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edhec-risk.com/events/EDHEC_Events/... edhec-risk.com/events/EDHEC_Events/... Presentation Transcript

  • Edhec European Alternative Multimanagement Practices Survey Noël Amenc PhD, Professor of Finance, Edhec Business School Director of Research, Misys Asset Management Systems [email_address] December 5 th 2003 Survey supported by:
  • Agenda
    • Methodology
    • Facts, figures and trends in the European alternative multimanagement market
    • Asset allocation and portfolio construction
    • Fund selection and due diligence
    • Risk and performance reporting
    • Regulatory framework
    • Conclusions and recommendations
    • Glossary
    • Typology of hedge fund styles
  • Methodology Scale of the initiative
    • A pan-European initiative
    • Two main questionnaires:
      • General questionnaire for large asset managers
      • Specific questionnaire targeting multimanagement structures
    • Survey conducted from 30/06/2002 to 31/12/2002
    • 61 respondents managing €136bn at 31/07/2002
    Distribution of respondents by category Distribution of alternative multimanagers by number
  • Methodology Analysis of the size bias
    • 44% of the sample is individually managing more than €1bn;
    • Bias not inconsistent with the fact that the 50 largest FoHF manage 90% of assets (Freeman & Co, 2003);
    Distribution of respondents by size 17% 18% 18% 4% 4% 0% 5% 10% 15% 20% AUM < €250mn € 250mn < AUM < €1bn € 1bn < AUM < €5bn € 5bn < AUM < €10bn AUM > €10bn Distribution of respondents by size
  • Methodology Importance of the background research
    • The survey has been designed and commented on with reference to an analysis of the academic and professional state-of-the-art for alternative multimanagement practices
    • This state-of-the-art has been documented in the background section by the Edhec Risk and Asset Management Research Centre based on the information collected in the context of its permanent scientific and industrial observatory (more on www.edhec-risk.com).
  • Facts, figures and trends Main actors
    • A market structure similar to the US
      • High Net Worth Individuals still represent the main category of investors;
      • But institutional investors’ allocations growing at fast pace;
    Source: Goldman Sachs Prime Brokerage Annual Hedge Fund Survey, 2003 Fund of Hedge Funds investor composition (%)
  • Facts, figures and trends Relativisation of alternative performance
    • The growing importance of institutional investors
      • Investment approaches more related to diversification than absolute performance;
      • Need for normalisation of alternative investments (benchmarks, reporting);
      • Greater attention paid to operational risks.
  • Facts, figures and trends From an alpha to a beta logic
    • 63% of respondents offer FoHF by strategy;
    • Current motivations for investors, specifically institutional investors, lie in the diversification benefits rather than in the selection of the best managers, which is a preoccupation of Multimanagers;
    Do you offer pure strategy manager funds? Why do investors invest in FoHF? (rank)
  • Facts, figures and trends Relativisation of alternative performance
    • From an absolute performance to a relative returns approach
      • The absence of exposure to market risk does not mean that hedge funds do not carry any risk;
        • The risk free rate is not an appropriate benchmark
        • It is necessary to consider the risks strategies are exposed to in the performance measurement approach
        • Relative approach to performance measurement
  • Facts, figures and trends Relativisation of alternative performance
    • Alternative indices
      • The need to demonstrate relative performance leads to the significant growth of alternative indices.
      • These indices are not only used for hedge fund performance analysis but also as investment vehicles (trackers, structured products).
    What indices do you use?
  • Facts, figures and trends Relativisation of alternative performance
    • The utilisation of indices is not problem-free
      • Indices are not passive, they are constructed like active manager funds;
      • Indices suffer from numerous biases, mostly related to the absence of regulation with regard to the publication of performance and hedge fund composition;
      • Selection and construction methods are the source of the performance rather than the strategies.
