1
Introduction to:Hedge Funds and Fund of Hedge FundsAugust 2005
by
Pension Consulting Alliance, Inc
2
Introduction
Characteristics and Attributes
Performance and Volatility
Program Design
Discussion of Hedge Funds
3
In 1949, Alfred Jones established the first hedge fund in the US.
hedged against the likelihood of a declining market.
based on the premise that performance depends more on stock selection than market direction
utilized two speculative tools to implement his strategy: short selling and leverage
used leverage to obtain profits, but employed short selling through baskets of stocks to control risk
Today, a “hedge fund” is much more broadly defined
compensated primarily on the fund’s performance
seek superior returns relative to risk by utilizing a broad spectrum of investment styles, hedging strategies and financial instruments that have low or no market risk
do not have to be registered with the Securities Exchange Commission (SEC)
not be advertised or offered to the general public
Discussion of Hedge FundsIntroduction
4
Hedge funds are not an asset class
is a type or style of asset management
– normally skill based not homogenous (not many common factors)
Hedge funds are commonly considered alternative investments because they:
are privately structured and limited to “sophisticated” investors
can contain significant financial leverage and contain other risk factors– financial leverage (use of margin accounts and short-term loans)– instrument leverage (use of derivatives that magnify returns)
span a broad array of high risk strategies, producing highly volatile returns
exhibit return behaviors that can be independent from other asset classes
Discussion of Hedge FundsIntroduction
5
Arguments of hedge fund investing
Pros:
– low correlation to other major asset classes
– potential for high returns
– claim ability to add value throughout market cycles
Cons:
– high dispersion of returns
– lack of transparency
– concerns of fraud
– highly unregulated
– higher fee structures
Discussion of Hedge FundsIntroduction
6
Characteristics:
Not publicly-traded
Investment returns do not behave like public market counterparts
Eclectic strategies
Less transparency
Discontinuous valuation processes
Loss of management control of investment capital
Very high fees / costs of management
Roles:
Achieve higher investment returns than publicly-trade assets due to illiquidity
Markets are large and private: choppy information flow leads to exploitable inefficiencies / potential to add significant value
Secondary role: incremental diversification
Discussion of Hedge FundsCharacteristics and Attributes
7
Lack of disclosure
regulators require that hedge funds do not promote their services
– result: an unclear picture of industry performance
hedge funds disclose only limited amounts of investment data
– fund’s current investors have incomplete knowledge fund investments
summary: hedge fund managers compelled to withhold information
however, activities are increasingly becoming subject to regulation
There is a huge amount of survivorship bias in the industry
it is estimated that 20% of hedge funds fail each year
survivorship bias skews industry performance statistics
Discussion of Hedge FundsCharacteristics and Attributes
8
Higher costs
commonly 2% management fee with a 20% performance fee
fund-of-funds commonly add an addition 1% management fee and a 10% performance fee
Lower liquidity, commonly:
quarterly or semi-annual redemptions with restrictions
one-year “lock-up”
however, more liquid than other alternative investments (i.e. private equity, real estate, etc.)
in addition, monthly subscriptions provide greater flexibility
Range of performance targets
absolute return targets (i.e., 10%-20% per year)
relative return targets (i.e., T-Bills + 5% over a market cycle)
Spectrum of investment strategies and approaches
Discussion of Hedge FundsCharacteristics and Attributes
9
Hedge Funds
Typically limited partnership ranging from $10 million to $5 billion
Limited partners typically make one-time capital contribution
After “lock up” period, limited partners can access capital
Very wide array of strategies, including taking short positions
May invest in both public and private vehicles
General partners compensated by ongoing fee plus proportion of profits
Discussion of Hedge FundsCharacteristics and Attributes
10
Hedge funds have exhibited significant growth
estimates vary significantly
from approximately 300 funds in 1990 to more than 7,000 today
– some estimate up to 8,000
estimated to be near $900 billion in capital, before leverage
pace of commitments to hedge funds continues to accelerate
Concern: too many assets flowing into management style/approach
Capital Allocated to Hedge Funds
0
100
200
300
400
500
600
700
800
900
1000
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Q32004
$ B
illio
ns
Discussion of Hedge FundsCharacteristics and Attributes
Source: Hedge Fund Research, Inc.
