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Hedge fund industry: is there a capacity effect?

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  • 1. Hedge fund industry: is there a capacity effect? July 2005 Rudy Sillam Edhec Risk and Asset Management Research Centre
  • 2. CONTENTS Foreword 1 Executive summary 2 Hedge fund industry: is there a capacity effect? 3 Introduction 3 Survey methodology 5 Have some strategies reached saturation point? 6 The alpha problem 7 Talented managers 9 Size effect? 9 Conclusion 10 References 11 Appendix: Statistical results 12 Edhec Risk and Asset Management Research Centre 20 Copyright © Edhec 2005
  • 3. FOREWORD: Capacity Effect or Incapacity Effect? F or several months, investors and their advisors have been worrying about the profitability prospects for hedge funds. accordance with speculative opportunities. In certain situations, hedge fund profits can be limited by the depth of the market, but it is not strictly speaking a reduction in inefficiency, simply a concern on the part Modestly entitled the "capacity effect", the analysis of of managers not to be the only providers of liquidity. the reasons behind the fairly disappointing performance in 2004 constitutes, if we believe those It has not been demonstrated either that the new who are putting the argument forward, a serious entrants into the industry have less talent than the calling into question of the alternative investment initial entrants. Academic research and empirical work industry's value proposition. Alphas would be tending on the "age" effect on hedge fund performance gives to become rarer, for two main reasons: conflicting results. Besides, estimating a hypothetical increase in the number of fund failures is not possible The significance of the sums drained into the either, given the reporting biases and the alternative investment industry are making the insufficiencies of databases in this area. implementation of "niche arbitrage" strategies more and more difficult (for example, convertible In fact, the essential part of hedge fund performance bonds or arbitrage on small stocks); more globally, comes from their betas. Their talent resides in the the increase in operational volumes is reducing management of those betas, namely, correctly taking market inefficiency and market anomalies, which risks for which the premiums, i.e. the "normal" are allegedly the main source of performance for returns, are less easy to capture in the equity and bond hedge funds. markets. Allowing investors, for example, to access the credit and volatility markets in good timing and The windfall represented by the remuneration price conditions undeniably constitutes added value model and the very strong growth in assets under which justifies turning to specialists. management is attracting more and more managers, which is leading to a dilution of the Even the performances of so-called "Relative Value" talent available in the industry. The strategies such as Long/Short Equity and Equity "democratisation" of hedge funds is making them Market Neutral are conditioned by bets on particular increasingly dull. risks like, for example, the evolution of the Large Cap - Small Cap spread. However, this pessimism doesn't hold up when we examine the facts. It is related more to the incapacity By constantly highlighting arbitrage alphas that are on the part of both investors and managers to difficult to measure, hedge funds have themselves understand or explain the true benefits of investment fallen into the trap of the capacity effect, with the risk in hedge funds than to the capacity effect. of forgetting their true virtue - that of offering new betas to investors who are always looking for effective The capacity problem that is supposedly linked to the diversification. disappearance of arbitrage opportunities has not been demonstrated and cannot, in our opinion, be The aim of the current survey, which follows a recent demonstrated. On the one hand, the alternative Edhec research paper by Walter Géhin and Mathieu industry, even taking the leverage effects into account, Vaissié entitled “The Right Place for Alternative Betas represents less than 2% of worldwide stock market in Hedge Fund Performance: an Answer to the capitalisation and, on the other, even when Capacity Effect Fantasy”, was to check whether the considering specific market segments (the raw opinions on the capacity effect of the finance material derivatives market, stock loan/borrowing professionals in the field, and their views on the real market, etc.), it is true that one can reach very sources of hedge fund performance, corresponded to significant proportions of activity relating to the the results of our research in this area. intervention of hedge funds, representing up to 30% of operations on certain stocks or up to 50% of some open positions, but these volumes rarely correspond to arbitrage operations. They generally involve bets that are directional (CTA, Global Macro) or related to the Noël Amenc, PhD unfolding of events on securities that by definition are Professor of Finance at Edhec & Director of the intended to move between market segments in Edhec Risk and Asset Management Research Centre Hedge fund industry: is there a capacity effect? 1
