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).

Liquidity or Objectives Mismatch?

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

Hedge Fund Evolution

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

Where does the new set of opportunities lie?

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

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

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

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

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

- T. Sanzin, December 2008

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

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

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.)

This accords with our view of the number of stocks in Asia with institutional levels of liquidity.  (From a Singapore base, we naturally see more data points from Asia than the ‘developed’ markets.) In the summer of 2007, this was perhaps 500.  Now, it’s more like 50, across the whole region.  In brief, alpha-seeking capital has shrunk by an order of magnitude.  As liquidity across the financial system continues to ebb, we believe that we may still not be at the low point.

Other discretionary flows into risk assets will also slow, as individuals and trustee-directed investments will lose their enthusiasm for market-related investments, further constricting liquidity.

Without market liquidity, arbitrage opportunities will be wider for longer, and markets will generally offer far more persistent opportunities.  Whether the opportunity is simply a hugely undervalued equity, or a mispricing in a complex derivative relationship, inefficiencies will be larger and more persistent – creating supernormal returns for investors with the skills to find and execute.

With a lack of general appetite for equity market risk, indexed or quasi-indexed returns will be meager, making the relative attraction of alpha returns much stronger.

We will, at some point in the next 6-12 months, enter a golden age much like that of the 1990’s, for hedge fund returns – indeed, returns from all but simple benchmark investing will be high.  We prophecy that the broad hedge fund return indices will annualize at 20% from 2009-2011.

The >US$5bn funds will be the new investment banks, and no longer relevant as hedge funds

We’ve pointed this out before, but hedge funds have been far better risk managers than any other investor group.  In 2007, aggregate hedge fund profits to investors were roughly equal to bank write-offs.  So far in 2008, although hedge funds have had a disastrous year, it’s been only half as disastrous as that for mutual funds, and exponentially less disastrous than for the owners of the banks (the other main risk-takers in financial markets).  Clearly this is where risk capital should and will be concentrated.  We can only suppose why this should be… but our supposition is that risk is best managed in discrete pools, by experienced professionals, remaining close to their specific experience, and with their own wealth at stake.  That mandates a boutique approach.

Secondly, the businesses-formerly-known-as-investment-banks will be very tightly constrained, not just by penal regulations, but also by their new owners, the commercial banks or sovereign entities.  While hedge fund regulation is clearly going to tighten, the hedge funds may be better placed to work round whatever’s put in their way.  The regulatory arbitrage between implementing a strategy within an investment bank, and within a hedge fund, will be strongly in the hedge funds’ favour.  The U.K. F.S.A. chief executive recently said:

“Hedge fund managers in general are weathering the market turmoil pretty well in the circumstances, certainly versus other components of the financial services industry.”

However, while a few months’ ago, we would have argued that hedge funds will be regulated fairly lightly compared with investment banks, we’re having doubts.  The industry’s larger players are increasingly being found guilty by their investors of having abandoned their fiduciary responsibilities, in favour of entrepreneurial zeal.  While 18% of hedge fund capital has been subject to gates or other restrictions on redemptions, this is concentrated within about 5% of funds by number.  In other words, it’s the big boys who are alienating investors.  The building crescendo of complaint from investors will I’m sure reach regulatory ears.

We think there’s an argument for regulating very large funds pari passu with investment banks, while leaving the boutiques largely unregulated.  We have a comparable situation in Singapore, where large institutional managers are generally subject to full investment management regulation, comparable with that mandated by the SEC or FSA, while smaller specialists can opt to be exempted.  This has worked remarkably well in balancing the growth of a dynamic indigenous industry, with the needs of very large allocators and their preferred managers.

Thirdly, running large amounts of money will be very difficult in a world of shrunken and much less liquid securities markets.  Much of the trend to multistrategy funds has been an attempt to create the scale that institutional investors would like to see (our humble opinion has been that ‘multistrategy’ has always been far less an investment strategy than a business model – and it’s always been the most difficult strategy to recommend to clients).  Alpha is never scaleable at the best of times and we believe the optimum size for almost all strategies has decreased very substantially of late.

We believe that the current very-large hedge funds will see the most dramatic changes.  Some will fragment into their constituent parts, some will become investment banks and be regulated as such, and some will disappear having committed suicide by gating their investors.

One effect of this is likely to be that a few remaining mega-funds will typically compete for similar returns, finding their scale a handicap.  They will also be among the few able to run heavily leveraged strategies, meaning that this universe is where the system-shaking implosions will happen next…  but not yet!