11
Manager styles can be organized by market exposure
Source: UBS Warburg, “In Search of Alpha”
Discussion of Hedge FundsCharacteristics and Attributes
Hedge Fund Styles
Relative Value Event-Driven Opportunistic
Convertible arbitrage
Fixed income arbitrage
Equity market neutral
Risk arbitrage
Distressed securities
Macro
Long region industry or style
Emerging markets
Long/short equity
Short sellers
Market ExposureLow High
12
Strategies Definition Relative Value Convertible Arbitrage Invests in the convertible securities of a company. A typical investment is to be long the convertible bond and short the
common stock of the same company. Positions are designed to generate profits from the fixed income security as well as the short sale of the stock, while protecting the principal from market moves.
Fixed Income Arbitrage Fixed income arbitrage managers seek to exploit pricing anomalies within and across global fixed income markets and their derivatives, using leverage to enhance returns. In most cases, fixed income arbitrageurs take offsetting long and short positions in similar fixed income securities that are mathematically, fundamentally or historically interrelated. The relationship can be temporarily distorted by market events, investor preferences, exogenous shocks to supply or demand, or structural features of the fixed income market.
Equity Market Neutral Equity market-neutral is designed to produce consistent returns with very low volatility and correlation in a variety of market environments. The investment strategy is designed to exploit equity market inefficiencies and usually involves being simultaneously long and short matched equity portfolios of the same size within a country. Market neutral portfolios are designed to be either beta or currency-neutral or both. Equity market-neutral is best defined as either statistical arbitrage or equity long/short with zero exposure to the market.
Event Driven Risk Arbitrage Risk arbitrage (also known as merger arbitrage) specialists invest simultaneously in long and short positions in both companies
involved in a merger or acquisition. In stock swap mergers, risk arbitrageurs are typically long the stock of the company being acquired and short the stock of the acquiring company. In the case of a cash tender offer, the risk arbitrageur is seeking to capture the difference between the tender price and the price at which the target company’s stock is trading.
Distressed Securities Distressed securities funds invest in the debt or equity of companies experiencing financial or operational difficulties or trade claims of companies that are in financial distress, typically in bankruptcy. These securities generally trade at substantial discounts to par value. Hedge fund managers can invest in a range of instruments from secured debt to common stock. The strategy exploits the fact that many investors are unable to hold below investment grade securities.
Opportunistic Macro Macro hedge funds pursue a base strategy such as equity long/short or futures trend following to which large scale and highly
leveraged directional bets in other markets are added a few times each year. They move from opportunity to opportunity, from trend to trend, from strategy to strategy.
Short Sellers The short selling discipline has an equity as well as fixed income component. Short sellers seek to profit from a decline in the value of stocks. In addition, the short seller earns interest on the cash proceeds from the short sale of stock.
Long Region, Industry, or Style
Traditional equity fund structured like a hedge fund; ie, uses leverage and permits managers to collect an incentive fee. Focus of the fund could be a specific geographic region (i.e., Japan) , industry (i.e., technology) or style (i.e., growth)
Emerging Markets Emerging market hedge funds focus on equity or fixed income investing in emerging markets as opposed to developed markets. This style is usually more volatile not only because emerging markets are more volatile than developed markets, but because most emerging markets allow for only limited short selling and do not offer a viable futures contract to control risk. The lack of opportunities to control risk suggests that hedge funds in emerging markets have a strong long bias.
Long/Short Equity Long/short strategies combine both long as well as short equity positions. The short positions have three purposes, which can vary over time or by manager. First, the short positions are intended to generate alpha. This is one of the main differences when compared with traditional long-only managers. Stock selection skill can result in doubling the alpha. A long/short equity manager can add value by buying winners as well as selling losers. Second, the short positions can serve the purpose of hedging market risk. Third, the manager earns interest on the short as he collects the short rebate.
