Download - Dead Strategies and Other Travails:
Dead Strategies and Other Travails: An Update on Hedge Funds
March, 2005
R. McFall Lamm, Jr. (Ph.D.)Chief Investment Strategist, DB Absolute Return Strategies (ARS)/
Global Investment Management
Deutsche Bank
New York/London
Page 2
Agenda
Flows and cyclical issues
The hedge fund cycle
Strategy-by-strategy update
Flows and Cyclical Issues
Page 4
Smart Money? Stark Differences Remain between Institutional vs. Endowments Market Exposure
Institutions continue to move slowly into alternatives:
Rationale is to correct prior overconcentration in stocks and bonds, underperformance, and new funding pressure. Represents herding behavioral pattern in chasing past returns.
Ivy Endowments Asset Allocation
Equity38%
Hedge funds22%
Bonds18%
Other6%
Real estate7%
Private equity6%
Venture capital
3%
Source: endowment annual reports.
US Corporate Pension Funds: 2004 Asset Allocation
Fixed income29%
International stocks
15%
Domestic stocks
46%Hedge funds
1%Private equity
4%
Other1%
Real estate4%
Source: Greenwich Associates.
Page 5
Smart Money Paranoia: Where to Go Next?
Future Institutional Investor Asset Allocation Shifts
Company stock
Hedge funds
Private equity
Real estate
Fixed income
Intl.stocks (passive)
Intl. stocks (active)
US stocks (passive)
US stocks (active)
-20%
-15%
-10%
-5%
0%
5%
10%
15%
20%
25%
30%
Greater by 2006
Lower by 2006
Source: Greenwich Associates
Endowments and ultra high net worth investors fear the ongoing institutionalization of the alternative market due to its negative effect on returns—to many, the game is over.
There is extreme intellectual fragmentation and a lack of any consensus on where the new investment frontiers are. Many recycled old ideas promulgated as new are dismissed as plain vanilla.
As a result, there is rising pressure on investment professionals.
Alternatives to Public Markets: Growth in Private Assets Under Management
$0.0
$0.2
$0.4
$0.6
$0.8
$1.0
$1.2
$1.4
$1.6
81 83 85 87 89 91 93 95 97 99 01 03
Tri
llio
n
Buyouts and mezzanine funds
Venture capital
Hedge fund assets
Source: Thomson Venture Economics, CISDM, and HFR.
Page 6
New Investment Frontiers or Rediscovery?
Macro issues
Mid-cycle or late cycle
Search for real returns
Dead strategy risk in HFs
Reinflation implications
Emerging markets—profitable growth or not
Small cap vs. micro cap
Global integration inducing rising market correlation
Systematic risk/leverage
Post modern portfolio theory
Higher order moments (asymmetry) optimization
Risk management vs. asset allocation
Strategy allocation or asset allocation
Manager selection vs. indexing
Strategic vs. tactical asset allocation
TIPs as risk-free asset
Alpha transfer or camouflaged beta
New rediscovered assets
Farmland/timberland
Art/collectibles
Oil/gas partnerships
Insurance-linked securities
Real estate
Commodities/currencies
CDOs/derivatives
Value and dividends
Page 7
Life vs. Asset Cycles
Bubbles arise as naïve investors bid up asset prices beyond rationale equilibria.
The process arises due to linear extrapolation of the recent past by inexperienced short-termers.
Elongated business cycles are extending the duration of bubbles. This complicates predicting how long the Ponzi phase can endure.
The Collectible Art Cycle
$0
$50
$100
$150
$200
$250
$300
$350
$400
$450
1 2 3 4 5 6 7 8 9 10 11 12 13
Years into cycle
Beg
inn
ing
yea
r =
100
1997
1982
1965
Mei-Moses Index
Source: AER
Commodity Super-Cycles
-50
0
50
100
150
200
250
1 5 9 13 17 21 25 29 33 37 41 45 49 53 57
Months from trough
Ind
ex
va
lue
, 1
st
mo
nth
= 1
00
50
100
150
200
250
300
350
Re
al
ind
ex
, 1
st
mo
nth
= 1
00
Jan 72
Sept 77
Jan 02
CRB Index
Nominal values (left)
Real values (right)
Real values are obtained by deflating by the CPI. Source: Bloomberg.
