out.

We at AllAboutAlpha.com and certainly many others have written about the rise and fall of exchange-listed hedge fund firms – from the go-go days of 2007, when hedge fund firms were tripping over one another to become publicly traded entities, to more recent times when the words ‘hedge fund’ and ‘IPO’ simply did not go together. (Click here for some of AllAboutAlpha.com’s coverage of hedge funds and IPOs.)

And certainly more than a few hedge fund IPOs never made it. Some died before reaching their optimal targeted operating size. Others decided to return assets to shareholders because of widening discounts. Indeed, the biggest challenge of listed hedge funds, according to the paper’s authors, is the potential discount or premium to net asset value (NAV).

During the panic of September-October 2008, for instance, average discounts to NAV surged to 20% from just 1% for hedge funds listed in London.

Still, many funds now have mechanisms that effectively control the discount. This mechanism allows them to invest in their own shares when the discount between NAV and the quoted price becomes large. The funds will then sell their shares at a profit when the discount becomes smaller.

Combine that with the slow crawl out of the deep, dark hole for equity markets around the world and one could potentially envisage a hedge fund IPO market coming back to life – a new dawn on the island, so to speak. Just look at UK fund firm Gartmore’s latest earnings, which suggest they may finally have turned the corner.

Maybe.

As this Reuters piece reminded everyone recently, hedge funds are “battling to offer more flexible fee structures.”

But as we recently learned, it’s not just hedge fund managers that are battling to be more flexible.  It’s also traditional managers who see flexibility as a critical tool in their battle against the hedge fund newcomers that are now battling for business from large institutional investors.

On January 22, 2010, the investment board of the Pennsylvania Public School Employees’ Retirement System (PSERS) voted to accept staff proposals to invest in two hedge funds, one from Brevan Howard and one from Oppenheimer Capital (final terms and conditions of both are still pending).

The Brevan Howard fund is described in internal PSERS correspondence as a “global macro/relative value absolute return fund.”  According to this correspondence, the fund has a 1.5% management fee and a 20% performance fee (paid semi-annually).  It also has an “operational services charge” of 0.5% and a redemption fee of “10% payable on redemption made within three years of acquisition.”

The Oppenheimer Capital fund is described in similar internal correspondence as being part of its proprietary “structured alpha strategy” that invests in the options markets.  The firm seems to have positioned its offering as an “innovative alternative strategy offered by traditional managers” (at least, according to PSERS internal correspondence).

Notably, the Oppenheimer fund has a zero percent (0%) management fee and sliding-scale performance fee that, according to internal correspondence, look like this:

• 27% of excess performance on first $100 million
• 24% of excess performance on second $100 million
• 21% of excess performance on assets in excess of $200 million

It also has a hurdle of 90-day T-bills and, like the Brevan Howard Fund, has a high water mark provision.

Culture Clash

Although both fund aims to deliver alpha, the terms surrounding these funds could not be more different.  In a way, they illustrate the choices facing institutional investors as they navigate the “convergence” between traditional and alternative investing.

The Brevan Howard Fund apparently has a 2% fee with a 20% performance fee paid semi-annually (historical returns contained in internal PSERS correspondence seems to suggest that the usual performance fee is actually 25%).  By contrast, the Oppenheimer fund has a 0% management fee and a slightly higher performance fee.

If the Oppenheimer fund had a weighted average performance fee of 25%, the additional 5% (over BH’s 20%) would equate to an additional  2% for the manager if the fund posted a return that was 40% higher.  In other words, you would be ambivalent between a guaranteed 2% or an additional 5% of profits if you believed you could generate an additional 40% returns – a tall order indeed.  (Compounding this fee drag is the fact that, according to PSERS’s internal correspondence, the Brevan Howard fund has a hurdle rate of 0%, while the Oppenheimer fund has a hurdle of 90 day T-Bills.)

PSERS internal correspondence described Brevan Howard’s “transparency” as “partial” and Oppenheimer’s as “full.”  We have no idea exactly what is meant by those terms.  But it would appear as though PSERS believes the traditional manager provides more information.  This could simply be a result of the different securities in each fund – or it could be representative of the typical modus operandi of each genus of investment manager.

In the tradition of many great hedge funds, the Brevan Howard fund has an initial lock-up period of 3 years (with an escape clause – albeit an expensive one) and quarterly redemptions.  By contrast, the Oppenheimer Fund is described as having no lock-up period and daily liquidity.