  • 4. EXECUTIVE SUMMARY Introduction F ollowing recent studies claiming that the hedge fund industry will suffer from a capacity effect, the Edhec Risk and Asset Management Research study by Gehin and Vaissié (2005) has shown, most of the respondents agree that alternative betas are predominant in relative value arbitrage strategies, Centre published a paper entitled "The Right Place and they find that cyclical factors (for 69.7% of our for Alternative Betas in Hedge Fund Performance: respondents), rather than a disappearance of "pure an Answer to the Capacity Effect Fantasy", which alpha", explain the disappointing performance that refuted the idea of capacity constraints within the these strategies have experienced recently. industry and promoted the importance of alternative betas in hedge funds' returns, rather than Manager capacity and size effect focusing exclusively on alpha. In order to analyse W the opinions of industry professionals and hile a market capacity problem seems to be academics, we decided to conduct a survey to try to refuted by our respondents, the results respond to the question: Is there a capacity effect regarding the problem of manager capacity are within the industry? mixed. Although the industry does not suffer from a shortage of talent, the huge growth in the number Market capacity of hedge funds has increased the difficulty of selecting talented managers. Moreover, our M ost of our respondents think that only relative value arbitrage strategies suffer or will suffer from a capacity constraint. These results respondents do not think that a critical hedge fund size exists within the industry. are in line with the impact of hedge funds in Conclusion different markets, with overall hedge fund industry T assets representing no more than 3% of worldwide he results of our survey show that the hedge financial assets, but accounting for up to 90% of the fund industry is not suffering from a capacity trading in the markets for relative value arbitrage constraint but is facing new challenges. The hedge strategies. Moreover, our respondents are confident fund industry has to understand that returns come about the growth prospects of the industry, with more from the exposure to alternative risk more than 65% expecting double-digit annual premiums rather than alpha, and that the main growth rates. advantages to investing in hedge funds relate to their diversification benefits with traditional assets The Alpha problem (approximately 60% of our respondents invest in hedge funds for their diversification benefits with W hedge hile investors seem preoccupied with the problem of alpha, they are aware of where fund performance comes from. traditional assets). Moreover, the industry is maturing and becoming more competitive as 81% of our respondents claim. With professionalism and Approximately half of the respondents think that innovation, the hedge fund industry is more likely alpha is the main source of performance within the to keep growing and create high and stable returns. industry, but 95% of the respondents think that alpha is overestimated and they are aware of hedge funds' exposures to alternative betas as a source of return (69.8% of our respondents). Moreover, as the 2 Hedge fund industry: is there a capacity effect?
  • 5. HEDGE FUND INDUSTRY: IS THERE A CAPACITY EFFECT? Introduction D uring the last five years, the hedge fund industry has experienced tremendous growth, with an average annual growth rate of 15%. According to Van Hedge Fund Advisors, the industry went from 6,200 funds representing $480 billion in assets under management (AUM) in 1999 to 8,700 funds representing $950 billion in AUM at the end of 2004. Moreover, analysts forecast that the industry will represent $1.7 trillion in assets in 2008 with more than 11,000 funds. The current 8,700 funds use different strategies, naturally, to manage their assets. Among these strategies, Long/Short Equity represents more than 33% of hedge fund industry assets (see exhibit 1). Exhibit 1: Breakdown of assets under management by strategy in the hedge fund universe 0% 8% 11% 7% 5% 33% 7% 15% 7% 0% 7% Convertible Arbitrage CT A Global Emerging Markets Equity Market Neutral Event Driven Fixed Income Arbitrage Funds of Funds Global Macro Long/Short Equity Short Selling Other Source: Hedge Fund Research, Watson Wyatt (2005) Hedge fund industry: is there a capacity effect? 3
  • 6. After good returns in 2003 (11.45% for the EDHEC There is a shortage of talent in the industry to Fund of Funds Index, see exhibit 2), the industry cope with the growth of assets has experienced decreasing positive performance in Size is becoming a problem 2004 (7.08% for the EDHEC Fund of Funds Index) with even negative returns in the second quarter of In order to analyse the arguments relating to the 2004. These returns, confirmed by the returns of problem of capacity in the industry, we conducted a April 2005, have led some investors to talk about a survey among investment professionals who have an capacity effect in the industry, claiming that the interest in the hedge fund industry. The results industry is a victim of its success and therefore that produced by our survey are in line with those of the market opportunities will disappear and talented Gehin and Vaissié study, "The Right Place for managers will be more difficult to find. Alternative