Today, we bring you another installment of our “Summer of 1,000 posts” (more…)

This week’s sampling from our archives covers the topic of Hedge Fund Industry Trends…

HF managed accounts may not be no-brainer.  May require quarter - maybe half - a brain after all. Hedge fund managed accounts used to have only “limitations”.  Now they have “drawbacks”…

A three-way battle for supremacy in Hedge Fund Industry 2.0 Hedge funds, mutual funds, and pension funds seem to be positioning themselves for the “renaissance” in Hedgistan.

Does HF “enlightenment” actually herald an end to the industry as we know it? A column in the FT compares the current state of the hedge fund industry to the e-business industry circa 1999.  Do the uncanny parallels between the two industries mean we can now predict what’s to come? More…

By Michael Newman, CAIA (AllAboutAlpha.com Editorial Board) Recently the Financial Times reminded us what a challenging time the private equity industry is facing by highlighting Coller Capital’s semi-annual Private Equity Barometer.  The Barometer is a survey collected from approximately 120 institutional investors with allocations to private equity.  Coller, as a secondaries specialist, is keen to discern the sentiment and expectations of private equity investors as it has a direct impact on their own opportunity set within the secondary market for private equity investments.  However, in reporting on the survey results, the FT focused almost exclusively on the possibility of defaults and the continuing difficulties private equity faces:

One in 10 investors in private equity are likely to default on commitments to invest funds in the next two years, research has suggested.  The findings underline the scale of challenges facing the sector as it scrambles to adapt to a harsh new environment of falling returns, cash-strapped investors and a backlash from regulators and politicians.

However, in looking at the details of the survey, not all is doom and gloom for the private equity industry.  Moreover, there are some bright spots that institutional investors in private equity, both old and new, should focus on as they look to continue their commitment to the asset class.

Is Private Equity Here To Stay?

Another eye grabbing data point from the survey is that over 20% of surveyed investors expect to decrease their private equity allocations.  But is this really any surprise?  With equity markets still down 40% from their peaks, it’s only logical that institutional investors must re-balance their portfolios.  With private equity valuations generally lagging the market, it’s logical that pension managers would feel over exposed and decrease future asset allocations in the near term. More…

Linear regression models (a.k.a. factor models) have a number of emerging applications in the hedge fund industry.  One of the most often-cited here and elsewhere is hedge fund replication (see related posts).  But as we discovered recently, regression-based models can also be used to estimate the daily returns occurring between monthly hedge fund reporting cycles (see related post).  In addition, MIT’s Andrew Lo has proposed several other applications of linear factors models to address situations such as transitioning between managers and portfolio rebalancing for risk management purposes (see related post).

Now Lo has teamed up with Alexander Healy of Alpha Simplex Group (the company with which Lo is closely affiliated) and proposed yet another application of this truly alpha-centric approach to portfolio management: dealing with redemption gates.

The two suggest that when hedge fund investors are confronted with redemption gates, they can essentially remove their economic exposure to many of the underlying hedge fund betas in much the same way an executive can monetize un-vested stock options.  By basically shorting the basket of betas that make up the returns of lock-up hedge fund allocations, investors can reduce volatility dramatically and in some cases, even increase returns (i.e., if the alternative betas in question temporarily deliver negative risk premia).

Drawing on a knack for colourful metaphors, Lo says this is not unlike the strategy taken by the drugs often prescribed to those with high blood pressure: More…

Although the mainstream financial media now routinely ridicules “exotic” investment strategies such as portable alpha, institutional interest in managing alpha and beta separately has not gone away.  As we have reported on these pages, portable alpha strategies performed poorly in 2008 not because there was anything wrong with the concept, but because the supposedly-uncorrelated alpha sources happened to keel over and die along with the market.  As a result, portable alpha investors lost money on the beta side and the alpha side.

Sophisticated investors are well aware that the real culprit was the questionable uncorrelation of the funds of funds often used as an alpha source - not portable alpha per se.  An interesting paper by Rob Brown of Benchmark Plus Management makes the case that portable alpha will experience a “rebirth” and will eventually become “dominant” and “commonplace”.  (available here in P&I’s white paper library)

Writes Brown: More…

On November 25, the Pennsylvania State Employees Retirement System (SERS) announced its Q3 results.  Public pensions across the US issued similar press releases detailing the Q3 carnage.  But what makes this pension plan different is its widely publicized use of portable alpha (see our April 2008 post.)  As a result, the media has been quick to associate the fund’s losses with the “aggressive“, “exotic” and “unusual” investment strategy.  To be sure, it appears that portable alpha cost the plan in Q3.  But is that an indictment of the portable alpha architecture per se?  We’re not so sure.

The Wall Street Journal reports that:

“The blowup is yet another example of the wide-ranging damage caused by sophisticated investment strategies peddled to pension funds and other institutional investors when the stock market was soaring.”

