hedge funds for the 2010s
DESCRIPTION
Barcelona GSE Financial Institutions Seminar: Drago Indjic Quantitative Investment Manager and Technologist Investment Manager, Blue White Alternative Investments; Project Manager, Hedge Fund Centre (London Business School) More information about Barcelona GSE Financial Institutions Seminars: http://j.mp/BGSEFinSems Any opinions, findings, and conclusions or recommendations expressed in this material are those of the author(s) and do not necessarily reflect the views of the Barcelona GSE or those of the home institution of the author(s).TRANSCRIPT
Hedge Funds for 2010sDr Drago Indjic
London Business SchoolSunningdale Capital LLP
15 January 2009GSB Barcelona, Uni. Pompeu Fabra,
Warnings
• The views are my own– Not Sunningdale Capital LLP, London
Business School etc• Biases
– By a “quant”, not an economist– Instant history bias
• Length is only two hours (or less)
Contents
• Status– Some numbers– Regulation
• Quick Introduction– “User manual”– Structure rather than composition
• Trends• Q & A
Alternative Investments• Many definitions ...
– Valuation and liquidity: no secondary market• Search for uncorrelated, “absolute” returns
– “absolute” (“cash + x”) objective ≠ tracking index • Many leading funds allocate to alternative
investments– Not just real estate or private equity– Not indirectly: many structured investments failed
or returned cash– Alternative investment strategies: non-β (or –β);
exotic payoff
Post-Festum• “Investor redemptions were widespread
and indiscriminate across fund strategies, regions, asset sizes and performance dynamics”– Many funds had to restrict investor outflows to
protect their remaining investors– by applying “gates”, suspending redemptions
or NAV calculation or even by fund restructurings and creating “side-pockets”
2009: Recovery
• CY investable HF indices:14-19%
A Few More 2009 Numbers
• HFRI (non-investable) / HFRX indices– Fund Weighted 20% / Global 13.4%– FoF Composite 11% /RV MS 42%– RV FI CB 58.4% / 42.4%– Macro Total 4% / -2.6%
Status Quo
• Total assets of $1 trillion– ~ 30% down (Huw van Steenis, MS)– Record $152 billion in withdrawals during
4Q08 (HFR)– The biggest redemptions were by FoHF, also
to fund private-equity commitments. – NB. ETF iShares $~0.36 tn s ing le counterparty
(inflows ~0.1t)
“Oversold”
Critical but Stable• Systemic stress costs $9tn, damaged investments• Crisis not caused by hedge funds (witch hunt – e.g.
short sellers, etc)
• Investment banks are investment fund counterparties: they increased portfolio funding risk, even defaulted – Rehypothecation.
What is Risk Then?
• Not just variance• Loss of capital• Correlation• Beta• Liquidity• Access to capital (“return of capital”)
Capital PreservationGlobal Equity Hedge Funds
January 2008 100 100
December 2008 55 80
December 2009 ~65 ~94
• Stability: lower variance and drawdowns
Hedge Fund Products (1)• Hedge funds: micro businesses
– Owner/manager, entrepreneurs: SME in capital markets (credited)
– Innovation, grassroots brands• Legal fund structures
– Not just off-shore anymore– “Open by invitation” and risky– Labeling may be false “signalling” of skill-
based investment?
Products (2)
• Funds of hedge funds– Best “Alpha” is still packaged in hedge fund
form, but illiquid• Synthetic
– Passive alternatives: “alternative Beta”, commoditised and liquid (ETF)
– →Decouple Alpha and Beta, mean and tail; fair liquidity premium
What is (not) a hedge fund?