Betas in Hedge Fund Performance: an Answer to the Capacity Effect Fantasy", which The four major arguments behind this supposed affirmed that the reduction in the number of market capacity effect are the following: opportunities and the capacity effect are false problems and that recent disappointing performances In some strategies, the huge number of players come more from cyclical factors (for 69.7% of our has reduced market opportunities respondents) than a reduction in market opportunities Due to the capacity constraint, alpha is and more generally that hedge fund performance disappearing comes more from exposure to alternative risk factors (alternative betas) than from pure alpha. Exhibit 2: Historical returns of EDHEC Indices by strategy Annual Average Edhec Indices Y 2002 Y 2003 Q2 2004 Y 2004 Q1 2005 April 2005 Return since Inception Convertible 8.60% 10.80% -2.13% 1.10% -2.91% -3.16% 6.18% Arbitrage CTA Global 14.57% 11.64% -9.39% 5.17% -4.39% -3.54% 6.31% Distressed 5.86% 27.34% 2.87% 17.89% 2.04% -0.52% 14.36% Securities Emerging Markets 5.76% 31.27% -4.09% 14.30% 2.87% -0.49% 14.32% Equity Market 4.71% 6.29% -0.16% 4.71% 1.81% -0.30% 5.72% Neutral Event Driven -1.08% 20.48% 0.92% 12.43% 1.44% -1.28% 8.98% Fixed Income 7.56% 8.35% 1.58% 6.26% 1.54% -0.03% 7.06% Arbitrage Funds of Funds 1.26% 11.45% -1.16% 7.08% 0.97% -1.41% 5.12% Global Macro 4.96% 17.25% -2.76% 4.60% 0.96% -0.80% 7.20% Long/Short Equity -6.38% 19.31% -1.10% 8.62% 0.95% -1.84% 4.16% Merger Arbitrage -0.90% 8.34% -0.22% 4.83% 0.97% -1.05% 3.41% Relative Value 2.77% 12.15% -0.60% 5.71% 0.51% -1.08% 6.41% Short Selling 27.27% -23.87% 3.06% -4.66% 7.66% 3.93% 4.20% Source: Edhec Risk and Asset Management Research Centre 4 Hedge fund industry: is there a capacity effect?
  • 7. Survey Methodology I n this survey, conducted from May 31st to July 8th 2005, we sent out an email to financial professionals informing them that our questionnaire was available at www.formdesk.com/edhecrisk/capacityeffect and asking them to participate in the survey. We collected 183 responses, of which 65.6% work in funds of hedge funds and 10.9% in hedge funds. 11.5% of our respondents are institutional investors and 12% work in a consulting or research company (see exhibit 3). Statistical results are given in the appendix. Exhibit 3: Breakdown of respondents by category 12.0% 11.5% 10.9% 65.6% Institutional Investors Funds of Hedge Funds Hedge Funds Others (advisors, consultants…) Source: Edhec Risk and Asset Management Research Centre Hedge fund industry: is there a capacity effect? 5
  • 8. Have some strategies reached saturation point? T o the question, "Of the following strategies, which suffer or will suffer from a capacity constraint?", results show that relative value However, we have to note that professionals seem confident about the future of the industry and its capacity to keep growing. More than 65% of the arbitrage strategies may suffer from a capacity effect. respondents (see graph 2 below) think that industry Indeed, for 83.2% and 65.92% of the respondents assets will grow at a minimum annual rate of 10% respectively, the convertible arbitrage and merger over the next five years with a large number of arbitrage strategies suffer from a capacity constraint respondents putting this growth at between 10% and (see graph 9 below). Moreover, for 70.9% of the 15%. respondents, arbitrage opportunities have been reduced and will be difficult to exploit (see graph 8 The main reasons behind this belief that the industry below). These results are in line with the impact of will continue to grow at a double-digit annual rate are hedge funds in different markets. the capital inflows from institutional investors and the increase in regulation (48% of respondents) and Even if the hedge fund industry represents $1 trillion the benefits of hedge funds in comparison with in assets today, the size of the industry remains small traditional investment (20%). We should recall that in comparison with the overall asset management the growth of the industry during the past five years industry. According to UBS, the worldwide financial was 15% per year. Therefore, most people expect to market (equities + bonds) represents $87.4 trillion in see the industry continue to grow at the same rate. assets, which means that the hedge fund industry represents only 1.1% of total financial assets. Moreover, if we include the use of leverage, the industry still represents no more than 3% of total financial assets. For instance, hedge fund investing in equities represents a mere 2% of the equity market. If we look at relative value strategies, some arbitrage strategies can represent a huge share of the assets and trading. For example, convertible arbitrage funds account nowadays for 70% to 90% of the trading in the convertible market, and in 2004 and the first quarter of 2005 the strategy has experienced its worst returns since the LTCM crisis in 1998 (annual return of 1.1% for the EDHEC Convertible Arbitrage index in 2004 and a negative return of -2.91% for the first quarter 2005 against an historical average annual return of 6.18%). Market opportunities seem to have been eroded in these markets and "pure alphas" may be more difficult to find due to the huge number of players. 6 Hedge fund industry: is there a capacity effect?