    Investment Styles Convertible Arbitrage 7.55% Dec 01 EACM (-6.93%) vs. Hennessee (0.62%) CTA 5.09% Feb 99 CSFB (-0.54%) vs. HF Net (4.55%) Distressed Securities 6.99% Feb 00 EACM (1.23%) vs. Zürich (8.22%) Emerging Markets 19.45% Aug 98 MAR (-26.65%) vs. Altvest (-7.20%) Equity Market Neutral 5.00% Dec 99 Hennessee (0.20%) vs. Van hedge (5.20%) Event Driven 5.06% Aug 98 CSFB (-11.77%) vs. Altvest (-6.71%) Fixed Income Arbitrage 10.48% Oct 98 HF Net (-10.28%) vs. Van Hedge (0.20%) Funds of Hedge Funds 8.01% Dec 99 MAR (2.41%) vs. Altvest (10.42%) Global Macro 14.17% Oct 98 CSFB (-11.55%) vs. Altvest (2.62%) Long/Short Equity 22.04% Feb 00 EACM (-1.56%) vs. Zürich (20.48%) Merger Arbitrage 2.71% Sept 01 EACM (-4.32%) vs. HF Net (-1.61%) Relative Value 10.47% Sept 98 EACM (-6.08%) vs. Van Hedge (4.40%) Short Selling 21.13% Feb 00 Van Hedge (-24.30%) vs. EACM (-3.17%) Source: Edhec Risk and Asset Management Research Centre Max differences (with dates and indexes) Maximum Return Differences by Investment Style (From January 1998 through July 2003) Maximum return difference by style (From January 1998 through July 2003)
  • Facts, figures and trends Relativisation of alternative performance
    • In order to overcome these difficulties, Edhec has constructed a series of indices of indices that exhibit higher levels of representativity and purity
    Representativity Source: Edhec Risk and Asset Management Research Centre, 2003 Representativity Purity
  • Facts, figures and trends Increasing attention to operational risks
    • The increasing importance of institutional investors and their desire to protect themselves against operational risks is resulting in greater attention being paid to these types of risks, which represent the most significant source of hedge fund failures.
    Source: Capco research and Working Paper “Understanding and Mitigating Operational Risk in Hedge Funds”, 2002 Source: Edhec Risk and Asset Management Research Centre, 2003 Analysis of Hedge Fund Failures % of HF potentially open to a specific operational issue
  • Asset allocation and portfolio construction Specialization of offerings
    • Specialized fund offerings are provided more as an answer to benchmarking needs rather than for their real diversification benefits;
    • Only 42% of respondents offer funds exhibiting specific diversification attributes with other asset classes;
    Do you offer FoHF with specific behaviour or diversification objectives in relation to other asset classes?
  • Asset allocation and portfolio construction Specialization of offerings
    • Multimanagers’ lack of attention to the diversification properties of hedge funds is probably linked to the confusion that exists between the fund selection tasks, which constitute the original value-added of the FoHF, and those relating to allocation or diversification by style.
    • While a significant majority of European FoHF (75%) have a team dedicated to portfolio construction and/or return forecasts for alternative styles, one cannot help but observe that numerous European multimanagers continue to confuse portfolio allocation with the choice of the best managers (22%).
    Do you have a team dedicated to portfolio construction and/or economic style return forecasting?
  • Asset allocation and portfolio construction A necessary clarification of means and practices
    • Only 13% of respondents combine a quantitative approach with a qualitative portfolio construction approach, even though it is the only method that allows scenarios on extreme market conditions to be taken into account while, at the same time, disciplining and formalising the manager’s intuitions;
    • 65% of European multimanagers do not use a quantitative approach in the area of strategic portfolio allocation, despite the results of such approaches that have been highlighted by academic research;
    • Only 47% of the professionals questioned take the correlation between funds into account to organise the diversification of their portfolio.
    How do you construct your portfolio for multi-strategy or multi-style funds?
  • Asset allocation and portfolio construction How much diversification is enough?