• Investment structures blurring– UCITS mutual hedge funds, absolute return
funds • Indexes
– Reuters Lipper TASS; Morningstar MSCI; HFR
• “A placebo is a medical procedure that has no medicine in it”
Regulations
• Legal structures– http://www.hedgefundmatrix.com/en/overview.cfm
• EU– Prohibition-like? AIMA lobbying– future of listed, OEIC, ETP
• Distribution ≈ investor “protection”– (In)dependent 3rd Party Marketers: case
study: Sandra Manzke; commissions and incentives
Trustee Regulatory Constraints
Above Law or Under It
• “Optimal intervention”– (+) Regulation of distribution; off- vs on-shore
(“import / export”); service providers– (-) Corporate governance: minority investor
rights, non-voting shares, claw back• Market efficiency policing
– Social enterprise, not prop trading and “OPM”
Asset Control
• Lehman, Madoff: lessons learned– Valuation fraud + fund control– Fund seizure and forced liquidation
• Structurally liquid portfolio components– Liquidity management– Non-commingled custody; separated
managed accounts
Capital Market Policing
• Great Accidents: – LTCM (12 years ago): leverage– Amaranth (5): overbetting– Maddoff (1): security fraud
• Small accidents– Market timers– Death spiral “private” convertibles
Hedge Fund Techniques
• Only legal– Madoff ≠ hedge fund
• Borrowing– Cash: Leverage– Securities: short selling
• Hedging• Non-standard instruments
Operational Risk• Valuation
– Fund Administrators: “independent directors” ordered to suspend NAV calculation
– value of “audit” (Enron) • Counterparty
– Lehman (7c/$) ; Sentinel (est. 40c/$) – Cash investments – “money market” funds not
AAA?• “Due dilligencing”
Investment Strategies
• Beyond taxonomy– Insight from replication techniques
• Best α is ideally like “extremophile bacteria”– Astrobiology
Reminder: 2008 Performance
•
One hedge fund strategy was the top performer
Liquidity of strategies0
2040
6080
Managed Futures
Duration
Cou
nt
0 31 60 90 120 150 1800
510
15
Fixed Income: Mortgage-Backed
Duration
Cou
nt
0 60 130 210 390
Aggregated Transparency
• "One of the challenges that we need to address (...) is to have a common language to describe derivatives. Every firm uses a different set of terminologies, a different set of representations to describe their derivatives portfolios."– Kenneth Griffin, Citadel, U.S. House
Committee, November 13, 2008.
Case Study
• Institutional investors: increased liabilities– “BA/Iberia pension fund”
• Mandate Search– Structure, performance, correlation, liquidity
management, costs
2009 Case study
• Supranational reserve pension fund• Strategic allocation advise
– 3% to “defensive” investment strategies – Diversified fund of hedge funds (FoHF)– At least 10 year track record– Negative correlation to equity and bonds– Low volatility, EURIBOR target
Fund Liabilities
• Macro view: shortfalls and underfunding – Low inflation, government deficits ...
• Regulation and mandate– Legal risk: asset control and contractual
liquidity• Competition
– How to outperform peers and benchmarks?
FoHF Universe: AgeAge vs FoHF.AUM
10.01 , 19.2%
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
0 5 10 15 20 25 30 35
Age
% u
nive
rse
FoHF: VolatilityReturn vs Volatility
Montly Data from 31-03-99 to 31-03-09
-7%
-2%
3%
8%
13%
18%
23%
0% 5% 10% 15% 20%
Volatility
ACR
FoHF: Decorrelation
Return vs Correlation to MSCI WorldMontly Data from 31-03-99 to 31-03-09
-7%
-2%
3%
8%
13%
18%
23%
-100% -80% -60% -40% -20% 0% 20% 40% 60% 80% 100%
Correlation
ACR
Return vs Correlation to MSCI World (Down)Montly Data from 31-03-99 to 31-03-09
-7%
-2%
3%
8%
13%
18%
23%
-100% -80% -60% -40% -20% 0% 20% 40% 60% 80% 100%
Correlation
ACR
Indirect Cost• Monthly redemptions, 45 days notice• Quarterly, 65 bd, 12 month Lockup• Quarterly, 120d, 20% gate• Quarterly, 60d OR Monthly 35d @ 2%• 1y hard Lockup, 2.5y soft lockup @ 6%,
1/3 per year, 2/3 @ 6% with 20% gate• …• Anniversaries, side pockets, side letters …
“Normal” Market
FoHF Liabilities
• Duration of liabilities is structurally mismatched to assets (hedge funds)
020
040
0Fund of Funds
Duration
Cou
nt
0 90 215 360 498 750
“Normal” Liquidity Target
0%
20%
40%
60%
80%
100%
Oct-08 Apr-09 Oct-09 Apr-10 Oct-10 Apr-11 Oct-11 Apr-12
S Fund (MP=100%, GI=0%) - Redemption
S Fund (MP=0%, GI=0%) - Redemption
S Fund (MP=0%, GI=100%) - Redemption
S Fund (MP=100%, GI=0%) - Still at risk
S Fund (MP=0%, GI=0%) - Still at risk
S Fund (MP=0%, GI=100%) - Still at risk
Liquidity Crisis
Alpha vs Beta Distributors
• Fund of hedge funds are still required– Best managers are packaged as hedge funds– Inc. regulation, accessibility, monitoring ....