Commercial Real Estate Cycles
$80
$100
$120
$140
$160
$180
$200
1 5 9 13 17 21 25 29 33 37 41 45 49 53 57 61 65 69
Months from trough
Ind
ex,
beg
inn
ing
mo
nth
= 1
00
Jul-82
Oct-90
Oct. 02
Equity REIT Price Index deflated by CPI
Source: NAREIT, BLS. Note correlation with business cycle.
The Hedge Fund Cycle
Page 9
Hedge Fund Performance is Largely Derivative
Returns are linked to performance in markets where HF positions are concentrated.
Equity and credit spread returns continue to explain most of the variation in HF performance.
The HF cycle therefore is empirically a direct function of equity market behavior and credit spread developments.
Hedge Fund Performance vs. Stocks and Bonds
-40%
-30%
-20%
-10%
0%
10%
20%
30%
40%
50%
60%
84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
Treas. bonds HF composite
S&P 500 FOFs
Year-over-year returns
Hedge Funds vs. Equity Returns
-30%
-20%
-10%
0%
10%
20%
30%
40%
50%
60%
86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
HF composite
S&P 500
FOF composite
Year-over-year returns
Source: S&P, DB.
Hedge Fund Returns Versus Credit Spreads
-30%
-20%
-10%
0%
10%
20%
30%
40%
50%
91 92 93 94 95 96 97 98 99 00 01 02 03 04
HF composite
FOFs
HY less Treas. return
Year-over-year returns
Source: DB, Bloomberg
Page 10
Alpha Decay and Dead Strategies
Risk-adjusted HF returns are declining:
Attributable to market inflows causing capacity exhaustion.
Some strategies are being labeled “dead” by pundits—eg., equity market neutral, stat arb, convertible arbitrage, and merger arbitrage,
New questions are also being raised about CTAs/managed futures after 04’s large drawdown.
Hedge Fund Return Correlations with Other Market Aggregates
-1.0
-0.8
-0.6
-0.4
-0.2
0.0
0.2
0.4
0.6
0.8
1.0
HF returns vs. S&P
HF returns vs. credit spreads
HF returns vs. VIX
Trailing 24-month correlation
Source: DB, Bloomberg.
Trendline Performance for Selected Hedge Fund Strategies
-10%
-5%
0%
5%
10%
15%
20%
25%
92 93 94 95 96 97 98 99 00 01 02 03 04
Convertible abitrage Equity market neutral Merger arbitrage
Year-over-year returns
Source: index of indexes from EAI, CSFB, HFR, Hennessee, Altvest, VanHedge, and TUNA.
CTA/Managed Futures Returns
-20%
-10%
0%
10%
20%
30%
40%
50%
60%
70%
80%
Year-over-year performance
Source: Average of available indexes from Barclays, TUNA, EAI, and CSFB.
Page 11
Thematics and IssuesHedge Fund Strategy Returns, '03 vs. '04
1.2%
5.8%
3.5%
2.5%
4.5%
17.7%
12.4%
-6.7%
14.9%
3.7%
4.9%
10.9%
3.5%
1.4%
8.8%
-10% -5% 0% 5% 10% 15% 20% 25% 30% 35%
Convertible arb
Fixed income arb
Eq. market neutral
Statistical arb
Merger arb
Distressed debt
Event
Long/short
Short
Emerging market
Discretionary macro
Systematic/CTAs
S&P 500
Treas. bonds
3-mo. Treas.