The Rub

By now, you might be wondering why anyone in their right mind would pay “2 and 20″ with a 3 year lock-up and semi-annual performance fees over a “0 and 25″ fund with no lock-up and daily liquidity.

The answer may lie in the historical performance of these two funds.  Both have produced impressive returns.  But the Brevan Howard fund has a Sharpe ratio of 1.6 – twice as high as the Oppenheimer fund’s still-respectable 0.82.  (Both funds protected clients’ capital relatively well in 2008, but Brevan Howard’s apparently posted a +20.45% return after fees).

Note that this is based on net (after fee returns).  So whatever extra fees Brevan Howard seems to charge should really be moot if the investor is still receiving a higher return.  This is a tough nut to swallow for those who find hedge fund compensation to be distasteful, unethical or unfair.  But if you have a fiduciary obligation to pension plan members, then it’s one that might need to be eaten.

In any event, not all hedge funds produce 1.6 Sharpe ratios and not all traditional managers are willing to take a flier on their own success with a 0% management fee.  So both managers seem to have played to their strengths. But their contrasting terms and conditions are emblematic of a growing clash of cultures as hedge funds and traditional managers engage in skirmishes along the “convergence” front lines.

Just as the media started to shovel dirt into portable alpha’s grave, Institutional Investor ran a very well-balanced piece this month about the trials and tribulation of the once-mighty strategy (written by Imogen Rose-Smith).  Anyone who faces questions from investors, pensioners, or investment board members about portable alpha strategies needs to read all 4200 words of it.

It begins with the usual colorful and dichotomous language you’d expect to see in relation to such a controversial topic, such as “the Rosetta Stone of investing,” and “the toxic waste of portfolio strategies.”

Rose-Smith writes that:

“Portable alpha conferences sprang up like umbrella salesmen during a downpour in Times Square. Articles on portable alpha became a deluge of their own. As many as 50 a month were being published by 2006, estimated John Coates, head of Morgan Stanley & Co.’s portable alpha program, and Mark Baumgartner, the bank’s portable alpha portfolio manager, in an article of their own.”

While Morgan Stanley (and AllAboutAlpha.com, the small research blog it sponsored into existence) was busy trying to keep people dry in Times Square, the wind began to howl, making even the best umbrellas ineffective.

Requisite hyperbole dispensed, Rose-Smith then begins to ask the critical question:

“Is portable alpha truly to blame? Or is it possible that a perfectly valid, rather ingenious portfolio management approach was misunderstood and hence misused?  Should a Committee to Save Portable Alpha be formed, if only to preserve a legitimate strategy for a more circumscribed function?”

In other words, did the Force 12 gale in Times Square prove that umbrellas are a bad idea?

Clearly not.  As Rose-Smith writes, hedge fund managers were tasked “with one simply injunction: ‘Beat the market, any way you know how’.”  Although the alpha portions of portable alpha strategies took a bath in 2008 (down 20% on average), they did in fact beat the market.  That’s why we proclaimed 2008 to be one of the best years ever for hedge funds.

The article also touches on one operational issue that seems to have caught investors by surprise – the possibility that the derivatives-based beta exposure would tank so badly (in concert with the equity markets) and that more cash collateral would have to be put up – necessitating the sale of a portion of the (illiquid) alpha portfolio.

This was a very real problem for some.  But the fact that alpha portfolios (made up of quant strategies and/or funds of funds) contained a lot of beta doesn’t negate the value of portable alpha as a portfolio construction approach.

Rose-Smith cites incidences of hedge fund fraud as one reason institutional investors have turned their back on portable alpha.  But we’d suggest that incidence of hedge fund fraud should make investors second guess their due diligence procedures, or perhaps even their decision to invest in hedge funds, but not their decision to separate alpha and beta.

As she writes:

“Often the intellectual underpinnings of any given strategy are perfectly sound but poorly understood, and, as a result, the strategy is misapplied and mismanaged. That is precisely what happened with portable alpha in many cases.”

She reluctantly concludes that “it may not be correct to label portable alpha snake oil…” but also quotes AllAboutAlpha.com contributor Keith Black, CAIA who said “Clearly, the actual risk was higher than the anticipated risk.”

Rose-Smith ends with this fair and balanced conclusion – one that reaffirms our belief that the failure of an umbrella in Times Square gale should stop you from trying to stay dry.

