Yesterday we highlighted a series of media articles that described the ongoing skirmish between hedge funds and mutual funds as a “resistance” movement and a “turf war”.  Today, we examine one mutual fund that adopted several of the key weapons used by hedge funds without actually using the term “hedge fund.”

When asked to list the key differences between hedge funds and mutual funds, most point to the (potential) use of leverage, investment latitude and performance fees.  Indeed, these weapons have been banned by mutual fund regulators.

Leverage by any other name

Enter Putnam’s new “Equity Spectrum Fund”, listed as a “blend” fund on the firm’s website.  Like most mutual funds, this fund invests in equities without using any borrowed money.  But like many hedge funds, the Equity Spectrum Fund actually includes leverage – only this leverage exists within the holdings, not within the fund itself.  The fund invests in “leveraged companies”.  And according to the Putnam website More…

As we mentioned on Friday, many institutional investors felt somewhat burned by “complex” strategies such as portable alpha last year.  However, research conducted in Q1 seems to suggest that those investors remain positive on one of the key elements of portable alpha strategies – hedge funds.

The FT reported last week on a survey conducted by consultancy CREATE and UK money manager Martin Currie:

“Institutions also remain keen on hedge funds and real estate, despite the travails of these sectors during the credit crunch, but are wary of “bells and whistles” strategies such as liability driven investment, portable alpha and distressed debt.”

Similarly, the Economist is reporting this week on “the mysterious popularity of hedge funds“:

“…a recent survey of most of the world’s big hedge-fund investors, by Goldman Sachs, suggests that clients remain surprisingly happy…a couple of blow-ups aside, hedge funds have proved less risky than most other financial firms.”

And a couple of weeks ago, speakers at the Milken Global Institute were quoted by Reuters as saying things like: More…

Here’s an investment strategy perfect for Earth Week: hug a tree.  According to some estimates, owning trees would have produced over 13% per annum with low vol over the past 100 years.

This fact isn’t lost on the world’s pension fund community.  Mercer’s recent report on European pension fund asset allocations shows that “timber/forestry” allocations are relatively small, but are now in the same quantum as other more recognized alternative assets (far right side of chart):

Uncorrelated returns – even in 2008

In a year when many previously uncorrelated alternative assets became suddenly and mysteriously correlated, timber kept on growing.  A recent article by JP Morgan (available here at P&I) makes the case (that’s the NCREIF timber index in yellow): More…

One of the hallmarks of an alternative investment is an option-like payoff – a return distribution that is truncated or skewed.  If that is the case, then the ubiquitous penny and quintessential nickel could be the most popular alternative investments in the United States (and, we suspect, in many other countries around the world in similar forms).

According to an article by Espen Haug and John Stevenson, physical currencies – particularly those made from copper and nickel contain an option that is close enough to the money to have a material value and has even been in the money in the recent past.

Haug and Stevenson point out that pennies and nickels can be converted into electronic money at their face value, but that they also contain copper and nickel that, in 2007, was worth more than the denominations themselves.  Put another way, pennies and nickels are really just long positions in copper and nickel combined with a put option on each with strike prices of one cent and five cents.  If the price of the copper in a penny goes above one cent, the option is worthless.  Likewise, if the price of the nickel in a nickel goes above five cents, the option is also out of the money. More…

A new academic study examines how equity betas jump with the release of earnings announcements. It seems that, as in the hedge fund industry, a dearth of information in equity markets can lead to an over-reaction when news is finally released – even if that news is about a competitor.

It’s a widely-accepted axiom that “correlations go to one” in times of distress.  In volatile periods like August 2007 and October 2008, hedge funds using seemingly disparate, unrelated strategies, tend to exhibit strikingly similar performance.  This is often blamed on a “flight to liquidity” that can have a similar effect across different strategies.  At its heart, such a run for the exits is usually precipitated by investors who extrapolate specific occurrences (e.g. a fund collapsing) across the entire industry. In fairness, this may be a good bet.  After all, what affects one fund is bound to affect other funds operating with similar strategies.