2003
2004
Source: hedge fund performance based on a compilation of indexes from EAI, CSFB, HFR, Altvest, Hennessee, VanHedge, and Tuna; other data from Bloomberg.
Key industry questions:
Alpha decay—dead strategy risk from inflows and institutionalization reducing risk-taking and entrepreneurial flare.
Indexing appears to be a failure.
Correlation with equity performance continues high—alpha or camouflaged beta?
Hedge Fund Returns
$95
$97
$99
$101
$103
$105
$107
$109
Dec Jan
Feb Mar Apr
May Ju
nJu
lAug
Sep OctNov
Dec Jan
Feb Mar
Dec
. 31,
200
3 =
$10
0
HFRX investable index
SPHG investable index
Industry FOF composite
Industry composite
Source: The monthly composite consists of an average of reported returns from HFR, CSFB, VanHedge, and Hennessee while fund of funds returns are from HFR, VanHedge, and TUNA through October. The November figure is an estimate. The HFRX and SPHG are from HFR and S&P, respectively, through Nov. 30.
Maturing of industry implies returns will come from robust portfolio management: Strategy allocation Manager selection
Distinction from private equity blurring with HFs bidding on new deals.
Page 12
Equity Cycle Considerations
Lessons from Past Cycles: Stock Prices vs. Growth
-40%
-30%
-20%
-10%
0%
10%
20%
0 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
-20%
-10%
0%
10%
20%
30%
40%
Quarters beyond trough
Real GDP, past cycles (left)
Real GDP, current cycle (right)
S&P 500 Index change, past cycles
S&P 500 Index change, current cycle
Average of Past Seven Cycles
Source: Bloomberg
Modest equity returns expected due to:
Stage of cycle—profit growth moderating. Rising interest rates—higher discount factor and cash offering a better substitute. Restrained demand due to post-bubble risk aversion and alternatives attracting funds. Absence of extreme undervaluation.
S&P Change vs. Economic Growth: Stocks Lead Dynamically
-4%
-2%
0%
2%
4%
6%
8%
-8 -7 -6 -5 -4 -3 -2 -1 0 0 0 0 1 2 3 4 5 6 7 8Quarters before (after) recession
-8%
-6%
-4%
-2%
0%
2%
4%
6%
8%
10%
12%
14%
Real GDP (left, annualized)
S&P 500 Index (quarterly)
Average of last seven cycles
Source: Bloomberg
Equity Market Performance Over the Past Five Years
$20
$40
$60
$80
$100
$120
$140
2000 2001 2002 2003 2004
Dec
. 199
9 =
$10
0
S&P 500 Russell 2000 NASDAQ composite
International Emerging markets
Source: Bloomberg
Page 13
Equity Cycle Considerations (Cont’d)
S&P Price to Earnings Ratio vs. 10-Year Treasury Rates
0
5
10
15
20
25
30
35
1960
1963
1966
1969
1972
1975
1978
1981
1984
1987
1990
1993
1996
1999
2002
2005
0%
2%
4%
6%
8%
10%
12%
14%
16%
Price/earnings ratio (left axis)
10-year Treas. Rate (right, inverted)
Source: CEA, DB forecasts.
Monthly Mutual Fund Net Flows
-$70
-$60
-$50
-$40
-$30
-$20
-$10
$0
$10
$20
$30
$40
$50
97 98 99 00 01 02 03 04
Bill
ion
s
-$20
-$10
$0
$10
$20
$30
$40
$50
$60
$70
$80
$90
$100
Equity (left axis)
Bonds (right axis)
Source: Investment Company Institute.
Pension Funding Status of the S&P 500
-$0.5
-$0.3
$0.0
$0.3
$0.5
$0.8
$1.0
$1.3
$1.5
SurplusLiabilitiesAssets
Source: Standard and Poors; DB forecast for 2004.