Strong growth in new boutiques and strategies

There is, and will be, attrition of hedge funds.  While there will be consolidation of funds of funds, which have an asset aggregating business model and therefore clear scale advantages, hedge funds won’t generally consolidate. Diseconomies of scale, and the extreme individuality of hedge fund professionals mean that hedge funds evaporate, not merge. Furthermore, the prospect of a year or two scrabbling back to high watermarks and therefore performance bonuses, will loosen the ties of many investment people to their current firms.  In addition, the overall contraction of the financial services industry will result in a widespread freeing of talent.

There will be increasing numbers of Ronin on the streets – skilled warriors answering to no master – easing dramatically the key constraint to growth of the industry, namely finding experienced people.  While some will attach themselves to the relative security of large funds, many will try their hands at starting their own shops, however tough fund-raising may be for a while.  We started GFIA in the depth of the Asian crisis, and can attest first hand that it’s far easier to start a business in a recession, with little competition for resources as diverse as research talent and airplane tickets, than in a booming economy.

We will a return to the early noughties, with plenty of highly skilled professionals starting firms with few staff and few assets, producing very attractive returns for a few years before gradually attracting assets from initially-shy investors.  This is exactly the experience post the Asian crisis, which left a lot of excellent but dislocated talent looking for a home for their skills.  The period 1998-2002 was the genesis of the boom in Asian hedge funds, which really happened from 2003-2006 before leveling off.  We will see a rerun of this movie starting in 2009, but this time it’ll be global not regional.

The way the investment world will change, with the current huge dislocations opening new arbitrages, and new ways to access the opportunities available, will facilitate plenty of good new pitchbooks.  The revised realities of working in a world with few mega-buck opportunities in investment (or any other sort of…) banking, with a backdrop of a vicious developed-economy recession, will make it relatively attractive for very good people to manage a few 10s of US$m in a strategy.

Conversations with law firms and prime brokers confirm this is in motion.  While prime brokers see a lot of wannabes alongside the likely starters, the law firms (who cost money!) only usually work on high-likelihood propositions.  And they’re seeing a strong pipeline of new funds for 1Q and 2Q 09.  While as an allocator, we’ll find it hard to allocate to any PM that didn’t have p&l responsibility through 2008, we’re sure we’ll be kept busy reviewing the propositions.

Inevitably, of course, a few of the new mini-boutiques will achieve scale, and the cycle will turn again…  But we feel that the next few years will be remarkable for the crop of new, small, skill-driven boutiques that appear.  It will be very exciting for investors.

Leverage will be used in fewer strategies

Only the very large funds will be able to convince their bankers to make significant leverage available.  But in any case, referring back to our earlier comments, you won’t need leverage to find good alpha returns.

This is likely to provide a conundrum, however.  In a generally unleveraged world, markets are likely to be substantially less leveraged than of late.  Large firms may well have access to leverage, but in relatively illiquid and volatile markets, will they be able to deploy that leverage well?  We expect that some will, and some won’t, and that the inherent riskiness of larger funds will, if anything, increase.

Systemic risk may reappear, but concentrated in the mega-funds, while mitigated in the smaller funds.  This is a further reason why the very large hedge funds will increasingly be regulated like investment banks – it’s because that’s where the risk will be concentrated.  Smaller boutique houses will be fragmented and largely unleveraged, and will operate with considerably more freedom.  It’ll be easy to argue that large funds should be regulated like investment banks.

Diversification will become easier

Their will be clearly be a period of good beta returns from dramatic market swings, as investors grapple with the likely direction of the new world order.  While simple ETF-like exposure is likely to be a rollercoaster, good directional equity managers with stock-picking skills will make good returns.

(From 1929 to 1934 there were 5 dramatic bear market rallies, 2 of which were >100%, before the Dow finally bottomed, with a peak-to-trough fall of almost 90%.)

Buy, hold, work-out and sell distressed strategies will make money.  So will arbitrage specialists whether they be event driven, market neutral, or any other convergence strategy.

But in the absence of blanket leverage floating all boats, it’ll become much easier to identify the specific characteristics of various sources of return, and it’ll become significantly easier to achieve effective diversification again, reviving the fortunes of the fund of funds industry again (albeit, see below, likely within a fragmenting range of business models).

Differentiation of fees

Investors will be in control, given the new scarcity of investment capital.  2 & 20 may be the sticker price, tho’ some new funds may go for a more conciliatory 1 & 20, but the effective pricing of investment strategies is likely to disperse dramatically, through the use of separate accounts, co-investment rights, and advisory contracts, as well as through simple fee rebates.