Discussion of Hedge FundsCharacteristics and Attributes
13
Breakout of Hedge Fund Industry by Major Strategy Type
Long/Short34%
Event Driven19%
Global Macro10%
Convertible Arb.6%
Market Neutral5%
Fixed Inc. Arb.7%
Other10%
Em. Mkts.4%
Mng. Futrs.5%
By Assets(as of 12/31/04)
Market dominated by Long/Short, Event Driven and Global Macro
Discussion of Hedge FundsCharacteristics and Attributes
Source: TASS Asset Flows – January 1994-December 2004
14
There are several risks unique to hedge funds: disclosure risk (i.e. lack of transparency)
partnership mortality risk (average life of partnership - 3 yrs.)
financial leverage risk (mitigated to some degree by ERISA)
return dispersion risk
Other risks: event risk
– correlations tend to increase during global shocks
manager selection risk
– more critical with hedge funds than anywhere else
complexity risks (of process, of transactions, of securities)
personnel risks (hedge funds are usually run by smaller firms)
asset growth (too large an asset base threatens nimbleness)
liquidity risk
fraud risk
Fund of funds manage these risks
Discussion of Hedge Fund of FundsSummary of Characteristics and Attributes
15
At first blush, hedge fund strategy returns appear compelling…
…however, several key nuances must be taken into account
performance not an asset class, but a universe – issue: significant survivorship bias
Cumulative Returns: Stocks, Bonds, and Hedge Fund-of-Funds
0.8
1.3
1.8
2.3
2.8
3.3
3.8
4.3
Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05
Gro
wth
of
$1
CSFB/Tremont Hedge Fund Index LB Agg S&P 500
Notes:
Stocks: S&P 500, Bonds: Lehman Aggregate, Hedge Fund of Funds: CSFB/Tremont Hedge Fund Index.
Sources: CSFB/Tremont, ITI.
Discussion of Hedge FundsPerformance and Volatility
16
Source: Altvest, CSFB/Tremont, Hennessee
Return vs Risk(latest 3 Years ending 12/31/04)
-10.0%
-5.0%
0.0%
5.0%
10.0%
15.0%
20.0%
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% 18.0%
Annual Standard Deviation
Ann
ual R
etur
n
Market Neutral
Macro
Emerging Mkts
Short Biased
Distressed Only
Opportunistic
Convertible Arb.
Merger Arb.
Strategies have a spectrum of risk and return characteristics
difficult period for short biased strategies
Discussion of Hedge FundsPerformance and Volatility
LB Aggregate
MSCI EAFE
S&P 500
17
Discussion of Hedge FundsPerformance and Volatility
Source: Altvest, CSFB/Tremont, Hennessee
Return vs Risk(latest 5 Years ending 12/31/04)
-10.0%
-5.0%
0.0%
5.0%
10.0%
15.0%
20.0%
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% 18.0%
Annual Standard Deviation
Ann
ual R
etur
n
Market Neutral
Macro
Emerging Mkts
Short Biased
Distressed Only
Opportunistic
Convertible Arb.
Merger Arb.