Short Interest Outstanding Generally Holding Flat Recently
0
2
4
6
8
10
12
14
16
01 02 03 04
Tri
llio
n s
har
es
AMEX
NASDAQ
NYSESource: AMEX, NASDAQ, and NYSE.
Page 14
Equity Cycle Considerations (Cont’d)
US Merger and Acquisition Activity
$0
$500
$1,000
$1,500
$2,000
$2,500
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
$m
illi
on
Total value of deals
Stock vs. Bond Market Risk
0%
5%
10%
15%
20%
25%
30%
35%
40%
74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04
0.0
1.0
2.0
3.0
4.0
5.0
6.0
7.0
S&P volatility
US bond volatility
Ratio (right)
Trailing 24 months
Volcker
'87 crash
Source: Bloomberg.
US New Equity Issuance
$0
$50
$100
$150
$200
$250
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
$bill
ion
Additionals
IPOS
Source: Bloomberg
VIX vs. Realized S&P Volatility
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50%
88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05
Realized trailing 2-year vol
VIX index
Source: VIX from Bloomberg; trailing vol via author's calculations
Page 15
Credit-Spread Cycle: Room to Run
High Yield Default Rates vs. Implicit Default Risk Indicator
1.0
1.2
1.4
1.6
1.8
2.0
2.2
2.4
2.6
89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
Annual default rate (right axis)
High yield/corporate bond yield ratio (left)
Source: Bear Sterns, Merrill Lynch
Fixed Income Asset Correlations with Treasury Securities
-1.0
-0.5
0.0
0.5
1.0
91 92 93 94 95 96 97 98 99 00 01 02 03 04 05
Corporate MortgageAgency High yieldEmerging mrkts. ConvertsTIPS
Source: Derived from Merrill Lynch data.
Trailing 24-months
Credit Spreads: Nearing Mid-90s Levels
0
5
10
15
20
25
92 93 94 95 96 97 98 99 00 01 02 03 04 05
Yie
ld t
o m
atu
rity
(%
)
3-mo. Treas. Treasuries Corporate Mortgage
Agency High yield Emerging mrkts.
Source: Merrill Lynch
Mexican peso crisis
Russian debt default
WorldCom default
Volatility of Fixed Income Asset Classes
1%
10%
100%
91 92 93 94 95 96 97 98 99 00 01 02 03 04 05
Treasuries CorporateMortgage AgencyHigh yield Emerging marketsConverts TIPS
Trailing 24-month standard deviation
Source: Derived from Merrill Lynch data.
Page 16
Forecasts and Strategy-by-Strategy Views
Page 17
Market Views (Absent Shock)
Recent Return History and Forecasts Strategy 01 02 03 04 05F
Hedge fundsConvertible arb. 12.8% 9.2% 11.3% 1.2% 1-2%Fixed income arb. 6.4% 6.1% 6.4% 5.8% 4-6%Equity market neutral 6.5% 1.3% 2.2% 3.5% 1-3%Merger arb. 3.2% -1.8% 8.8% 4.5% 3-6%
Distressed debt 15.0% 4.4% 27.1% 17.7% 6-10%Equity long/short -1.0% -4.4% 19.4% 8.8% 5-8%Discretionary macro 3.8% 1.2% 20.6% 3.7% 4-8%CTAs/mngd. futures 2.5% 16.0% 13.2% 2.9% 5-9%FOF index 3.9% 1.6% 11.7% 6.9% 4-6%HF composite 5.0% 1.1% 17.9% 7.9% 5-7%
Traditional assets Large caps (SPX) -11.9% -22.1% 28.7% 10.9% 6-11% Small caps (RTY) 1.0% -21.8% 45.4% 15.0% 4-14%Convertibles (Merrill) -4.0% -5.0% 25.8% 8.5% 4-5%Bonds (Merrill Treas.) 6.7% 11.6% 2.3% 3.5% 2-3%High yield (Merrill) 6.2% -1.9% 27.2% 10.9% 5-8%Cash (3m Treas. ave.) 3.4% 1.6% 1.0% 1.4% 2.9%
Source of historical hedge fund data: index of indexes from major data disseminators.