Differentiation of liquidity terms

Recent experience has shown that there cannot be one-size-fits-all liquidity terms.  Long term institutional investors want limited liquidity to protect themselves from other investors.

Intermediating investors (such as FoFs) legitimately need frequent liquidity to be able to adjust their exposures.  The two don’t mix.

Within the proviso that of course fund liquidity must match underlying asset liquidity, hedge funds will increasingly polarize between the two investor groups, defined by their liquidity needs.

The classic upward mobility of successful hedge funds, graduating investor profiles from agency to principal investors, may be constrained, as funds are defined either as “intermediary” or “proprietary/fiduciary” in nature.

Operational infrastructure will be more fragmented and expensive, and therefore operational expertise will be critical

Hedge funds will continue to appoint multiple prime brokers as a need-to-have rather than a nice-to-have; they will diversify their counterparties as much as possible; manage their cash more proactively; and quite possibly disaggregate many of the current package of prime broking services.  Investors will require this even if hedge funds don’t see it.  The de minimis internal infrastructure within hedge funds, needed to manage this increase in professional relationships, will increase, even for very small firms.

As the current prime broking model morphs, prime brokers will charge in more visible ways for their services; service providers generally will act for a larger number of smaller players with a corresponding impact on their cost base…  frictional costs will rise.

Good hedge fund ops managers will, even in the near-term shrinking environment, be bid-only.

Strong geographical movement to less politicized jurisdictions

The current financial crisis has galvanized policymakers to think and act globally, and regulatory agencies will be under pressure to homogenize regulations.  However, there will remain underlying philosophical differences, as well as different models of political and regulatory interaction.  In particular, we envisage that the main continuum of regulatory policy will be along the axis “politicized – non-politicized”.

Jurisdictions where regulatory policy is relatively free of political interference, and hence regulatory environments driven by pragmatism and effectiveness rather than dogma and populism, will see measurable increases in business.

Regulatory arbitrage will continue to exist, but be driven as much by perceived regulatory policy as by current compliance cost.  There’ll be further arbitrage between those managers serving investors with little need to deal with regulated entities (who will inevitably find ways to structure themselves to avoid burdensome regulation), and those managers serving investors that do need regulated counterparties, who are likely to maintain a far more costly compliance overhead.

- P. Douglas, November 2008

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

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.

Market Size

The number of natural catastrophes and its consequences vary wildly from year to year. In 2005, 397 catastrophes caused more than 97,000 casualties and total losses exceeded USD 230bn.   Last year, the insured losses were lower, reaching USD 28bn and more than 20,000 causalities.  Insured losses tend to be higher in developed countries than elsewhere; North America absorbed in 2005 87.1% of all losses and Europe accounted in 2007 for more than 45% of the losses.

These figures show the huge potential for Cat-Bonds.  Last year (2007) was a record year, with cat-bonds reaching an issuing volume of USD 7bn in 27 transactions that were publicly disclosed.  Since 1997, more than 100 cat-bonds have been issued, accounting for a risk capital outstanding by mid 2008 of over USD 14bn.

The main players in the market up to now have been sovereigns, insurers, re-insurers and some corporate entities.

Examples

Currently most cat-bonds are linked to US hurricanes and earthquakes, Japanese typhoons and earthquakes, and European windstorms.   However, in recent years there has also been additional coverage issued to cover areas such as the Mediterranean, Central America and Mexico from earthquake and some UK areas from floods.  Additionally, cat-bonds, or more generally speaking insurance-linked securities, that transfer liability, credit, motor and reinsurance recoverable risks have been issued.

However, cat-bonds may also be issued to cover other catastrophes such as drought, hail, tsunamis, bush fires etc., as well as man-made-disasters, such as nuclear fallout, aviation, space, shipping, rail and mining accidents, electricity blackouts, and even terrorism and social unrest.  But such man-made disasters have so far not been widely covered by cat-bond issuers. Another area of growing interest are longevity and mortality bonds, a development out of traditional cat bonds.

Some examples have included:

• Disneyland Tokyo issued the first ever corporate cat-bond in 1999. What would have triggered the Bond was not damage to the Disneyland property itself, but an earthquake that measured 6.5 or more on the Japanese Meteorological Agency Scale. It was aimed primarily at protecting against income expected to be lost as a result of fewer tourists visiting Japan in the aftermath of such an earthquake
• In 2007, Allianz Global Corporate & Specialty issued a USD 150m cat-bond to insure earthquakes in the USA and Canada (excluding California) and floods in the UK. The bond offers a spread of LIBOR + 3.15% and was rated BB+ by Standard & Poor’s.
• The United Services Automobile Association for military personnel (USAA) has already issued 11 cat-bonds. The last one on hurricanes in 2007 amounted to USD 600m. The long track record and good reputation of USAA has led to substantially reduced risk spread premiums for its bonds.