Significant improvement for short biased strategies
reflective of market cycle
LB Aggregate
S&P 500
MSCI EAFE
18
Dispersion of Returns - Actual Dispersion of Managers
Source: Altvest, Nelsons, PCA
45.8
29.9
16.6
36.9
68.9
27.7
15.1
39.6
120.1
26.4
-4.5
-18.1
0.0
-8.9
-53.5
-0.9-5.3-20.1
-54.2
-11.9
-80
-60
-40
-20
0
20
40
60
80
100
120
140
MarketNeutralFunds
Long/ShortFunds
Macro Funds MergerArbitrage
US EquityManagers
MarketNeutralFunds
Long/ShortFunds
Macro Funds MergerArbitrage
US EquityManagers
One Year Five Years
Dispersion of Manager Returns Comparison - Periods ending 12/31/04(selected Hedge Fund categories)
Dispersion of hedge manager returns often greater than equity managers
Market neutral manager returns widely dispersed
notion of “consistent alpha” not evident
Merger arbitrage managers most consistent, long/short managers least consistent
Significant survivorship bias evident
Universe Participants55
Discussion of Hedge FundsPerformance and Volatility
31109 4151 30800 6894821011
An
nu
aliz
ed R
etu
rns
(%)
19
Hedge fund-of-funds provide:
manager selection and monitoring
portfolio construction
– customized, strategy-oriented, blind pool
risk management
diversification
– combining various strategies can result in a desired spectrum of risk/return options
Additional layer of fees
commonly 1% management fee and 10% incentive fee
– in excess of underlying managers’ fees
highly dependent upon return objective
Limited liquidity
Limited transparency
Discussion of Hedge FundsHedge Fund-of-Funds
20
Return vs Risk(latest 5 Years ending 12/31/04)
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
14.0%
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% 18.0%
Annual Standard Deviation
Ann
ual R
etur
n
Discussion of Hedge Fund of FundsPerformance and Volatility
Fund-of-funds exhibit attractive risk/return characteristics
Source: Altvest, CSFB/Tremont, Hennessee
Market Neutral
Macro
Emerging Mkts
Short Biased
Distressed Only
Opportunistic
Convertible Arb.
Merger Arb. Directional Fund-of-Funds
Event Driven Fund-of-FundsRelative Value Fund-of-Funds
21
Dispersion of Returns - Actual Dispersion of Fund-of-Funds
Source: Altvest, PCA
25.6 19.613.1
50.0
22.925.6
0.0
-8.1
4.6-5.3-3.1-2.1
-80
-60
-40
-20
0
20
40
60
80
100
120
Relative Value Event Driven Directional Relative Value Event Driven Directional
One Year Five Years
Dispersion of Fund-of-Fund Returns Comparison - Periods ending 12/31/04(selected Hedge Fund categories)
Dispersion across hedge fund-of-funds still significant
however, lower than most single-strategy funds
fund-of-funds selection still critical
Strategy specific fund-of-funds exhibit lower dispersion
Universe Participants360 1955 157152 69
An
nu
aliz
ed R
etu
rns
(%)
Discussion of Hedge Fund of FundsPerformance and Volatility
22
significant dispersion among fund of funds
there is potential of missing return objectives by a material margin
– defining return objectives and manager selection is critical
Annual Dispersion of Fund of Hedge Fund Returns
84.2 81.3
116.1
51.1
18.6
128.9130.4
58.7
43.852.3
64.971.572.6
60.4
30.0
-14.9-13.9
-30.3-28.1-19.1
-61.8
-13.1
-45.5-40.3
-2.1-9.15.9
-6.0-0.1-2.7
-100
-50
0
50
100
150
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
Sources: Altvest, PCA
Dispersion of Returns – Calendar Year ResultsA
nn
ual
Ret
urn
s (%
)
Discussion of Hedge Fund of FundsPerformance and Volatility
23
Three general approaches:
include as a segment of an existing asset class :
– commonly a segment of the Alternative Investment asset class
adds consistency and some liquidity to otherwise privately-held strategies
– also could replace equities, fixed income, cash, etc
– depending upon targeted risk and return objectives
treat as a new asset class:
– allocation has to be material to have impact
– allocation level typically relies on optimization techniques
– key role is largely as diversifier versus other asset classes
– strategies with higher return objectives have higher exposure to underlying asset classes (i.e., more “directional”)
an alpha “overlay” to existing asset classes
– must be material to have impact within overall asset class portfolio
– utilizes significant amount of highly liquid derivatives to obtain market exposure
– assumption of “zero beta” to underlying asset class returns
Implementation ApproachesProgram Design
24
At least 10% of Alternative Investments
large enough to be worth the cost/effort and impact results