• But they failed in 2008– Blocked assets by mismanaging liquidity: gated,
suspended redemptions, restructured ...– Underweighted systematic strategies– Sold Beta at Alpha price– Industry AUM reduced by 1/3 or more
Page 39 Indjic – 30 Sep 2008
FoF Underperformance
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
20%
< -3
-3 to
-2.5
-2.5
to -2
-2 to
-1.5
-1.5
to -1
-1 to
-0.5
-0.5
to 0
0 to 0.
5
0.5 to
1
1 to 1.
5
1.5 to
2
2 to 2.
5
2.5 to
3
3 to 3.
5
3.5 to
4
4 to 4.
5
4.5 to
5
5 to 5.
5
5.5 to
6
6 to 6.
5
6.5 to
7
7 to 7.
5
7.5 to
8
8 to 8.
5
8.5 to
9 >9
Returns (May 2007 - May 2008)
• %FoF outperforming Alternative Beta replicator
Shipping Performance• Navigate in the high seas of illiquidity
NB. Risk, optimisation et al quant tools irrelevant
Fees
Liquidity
BetaHF
Capacity
Counterparty
Conclusions
• Increased regulation– “False positive” test for hedge fund– Safer custody– Calls for “Financial Product Safety Board” like
FDA in the US (Lo, Stiglitz)
• Optimise liquidity and Beta• hybrid Alpha (satellite) + ETF/ synthetic (core)
Takeaway
• Managing investments relative to benchmark index ≠ managing to preserve capital
• Long only equity investment managers lost ~50% twice during 2000s
• Costs and fees– Indexing (passive) << benchmark relative
(traditional active) < <skilled (highly active)
3 Year Old Alternative Beta
Product Design/Selection
• Plan• Objective, target, mandate, delegation and
approval
• Structuring• Regulation: Listing, domicile, liquidity; Capacity
• Marketing– “(UCITS hedge) providers intend to launch
despite higher costs and lower returns”, FTfm Jan 11th, 2010
Evolving Packaging• Wrappers, feeders, guarantees etc.
• No customer choice – vs 401k (US), SIPP (UK), private/HNW clients
Alpha Legal Form Beta Distribution Fees/Cost0 ETF “Constant” “Safe for public”,
PLC~0
UCITS
Non-UCITS (FCP)
“High” Cayman 0 “Unsafe”, private LP “High”
Packaging Innovation
• NAV denomination experiments: valuation fiat money vs “real” units– commodities like oil, gold, CPI baskets?
• Santander’s Maddoff investors– Repay in 2% prefs @10 years: better
response than UBP, UBS (Holocaust custodian) and others (esp. FoHF)
Big Lesson
Future
• Capital protection and diversification– Maintain exposure to (liquid) alternative
investments– Non-traditional sources: e.g. convertible
arbitrage, managed futures• Indices and benchmarks can be
“alternative”– Convergence of long and hedged strategies
(UCITS, indices)
Downside Risk• Hedged strategies outperform: smaller
losses, lower variance
• Long-only strategies are riskier
Research
• Alpha/Beta/Gamma separation• Optimal contracting: fees decomposition into α, β
subject to options (inc. clawbacks); pricing α; active portfolio insurance (Δ risk appetite cursors)
• Demand in equilibrium: passive indexing (Beta, ETF) vs skilled
• Liquidity • Corporate law requires illiquid funds to be frozen in
order to prevent them becoming insolvent• Fund governance
Principles Revisited
• A Green Pig Down Wall Street, A. Inechien
• Perpetual Innovation– Bookstaber, R. (2007) “A Demon of Our Own
Design”, Wiley• Incentives
– Das, S. (2006) “Traders, Guns and Money”, FT Prentice Hall; Shiller & Axlerod (2009) “The Animal Spirit”; Hare, D. “Power of Yes”
References• www.london.edu/hedgefunds• www.aima.org• Indjic, D., Billieux, S. (2009) “Feature: Hedge
Fund Redemptions, Hedge Fund Value”, Professional Investor, CFA UK , Spring 2009
• Kärki, J. P., Indjic, D. (2009) “A new investment paradigm: Alpha-Beta separation”, Euromoney Hedge Fund Handbook 2009; the Hedge Fund Journal, November 2008