Triggers

With so much capital at stake, the exact moment when a loss will be covered by a cat-bond is determined by pre-established “triggers”. There are a variety of different trigger classes:

• Indemnity trigger: based on the actual loss
• Industry index trigger: based on a percentage of the estimated industry damages
• Parametric trigger: based on physical parameters such as wind speed or earthquake magnitude, sometimes based on an “index” of parameters where parameters from heavily populated areas could for example receive a greater weighting
• Modelled loss trigger: based on expected losses calculated by a specialized modelling firm
• Hybrid trigger: based on two of more of the above

Mechanics of a typical cat bond structure

The sponsor (i.e. the company seeking insurance against the catastrophe) sets up a Special Purpose Vehicle (SPV) as issuer of the cat-bond.  The SPV then issues bonds to the capital markets and puts the proceeds in a collateral account administered by an independent trustee.  The sponsor then enters into an insurance or derivatives contract with the SPV, and pays a premium.

If the insurance event is not triggered during the lifetime of the bond, at maturity the trustee will sell all the assets held in the collateral account and pay back the principal to the investors. If the loss event occurs, the collateral will be sold in the specified amount and be paid-out to the sponsor.

The main driver of cat-bond prices is the loss probability, which normally is modelled by one of the independent modelling companies and not, as in the capital markets, supply and demand.  The pricing of cat-bonds shows some similarities to a defaultable bond, but Cat-Bonds offer higher returns due to the unfixed, binary nature of the catastrophe risk

Portfolio Construction with Cat-Bonds

Cat-bonds can be a valuable source of diversification to portfolios since they tend to be less volatile than corporate bonds with the same rating, and because they are mostly uncorrelated with financial markets as could be seen during the current market-turmoil.  However, it is not clear if the correlation between the stock and the fixed income market with cat-bonds is a zero-beta event, since natural catastrophes of a large magnitude tend also to impact on traditional financial markets.  Additionally, whilst corporate bonds have an almost normal probability distribution, cat-bonds show very high tail risks.

The Future: Cat-Bonds and Public Private Partnerships (PPP)

Cat-bonds could also be used by governments to insure and finance infrastructure (roads, airports, hospitals etc.).  Public entities, consciously or not, decide to retain risk by not insuring infrastructure.  Diverting government funds after a catastrophe may be costly or complicated and is predominantly to the detriment of existing projects. On the other hand, raising debt after a disaster has occurred may be difficult or much more expensive and raising taxes after a catastrophe might lead to a further weakening of an already stricken economy.  “PPP-Cat-Bonds” could make it easier for governments to cope with disaster and help to finance new projects efficiently without necessarily adding to budget constraints.

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

The problem is particularly acute for defined benefit schemes – occupational schemes where the pension benefits are fixed in advance and are often calculated as a proportion of an employee’s final salary. Many often include provision for dependents such as widows and can even be indexed to inflation. These proved to be enormously popular in the aftermath of the Second World War, where many companies saw them as an effective way of deferring compensation for many workers to future years. However, these schemes placed a host of unintended and poorly understood risks with the sponsoring employer, such as exposure to longevity, future interest rates and the capricious whims of financial markets.

Any views on interest rates over the next decade?  The company’s debt financing may have excellent terms and it may seem a moot point, but the pension fund’s liabilities and associated accounting costs will swing violently over the next few decades with the prevailing interest rates. By some estimates, the drop in long-term interest rates from 1999 to 2002 increased the value of pension liabilities by 30-40%.

How about inflation?  Scheme members may have index-linked pensions and the burden of payments can quickly become onerous. Figures from the UK Office of National Statistics show that from 1970 to 2007, annual employer contributions into pension schemes went up 53 times, and trebled over the last seven years alone.

And what about people living longer? For individuals and society, increased longevity is desirable, but living longer can often also create large unanticipated costs. Ever since the German Chancellor Otto von Bismarck thought he’d pulled off a politically brilliant move back in 1889 by promising pensions at 70 when the average German lived to less than 50 years, the continual improvements in life expectancies have rapidly unravelled the best laid pension plans. Even more troubling, the current upwards trend shows little sign of levelling off.