“In any case, separating alpha and beta return streams still has validity. Mark Carhart, who retired as head of quantitative strategies at Goldman Sachs Asset Management last year, thinks managers should separate investment returns into beta and “true alpha” and price them accordingly. “All managers have their embedded beta,” he says. But investors should not pay high fees for beta, Carhart asserts.

Portable alpha might be in disrepute among many public funds, but what the strategy represented from the outset — a loosening of portfolio manager restrictions, the use of leverage to enhance returns and reliance on quantitative investing techniques — is not about to slink away from the scene. Paradoxically, portable alpha’s setbacks might encourage public funds that invested in hedge funds indirectly to now invest in them directly. And after a hiatus they will surely explore other leveraged, quantitative approaches to investing. But they had better read the instructions carefully first.”

In related news, it seems that there are still a lot of major investors that like umbrellas…

• Arizona Public Safety Personnel Retirement System allocates $300 million to portable alpha (Mar. 2010)
• Ohio Fire and Police (OP&F) Pension Fund allocates $300 million to portable alpha (Feb. 2010)
• Iowa Public Employees’ Retirement System allocates $200 million to portable alpha (Dec. 2009)
• South Carolina CIO says “the only thing that really went wrong … was assuming that your alpha engines were more stable and uncorrelated than they were…” (Feb, 2010)

Editor’s Note:  Check out the number of Google News articles on “Portable Alpha” over time.

Despite continued interest, it looks like the “deluge” of hype raining down on portable alpha did indeed peak in 2006…

Investment consultants are paid by institutional investors to anticipate what the future might bring – what asset allocations are safest, which managers are more likely to deliver alpha, and what liabilities a pension plan will face in the future.

But consultants seem to be absolutely inept at one thing: predicting the growth of their own businesses. In the latest installment of their “Annual Consultant Search Forecast,” management consultancy Casey Quirk and data vendor eVestment Alliance report that investment consultants underestimated 2009’s search volumes by a whopping 115% (on the basis of assets). Respondents to last year’s survey (conducted in last 2008) predicted a slight recovery in 2009 after a decidedly dismal 2008. But check out what actually transpired (chart created with data from 2009 edition available here and 2010 available edition here).

Coincidentally, respondents to this survey anticipated a growth of around 15% this year – nearly the same growth rate predicted at the outset of 2009.

Regular readers may remember Casey Quirk’s “Product Opportunity Map” from previous AllAboutAlpha.com coverage of this annual survey.  The April 2007 edition trumpeted hedge funds as “highest opportunity” with growing interest and a high “search focus.” (See 2007 post.)

Hedge funds remained the cat’s meow in the March 2008 edition, as Casey Quirk observed that:

“Seventy percent of the consultants surveyed expect to conduct the most searches in the hedge fund area, with nearly half of these consultants expecting to focus solely on hedge funds.”

Then came 2009, when the floor fell out of hedge fund demand and many investors put hedge fund callers on hold while they took calls from traditional managers (see 2009 post).  After being ranked #1 in expected search activity in 2008, hedge funds fell to #4, behind global equities, domestic (US) equities and fixed income.

(The most recent version of the Product Opportunity Map drops the reference to “search focus” and relies solely on expected growth in search interest.)

I get knocked down…

What a difference a year makes.   As one-hit wonder Chumbawamba once said “I get knocked down, but I get up again!” (Note to self: Find out if Chumbawamba ever got up again.)  Casey Quirk and eVestment Alliance now finds that hedge funds have clawed their way back to #2 in terms of expected search activity.

“Respondents predict resuscitating interest in hedge funds. More pension funds of all sizes realize non-correlated alpha will represent one of the few methods through which they can shore up funding gaps that collapsing equity markets re-opened in 2008-2009.”

Domestic equity is now the basement at #6 and check out the alternative investment newcomers:  “Emerging Market Equity” at #3 and “Commodities” at #5.

20/10 Vision

You know when you go to the optometrist and he asks you to compare endless pairs of possible lens prescriptions?  Well that’s what Casey Quirk and eVestment Alliance did this year.  The result is the following chart (click to enlarge):

Unfortunately, 2010 is the first year the firms have produced this data.  So we have nothing to compare it to.  Still, long (short) extension and quantitative strategies seemed to have totally struck out with investment consultants this year – making it a tough slog for our friends in the quant marketing field (you know who you are).  The report blames this on the lack of “…string three year performance numbers from these categories.”

Funds of private equity funds and funds of hedge funds are reported to be “rising in favor as mid-sized pensions, too small to make impactful direct investments boost their non-traditional allocations.”