    • Academic studies have documented the fact that increasing the number of funds may have adverse effects:
      • Dilution of the specific betas of the different strategies employed;
      • Alpha dilution and increase in additional costs (due diligence, monitoring, etc.);
      • Increase in the kurtosis of the funds;
      • Quantity can not replace adequate
      • due diligence;
    Country France Switzerland United Kingdom Others Europe Fewer than 10 0% 6% 20% 22% 13% 10 to 15 0% 6% 0% 11% 5% 15 to 20 30% 47% 50% 11% 33% 20 to 25 20% 6% 10% 28% 16% 25 to 30 10% 0% 10% 6% 5% More than 30 30% 29% 10% 17% 22% No answer 10% 6% 0% 6% 5% How many funds on average make up your own funds? 13% 5% 33% 16% 5% 22% 5% Fewer than 10 10 to 15 15 to 20 20 to 25 25 to 30 More than 30 No answer
    • The numbers for practitioners are significantly above the optimal academic findings (Amin and Kat, Lhabitant and Learned), as only 18% of respondents hold FoHF that include fewer than 15 funds.
    How many funds on average make up your own FoHF?
  • Fund selection and due diligence A match made in heaven?
    • While most alternative strategies exhibit abnormally distributed returns, the vast majority of hedge fund selectors continue to use tools from traditional management to evaluate their performance.
    • 82% consider the Sharpe ratio and only 4% calculate an Omega ratio, despite the fact that the latter is more appropriate for the alternative universe.
    Which quantitative indicators do you use when monitoring manager performance?
  • Fund selection and due diligence Importance of the quality of hedge fund data
    • The performance databases play a central role for 67% of the respondents, even though these databases contain numerous biases and it is easily shown that the choice of database, and thus the choice of particular biases, condition the performance of the funds selected.
    • In spite of these problems, 44% of the respondents give quantitative analysis a significant role in fund selection, even if, in the end, the weighting accorded to the analysis does not exceed 37% on average.
  • Fund selection and due diligence Importance of the quality of hedge fund data
    • Only 15% of the respondents limit the use of quantitative analysis to the first screening.
    How important do you consider quantitative analysis when selecting managers?
  • Fund selection and due diligence The need for appropriate due diligence
    • In an unregulated environment, the FoHF capacity to limit operational risks is essential and is now seen as clear value-added for both investors and multimanagers.
    • This value-added is however questioned by the figures as FoHF are not spared from the substantial and highly publicized hedge fund failures. There is no significant difference in exposure between FoHF and direct hedge fund investors.
    • If we examine the hierarchy of criteria, it is curious to note that the quality of reporting and risk control of the underlying funds is essential in the eyes of the managers who themselves do not always have sufficient tools or skills of that type. As an example, one-third of European FoHFs do not have a dedicated team for risk analysis.
  • Fund selection and due diligence The need for appropriate due diligence
    • It should be noted, in the same spirit, that, for want of a capacity to genuinely reassure themselves on the transparency of the funds in which they invest, European multimanagers rely more on the reputation of their counterparty’s service providers (prime brokers, custodians, auditors etc.) than on the operational analysis itself, notably the off-balance sheet operations, which is not considered important or indeed not taken into account at all by 27% of the respondents.
    Which qualitative criteria do you apply to due diligence a manager? Do you have a specialized risk analysis department?
  • Fund selection and due diligence The need for appropriate due diligence
    • More generally, we could set out the problem of the economics of the profession of alternative multimanager. Projecting the costs of a due diligence process cannot be sustained by FoHFs with assets under management that amount to less than 200 million US dollars.
    Fund Size Cost of due diligence in bpts $50mn 160 bpts $250mn 32 bpts $600mn 13 bpts $1,000mn 8 bpts Cost of operational due-diligence expressed in basis points of assets under management Cost of operational due diligence expressed in basis points of assets under management.
  • Fund selection and due diligence The need for appropriate due diligence
    • This tight business model will lead to a clear consolidation and/or outsourcing trend.
    • A pre-requisite for outsourcing however is that FoHF demonstrate their ability to substitute for fund selection a clear new value-proposition: asset allocation and portfolio construction.
    How do you select managers?
  • Fund selection and due diligence The recurring question of transparency
    • 76% of FoHFs do not set up “managed accounts,” regardless of the amount of assets entrusted to the managers selected.
    • The associated costs and the fact that managed accounts have so far not allowed extreme hedge fund losses to be avoided do not favour this approach for FoHF. Managed accounts, however, have the preference of large investment banking groups wishing to implement structured products based on baskets of hedge funds.