Page 18
Low Vol Strategies: Struggling to Beat Cash
Return Contribution from the Convertible Arb Short Equity Hedge
-50%
-40%
-30%
-20%
-10%
0%
10%
20%
30%
40%
91 92 93 94 95 96 97 98 99 00 01 02 03 04 05
-40%
-30%
-20%
-10%
0%
10%
20%
30%
40%
50%
60%
70%
Convertible arb less convertible returns
Russell 2000 returns (right, inverted)
Year over year returns
Source: Merrill Lynch and DB.
Determinants of Convertible Security Returns
-40%
-30%
-20%
-10%
0%
10%
20%
30%
40%
50%
60%
70%
91 92 93 94 95 96 97 98 99 00 01 02 03 04 05
Convertible securitiesRussell 2000High yieldRussell 2000 realized volatility
Year over year returns
Source: Bloomberg, Merrill Lynch
Equity Market Neutral Performance vs. Value/Growth Rotations
-2%
-1%
0%
1%
2%
3%
4%
5%
6%
7%
8%
02 03 04 05
-40%
-30%
-20%
-10%
0%
10%
20%
30%
40%
50%
Equity market neutral (left)
Barra S&P Value Index less NASDAQ
Year-over-year returns
Source: Bloomberg, DB.
Fixed Income Arbitrage Returns vs. Treasury and Corporate Yields
-15%
-10%
-5%
0%
5%
10%
15%
20%
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05
Fixed income arb returns
3-mo. Treasuries
Treasury bonds
Investment grade corporate
High yieldSource: Merrill, DB.
Page 19
Mid-Vol Strategies: Event-Driven Attractive on Risk/Return
Global Merger and Acquisition Activity Rising Again
$0
$50
$100
$150
$200
$250
$300
$350
$400
$450
$500
Bill
ion
s
0
10
20
30
40
50
60
Per
cen
t
Volume (left)
Average premium paid (right)
Source: Bloomberg
Distressed Debt vs. High Yield Bond Returns
-20%
-10%
0%
10%
20%
30%
40%
50%
91 92 93 94 95 96 97 98 99 00 01 02 03 04 05
Distressed debt hedge funds
High yield securities
Year over year returns
Source: Merrill Lynch, DB.
Time-Varying Hedge Fund Strategy Skew
-5.0
-4.0
-3.0
-2.0
-1.0
0.0
1.0
2.0
3.0
88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05
Convertible Fixed income arbMarket neutral Merger arbDistressed Long/shortDiscretionary SystematicS&P 500
Trailing 24-months
Hedge Fund Strategy Volatility
0%
5%
10%
15%
20%
25%
92 93 94 95 96 97 98 99 00 01 02 03 04 05
Convertible Fixed income arbMarket neutral Merger arbDistressed Long/shortDiscretionary Systematic
Trailing 24-months
Page 20
High-Vol Strategies: Equity and Trend Dependent
S&P Managed Futures Index vs. the Euro
950
1000
1050
1100
1150
1200
1250
S&
P i
nd
ex
, D
ec.
31
, 2
00
2 =
10
00
-$0.10
-$0.08
-$0.06
-$0.04
-$0.02
$0.00
$0.02
$0.04
$0.06
$0.08
$0.10
De
via
tio
n f
rom
tre
nd
in
do
lla
rs
Euro (trend deviation, right axis)
S&P managed futures index
Correlation > 90% over past year
Source: Bloomberg.
Equity Long/Short Fund Returns vs. the Russell 2000
-60%
-40%
-20%
0%
20%
40%
60%
80%
86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05
Long/short
Russell 2000
Year over year returns
Source: Bloomberg, DB.