It’s a growing headache for many firms, for whom such risks often lie far from familiar territory and who are charged with looking after a broad church of stakeholders, not just pensioners. Though the increased pension fund liabilities are often longer-term than most corporate horizons, they must be carried on the company’s balance sheet, reducing net asset value and increasing financial leverage. As the corporate sponsor, they generally also have an obligation to fund at least part of these unexpected costs, giving them an uncertain command over their own cash-flow and reducing future distributions to investors as well as impacting the share price.

In the case of General Motors, for example, net obligations are estimated to be about $170 billion across all of GM’s US operations, dwarfing its current market cap of about $5 billion. To meet its soaring obligations, the company contributed an astonishing $30 billion to its US pension plans in 2003 and 2004 but the accounts are still tens of billions of dollars in deficit. Now, pension and healthcare costs make up more of the average GM vehicle’s price tag than the steel used to build it. The result is that the company is inexorably losing ground to a wave of foreign competitors with lower cost bases and less debt on their balance sheets. The result has been a catastrophic decline for investors in stock price from $55 in January 2004 to under $10 today.

New Solutions

These are numbers of little concern to most of the readers on this website. Instead, GDP, the market indices, and FX rates are all far more pressing and important to their day to day jobs.  If it all goes well, having a decent pension at the end of the day is the least of the rewards.

So why care? Because problems demand solutions and where solutions can be found, investors are usually not far behind. Like any other risk, these uncertainties – interest rates, inflation and longevity – can be managed and even reduced once understood.

It’s a market opportunity that astute investors have not missed. A whole industry is springing up in the UK offering so-called pension buy-outs, where the pension liabilities are transferred away to dedicated specialists. In return, these dedicated specialists acquire assets up to the value of the liabilities and seek to manage the whole lot holistically and efficiently.

It’s a win-win situation for everyone. Buyouts can often improve the situation for pension scheme members as these specialist companies are tightly regulated, operate within strict investment and asset-liability guidelines, and have to hold capital against any extreme losses. It also helps troubled sponsors: securing pension liabilities away from balance sheets improves their ability to raise finance. Above all, it enables management to get on with running the business, free from the peripheral distractions of administering a pension scheme.

Since the niche began about 2 years ago, it has taken off in a big way, with the entrants including blue chip financial companies, hedge funds and private equity firms. Some participate directly but most have gone through other vehicles as one of a consortium of backers.

Pension Corporation, for example, raised close to $1.7bn in 2006 from investors including JC Flowers, Swiss Re, Och-Ziff, HBoS, RBS and UBP Private Equity.  That should allow the firm to buyout around $16bn of liabilities.

It may seem a large number but it is a drop in the bucket compared to the potential size of the market. To give you an idea of the scale, the private sector in the UK has some $1.6 trillion of pension liabilities and there are an additional $2 trillion of public sector liabilities on top. So far, all the deals done in the marketplace make up perhaps a mere $20 billion – a fraction of the one-third of trustees that want to buyout within the next decade.

It’s a rapidly growing business and is leading to wide-ranging changes in the way pension funds manage their assets and liabilities. The new mantra is asset-liability management, new strategies for hedging interest rates and inflation, innovative ways of mitigating longevity risk, portfolios run on an absolute return basis and the demand for superior risk-adjusted returns from managers.

In short, pensions are catching up with the rest of the investment community. But that’s a post for another time.

- Bob Swarup, October 3, 2008

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

Most investors are familiar with the concept of beta.  Beta gives us an idea of how the returns of a security are likely to act in the long run given the returns of the broader market (or the returns of a narrow slice of that market).  But that definition assumes that both the security in question and the market in general have bell-shaped normal returns.  Hedge funds tend not to fit neatly into this model.  Instead, they are positively or negatively skewed and tend to have “fat tails”.   So now researchers have come up with new betas that measure how one asset’s variance, skewness and kurtosis (tail-sizes) react to the variance, skewness and kurtosis of other asset classes.  In our monthly spot featuring the thoughts of a CAIA Association member, Mikael Haglund of Altevo Research tells us about how to use these “higher moment betas”.

Special to AllAboutAlpha.com by: Mikael Haglund, CAIA, Founder, Altevo Research

Traditionally, the CAPM and the mean-variance asset allocation approach have been the standard ways of constructing portfolios.  But implementing a similar approach is problematic when hedge funds are included.  Numerous studies have shown that the returns for different hedge fund indexes display non-normal return distributions when longer time frames are studied. Therefore, working with a framework that assumes asset returns are normally distributed can over- or under-estimate downside risks and lead to suboptimal portfolio allocations. 