    Above which amount do you require segregation of your assets in a managed account? 76% 2% 5% 2% 7% 2% 5% No managed accounts 2mn 5mn 10mn 20mn 30mn 50mn Country France Switzerland Europe No managed accounts 60% 88% 76% 2mn 10% 0% 2% 5mn 10% 0% 5% 10mn 0% 0% 2% 20mn 10% 6% 7% 30mn 10% 0% 2% 50mn 0% 6% 5% Above which amount do you require segregation of your assets in a managed account?
  • Risk and performance reporting Multimanagers favour mean/variance reporting
    • The Sharpe ratio (69%) is well ahead of the VaR (20%) or the Sortino ratio (22%) among the indicators that are favoured in the performance reporting of European FoHF.
    • It should be stressed that volatility is considered by 84% of Multimanagers to be the major concern of their clients.
    • However this concern does not result in information on the diversification qualities of FoHF. FoHF are considered to be volatility reducers not because they are exposed to interesting risk factors within the framework of multi-style/multi-class diversification, but simply because they exhibit low volatility themselves, even if this entails a magnification of extreme risks that are neither measured nor documented.
  • Risk and performance reporting Multimanagers favour mean/variance reporting
    • Only 20% of respondents give information on the leverage effect of the fund. This insufficiency could lead to erroneous performance analysis, notably when a comparison with hedge fund indices is carried out, which is the case for 62% of FoHFs.
    Which indicators and information do you use for reporting to your clients?
  • Risk and performance reporting No place for third party certification
    • While studies on the failures of hedge funds have shown that certification of their performance significantly reduces the failure rate, it should be noted that only 13% of the respondents have implemented certification by an independent third party.
    • The implementation of a FoHF performance standardisation and certification process would be clear value-added for investors in a universe where performances need to be analysed cautiously.
    Is your reporting certified by an independent third party?
  • Regulatory environment Local rather than European initiatives
    • The UCITS III European Directive favours the development of traditional multimanagement but does not allow for the development of FoHF.
    • The regulatory competitiveness is a challenge not only for the asset management industry but also for investors.
    Do your clients have an influence on the choice of legal framework for your multimanagement activity?
  • Regulatory environment A long way to go for both parties
    • A change in the regulator’s mind will most likely also require a change in industry practices.
    • Selling alternative investments on the basis of indicators that do not reflect extreme risks does not help.
    • A better level of information on practices related to the management of operational risks is a pre-requisite for the development of HF and FoHF marketing. The recent SEC report is moving in this direction by no longer ignoring HF and FoHF and considering them as potentially interesting vehicles for diversification within mutual funds.
    Which country offers the best compromise between flexibility and security with regards to your alternative investment activity?
  • Conclusions and recommandations 1. The importance of portfolio construction
    • A major benefit of the Funds of Hedge Funds model resides in the portfolio construction phase. Portfolio construction allows for determining the optimal selection of hedge funds that compose the portfolio in terms of risk and return profiles, but also for elaborating the optimal mix of hedge funds that are required to complement a portfolio invested in traditional asset classes.
    • Strategic and Tactical Asset Allocation approaches should therefore be favored by funds of hedge funds managers rather than a bottom-up, or fund-picking, approach aimed at selecting the future best performers.
  • Conclusions and recommandations 2. Relativising absolute performance
    • The risk-free rate is probably not the adequate benchmark for measuring hedge-fund risks as alternative investments exhibit exposure to various non traditional risk factors (liquidity risk, volatility risk, credit risk …).
    • Appropriate benchmarks need to be defined in order to assess the real risks and returns of hedge funds and analyzing manager’s alpha adequately.
  • Conclusions and recommandations 3. The need for appropriate reporting
    • Volatility is not representative of hedge fund risks, indicators restricted to the mean-variance model should be supplemented by more appropriate indicators.
