There is a common belief among many that hedge funds thrive in times of market chaos.  Hedge funds provide the market with much needed liquidity during times of crisis.  Whether you call this market making, or contrarian investing, hedge funds have the flexibility to trade with desperate sellers (“fear”) on one day and desperate buyers (“greed”)  the next – making them a useful balancing mechanism in financial markets.

But some types of hedge funds clearly benefit from market volatility while others don’t.  In today’s installment of our “Alternative Viewpoints” column by a member of the CAIA Association, we feature an interesting study by Mikhail Munenzon of the relationship between the VIX and hedge fund returns.  What you are about to read may surprise you or it may confirm your intuition.  But regardless, it will likely help to clarify your understanding of the relationship between the volatility and hedge fund returns.

Special to AllAboutAlpha.com by: Mikhail Munenzon, CFA, CAIA

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The relentless German drive for hedge fund regulation has raised the hackles of many over the past few months. The latest to raise concerns about the EU’s AIFM Directive is freshly-minted UK Prime Minister David Cameron, who sees the protectionist slant of German proposals as a threat to London’s hedge fund industry. The protectionist elements of the AIFM Directive may eventually be toned down, but the apparent adoption of UCITSIII as a sort of de facto global stamp of approval may ensure that European policies have extra-territorial implications for years to come.

We’ve covered several industry surveys on the topic of UCITS. But in today’s post, Ahmet Peker, CAIA, of Deka Investments in Germany examines his firm’s proprietary database of UCITS hedge funds.

By: Ahmet Peker, CAIA, Deka Investments

The financial crisis led to changes in the preferences of many investors. Illiquidity, transparency, the lack of regulation etc. are seen as more critical than before. Combined with the political will to have no “grey areas” on the financial markets map, this has forced Hedge Funds to rethink their fund-vehicles. European Managers notably reacted on this by launching UCITS III compliant funds.

But what exactly is UCITS? This was/has been the question many people asked, when the trend kicked-off in early 2009. As readers of this website know, UCITS stands for “Undertakings for Collective Investment in Transferable Securities” and is a directive that standardises the framework for funds across the EU.

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By: Miran Ahmad, CAIA, AllAboutAlpha.com Editorial Board

The search for alpha would not be complete without the search for managers who consistently beat their peers year after year, despite the ubiquitous disclosures that “past performance does not guarantee future results.” The groundbreaking and wildly popular AllAboutAlpha.com post “What US college basketball can teach us about survivorship bias” taught us two important lessons: first, Duke actually stopped choking long enough to win a tournament; and secondly, that “hidden survivorship bias” might be a better metric when looking at hedge fund database returns (Editor’s Note: The occasionally misguided sporting opinions of the author are not necessarily shared by AllAboutAlpha.com…). So if basketball can teach us about survivorship bias, what can NASCAR and Formula One racing teach us about return persistence? More…

Today we bring you part 2 of Erik Einertson’s special to AllAboutAlpha.com “The Five face of Alpha”  (first installment here)…

Alpha #2: Insurance Beta

The second type of “Alpha” often found in the market can be referred to as insurance beta or Informationless Investing (Weisman 2002). This type of exposure has persistent tilts towards strategies that have an insurance like payout. The payout for this type of strategy will experience long periods of modest positive returns (and high IR) followed by short periods of large negative performance. While the selling of insurance can be part of a diversified portfolio, it is the tactical use of these strategies that creates real alpha, not the systematic tilts toward these exposures. Unfortunately, many investors in these types of strategies are unaware their portfolios have this type of risk exposure. More…

As we have noted over the past several years, alpha is notoriously difficult to define and isolate since its existence depends not only on the target being observed, but on the perspective of its observer.  The more we study alpha, it seems, the less we know about it.

We are reminded of this irony by today’s CAIA guest post.  Erik Einertson is with Los Angeles quant manager First Quadrant.  (Regular readers may remember this guest post by Einertson’s colleague Jia Ye.)   He takes a very comprehensive look at what is and what isn’t true alpha – so comprehensive that we decided to deliver it in two parts with part one below. More…

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

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

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

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

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

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

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

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

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

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

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

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

Today, guest contributor Steve Deutsch of Morningstar says that despite all the talk of “transparency”, the micro-economics of the institutional investment industry often prevent the message from getting through.