The standard deviation used as a measure of risk in traditional asset allocation techniques only measures deviations from the mean and puts equal weight to positive and negative deviations from that mean. However, usually preferences are asymmetrical.  The utility derived from a positive result is often less than that derived from a negative result of equal magnitude. One way of accounting for this preference structure and for the non-normal distributions of hedge funds is to use “higher moment betas” in the portfolio construction process.

Higher co-moment diversification benefits include a marginal reduction in portfolio variance, skewness and kurtosis, and can therefore help determine the appropriate hedge fund strategies to include in a portfolio. The overall aim here is to reduce not just the volatility, but the downside risk of the portfolio.

To determine which of the sub indexes that is suitable to use as equity diversifier for the equity part in a traditional portfolio of stocks and bonds we calculate the higher moment betas (for details on how to calculate these measures, see our white paper on the topic available at the Altevo Research website).

Due to the negative skewness seen in MSCI World, we would want to look for a value below 1 in all the higher moment betas presented in this chart.  This would indicate higher moment diversification benefits. As you can see in the chart, Managed Futures, Fixed Income Arbitrage, Equity Market Neutral and Convertible Arbitrage demonstrate the best values of higher moment diversification benefits.  So we use these sub-indices to construct the optimal diversifier for our long-only (MSCI World) portfolio.  When we add progressively more of the diversifier to the long-only portfolio, the result is marked improvement not only in volatility, but also in “Modified Value at Risk”, a measure that also takes into account skewness and kurtosis. 

As we all know, hedge funds have had a tough time during the current credit crisis and Convertible Arbitrage is one of the strategies that suffered the most.  So we thought it would be useful to examine how the higher moment diversification benefits of Convertible Arbitrage have developed during the recent crisis.  As you can see in the chart below, the diversification benefits on extreme risks of including CSFB/Tremont Convertible Arbitrage hedge fund index in an equity portfolio have indeed decreased somewhat (the higher moment betas have risen) but the strategy still demonstrates significant positive diversification effects (higher moment betas remain well below 1.0).

As you can see, accounting for non-normal return distributions in the portfolio construction process can create more stable portfolios and limit the large drawdowns often seen in traditional equity portfolios during bear market periods.  This is especially appealing for investors with defined liabilities, e.g. pension funds, where it can result in a better match between assets and liabilities and thereby limit the risk of the pension plan being under-funded due to decreasing asset values.

- M. Haglund, August 25, 2008

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

With so much interest in commodities, we thought this might be a good time to revisit the rationale for so-called managed futures funds. But as Keith Black, CAIA, of consultant Ennis Knupp + Associates says, commodity investing is about a lot more than buying and holding commodities in hopes that the Chinese continue to buy new cars.

The Case for Commodities

Special to AllAboutAlpha.com by: Keith Black, CFA, CAIA, Associate, Ennis Knupp + Associates

Over the last several years, institutional investors have more than doubled their allocation (to over $200 billion), to financial products whose returns are linked to those of commodity indices. Commodities may be attractive due to: the low correlation between their returns and those of other asset classes, the high correlation of commodities returns with unexpected inflation, and the rising demand for commodities from fast-growing emerging markets countries, such as China and India.

In fact, when you look at the performance of these commodity indices during the best and worst quarters for the Wilshire 5000 (and quintiles in between), you can see that they have produced modestly positive returns in almost all quintiles. In fact, the correlation between commodity indices and other major asset classes is generally below 0.2.

Commodity Beta via Equities

While these indices provide a simple method of gaining commodity exposure, one could always implement their views on commodity prices by investing in equity securities. The prices of these stocks may be somewhat correlated with those of commodity futures. Metals firms include Alcoa and Anglo American, while agricultural firms include Archer Daniels Midland. In the energy sector, stocks such as Exxon-Mobil, Chevron and ConocoPhillips may be used as a crude oil proxy.

But the problem is that existing exposure to equities means commodity-linked equities may not be the best way to express a view on commodity prices alone. To make matters worse, commodity stocks are likely to underperform commodity futures during times of high inflation. When inflation and commodity prices rise, stock prices typically decline, meaning an investor may not actually earn the anticipated return.

The bottom line is that commodity futures are a more direct way to earn the diversifying benefits of commodity investments (especially metals, energy and agricultural commodities) without increasing the stock market risk of the overall portfolio.

Sources of Return

Part of the reason for this is that the total return to a commodity futures index consists of three components: spot return, roll return and yield. The spot return is the return to an investment in physical commodities. The roll return is earned in the process of passively trading (rolling) futures contracts as they mature and must be replaced. The yield is the interest earned on a short-term fixed income investment that is pledged to the futures exchange in order to maintain the collateral required to back the futures investments. As you can see from the table below, the annualized return of the S&P GSCI can be attributed to each of these three components.