Pennsylvania SERS reportedly lost $1.5 billion on swaps used to gain market exposure.  These swaps allowed the plan to get the exposure it wanted without having to allocate as much capital (i.e. it only had to post margin on the swaps).  It then invested the savings in “absolute return” funds (funds of hedge funds in this case).  According to media reports and the plan’s own press release, it appears that it lost on both the swaps AND the absolute return funds in Q3.

More…

Okay.  So the truth is out, hedge funds have long equity exposure.  Our back-of-the-envelope analysis of the HFRI Index last week showed that all strategies - particularly “Equity Hedge” had a positive correlation with equity markets.

So what can an investor seeking truly uncorrelated returns do about this?  After all, it’s quite possible that a hedge fund could produce alpha, but deliver it to investors with a side helping of over-priced beta.  Short bias managers, for example, are often said to produce a positive alpha even though they lose their shorts year after year.  It’s cases like this that make the term “absolute returns” a misnomer (see related post).

A new paper by the Edhec Risk and Asset Management Research Centre illustrates the ways that a fund of hedge funds can mitigate itself from these not-so-hidden factor exposures.

To begin with there’s that pesky equity exposure.  The following graph from the report shows the contribution of the MSCI World (blue line) to the volatility of the HFRI Fund of Funds Index:

More…

Is the quest for alpha a religion?  In some ways, it just might.  This according to The Economist last week.  Says the magazine (sorry, “newspaper”):

“The concept of alpha is a slightly metaphysical one and resembles the “God of the gaps” familiar to Victorians. Traditionally, people were inclined to attribute natural phenomena such as earthquakes and plagues to God; eventually they discovered plate tectonics and bacteria. The role of God was steadily diminished to that which people could not explain by other means.”

Separating the secular (beta) from the spiritual (alpha) has been the mantra not only of liberal democracies, but also of a new breed of investor.  Hedge funds find themselves at the center of this metaphysical revolution, not because they simply aim to make “absolute returns”, but because they (claim to) have taken a vow of beta-celibacy.  Continued The Economist:

“In a way, hedge funds, by virtue of their complex strategies, are one of the main perceived repositories of alpha left in the market (the average traditional fund underperforms the market, after fees).”

In an attempt to repent for their historical portfolio management sins, institutional investors such as pension funds aren’t just looking to hedge funds for short term gratification, but they are looking to them for something deeper - something to balance out the day to day ups and downs of beta.

Unlike many traditional religions, the alpha-centric religion is flourishing in both North America and in Europe.  Citywire, a London-based online publication wrote in August: More…

Axing investment managers is nothing new for institutional investors.  So initially we didn’t see anything particularly interesting about this story in P&I about how the pension fund for Massachusetts teachers and public employees was dumping a few of its underperforming managers.

But when we took a closer look, it was apparent that something else was at play here.  P&I reports that this move was actually a “strategic shift in the $50.6 billion system’s domestic equity program to index funds and portable alpha”. In other words: a shift out of traditional “pre-packaged” alpha and beta and into a bifurcated alpha/beta program.

A third of the freed-up capital was immediately reallocated to three portable alpha managers and two-thirds was destined for an index fund.

But the story gets even more interesting.  Bridgewater, a company we applauded for not messing around when it came to portable alpha, was actually fired in the shake-up.  Why?  Remember a couple of years ago when we told you about the firm’s plan to drop clients that didn’t want to move to a portable alpha strategy?  Well, apparently, Mass PRIM let them do just that.  According to P&I, the pension said “no way” to a pure alpha mandate and it promptly showed Bridgewater the door…

“Bridgewater Associates, which ran $591 million in global inflation-linked bonds, including an allocation to commodities via swaps, was terminated after the board rejected its request to change the portfolio to a pure alpha strategy. Bridgewater’s offer to wind it down over the coming 12 months was turned down; Mr. Mavromates said PRIM decided it didn’t want someone who wasn’t interested in managing the strategy over the long term to look after it for the coming year.”

It appears Bridgewater’s Ray Dalio wasn’t kidding.

With its (appropriate) focus on generating returns, the asset management industry tends not to spend inordinate amounts of time on introspection - on the way firms in the industry management and organize themselves.  As management consults are fond of saying “form follows function”.  That’s consulting-speak for “structure follows strategy”.

A great example of an organization that realizes the holistic implications of alpha/beta separation is Sweden’s AP7, one of the country’s many so-called “buffer funds” designed to fund the retirements of its citizens.  Regular readers may recall AP7 and its forward-thinking CIO Richard Grottheim.  As we reported in January, AP7 has recently awarded what it calls “pure alpha briefs” that are essentially notional overlays applied to the fund’s passive portfolio.

A few weeks ago, Grottheim and colleagues including one from the Stockholm School of Economics, revealed how AP7 is set up to undertake this kind of innovation in a new white paper.  In this paper, Grottheim and friends propose an org. structure that they say shows “not only significant improvement in portfolio performance, but also a more transparent and cost efficient portfolio structure.”

More…