Special to AllAboutAlpha.com by: Steve Deutsch, CFA, CAIA, Director of Separate Accounts/Collective Investment Trusts and the Pensions, Endowments, and Foundations Database, Morningstar, Inc.

As we continue to experience an economic and financial correction, all sorts of remedies have been prescribed.  Most recently, the Investors’ Working Group, composed of the Council of Institutional Investors and the CFA Institute, have made several recommendations.   And no less an authority than the Pope himself has weighed in on the subject in his June 29th, 2009 Encyclical Letter, which the Financial Times summarized as a condemnation of capitalism’s failures and a call for stronger government regulation.

A standard elixir during financial calamities, in years past and right now, is always “transparency”.  But what exactly does this mean for institutional investors?

“Shenanigans”

While the world may be “flat” when it comes to global trade (see Thomas Friedman’s “The World is Flat: A Brief History of the Twenty-first Century”), the world is still as round as ever for financial markets (as proposed by author David Smick in “The World is Curved: Hidden Dangers to the Global Economy.”)

Smick argues that: More…

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

Alternative Viewpoints: The Ascendancy of Risk Management

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Alternative Viewpoints: Alternative Investments in India

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

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

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

Hedge Fund Regulation

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

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

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

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

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

Clear and Present Danger

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

Peter Douglas, CAIA, the founder of Singapore-based hedge fund consultancy and money management firm GFIA, is a well known and often-quoted figure in the alternative investment industry.  Regular readers may recall our conversation with him in his Singapore offices last fall (see post).  But Douglas also has another claim to fame.  As the Asia-based director of the Chartered Alternative Investment Analyst (CAIA) designation, he is a pioneer-cohort charterholder, and was the first CAIA in Singapore.  So we are pleased to bring you Douglas’ latest comments on the hedge fund industry as part of our monthly column featuring the ruminations of a CAIA charterholder, “Alternative Viewpoints”.

Today, Douglas pulls out his crystal ball to look at the future of the hedge fund industry.  He says that a dearth of alpha-seeking capital will usher in a “golden age” for alternative investing.  He also foresees larger hedge funds regulated as investment banks, and most large multi-strategy funds morphing or fading.  He says that as boutiques flourish, diversification across funds will become easier and price differentiation will finally take hold.  In addition, predicts Douglas, leverage will fall out of favour, operational expertise will become even more critical, and regulatory arbitrage will remain alive and well.

Alternative Viewpoints: What Next for the Hedge Fund Industry?

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

The future will (not ‘may’) hold many surprises, and some could make a huge difference to our world view.  However, here are our thoughts on how the hedge fund world may pan out over the next 2-3 years.

In summary, the hedge fund world will (i) see higher returns (ii) see strong new manager formation (iii) be dominated by small boutique managers (iv) have relatively few very large funds.

Returns will be higher, possibly much higher, than they were 2006-2008

Of (very roughly, erring on the conservative side) US$2tn of hedge fund assets, and >US$4tn of investment bank trading assets, at the beginning of this year, we will, by the beginning of 2009, have lost perhaps 1/3 of the hedge fund assets and 3/4 of the world’s banks’ prop trading assets.  Assuming (and this is perforce guesswork) that aggregate leverage in the hedge fund ecosystem falls from 3x to 1.5x, and that ditto in the prop desks drops from 20x to 10x, that means that US$86tn of alpha-seeking capital will become US$12tn, an almost 90% implosion.  This is conservative. At a recent conference, we heard Paul Marshall, of Marshall Wace, estimate that half of all hedge fund capital, and 80% of investment bank trading capital, would evaporate.