But commodity price increases have not exceeded the rate of inflation over long periods of time. As new natural resources are discovered, production technologies improve and research advances in areas such as crop engineering and alternative energy, commodity prices tend to decline in real (after-inflation) terms. So how could commodities futures have offered a total return rivalling that of equities since 1970 if the ownership of physical commodities does not offer a return that exceeds inflation? The answer is in the roll return and the collateral yield, as shown in the chart below.

The roll return and collateral yield can only be earned when investing in commodity futures. The return to commodity futures investments has significantly exceeded that of a direct (spot) investment in commodities over the last 37 years. This is because futures contracts have a finite life. Commodity index investors normally invest in the contract nearest to expiration, which is typically less than three months. In order to maintain a consistent exposure to a given commodity, the investor must purchase a new contract at or before the time of expiration of the current contract. The roll return to a commodity futures investment is earned when the futures position is rolled from the current contract to a later-dated contract.

When a futures curve is in backwardation the investor buys a contract at a lower price, say $70 for the June contract, and sells it at a higher price of $75 when prices rise as the contract nears expiration. Should the curve retain the same shape, with the front month futures trading at a premium to later-dated contracts, the investor will earn a positive roll return as time passes and the June contract becomes the premium-priced front month contract.

Conversely, an upward-sloping futures curve is one in which later-dated contracts trade at a higher price than the current futures contract (contango). Contango markets are undesirable for a commodity futures investor as the return to rolling futures contracts is negative.

The secret behind commodity futures: roll return

Futures markets are likely to remain in backwardation when producers of a commodity desire to hedge the sales price of their commodity production. A positive roll return can be earned when producers view futures markets as insurance and are willing to sell futures at a low price in order to insure against a decline in the commodity price.

The market will continue to offer a positive roll return as long as the demand for producers to sell is larger than the demand from investors or speculators to purchase those contracts. However, over the last two years, investors have funnelled over $50 billion into indexed futures investments and a number of exchange traded funds (ETFs) were launched that invest in oil, gold and silver futures.

The result of this additional demand for investments in commodity futures has served to move many futures markets into contango. The potential to experience a negative roll yield during certain market conditions is one reason why EnnisKnupp does not recommend passive investment in products that track commodity futures indices for most clients. Another reason is that over time, commodity investments have been quite volatile and the returns don’t fit well into a traditional asset valuation framework, such as the Capital Asset Pricing Model (CAPM). Variables such as political strife and weather can have a significant impact on both long-run and short-run commodity prices.

Actively Managed Commodities Funds

Given the drawbacks of commodity-linked equities and commodity futures indices, where does this leave us? It turns out that active management of roll dates and index selection can add significant value in commodity futures markets. For example, in a case where the entire futures curve for a given commodity is in contango, an active manager can choose to reduce or eliminate exposure to that commodity.

In addition, managed futures funds (CTAs) allocate about 25 percent of their assets to commodity markets and 75 percent of their assets to financial markets, including currencies and futures on equity indices, interest rates and bond prices.

Flexibility and the addition of non-commodity futures results in a relatively low correlation between managed futures and (passive) futures indices. Global macro hedge funds, which often trade commodity futures also have a low correlation to futures indices as the table below shows.

Conclusion

Commodity investing is about a lot more than simply hoping commodities will rise over time. After all, the GSCI spot index earned an annual return of only 4.0 percent since 1970, cash returned 5.8 percent and CPI increased by 4.6 percent per year over the same time period. But with so many factors influencing price movements (roll, demand/supply etc.), active commodity management can provide real alpha opportunities.

Ennis Knupp + Associates does not recommend strategic allocations to commodity futures investments. However, we do believe that commodities have a role in the portfolio of plans that value the historic tendency of commodity futures investments to have a higher correlation to inflation and a lower correlation to traditional stock and bond investments.

- Keith Black, June, 2008

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

Editor’s Note: Keith is the author of a more detailed paper on commodities and timberland in institutional portfolios available here at Ennis Knupp + Associates’ website.

In our monthly column featuring the thoughts of a member of the Chartered Alternative Investment Analyst (CAIA) Association, we feature an active publisher in highly rated journals who has recently written an article on weather variables and their impact on financial markets. Wessel Marquering, Ph.D., CAIA, is quantitative researcher at the Talergroup.  Marquering and fellow researcher Ben Jacobson wrote an interesting paper on weather and financial markets for the Journal of Banking & Finance.  What follows are Marquering’s thoughts on the promise and peril of trying to extract alpha from the weather.