  • 9. The alpha problem Indeed, 69.8% of respondents are aware of F or those claiming that the industry is suffering from a capacity constraint, the main problem would seem to be that alpha (manager skill) is "alternative betas" i.e. betas coming from exposure to risk factors other than market risk (see graph 4 below). Not surprisingly, 74% of the respondents becoming rarer. The results of our survey show that who are aware of alternative betas claim that while investors seem preoccupied with the problem alternative betas are predominant in relative value of alpha, the main concern in the industry now is to arbitrage strategies, mainly in convertible arbitrage evaluate this alpha and to understand the benefits of (58.33%, see graph 5 below) and fixed income hedge funds. arbitrage strategies (50%). Therefore, we can wonder whether the disappointing performance that We have seen previously that "pure alphas" seem to these strategies have experienced recently are due be difficult to find because some strategies may be to a reduction in the risk premiums with regard to overcrowded. However, no more than 53.3% of the the systematic risks that these funds are taking respondents think that alpha is the main source of (credit risk, volatility risk, etc., see exhibit 4) rather performance within the industry (see graph 3 than to "pure alpha" that would be becoming below). Moreover, 95% of the respondents think difficult to produce due to a shortage of market that alpha, through poor measurement of different opportunities and to overcrowding in these risk exposures, could be overestimated (see graph 6 strategies. These results confirm the analysis in below), showing that alpha is not such a major Gehin and Vaissié (2005), which indicated that source of returns and that exposure to different risk 103.17% and 95.81% of the performance level of exposures plays an important role in explaining Convertible Arbitrage funds and Fixed Income returns. As Fung (2003) says, Arbitrage funds, respectively, comes from their exposures to static betas (see exhibit 5). " hedge funds deliver alternative risk premia for bearing risk in factors different from traditional investment ", by for instance being exposed to volatility risk, default risk or liquidity risk. Hedge fund industry: is there a capacity effect? 7
  • 10. Equity Factors Bond Factors Other Lehman Global Bond Index (Bond Return) Change in Small Cap versus Large Cap Historical Volatility in Bond Return Change in Implied Volatility (VIX) Change in Value Versus Growth Exhibit 4: Exposure to Small Cap versus Large Cap risk factors by strategy Change in Credit Spread From January 1997 to Change in Term Spread Implied volatility (VIX) December 2004 Value versus Growth Commodity Index T-Bill 3 Months Credit Spread Term Spread US Dollar S&P 500 Equity Market Neutral + + + + + - - + + Fixed Income Arbitrage + + - - - Convertible Arbitrage + - + - + + Merger Arbitrage + + + + - - - + Distressed Securities + - + + - Long/Short Equity + + - + + - - - + Global/Macro + + + - + - - + - CTA Global + - - + + - + Emerging Markets + + + + - Source: Edhec Risk and Asset Management Research Centre Exhibit 5: Decomposition of Hedge Fund Strategies' Return Variability From January 1997 through December 2004 Investment Styles Static Betas Dynamic Betas Pure Alpha Total Convertible Arbitrage 42.13% 21.15% 36.72% 100.00% CTA Global 26.97% 34.60% 38.43% 100.00% Distressed Securities 66.76% 8.62% 24.62% 100.00% Emerging Markets 60.91% 14.74% 24.35% 100.00% Equity Market Neutral 51.53% 27.37% 21.09% 100.00% Fixed Income Arbitrage 37.28% 36.32% 26.39% 100.00% Global Macro 35.49% 34.52% 29.99% 100.00% Long/Short Equity 83.06% 9.25% 7.70% 100.00% Merger Arbitrage 59.51% 26.21% 14.29% 100.00% Average 51.52% 23.64% 24.84% 100.00% Source: Edhec Risk and Asset Management Research Centre 8 Hedge fund industry: is there a capacity effect?