A new study by academics at Oxford University and the London School of Economics shed some light on this phenomenon.  Michael Patton and Michela Veradero find that individual stocks also experience an increase in correlation with their peers when they announce any news.

This makes intuitive sense.  When a company announces news such as earnings, information-starved investors are likely to jump on that as an indication of industry conditions.  As a result, the fortunes of competitors, suppliers and other industry participants respond accordingly.

They divide the beta of individual securities into its two components: relative volatility and covariance.  While volatility relative to the market is bound to change when news is announced, they find that the lion’s share (80%) of any change in beta can be attributed to a pop in the covariance.

As the authors put it: More…

There are nearly a dozen commercial hedge fund databases in existence today.  As most practitioners and academics are painfully aware, the voluntary nature of these databases means that they are susceptible to various widely-reported biases.  For example, since databases only track funds that currently exist, they necessarily ignore the historical returns of funds that no longer exist.  In addition, since the decision to report to a database remains at the discretion of the manager, only funds they consider worthy of publicizing are included.  Funds that started off poorly are apt to be shut down or folded into another fund before they ever hit the radar screens of hedge fund databases.

Many funds only report their returns to one database.  A small minority report to 3 or more.  In fact, a 2005 study (see related post) found that only 3% of hedge funds reported to all of the five largest databases.  As a result of this, each database is forced to extrapolate its results across the entire hedge fund universe.

But there is one company that, by virtue of its unique business model, is able to see across all sources.  That company is Pertrac, a provider of performance analytics software that maintains relationships with all hedge fund databases. More…

Some have suggested that the strong performance of hedge funds relative to equities over the past 12 months could come back to haunt it in a rather circuitous manner.   The theory goes that institutional investors with fixed target allocations to different asset classes might decide that alternative investments now represent too large a portion of their holdings – simply because alternatives depreciated much less than equities over the past year.

That was the theory.  But a report from consultancy Casey Quirk and institutional investment database eVestment Alliance says that hedge funds represent the same portion of institutional portfolio allocations now as they have over the past few years.  In fact, institutional allocations to alternative investments (of all sorts) have remained pretty stable at around 3.5% since way back in 2004.

The report also contains some other interesting observations about the greater asset management industry.  For example, check out the chart below showing the average allocations to equities, fixed income and alternatives by type of institution (click to enlarge). More…

French business school spin-off Edhec Risk and Asset Management Research Centre is in the business of education.  So it may come as no surprise that a recent white paper by the organization concludes that we all need more education on modern portfolio construction techniques.

While the report ostensibly covers the results of a survey of investment professionals, it does contain a certain element of brow-beating (“practitioners rely mostly on the assumption of a normal distribution…skewness and kurtosis is thus ignored…advanced techniques are not widely used…shortcomings in the area of portfolio construction…“).

However, Edhec makes several valid points about the resistance to measuring higher moments (skew & kurtosis, co-skew & co-kurtosis – see related AAA post) and relative returns vs. absolute returns.  Says the report: More…

Critics of hedge fund compensation often argue that hedge fund managers – and by extension, asset managers in general – do not provide a “social good”.  Highly compensated traditional entrepreneurs, they say, make life better for people instead of just shuffling the chairs.

In fairness, it’s not like Obama is encouraging American teens to give back to society by volunteering at their local hedge fund.  No one is encouraging people to “make a difference” by launching a hedge fund and there is no “Hedge Corps” (although there are now many examples of a hedge corpse).  But Edhec’s Arjuna Sittampalam argued earlier this week that hedge funds actually do contribute a social good.  Wrote Sittampalam:

“Amidst all the criticism, there are many aspects in which hedge funds deserve praise. Their strongly pioneering role in venturing into new investment areas, and in the process bringing them to the attention of other investors, is one major aspect. In other ways too, they make a strong social contribution…” (our emphasis)

By “social contribution”, he’s not just talking about hosting society parties in Greenwich either.  Sittampalam is talking about things like Reinsurance, Pulp derivatives, Carbon dioxide emissions credits, Global real estate, including derivatives, Weather derivatives, Credit cards, Higher-risk lending, Socially responsible investments, Film-making and film finance, Catastrophe bonds, Freight derivatives and shipping, Lawsuit funding, Directors’ dealings, Song copyrights and Trade finance.