(Goldman Sachs’ reduced their overall leverage from 24x to 16x, still, to our mind, an extraordinary number. We’re assuming that the majority of the new owners of investment banks will not be as confident of their new-found treasure’s ability to manage risk and will run significantly lower leverage. Professional trading units outside banking, such as Cargill, typically run at around 10x and we feel this is a realistic estimate.) More…

As Andrew Lo said at a major hedge fund conference in Boston last week, humans have a bad habit of confusing “very low probability” with “no probability”.  While this heuristic might help us from becoming a bunch of paranoid freaks, it can clearly be dangerous if the “low probability” event is catastrophic.  Enter catastrophe bonds.  In this month’s “Alternative Viewpoints” column, CAIA Association member Robert Koller-Vernot discusses the growth of the catastrophe bond (“cat-bond”) industry.  Koller-Vernot is a financial services and securities lawyer in Frankfurt with several years of experience in the fund management industry throughout Europe.  He also writes an interesting blog.

We think you’ll find his industry survey below (and in an expanded form available here) to be a concise and informative description of this interesting, if not a little macabre, quarter of the financial sector.  Read on to find out why Disney was a pioneer in cat bond issuance.  (For loads of references and external sources, refer to the full article.)

Special to AllAboutAlpha.com by: Robert Koller-Vernot, CAIA

Cat-Bonds are financial markets instruments that include an extra feature – an insurance element.  The main idea behind a cat-bond, as initially conceived, is to transfer risk of a natural catastrophe.

The issuer of a cat-bond issues securities that pay regular interest and return their principal at the end of their lifetime.  The normal maturity of a cat-bond is around three years.  However, the principal re-payments are conditional on certain pre-defined “triggers” (see below).  For example, in an earthquake-linked cat-bond, the trigger might be defined as a specific level of seismic activity.  If that activity occurs, then, generally, the principal will not be paid back or will be reduced at the end of the lifetime of the bond.

The flexible structure of cat-bonds allows the linking of the event (or even several events) to the repayment of the principal, the interest payments or both.  It is also possible to include staggered events as triggers. For example, if the earthquake magnitude reaches X but not Y on the Richter scale, then only 75% of the principal will be paid back, if it exceeds Y but not Z, the 50% will be paid back. More…

Over the past 2 years, a revolution has been quietly brewing.  Rather than using portable alpha or liability-driven investing some pension plans are throwing in the towel entirely and off-loading their funds to third parties.  One such third party is the innocuously-named Pension Corporation, a London-based company whose business includes buying up pension liabilities.  Today as part of our series featuring members of the CAIA Association, Dr. Bob Swarup, CAIA, a Partner with that firm explains what led to the birth of this potentially massive new industry.  Bob holds two Master’s degrees and a Ph.D., is active in the CAIA Association and has written various articles for FT Publications, the Daily Telegraph and New Scientist.

Alternative Viewpoints – “Pension Buyouts”

Special to AllAboutAlpha.com by: Dr. Bob Swarup, CAIA, Partner, Pension Corporation

To much of the investment community, most pension funds are boring entities eternally bound to old family recipes of formulaic asset allocations – Balanced, Conservative and Growth – all left to ferment for the next half century or so.  The logic is impeccable – they have the luxury of a long-term perspective, many adherents will argue, that allows them to ignore the short-term volatility of the financial markets and focus on harvesting the inevitable risk premia of these asset classes over time to meet the liabilities of their pensioners as they fall due.

Ironically, this same attitude is also responsible for making pension funds the perennial cold call for every manager looking to add some ‘sticky’ money to their assets. They are comfortable with modest (others may term “disappointing”) returns, they are slow to redeem (unlike the rest of those pesky investors) and they are remarkably understanding of failure, just like your mother was after you drove over the family cat.

But there is a small problem in the background of the picture. Most pension schemes are chronically in deficit and the problem is only set to worsen in the current economic climate. Everyone has talked ad infinitum about the $700bn bailout package in front of Congress to stem the hemorrhaging from the credit crunch.  I doubt if many realise that a similar amount is also needed, for example, in the UK to fill the deficit in just that country’s private sector pension schemes. Throw in the public sector and you’re talking up to another $2 trillion.

Old Problems More…