  • 11. Talented managers Size effect? T he third argument behind the problem of capacity constraint within the industry would E ven if research on the "age" and "size" effect shows varying results, an argument of those alleging that the industry suffers from a capacity be that the industry suffers from a lack of talented individuals. According to Watson Wyatt (2005), no effect is that size would impact the fund more than 10% of current hedge fund managers are performance and therefore that there would be a highly skilled. With the increase in the number of critical size for a fund. funds and the fact that many managers with good track records are closed to new investment, the Our results seem to refute this idea. Half of the argument would be that fund of hedge funds respondents think that there is no size limit for a managers would have more difficulty finding fund of hedge funds, whereas the other half thinks talented hedge fund managers only and their future that a critical size exists (see graph 13 below). returns would be expected to go down. However, those who think that a critical size exists differ in their definition of the critical size (see The results of our survey show mitigated opinions. graph 14 below). For 23.2% of these respondents 59.3% of respondents find it difficult today to select the critical size of the fund of hedge funds depends talented managers (see graph 10 below), but only on the underlying strategies. For 18.3% the size is 36.3% of the respondents claim that the manager around $500 million and for 22% the critical size is capacity constraint is an important threat to returns between $1 billion and $2 billion. in the industry (see graph 11 below). It appears that the industry suffers more from the proliferation of 40.2% of the funds of hedge funds questioned are funds, which leads investors to improve their fund willing to buy or merge with a competitor in order selection process in order to find talented to gain capacity in the industry (see graph 15). managers, rather than from a shortage of talented managers. Hedge fund industry: is there a capacity effect? 9
  • 12. CONCLUSION C apacity constraint in the hedge fund industry Moreover, the hedge fund industry is maturing and is currently a matter of concern to investment becoming more competitive, with institutional professionals. However, as the results of our survey investors' current interest in the industry, the high show, the industry does not suffer from a capacity fees that have characterised the business and constraint but is facing new challenges. increasing regulations. As 81.3% of our respondents acknowledge (see graph 12 below), the 69.8% (see graph 7 below) of our respondents hedge fund industry is becoming more consider that cyclical factors were among the main professional. With professionalism and innovation, reasons behind recent lower-than-expected returns the industry is more likely to keep growing and (for 42.3% of our respondents cyclical factors were creating high and stable returns. However, as Lo the only reason). This corresponds to the (2004) says, conclusions of Fransolet and Loeys (2004), for whom many of the current low returns of hedge " new opportunities are constantly being funds are due to cyclical factors which prevent the created as certain species die out, as emergence of momentum or large mispricing others are born, and as institutions and opportunities (no major change in economic views, business conditions change ". low volatility, high correlation in markets, low credit spreads, etc.). By exploiting opportunities in different markets and therefore increasing liquidity in these markets, Investing in hedge funds offers several benefits but hedge funds reduce some opportunities, but at the has its risks. Hedge fund managers are not same time create new ones. magicians who provide excess returns without taking any risk. They are managers who create returns by exploiting alternative risk premiums and offer the benefits of diversification for an investor's portfolio (for 53.5% and 47.7% of our respondents respectively, the benefits of hedge funds come from their diversification benefits with equities and bonds, see graph 1 below). 10 Hedge fund industry: is there a capacity effect?