Discretionary vs. CTA/Managed Futures Return Correlation
-0.4
-0.2
0.0
0.2
0.4
0.6
0.8
1.0
1.2
92 93 94 95 96 97 98 99 00 01 02 03 04 05
Trailing 24 months
Source: results of internal analysis
Implicit Stock Exposure Carried by Long/Short Equity Hedge Funds
-40%
-30%
-20%
-10%
0%
10%
20%
30%
40%
50%
60%
70%
92 93 94 95 96 97 98 99 00 01 02 03 04 05
Russell 2000
NASDAQ Composite
S&P 500
Based on trailing 24-month return regressions
Source: Bloomberg
Page 21
Selected References
Lamm, R.M. “Why Not 100% Hedge Funds?” The Journal of Investing, Winter (1999), 87-97.
_____. “How Good Are Equity Hedge Managers,” Alternative Investments Quarterly, January (2002), pp. 17-25.
_____. “Asymmetric Returns and Optimal Hedge Fund Portfolios,” The Journal of Alternative Investments, Winter (2003), 9-21.
_____. “Addressing the Issues and Challenges of Hedge Funds as an Asset Class,” Integrating Hedge Funds into a Private Wealth Strategy: AIMR Conference Proceedings, January (2004), 21-32.
_____. “The Hedge Fund Revolution,” Journal of Financial Transformation, February (2004), 87-95.
_____. Benchmarking Hedge Fund Performance: An Index of Indexes Approach, Deutsche Bank research monograph, January, 2004; updated January 2005.
_____. “Why Not 100% Hedge Funds? Still A Viable Approach” The Journal of Investing, Winter (2004), 12-20.
_____. “The Answer to Your Dreams?” The Journal of Alternative Investments, forthcoming, Spring (2005).
Page 22
Important – Please NoteR. McFall Lamm, Jr. is Chief Investment Strategist, DB Absolute Return Strategies (ARS) / Global Investment Management for Deutsche Bank in New York/London. This document is for discussion purposes only and not available for quotation. The opinions and analyses, including any predictions, expressed herein are those of the author and do not necessarily reflect those of Deutsche Bank. Such opinions and analyses involve a number of assumptions which may not prove valid. Any suggestions contained herein are general, and do not take into account an individual’s specific circumstances or applicable governing law, which may vary from jurisdiction to jurisdiction and be subject to change. Unless you are notified to the contrary, the products and services mentioned are not insured by the FDIC (or by any governmental entity) and are not guaranteed by or obligations of Deutsche Bank. These products are subject to investment risk including possible loss of principal. The past performance of a product or service does not guarantee or predict future performance. No warranty or representation, express or implied, is made by Deutsche Bank, nor does it accept any liability with respect to the information set forth herein. Distribution hereof does not constitute legal, tax, accounting or other professional advice. Recipients should consult their applicable professional advisors prior to acting on the information set forth herein.
Sources for all charts are Datastream, Bloomberg, or Deutsche Bank unless otherwise noted.
All opinions and estimates herein, including forecast returns, reflect our judgement on the date of this report and are subject to change without notice. These opinions and analyses involve a number of assumptions which may not prove valid. The past performance of securities and other instruments does not necessarily indicate or predict future performance.
“Deutsche Bank” means Deutsche Bank AG and its affiliated companies, including Deutsche Bank Trust Company Americas, as the context requires. Deutsche Bank Private Wealth Management refers to Deutsche Bank’s wealth management activities for high-net-worth clients around the world.
Appendix
Page 24
DB Absolute Return Strategies (DB ARS) Overview
• $8.9 billion USD invested in hedge funds assets
• 15 different fund of funds
• Single manager platform with 15 funds
• Over 140 professional with offices in New York City, Summit, NJ, London, Frankfurt and Tokyo
• Fiduciary orientation with focus on risk management
As of January 1, 2005
Page 25
Contact Information
Geoffrey S. Moore, Director
Deutsche Asset Management Canada Limited
(514) 875-5163