Finally, the report says that “interest in absolute return strategies has surged as institutional investors become more outcome oriented in their investment policies and asset allocations.”

If there is one point of contention that still smarts like a fresh wound in hedge fund managers’ hearts it is the global crackdown among policymakers and attorneys general on short-selling.

As the world financial markets were in free-fall in the fall of 2008, the idea at the time was that, to protect banks and financial firms – whose shares were on a one-way trajectory down – and in turn to stabilize financial markets, it would be good policy to ban short-sellers from continuing to bet against their shares.

From the US Securities and Exchange Commission, to the UK Financial Services Authority, to the states of Connecticut and Texas: Short-selling was outright halted. The chart below from Hennessee Group Research illustrates the historical exposure of equity hedge funds through the end of 2008.

Since 2008 and beyond, a host of academics and other naysayers have made clear that, aside from reducing market volatility somewhat, the bans never really worked. (For a more complete overview of the role of short sellers in the marketplace, click here.) They have further argued that the bans only served to imbalance the marketplace and reduce visibility for investors, for the simple reason that no one can truly tell how much a stock might be worth if no one is allowed to place a bet against its decline.

Yet the US Securities and Exchange Commission and other policymakers are marching forward with plans to keep short-selling bans in place, to varying degrees. The SEC last month voted to reinstate the so-called up-tick rule, though only on stocks that experience a one-day 10% decline in value. Meanwhile, Germany, Hong Kong and the European Union are all contemplating new and permanent rules on short-selling activity and disclosure.

From a practical standpoint, the billion-dollar question is how positive an impact the short-selling bans in their various forms and iterations have had on financial markets.

The original “uptick rule” was put in place during the Depression in the 1930s to prevent stocks on a downswing from being hammered by short-sellers. It barred traders from selling short, or betting that a stock would fall, unless there was an uptick in the price. The rule was abolished in 2007 by the SEC after it concluded that advances in trading strategies had rendered the rule ineffective. The new rule by the SEC essentially brings back the uptick rule, with the caveat the rule would stay in effect for only one day and lifted the day after.

According to a report on short selling published by the UK Financial Services Authority in February 2009, the UK ban did produce a “marked volatility decrease to around the still very high levels observed in mid-September before the introduction of the temporary short selling ban.” The graph below shows the volatility levels for the FTSE 350 and the financial sector from July 2008.

Source: FSA

The short answer, so to speak, is that aside from a slight reduction in overall volatility, the bans had little positive impact on the broader markets. In fact, many, UBS Asset Management’s Alexander Ineichen (who is also a regular contributor at AllAboutAlpha.com) and Ian Marsh and Norman Niemer have argued the bans ultimately had a negative impact, by simple virtue of preventing market forces from collectively determining the appropriate value of a particular stock.

The question now is whether the SEC’s compromise – which is a cross between a short-selling ban and the former uptick rule (click here for a pithy Q&A on the new rule, courtesy of the Wall Street Journal – no subscription required) – will in some way help moderate potentially cascading declines while at the same time providing some allowances for short sellers and others to bet on a stock’s decline as they see fit.

The jury is out, but if the research is correct, the answer is it likely won’t help much at all.

Almost everyone has a flashback childhood memory of being threatened with not getting dessert (or even dinner, in this author’s case) without cleaning up the old bedroom first. Make the bed, clear out the dirty socks and underpants and get the stray toys and other garbage off the floor, and you’ll get your “allocation.”

It is abundantly clear that any hedge fund manager interested in receiving an allocation from an investor these days needs to do the same thing: clean up their room, or at least clean up their back-end operations, the two most important issues being reducing counterparty risk (and risk overall) and increasing transparency – the socks and the toys, if you will.

How to do that for many managers is easier said than done. While many are responding to the lessons of the global financial crisis by implementing different kinds of operational improvements, it’s tough to know what kind of standard to apply, and even tougher to know what kind of standards potential investors are expecting.

Even so, managers are trying their best to beef up their operations, with a particular emphasis on reducing counterparty risk, improving reporting and transparency and in many cases securing independent firms to handle their valuations and accounting.

Indeed, according to a recent survey by Greenwich Associates and Omgeo (click here to download the full White Paper from Omgeo’s Web site – a short registration process is required), roughly 70% of hedge fund managers surveyed have already done something to spruce up their operations to reduce counterparty risk – boosting their cash accounts, outsourcing their valuation methodologies to a third party and increasing the frequency and detail of their reporting to clients. (See chart below.)