  • 13. REFERENCES Géhin, W. and Vaissié, M., "The Right Place for Alternative Betas in Hedge Fund Performance: an Answer to the Capacity Effect Fantasy", Edhec Risk and Asset Management Research Centre, June 2005. UBS, "The Critique of Pure Alpha", March 2005. Watson Wyatt, "Capacity in the Hedge Fund Industry", March 2005. Hedge fund industry: is there a capacity effect? 11
  • 14. APPENDIX: STATISTICAL RESULTS Graph 1 70% 1. If you invest in hedge funds, why do you do so? 60.0% 60% 53.5% 50% 47.7% % respondents 40% 32.9% 30% 21.8% 21.2% 20% 10.6% 10% 0% For their For their Hedge funds Better The volatility The potential Other diversification diversification offer absolute performance of hedge fund for maximal benefits with benefits with returns on average performance loss is lower bonds equities than that of is lower than than for traditional that of traditional funds traditional assets assets Graph 2 2. At what average annual rate do you expect hedge fund industry assets to grow over the next 5 years? 50% 45% 40% 36.3% % respondents 35% 30% 25.8% 25% 20.3% 20% 15% 10% 6.0% 6.0% 5% 2.2% 3.3% 0% Less than Between Between Between Between Between More than 0% 0% and 5% and 10% and 15% and 20% and 25% 5% 10% 15% 20% 25% Expected growth 12 Hedge fund industry: is there a capacity effect?
  • 15. Graph 3 3. To your mind, is alpha (manager skill) the main source of performance within the hedge fund industry? 60% 53.3% 50% 46.7% % respondents 40% 30% 20% 10% 0% Yes No Graph 4 4. Are you aware of what are referred to as “alternative betas” (betas coming from exposure to risk factors other than market risk)? 80% 69.8% 70% 60% % respondents 50% 40% 30.2% 30% 20% 10% 0% Yes No Hedge fund industry: is there a capacity effect? 13
  • 16. Graph 5 5. Within which strategies do you think that alternative betas are predominant? 70% 58% 60% 50% 50% % respondents 39% 40% 40% 33% 31% 29% 28% 28% 26% 30% 25% 25% 20% 10% 0% l ue ro es g ge ba ge ty ts en e l lin tra ag iti ac ke al ui a a lo riv itr el itr lM V itr r eu Eq ar G cu tS rb tD rb e tN rb M A Se tiv ba rt rA A A or en CT ho ng ke lo la ed Sh e e ge Ev bl ar /S gi G Re m ss er rti er ng co M re M Em e In Lo ty ist nv ui d D Co xe Eq Fi Graph 6 6. Do you think that alpha, through poor measurement of different risk exposures, could be overestimated? 100% 95.05% 90% 80% % respondents 70% 60% 50% 40% 30% 20% 10% 4.95% 0% Yes No 14 Hedge fund industry: is there a capacity effect?
  • 17. Graph 7 7. Do you think that the lower-than-expected returns in 2004 were due to cyclical factors or to capacity constraints? 45% 42.3% 40% 35% % respondents 30% 27.5% 25% 20.9% 20% 15% 9.3% 10% 5% 0% Cyclical Capacity Both Other factors constraints Graph 8 8. Do you think that arbitrage opportunities will be difficult to find in future years due to capacity constraints? 80% 70.9% 70% 60% % respondents 50% 40% 29.1% 30% 20% 10% 0% Yes No Hedge fund industry: is there a capacity effect? 15
  • 18. Graph 9 9. Of the following strategies, which suffer or will suffer from a market capacity constraint? 90% 83% 80% 70% 66% % respondents 60% 50% 45% 41% 41% 40% 40% 30% 24% 23% 19% 20% 15% 10% 11% 10% 5% 0% l ue ro ds es g e ba ge ty ts en e l ag lin tra ag iti ac un ke al ui a lo riv itr el itr lM eV itr r eu Eq fF ar G cu tS rb tD rb tN rb M A Se so tiv ba rt rA A A or en CT ng ho ke lo la nd ed Sh e e ge Ev bl ar /S gi G Re m Fu ss er rti er ng co M re M Em e In Lo ty ist nv ui d D Co xe Eq Fi Graph 10 10. Do you find it more difficult today to find talented hedge fund managers? 70% 59.3% 60% 50% % respondents 40.7% 40% 30% 20% 10% 0% Yes No 16 Hedge fund industry: is there a capacity effect?
  • 19. Graph 11 11. What is the main threat for returns in the industry? 50% 43.4% 45% 40% 36.3% % respondents 35% 30% 25% 20.3% 20% 15% 10% 5% 0% Manager capacity Market capacity Other constraints constraint (manager skill) (size of the industry) Graph 12 12. Do you think that the hedge fund industry is becoming more professional? 90% 81.3% 80% 70% % respondents 60% 50% 40% 30% 18.7% 20% 10% 0% Yes No Hedge fund industry: is there a capacity effect? 17
  • 20. Graph 13 13. Do you think that there is a critical size for a fund of hedge funds? 50.55% 49.45% 50% % respondents 40% 30% 20% 10% 0% Yes No Graph 14 14. Critical size for a fund of hedge funds 35% 30% % respondents 25% 23.2% 20% 18.3% 15.85% 15% 12.2% 12.2% 9.8% 10% 8.5% 5% 0% Less than Around Around Around Around Other Depends $300 $500 $1 billion $2 billion $5 billion size on the million million strategies 18 Hedge fund industry: is there a capacity effect?
