Much of the financial calamity of the past couple of years has been pinned squarely on one culprit (that can assume a myriad of forms): complexity.  As far back as early 2008, people were starting to blame complex strategies and financial instruments for the debacle that was unfolding before their eyes.

The Wall Street Journal wrote on February 23, 2008 that:

“The past decade has been the era of the hedge fund, as investors snapped them up for their track record of beating the market with often highly complex trades.  But now, as the credit crunch upends financial markets, that very complexity is coming back to bite some of them.”

Author Richard Bookstaber, an ardent advocate of the “flight to simplicity” (see related post), wrote on his blog last month that:

“Complexity is one of the demons that makes our financial markets crisis prone. Much of the complexity arises in the specter of derivatives and other “innovative” products. To reduce the risk of crisis we must exorcise this demon. We need a flight to simplicity.”

So it’s little wonder that a recent survey by CREATE-Research, the UK-based consultancy showed that institutional investors were boarding the “flight to quality” (report available here with free registration): More…

While government organizations are not generally known for their innovation, in the world of pension management, public plans - particularly national pension plans - have a record of innovation that would make most corporate plans envious.  Regular readers of this website will know that we have a soft spot for two national pension funds in particular, the ones managed by the Swedes and the Canadians (see an excellent case study on the innovative elements of the Swedish plan, for example).

Both plans view portfolio construction as a matter of combining betas, not simply combining different physical securities.  And in both cases, this approach has informed the organizational structure and business processes in the pension management organization itself.

Unlike its Swedish counterpart, the Canadian Pension Plan has been relatively mum about its approach over the past few years (disclosure: I am a member of this plan just in case I don’t get rich by blogging). But now one of its visionaries has penned this interesting case study for the Rotman International Journal of Pension Management.

In it, Don Raymond is Senior Vice-President, Public Market Investments at the Canada Pension Plan Investment Board (CPPIB) explains the $100 billion fund’s rather unique approach.

All About Alpha (and beta and “better beta”)

As you might guess, Raymond et al view the world as either passive (beta), active (alpha) or as something in between they call “better beta” (or what is often referred to on these pages as “exotic” or “alternative” beta).  Writes Raymond: More…

With apologies to Johnny Rivers…

There’s a man who leads a life of danger
To everyone he meets he stays a stranger
With every move he makes another chance he takes
Odds are he won’t live to see tomorrow

Placement agent man, placement agent man
They’ve given you a number and taken away your name

Beware of pretty faces that you find
A pretty face can hide an evil mind
Ah, be careful what you say
Or you’ll give yourself away
Odds are you won’t live to see tomorrow

Placement agent man, placement agent man
They’ve given you a number and taken away your name

It all started a few weeks ago with allegations of kick-backs surrounding the sale of investment vehicles to the New York State Common Retirement Fund.  As The Deal reported earlier this month, “go-betweens” (a.k.a. commissioned placement agents) are accused of surreptitiously linking investment allocations to political contributions.

Reactions: “disclosure” to “outlaw”

The reaction has been swift and has tainted the entire placement (a.k.a. “third party marketing”) industry.  CalPERS came out with a new policy last week governing the use of third party marketers.  In a statement the plan said its new policy would require: More…

As the Financial Times observed today in a piece about “gathering confidence” in the hedge fund industry, “The role of hedge funds in the rebuilding of Wall Street is still being written.”

While this may sound like empty cheer leading, the hedge fund model might actually have a lot to contribute to the success of US corporations - this according to an interesting article by University of Oregon professor Robert Illig (published in the Fall 2008 Alabama Law Review).

Illig argues that the corporate oversight role often ascribed to institutional investors is not being adequately fulfilled since institutional investors (mutual and pension funds) are unable to charge performance fees: More…

IBM’s internal think tank, the “Institute for Business Value” just released a report with the rather heady title “Toward Transparency and Sustainability: Building a new financial order.“  While it sounds like this paper is about corporate social responsibility or Nicolas Sarzoky’s “New World Order”, it’s actually about fundamental trends that affect the asset management industry.  The report is based on a survey of over 2500 individual investors, financial services executives and government officials over the past 6 months.

The report highlights a common theme here at AllAboutAlpha.com: the bifurcation of the asset management industry into beta providers and alpha providers.  Says the report:

“…tomorrow’s winners are most likely to be those firms that specialize, not those that try to do everything, and three specific areas of specialization are likely to emerge. The majority of financial markets firms will concentrate on becoming “beta transactors” - i.e., utilities that provide the infrastructure required to facilitate capital allocation in the same way that water companies provide the reservoirs, purification processes and pipes required to deliver clean water. A smaller number of firms will concentrate on providing advice - e.g., wealth management or mergers and acquisitions advice. And a handful of “alpha seekers” - typically private equity firms, hedge funds and boutique investment houses - will focus on generating high returns from high-risk investments.”