AIMA CEO Andrew Baker would probably concur with this assessment that hedge funds do provide social good.  As HedgeWeek recently reported: More…

Given the particularly strong headwinds faced by hedge funds in Hong Kong and Singapore recently, their managers may now be considering a move back into corporate life.  The only problem is that things aren’t much better there.

During our conversations last week with Hong Kong hedge fund industry participants, it became apparent that the industry may benefit from an unlikely source: the general melt-down in the financial services sector. Just as laid-off financial services workers might decide to launch their own hedge fund in response to a dearth of job opportunities – so too might many hedge fund managers stay in the game a little longer. With job opportunities so few and far between, we are told that many small hedge fund managers in Hong Kong might just stick it out – even if they are (temporarily, it is hoped) running at a a loss.

The result is that for now at least, this has staved off a possible hedge fund brain drain.

Cities duel as ship takes on water

After an interesting week in Hong Kong, we have now made our way down to its arch rival in the regional battle for asset management supremacy: Singapore.

Although it is thought to have no more than an eighth of the assets under management of Hong Kong (in all asset classes), Singapore has been wooing asset managers aggressively in recent years – particularly hedge funds.

Last week, the city-state stepped up its game by creating new tax incentives for asset managers.  As Asian Investor reports: More…

Given that Bernie Madoff had been (allegedly) running a hedge strategy for 2 decades by the time he packed it in, it’s not a huge surprise that many Madoff feeder funds weren’t spring chickens either.  Some were nearly as old as Madoff’s fund management business itself.  The seasoned funds of funds that invested in Madoff have now experienced a significant bump in their return volatility.  Meanwhile, younger funds (say, under a few years old) are less likely to have been able to join the exclusive Madoff feeder fund club.

This situation might have come as little surprise to the authors of a study published in this quarter’s Journal of Alternative Investments.  Ying Li and Jamshid Mehran of Indiana University examine the performance and risk profiles of “seasoned” and “new” funds of funds.  Their article is available for a limited time at the Chartered Alternative Investment Analyst (CAIA) website.

Contrary to their image of naive and overconfident johnny-come-latelies, younger funds of funds actually have a lower volatility than older more established funds of funds.  One of the reason for this is that gross leverage appears to be higher for the older funds than for the spring chickens (although as Li and Mehran point out, they estimate leverage by adding up the various beta exposures in a fund, so a higher volatility and higher implied leverage kind of go hand in hand).

And here’s a finding will surely make sense to Madoff victims: another reason for the higher volatility of seasoned funds of funds is that they tend to me more concentrated than newer funds of funds.

2001: A Fund of Funds Odyssey

Think there has been an explosion in funds of funds over the past few years?  There may have been a lot of institutional assets flowing into funds of funds, but according to data presented in this study, the halcyon days for fund of funds launches actually happened in 2001 (see chart below from paper). More…

High minimum investment levels have always been a sign of exclusivity in the hedge fund industry.  But does a higher minimum investment level mean a higher return?  According to one study, the answer may be “yes”.