  • 21. Graph 15 15. If you are a fund of hedge funds, are you willing to buy or merge with a competitor in order to gain capacity in the industry? 70% 59.8% 60% % respondents 50% 40.2% 40% 30% 20% 10% 0% Yes No Hedge fund industry: is there a capacity effect? 19
  • 22. EDHEC RISK AND ASSET MANAGEMENT RESEARCH CENTRE E dhec is one of the top five business schools in France owing to the high quality of its academic staff (over 100 permanent lecturers from The choice of asset allocation France and abroad) and its privileged relationship with professionals that the school has been developing since it was established in 1906. Edhec T he Edhec Risk and Asset Management Research Centre structures all of its research work around asset allocation. This issue Business School has decided to draw on its corresponds to a genuine expectation from the extensive knowledge of the professional market. On the one hand, the prevailing stock environment and has therefore concentrated its market situation in recent years has shown the research on themes that satisfy the needs of limitations of active management based solely on professionals. stock picking as a source of performance. On the other, the appearance of new asset classes (hedge Edhec is one of the few business schools in Europe funds, private equity), with risk profiles that are to have received the triple international very different from those of the traditional accreditation: AACSB (US-Global), Equis investment universe, constitutes a new opportunity (Europe-Global) and AMBA (UK-Global). in both conceptual and operational terms. This strategic choice is applied to all of the centre's Edhec pursues an active research policy in the field research programmes, whether they involve of finance. Its “Risk and Asset Management proposing new methods of strategic allocation, Research Centre” carries out numerous research which integrate the alternative class; measuring the programmes in the areas of asset allocation and risk performance of funds while taking the tactical management in both the traditional and alternative allocation dimension of the alphas into account; investment universes. taking extreme risks into account in the allocation; or studying the usefulness of derivatives in constructing the portfolio. Percent of variation between funds 3.5% 11.0% Strategic Asset Allocation 40.0% Tactical Asset Allocation Stock Picking 45.5% Fees Source: Edhec (2002) and Ibbotson, Kaplan (2000) 20 Edhec Risk and Asset Management Research Centre
  • 23. An applied research approach I n a desire to ensure that the research it carries out is truly applicable in practice, Edhec has implemented a dual validation system for the work Asset allocation and extreme risks This research programme relates to a significant of the Risk and Asset Management Research concern for institutional investors and their Centre. All research work must be part of a research managers – that of minimising extreme risks. It programme, the relevance and goals of which have notably involves adapting the current tools for been validated from both an academic and a measuring extreme risks (VaR) and constructing business viewpoint by the centre's advisory board. portfolios (stochastic check) to the issue of the long-term allocation of pension funds. This This board is made up of both internationally programme has been designed in co-operation with recognised researchers and the centre's business Inria's Omega laboratory. This research programme partners. The management of the research also intends to cover other potential sources of programmes respects a rigorous validation process, extreme risks such as liquidity and operations. The which guarantees both the scientific quality and the objective is to allow for better measurement and operational usefulness of the programmes. modelling of such risks in order to take them into consideration as part of the portfolio allocation To date, the centre has implemented six research process. programmes: Asset allocation and derivative Multi-style/multi-class allocation instruments This research programme has received the support This research programme focuses on the usefulness of Misys Asset Management Systems, SG Asset of employing derivative instruments in the area of Management and FIMAT. The research carried out portfolio construction, whether it involves focuses on the benefits, risks and integration implementing active portfolio allocation or methods of the alternative class in asset allocation. replicating indices. "Passive" replication of From that perspective, Edhec is making a "active" hedge fund indices through portfolios of significant contribution to the research conducted in derivative instruments is a key area in the research the area of multi-style/multiclass portfolio carried out by Edhec. This programme is supported construction. by Eurex and Lyxor. Performance and style analysis ALM and asset management The scientific goal of the research is to adapt the This programme concentrates on the application of portfolio performance and style analysis models recent research in the area of asset liability and methods to tactical allocation. The results of the management for pension plans and insurance research carried out by Edhec thereby allow companies. The research centre is working on the portfolio alphas to be measured not only for stock idea that improving