Alpha in the Weather: Alternative Viewpoints, powered by CAIA

Special to AllAboutAlpha.com by: Dr. Wessel Marquering, CAIA, Talergroup

As readers of this website are no doubt aware, weather derivatives trading is taking off – with trading volumes going through the roof and more hedge funds venturing into this space. Basically, a weather derivative is a financial product in which two parties agree to exchange cash flows determined by reference to a weather index. The reference indices include temperature, rainfall, wind speed, humidity, snowfall, to name a few, but the most heavily traded contracts are based on temperature indices.

On the one hand, weather derivatives can be used to manage risk, by insuring for example farmers against a bad crop, as an insurance against bad weather on holidays, by decreasing the exposure to temperature-related risk factors, etc. On the other hand, they have become a relatively new way to generate alpha.

These alpha opportunities arise because weather derivatives are difficult to price. And since weather patterns are not random, the Black-Scholes option model is not entirely appropriate. Some hedge funds actually hire meteorologists and run highly quantitative models to forecast the weather in an attempt to identify bargain contracts.  Since the weather is uncorrelated to, for example, sub-prime, Iraq war, etc., they are a great addition to investors’ portfolios.

More…

Regular readers may remember our survey of attitudes toward 130/30 funds last August.  Since that survey, several others (e.g. Merrill Lynch, Vodia Group) have come up with similar numbers – about 15-17% of institutions actively investing in 130/30 and another 25-30% considering investments in the next 12 months.  Today, Kathryn Wilkens tells us of a recent survey of practitioners (members of the Chartered Alternative Investment Analyst Association) on this topic in our regular installment of “Alternative Viewpoints”.

A true advocate of alternative investments herself, Kathryn Wilkens received a Ph.D. in finance at the University of Massachusetts in 1998, and received a Center for International Securities and Derivatives Markets (CISDM) fellowship in 1997.  She was on the CAIAA’s advisory board from the program’s inception in 2002 though 2005, and is now the CAIAA’s Director of Curriculum.

Alternative Viewpoints – powered by CAIA

Special to AllAboutAlpha.com by: Kathryn Wilkens, Ph.D., CAIA, Director of Curriculum, the Chartered Alternative Investment Analyst Association, Amherst, Massachusetts

Last month, 440 CAIA members responded to a survey on 130/30 funds and I presented the results at Terrapinn’s 130/30 conference in Santa Monica.  The survey questions were structured around two main themes frequently discussed here at AllAboutAlpha.com:

• What is the most appropriate benchmark for 130/30 funds?
• What best describes your opinion about 130/30 funds?

When I posed the first question to the attendees at the Terrapinn conference, all but one responded that a standard long-only equity index such as the S&P 500 index or the Russell 2000 is the appropriate benchmark for 130/30 funds.  Yet Dow Jones, Credit Suisse, and S&P have all recently developed 130/30 indices (see related AAA postings Dow Jones joins the 130/30 Index Parade, S&P follows CS into 130/30 index business, 130/30 Indices: True indices or like playing chess against a computer?)  Two of these indices are classified as a type of Strategy Index with another being a so-called fundamental index.

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Every year, pure random chance dictates that exactly half of all investors will outperform the median and half underperform the median.  The Holy Grail of alpha generation, of course, is to outperform more than pure random chance should allow.  In other words, to produce persistent alpha.

In our monthly column featuring the thoughts of a member of the Chartered Alternative Investment Analyst (CAIA) Association, we feature one academic who may have identified a way to uncover such non-random outperformance.  Daniel Capocci, Ph.D., CAIA, is a senior portfolio manager at KBL European Private Bankers, a lecturer at the Luxembourg School of Finance and a Research Associate at the Edhec Risk & Asset Management Center.

Alternative Viewpoints, powered by CAIA

Special to AllAboutAlpha.com by: Dr. Daniel Capocci, CAIA, KBL European Private Bankers

Three fields exist that examine hedge fund performance. The first includes studies that compare the performance of hedge funds with equity and other indices (some authors conclude that hedge funds are able to outperform these indices, whereas others are more cautious in their conclusions).

The second field of hedge fund performance analysis compares the performance of hedge funds with that of mutual funds (where some have found that hedge funds constantly obtain superior performance to mutual funds, although lower and more volatile returns than the reference market indices considered.)

Finally, the third group of hedge fund performance analysis examines the persistence of hedge fund returns.  Persistence is particularly important in the case of hedge funds because the hedge fund industry has a higher attrition rate than mutual funds.

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