Kelvin Huang, a Ph.D. candidate at Canada’s leading business school – Queen’s University School of Business (disclosure) obviously spent a lot of time examining this relationship.  His findings were published in December in his thesis “The Impact of Minimum Investment Barriers on Hedge Funds: Are retail investors getting the short end of performance.” (available here)

Before trying to figure out if big ticket funds have big ticket returns, Huang collected historical data on minimum investment levels from the CISDM database.  As you can see from the chart below from his paper, the number of hedge funds with a $1 million+ minimum grew disproportionately between 1995 and 2005:

More…

Hedge fund seeding is back in the news this week. But unlike a year ago, the news is not all that good.  Small funds, which were once coddled by their prime brokers, then were recipients of meaty seed investments from “incubators” now face a harsher environment where bigger players might either support them or eat them.  But it still seems that the creative renewal so important to the hedge fund industry will thrive in one form or another.

Enlightened Self-Interest

You don’t have to be a financial rocket scientist to figure out that prime brokers are interested in their hedge fund clients’ success.  More assets under management for them equals more trading, lending and stock loans for them.  This is why prime brokers have always been champions of “cap intro” events – a proto-seeding activity.

But enlightened self-interest wasn’t the only thing driving the growth of early hedge fund seeding.  Many investors in these early stage hedge funds also did well.  In fact, research showed time and time again that smaller, newer funds did better than older ones.  While some argued that this was a mirage caused by “backfill bias” in hedge fund databases, there was considerable interest in emerging managers for most of this decade.

More…

Does regulation prevent fraud?  Who knows?  But according to this colorful and detailed account of one famous case, the SEC should think again if it expects to stamp out fraud using new regulatory powers.  The case is Manhattan Capital and the chronicler is Chidem Kurdas, one of the world’s most experienced and articulate hedge fund journalists.  Kurdas’ account of the Manhattan case in the Winter 2009 edition of The Independent Review is well worth the read – particularly as we move into an era of greater hedge fund oversight.

Kurdas points out that “regulatory frenzy occurs every time another fiasco occurs.” And when it does, it’s often ineffective unless an interested party complains after the fact – that is, when the damage is done.”

Kurdas says that “at least one aspect of the Manhattan Fund vividly demonstrates regulations failure to deter fraud.” But it’s clear that this case study (written before the Madoff Affair) may provide some important lessons.  In a nutshell, here’s what happened…

Michael Berger, described by Kurdas in this blog post as a “restless” 22 year old Austrian immigrant, launched Manhattan in 1996 with a decidedly bearish view of equities.  According to Kurdas’ account, he raised $600 million over 4 years from investors who, like him, wanted to take out a sort of “insurance” against a market downturn.  The problem, of course, was that this market downturn didn’t come soon enough for Berger and his investors.

Although Manhattan was later described as a Ponzi scheme, Kurda’s explains that it was actually a “real investment operation”. But as losses mounted, Berger began to cook the books by submitting fake holdings data to his administrator.  That administrator trusted Berger’s data since it purportedly came directly from the fund’s introducing broker – a small Ohio firm that in turn used Bear Stearns as its prime broker.

The problem was, Manhattan accounted for a significant portion of the introducing broker’s revenue – leading some to believe that it was too quick to acquiesce to Berger’s demands.  One of the those demands was More…

Optimistic analysts and economic commentators are apt to interpret a downturn as a “cyclical bear in a secular bull market”.  It seems that this phrase can also describe the current state of the the hedge fund job market.  Few question that last year was an annus horribilis for the hedge fund industry.  But Euromoney reports on a survey conducted last summer by the website Hedge Fund Jobs Digest that reached a number of surprisingly rosy conclusions.  The president of Hedge Fund Jobs Digest tells Euromoney that despite the turbulence, “There is still a strong flow of private equity and hedge fund hiring.”

Bear in mind that the survey was conducted pre-Madoff and prior to drawdowns experienced by so many hedge funds in the second half of 2008.  But it’s still interesting to note that hedge fund career opportunities went into the second half with a considerable amount of momentum.

In fact, satisfaction with hedge fund job compensation rose from 25% to 42% last year and the hours worked by a typical employee remained pretty tame as the chart from the survey below indicates:

More…