asset management techniques picking but also for style timing. This programme is and particularly strategic allocation techniques has part of a business partnership with the firm a positive impact on the performance of Asset- EuroPerformance (part of the Fininfo group). Liability Management programmes. The programme includes research on the benefits of Indices and benchmarking alternative investments, such as hedge funds, in long-term portfolio management. Particular Edhec carries out analyses of the quality of indices attention is given to the institutional context of and the criteria for choosing indices for institutional ALM and notably the integration of the impact of investors. Edhec also proposes an original the IFRS standards and the Solvency II directive proprietary style index construction methodology project. for both the traditional and alternative universes. These indices are intended to be a response to the critiques relating to the lack of representativity of the style indices that are available on the market. Edhec was the first to launch composite hedge fund strategy indices as early as 2003. The indices and benchmarking research programme is supported by AF2I, Euronext, BGI, BNP Paribas Asset Management and UBS Global Asset Management. Edhec Risk and Asset Management Research Centre 21
  • 24. Edhec Risk and Asset Management Advisory Board I n a desire to guarantee that its research work is both relevant and operational, the Edhec Risk and Asset Management Research Centre has set up Launch of Edhec-Risk Advisory, the consulting arm of the research centre focusing on risk management issues within the buy-side industry, an advisory board chaired by Mr. Jean-François and offering a wide range of services aimed at Lepetit, associate professor with Edhec and former supporting fund managers and their service president of the French regulatory authority, the providers in the fields of operational risk, best COB (Commission des Opérations de Bourse). execution, structured products, alternative investment due diligence and risk management The board is made up of around twenty members, system implementation. chosen according to their experience and their expertise in the financial domain and, more Launch of Edhec Investment Research, in order specifically, in asset management. The functions of to support institutional investors and asset the board are, on the one hand, to validate the managers in implementing the results of the Edhec objectives of the research programmes proposed by Risk and Asset Management Research Centre’s the management of the centre and, on the other, to research. Edhec Investment Research proposes evaluate the results of the research with a view to asset allocation services in the context of a “core- the impact that they could have on the practices of satellite” approach encompassing alternative the asset management industry. investments. The board will also be called on to give its opinion Launch of Edhec Alternative Investment on the content of the projects that Edhec develops Education, which is the exclusive official CAIA from the research of its asset management research association course provider for Europe. centre (initial training, executive training, etc.). The board meets on a yearly basis during plenary sessions that allow current and future research The team centre developments to be reviewed. The board chairman may also, on certain subjects, form ad- T hoc working groups that would be in charge of he aim of the Edhec Risk and Asset preparing or studying in greater detail themes that Management Research Centre is to become the have been or will be brought up in the plenary leading European centre of research into asset session. management in the coming years. To that end, Edhec has invested significantly to give the centre an international research team made up of both professors and permanent researchers, with whom Research for business professionals are affiliated in the capacity of research associates. I n order to facilitate the dialogue between the To date, the Edhec Risk and Asset Management academic and business worlds, the centre has Research Centre has more than 28 members: 15 recently undertaken four major initiatives: permanent members and 13 associates that are operating in firms that are reputed for their Opening of a web site that is entirely devoted to the proficiency in asset management. activity of international research into asset management. www.edhec-risk.com is aimed at a This team is managed by Professor Noël Amenc, public of professionals who wish to benefit from who has considerable experience in asset Edhec's analyses and expertise in the field of management as both an academic and a applied portfolio management research such as professional. detailed summaries, from a business perspective, of the latest academic research on risk and asset allocation as well as the latest industry news assessed in the light of the results of the Edhec research programme. www.edhec-risk.com is also the official site for the Edhec Indices. 22 Edhec Risk and Asset Management Research Centre
  • 25. Edhec Risk and Asset Management Research Centre 393-400 Promenade des Anglais BP 3116 06202 Nice Cedex 3 France Tel. +33 (0)4 93 18 78 24 Fax +33 (0)4 93 18 78 40 research@edhec-risk.com www.edhec-risk.com

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