Managers are also moving to revise policies and controls – a biggie on many a due diligence questionnaire. Most importantly, many are increasing the number of prime brokers they work with – 60%, according to the survey results – a move virtually all have done as a way to reduce counterparty risk. The chart below shows how counterparty risk concerns have pushed the majority of hedge funds to the “multiple-primes” format.

To be sure, the tables haven’t completely turned over post-crisis. A whopping 98% of respondents noted they have no plans to join a clearing house to further mitigate counterparty risk, choosing instead to still rely on their prime brokers and other agents to clear trades.

The trade-off to increased operational oversight, of course, is cost. Roughly one-fifth of the survey’s respondents have had to spend money to hire or upgrade internal operations staff, and more two-thirds noted their initiatives have required sinking more money into IT.

And what needs to be fixed and / or automated? Reconciliation, first and foremost, in addition to cash management, collateral management, pricing, accounting and reporting.

Still, most managers have already noted the benefits, namely being able to attract investors and assets.

Of course, there will always be managers who are seemingly too big, too successful and too well-allocated to bother with heightened operations standards that investors might expect. Likewise, there will always be investors willing to let their guard down and drop a few stipulations off the questionnaire because  the strategy is great, the returns even better, the manager is finally open, because their peers are already allocated and because they really, really want to be in the fund. (Read our previous post on the risk-reporting chasm still prevalent between managers and investors here.)

But if Greenwich / Omego’s sampling is any sort of reflection of broader trends underway, the bar is likely to end up resting a bit higher for both sides than it used to be, with no one worse for wear.

In other words, a world of cleaner, tidier bedrooms, and more dessert – having your cake and eating it too.

By: Konstantin Danilov, CAIA, AllAboutAlpha.com Editorial Board

There has been a lot of debate about the social and economic impact of private equity in recent years.  For example, the third paper in the World Economic Forum’s Globalization of Alternative Investments working paper series provides some interesting insights into the macroeconomic impact of private equity. The project – launched in 2007 to provide a “fact-based look” at the global impact of private equity – brought together a team of international scholars to conduct extensive research on the subject.

The paper sets out to answer the following question: does the presence of private equity investment affect the growth rate and cyclicality of the industry where the investment is made? The research focuses specifically on private equity’s impact on productivity, employment and capital formation growth in the industry. The findings are positive, which is good news as private equity continues to face heavy scrutiny from public officials and regulators. More…

A Rock and Hard Place

Cayman Islands Premier McKeeva Bush is between a rock and hard place.  Despite riding a wave of financial services growth over the past decade, the past 2 years have wrought considerable fiscal stress upon this island paradise.  In turn, this has forced the Premier’s administration to balance the pressure to raise government revenues with the need to maintain Cayman’s time-honoured tradition of zero income and property taxes – cornerstones of its strategy to attract and retain financial services firms.  To hit the point home, March’s edition of The Cayman Islands Journal contains a front page story – above the fold – titled “Tax could kill Cayman’s Economy.” More…

Just in case you thought the Cayman Islands’ 15 minutes of hedge fund fame was falling victim to a global backlash against offshore tax havens, Norm McGregor of Deloitte & Touche’s office here has something to tell you.  McGregor kicked-off the annual “GAIM Ops” conference earlier today in Grand Cayman by pointing out that the 9500 funds domiciled on this island was only 500 below its all-time high.

This was emblematic of a sense of optimism that seems to permeate this year’s event.  Then again, last year was a pretty easy “comp.”  That winter, this conference came on the heels of the Madoff Affair – an episode that led many to question the seaworthiness of hedge fund due diligence processes.  This winter, the careers of the accounting, operations, and due diligence personnel in attendance here seem to be firmly intact – even promising. More…

Advocates of “short-extension” or “alpha-extension” strategies such as 130/30 funds often point out that traditional long-only managers are only able to bet against a stock by as much as that stock represents in the benchmark index.  After all, they argue, you can do no more than simply deciding not to hold a stock at all.

This logic applies in spades to emerging markets, where indexes are just as concentrated, if not more so.   In today’s installment of our “Alternative Viewpoints” column by Aquico Wen, a member of the CAIA Association, and Young Chow of Esemplia, a subsidiary of Legg Mason, we show how removing the long-only constraint can have an even more dramatic effect on emerging-market managers than on managers in more mature markets. More…