    • Risk indicators should therefore account for the non-gaussian aspects of risks hedge funds exhibit (skewness and kurtosis) as well as for risk factors that are not captured by historical volatility (credit risk,, liquidity risk …)
    • Appropriate indicators exist and are usually extensively used in trading desks (Value at Risk,BVAR etc…)
  • Conclusions and recommandations 4. Extreme risks are essential, but difficult to assess
    • Extreme risks form an important part of hedge fund risk. Two categories of extreme risks need to be distinguished:
      • Financial extreme risks (credit, liquidity …) that can fit into a quantitative model
      • Non financial risk that can only be assessed through an appropriate qualitative analysis
    • Fund selection based exclusively on quantitative analysis does not take into consideration the second category of extreme risks.
    • However, non Financial extreme risks represent an important part of the risks hedge-funds exhibit.
    • Funds of Hedge Funds need therefore to balance quantitative fund selection with an appropriate level of qualitative analysis.
  • Conclusions and recommandations 5. Qualitative analysis is challenging and expensive
    • Small and medium sized hedge funds encounter a difficult economic dilemma when attempting to provide a minimum level of qualitative investigations (lack of sufficient skills, resources and time);
    • The importance of these challenges will lead funds of hedge funds to:
      • Consolidate in order to minimize the relative cost of qualitative investigation, or
      • Evolve towards a model whereby focus is given to the portfolio construction and qualitative assessment sub-contracted
  • Glossary of terms Risk and performance indicators
    • The Sharpe Ratio vs. the Sortino Ratio
    • These two risk-adjusted performance measures involve computing the excess return of an asset (over the risk free rate for the former and over a predefined Minimum Acceptable Return for the latter) per unit of risk. The major difference comes from the way the risk dimension is defined. In the Sharpe Ratio the risk is defined as the total risk (i.e. volatility) of the asset while the downside risk (i.e. semi deviation) is used in the Sortino Ratio.
    • The Information Ratio
    • This indicator is again a risk-adjusted performance measure which involves computing the excess return of an asset over a benchmark per unit of risk. This time, however, only the relative risk (i.e. tracking error against the benchmark) is taken into account.
    • The Drawdown Ratio
    • The drawdown ratio involves calculating the maximum peak-to-valley drawdown. It is thus an interesting though simplistic way to assess extreme losses. This ratio is often associated with a recovery time that is the number of days or months needed to recover losses.
    • The Beyond VaR (BVaR)
    • This measure calculates the expected shortfall provided that the VaR has been reached. This indicator is based on Extreme Value Theory (EVT) and is thus well suited for assessing assets with fat tailed return distribution functions.
  • Glossary of terms Risk and performance indicators (continued)
    • The M2 or Risk Adjusted Performance (RAP)
    • This indicator is a classic risk-adjusted measure which involves calculating the excess return of an asset over the risk free rate and then leveraging it by the volatility of the asset. The result is then divided by the volatility of the market to obtain standardized values. This measure, however, does not account for investment style differences.
    • Omega Ratio
    • This indicator is a typical gain/loss ratio. It is calculated as the ratio of the (probability weighted) performance of an asset provided the predefined Minimum Acceptable Return has been reached by the (probability weighted) performance of an asset in the case the predefined Minimum Acceptable Return has not been reached.
    • Alpha and Beta
    • The return of an asset can roughly be divided into two parts. First, the &quot;normal&quot; return which corresponds to the market's fair reward for the risks to which the portfolio is exposed. The betas measure the exposure of the asset to each risk factor. Second, the “abnormal” return represents the fruit of the portfolio managers' expertise. Technically speaking beta corresponds to the loading factors of a regression of the asset’s returns onto risk factors, while alpha is the intercept of this regression.
    • Bull/Bear
    • This analysis aims to identify a potential non linear exposure to market risk. It involves comparing the performance of an asset in down- and up- markets. Note that this analysis may give some indications as regards the asset’s diversification properties.