Or, for the more graphically-inclined… More…

Casey Quirk just released its latest treatise on the hedge fund industry and like the previous reports produced by the firm in conjunction with bank of New York Mellon, this one also contains reams of data, charts and thought-provoking brain candy for observers of the alternative investment industry.  It’s definitely worth a read during your evening commute (unless you’re driving, then we suggest waiting until you get home…maybe read it to your kids as a bedtime story).

One of the themes that comes out loud and clear in the report is the continuing dominance of institutional investors.  While this was the result of growing institutional allocations to hedge funds in the 2000-2007 time period, this recent dominance has been thrust upon institutional investors as a result of their loyalty to the asset class.

This chart from the report makes the case in spades:

The majority of the reduction in assets managed by hedge funds over the June ‘08-June ‘09 period is expected to be from high net worth redemptions, not institutional redemptions.  While institutions are forecast to withdraw some capital from hedge funds, they still represent a growing percentage of all HF investors (AIMA recently put this number at over 50%).

This won’t surprise industry watchers over at Citi Private Bank who study the attitudes of the world’s wealthy.  According to a survey published in The 2009 Wealth Report, most of the planet’s high net worth individuals fled hedge funds in 2008: More…

It turns out that in the financial ecosystem, re-using collateral is good for the environment.  This according to a new IMF working paper.

Unfortunately, the demise of Lehman put a crimp in things and discouraged such recycling.  Says the working paper:

“…rehypothecation was acknowledged to be positive for the global financial system, prior to Lehman.” (our emphasis)

The report, titled “Deleveraging After Lehman - Evidence from Reduced Hypothecation” concludes that the practice of rehypothecation dropped off just as hedge funds began to think the unthinkable: what if their own prime broker went belly up?

This is a valid concern.  As The Independent wrote last fall:

“Funds have found that assets such as equities whose recovery from the prime brokerage division should have been straightforward are in doubt because of “rehypothecation”. The small print of the contracts said that Lehman could use the securities itself, including lending them out to short sellers. This meant the assets were reclassified as unsecured, putting them further down the queue for repayment and raising the prospect of big losses. Hedge funds may have up to $70bn in Lehman prime brokerage accounts, with the value of rehypothecated non-cash assets estimated at $22bn.”

The new IMF working paper (by Manmohan Singh of the IMF and James Aitken of UBS) finds that the collateral held by prime brokers that is eligible for rehypothecation fell not just because Lehman bought the farm, but also because clients of other major prime brokers pulled in the reigns - reducing the assets made available for rehypothecation.  As the table from the paper shows, the total rehypothecatable assets held by the largest 4 prime brokers fell from about $3.1 trillion in May 2008 to $1.1 trillion only 6 months later… More…

While global regulators debate what exactly “hedge fund regulation” means, the California Public Employees Retirement System (CalPERS) has taken matters into its own hands.  According to the WSJ, CalPERS has sent a memo to its 37 hedge funds and funds of funds asking for various new terms and conditions on their investments.  The Journal reports that these include preferential terms regarding fees and liquidity that would result from CalPERS investing via separately managed accounts.  Reports the newspaper:

“The pension fund also seeks greater control of its investment funds, saying it would explore opening managed accounts. In that scenario, hedge funds would place Calpers’s assets in a separate bucket from other investors’ assets, so if a fund faces an exodus of investors and sought to freeze redemptions, Calpers wouldn’t be limited from withdrawing its funds.”

Managed accounts have been one of the few bright spots in the hedge fund industry recently as redemption suspensions and “gates” have led investors to examine their options.  Last month, the FT wrote an article on the renewed interest in these custom one-client-only versions of hedge funds (”Hunger Growing for Managed Accounts“).  Reports the FT: More…

Earlier this week several US mega-pensions including Californian behemoth CalPERS (and others) issued a joint statement called “Principles of Financial Regulation Reform: A Model for Change” (PDF of full statement).  One of the five principles outlined in the document pertains to the freedom to invest where ever the pension plans see fit:

“…The ability to invest, consistent with fiduciary responsibilities, in an unconstrained investment opportunity set is critical to enable public pension funds to meet their obligations. Any limitations on the universe of available investments will potentially reduce the ability of these funds to generate the needed returns and may increase the risk of the plan.”

Given the preponderance of equity risk in today’s pension portfolios, some say that fiduciary responsibilities should not only provide the “flexibility” to invest in an “unconstrained investment opportunity set”, but the requirement to do so.  It used to be that investing off-piste would give the corporate counsel a case of hives.  Now, its beginning to look like any outright dismissal of alternative investments runs the risk of landing trustees in hot water.

Despite last year’s negative returns, hedge funds’ dramatic out-performance over equities (now pushing 40% over the last 12 months) and their diversification properties mean that many institutional investors are still drawn to the sector.  That continued interest probably helps explain the recent finding that over half of remaining hedge fund investors are institutions.

(Hedgefund.net later confirmed with CalPERS that the “unconstrained opportunity set” did, in fact, include hedge funds and private equity.)

New York State Common Retirement Fund, one of the signatories to the statement, recently increased its own internal limit on alternatives and shows no signs of decreasing it.  Crain’s New York Business reports: More…