If funded out of Alternative Investment segment hedge fund of funds could take capital from higher-return / higher-risk strategies
commitments to future private equity opportunities could decline
alternatively, hedge fund of funds could be used as “holding place” for future commitments
Requires enhancement to private equity portion of policies / guidelines
key function is providing liquidity; will also act as return stabilizer
absolute return objective
manager guidelines
Utilize either hedge funds or fund of hedge funds
depending upon resources, objectives and diversification needs
Implementation- Segment Approach Program Design
25
Determine allocation to absolute return strategies during asset allocation / asset-liability review
Allocation at least 5%, possibly more
of sufficient size to impact results
dependent upon assumptions utilized in optimization process
Requires establishment of appropriate policy documents / guidelines
asset class definitions, parameters, and benchmarks
absolute return objective
manager guidelines
Utilize either hedge funds or fund of hedge funds
depending upon resources, objectives and diversification needs
Implementation– New Asset Class ApproachProgram Design
26
Concept: attaching added value that is uncorrelated to an asset class to an existing passive asset class portfolio
takes advantage of higher information ratios in absolute return areas
passive asset class portfolio is likely to be a combination of cash and futures
Caveats:
creating synthetic passive portfolios is not costless
alpha may, in fact, be correlated to asset class(es)
Areas of application:
publicly-traded asset classes (heavy depth/breadth of futures markets)
Utilize either hedge funds or fund of hedge funds
depending upon resources, objectives and diversification needs
Implementation– Portable Alpha ApproachProgram Design
27
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Plan Assets
Establish Portable Alpha program to achieve an excess return at Total Portfolio level
Portable Alpha Program Portable Alpha Program
90% invested in Hedge funds
10% provides 100% of market exposure via Futures
200bp to 300bp excess over cash return
asset class return
Domestic Publicly-traded
Assets
Private Assets
International Publicly-traded Assets
MORE COSTLY TO HEDGE
TOO COSTLY TO HEDGE
ASSETS USED
ALLOCATION of ASSETS USED
Implementation– Portable Alpha ApproachProgram Design
28
Implementation– Hedge Fund of Fund SelectionProgram Design
$1,531 domestic publicly-traded
assets
Next steps across all strategic options: Manager Selection and Portfolio Construction
Up to 8,000 hedge fund managers
600 – 800 hedge fund of fund providers
Due diligence effort analogous to private equity asset class
On average, the typical hedge fund of fund contains more than one dozen individual hedge funds
– multiple managers with complementary strategies may be combined
Hedge fund of fund costs are significant: “2 & 20” at fund level + “1 & 10” at fund of fund level
Depending on option: different structures, different objectives, different funds
29
Manager selection and monitoring is crucial
due diligence and monitoring of managers should cover, at a minimum:
– people and organization
– investment strategy
– investment selection process
– portfolio construction process
– risk management procedures
– valuation guidelines and procedures
– investment terms
Implementation– Hedge Fund of Fund SelectionProgram Design
30
Rationale for outsourcing hedge fund management (i.e. fund of hedge funds)
risk management
expertise
cost/resource requirements
diversification
one or more fund-of-fund could be utilized
– varied by strategy and manager
Implementation– Hedge Fund of Fund SelectionProgram Design
31
Program construction a function of various factors
risk./return objectives
– low risk/return vs. high risk/return
– directional vs. non-directional
available resources
– Internally managed vs externally outsourced
– hedge funds vs. fund of hedge funds
diversification targets
– number of managers
– exposure across investment strategies
Implementation– Program ConstructionProgram Design
32
Variety of investment strategies
not homogeneous
differing risk profiles and return spectrums
Multiple approaches to implementation
can incorporate into different segments of the Portfolio
– dependent upon return objectives and risk tolerances
Program construction dependent upon specific needs
requires significant resources to source, research, and monitor investments
a function of the selected implementation approach
Discussion of Hedge FundsConclusions