  • Typology of hedge fund styles Hedge Fund Universe Relative Value Event Driven Opportunistic Convertible Arbitrage Fixed Income Arbitrage Market neutral Distressed securities Deal/Merger Arbitrage Special Situations Global Macro Long/Short Equity Dedicated Short bias Short Selling Emerging markets Hedge Fund Universe Relative Value Event Driven Opportunistic Convertible Arbitrage Fixed Income Arbitrage Market neutral Distressed securities Deal/Merger Arbitrage Special Situations Global Macro Long/Short Equity Dedicated Short bias Short Selling Emerging markets
  • Typology of hedge fund styles Relative Value
    • Convertible Arbitrage : in its simplest form, this strategy involves the simultaneous purchase of convertible securities (convertible bonds, preferred stock and various equity-linked structured products) with the short sale of the underlying common stock. By hedging the positions on a ‘delta neutral’ basis, the hedge fund manager can capture income while neutralising most market risks.
    • Fixed Income Arbitrage : the hedge fund manager tries to capture differences in performance between two or more portfolios of fixed income securities. The implicit assumption is that the actual behaviour of such securities will be related over some interval of time. However, beyond that simple (or simplistic) definition, there are many fixed income arbitrage strategies that combine long and short positions. These include yield curve strategies, spreads, swap spreads, basis trades, credit spreads, option relationships and cross-market trades.
    • Market Neutral : by definition, a market neutral fund holds long and short positions in equal dollar balance at all times, neutralising net exposure to equities. The manager will simultaneously buy undervalued stocks and sell short overvalued stocks within the same industry group or economic sector or the same investment style (growth, value, small caps, large caps), keeping a beta-neutral exposure by sector or investment style. In theory, an equity market neutral strategy’s return is not affected by the direction of the market, on condition that the manager has been careful to verify that the risk characteristics of his longs and shorts match.
  • Typology of hedge fund styles Event Driven
    • Distressed Securities : distressed securities fund managers seek substantial capital appreciation through investments in the securities of companies in, or about to enter or exit, bankruptcy or financial distress. Distressed securities can cover a wide range of possibilities, from senior secured debts (lower risk) to ordinary shares (higher risk).
    • Deal Arbitrage or Merger Arbitrage : merger arbitrage, also referred to as risk arbitrage or deal arbitrage, is designed to ensure profits regardless of the direction of equity markets. This strategy takes advantage of expected price movements, i.e. arbitrage opportunities, which occur after a merger or acquisition offer. A classic scenario consists of scooping up the stocks of the target company while selling the acquirer's stocks short. Nevertheless, if the deal fails, this strategy can result in heavy losses.
    • Special Situations : though these strategies are very close to distressed securities or deal arbitrage, special situations managers tend to focus on new investigative fields such as debt in emerging markets, or bad news that depresses the price of stocks sharply but temporarily. Leverage is not often used but the real nature of the investment makes this strategy more volatile than the previous two.
  • Typology of hedge fund styles Opportunistic
    • Global Macro: global macro funds were surely the most popular hedge funds 15 years ago. However, they are now in decline due to the disappearance of some traditional sources of profit, such as arbitrage opportunities on Forex, which made Soros’ fortune. These funds attempt to take advantage of macroeconomic trends and, by definition, can intervene in any market. Through a top/down management process, they implement multidirectional strategies (i.e. simultaneous exposure to several markets).
    • Long/Short Equity: long/short equity strategies cover a broad range of risk and return possibilities. As a result of this heterogeneity, the long/short equity category is the largest segment in the alternative investment markets. Equity investing on a long and short basis does not mean having a continuous market neutral approach as described above, even though such a possibility may temporarily occur, especially in the case of a bear market or when the manager no longer has a feel for the market.
    • Dedicated Short Bias: short-bias strategies involve managers taking short positions in overvalued assets, by either selling borrowed securities or using derivatives to create synthetic shorts. However these strategies can also take long positions over a limited period of time while keeping their short bias.
  • Typology of hedge fund styles Opportunistic (continued)
    • Short Selling : the hedge fund manager takes short only positions in anticipation of a decline in the stock value. At a later date, he will attempt to repurchase the same shares at a lower price level to lock in his profit.
    • Emerging Markets : this strategy consists of taking long only positions, since short sales are not allowed in emerging markets.
    • Managed Futures : this strategy consist of investing in futures and derivatives to capture and amplify market movements