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The Wave of the Future
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The Wave of the Future

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  • 1. The Wave of the Future THE 2005 NASRA ANNUAL CONFERENCE A CASE FOR HEDGE FUND INVESTING Sunday, August 7, 2005 7700 Bonhomme Avenue, Suite 300 St. Louis, Missouri 63105 314/727-7211 Stephen P. Holmes, CFA, President Summit Strategies Group
  • 2. HEDGE FUND Roles in Portfolio Construction
    • Provides diversification to a traditional fixed income portfolio in a rising interest rate environment.
    • Primarily non-directional strategies (relative value and event driven) with the objective of seeking consistent positive absolute returns.
    • Optimal Strategies included in this portfolio have low correlation to changes in interest rates.
    • Expected Return: 6-7%%
    • Expected Standard Deviation: 4-6%
    Summit recommends hedge funds be utilized in two roles as portfolio risk management tools in the context of total portfolio construction: FIXED INCOME ALTERNATIVE
  • 3. HEDGE FUND Roles in Portfolio Construction
    • The beta exposure from any portion of the portfolio (equity or fixed income) can be achieved synthetically and combined with the alpha generated by the hedge fund pool.
    • Allows investors to incorporate the alpha generated by a diversified portfolio of hedge funds with the returns of traditional asset classes.
    • The objective of the alpha pool is to generate consistent positive returns with minimum drawdowns in order to earn a spread over the beta exposure.
    • Expected Alpha: 3-4%
    • Expected Standard Deviation: 3-5%
      • Superior Sharpe ratio to a traditional diversified active manager pool
    (continued) PORTABLE ALPHA
  • 4. ONGOING SOURCES OF RETURNS HEDGE FUNDS LONG-ONLY ACTIVE MANAGEMENT Issue Selection (Incremental bets vs. benchmark) + Less Fees – Less Fees – Issue Selection & De-Selection + Latitude of Opportunity Set + Financial “Engineering” + Leverage +
  • 5. FIXED INCOME DIVERSIFIER Expected Return: 7.0% 6.0% Portfolio Weight Expected Total Return Standard Deviation 40% 5.0% 6.0% Equity Market Neutral 40% 8.0% 8.0% Multi-Strategy 20% 9.0% 10.0% Directional Strategies Low High Risk Spectrum HEDGE FUND STRATEGIES HEDGE FUND STRATEGIES Relative Value Relative Value Event - Driven Event - Driven Directional Directional Equity Market Neutral Equity Market Neutral Convertible Arbitrage Convertible Arbitrage Fixed Income Arbitrage Fixed Income Arbitrage Merger Arbitrage Merger Arbitrage Distressed Securities Distressed Securities Long/Short Equity Long/Short Equity Short Biased Short Biased Macro Macro
  • 6. PORTABLE ALPHA HEDGE FUND STRATEGIES HEDGE FUND STRATEGIES Relative Value Relative Value Event - Driven Event - Driven Directional Directional Equity Market Neutral Equity Market Neutral Convertible Arbitrage Convertible Arbitrage Fixed Income Arbitrage Fixed Income Arbitrage Merger Arbitrage Merger Arbitrage Distressed Securities Distressed Securities Long/Short Equity Long/Short Equity Short Biased Short Biased Macro Macro Expected Return: 3.5% 3.2% Portfolio Weight Expected Total Return less LIBOR Standard Deviation 50% 2.0% 3.0% Equity Market Neutral 50% 5.0% 5.0% Multi-Strategy
  • 7. FIXED INCOME DIVERSIFIER Client Example
    • Expected return of 6.5% to 7.0% vs. Lehman Aggregate expected return of 4.5%
    • Fixed income-like volatility
    • Low correlation to interest rates
    -2% 0% 2% 4% 6% 8% 10% 12% 14% 2002* 2003 2004 2005 YTD Hedge Funds Core Plus Fixed Income (1.18%) 6.32% 11.44% 8.84% 6.65% 6.75% 0.66% 3.00% Core Plus Total Fixed LB Aggregate Median Core Fixed Universe, 3 Years Ending 6/30/2005
  • 8. PORTABLE ALPHA Client Example Return and volatility assumptions: Based on return and volatility expectations, the data suggests an equal-weighted portfolio to deliver alpha of 5.5% with tracking error of 5.4% over a full market cycle *Volatility and correlations for the managers have been lower than we expect to see in the future For conservative reasons, we model 4.0%, with 4.0% standard deviation expectation Multi-Strategy Fund of Funds Direct Market Neutral Fund Market Neutral Fund of Funds Market Neutral Fund of Funds Direct Multi - Direct Multi - Strategy Fund - Strategy Fund - Manager Portfolio Weight Expected Tot Ret – LIBOR Std Dev Direct Multi-Strategy Fund 17% 9% 12% Direct Multi-Strategy Fund 17% 3% 6% Multi Strategy Fund of Funds 17% 6% 7% Direct Market Neutral Fund 17% 6% 3% Market Neutral Fund of Funds 17% 5% 4% Market Neutral Fund of Funds 17% 4% 4% 5.5% 5.4%
  • 9. CLIENT’S EXCESS RETURN EXPERIENCE by Individual Asset Class Large Cap Excess Return Large Cap Excess Return Non-Large Cap Excess Return Actual Actual Client Experience Non-Large Cap Excess Return
  • 10. CLIENT’S EXCESS RETURN EXPERIENCE by Individual Asset Class (continued) International Equity Excess Return International Equity Excess Return Fixed Income Excess Return Fixed Income Excess Return Actual Actual Client Experience
  • 11. A LOGICAL STARTING POINT TO USE PORTABLE ALPHA Consider Portable Alpha Definitely Use Portable Alpha Client's Summit's Portable Experience Expectation Alpha Large Cap Equity 1.3% 1.0% 4.0% Non - Large Cap Equity 2.1% 2.5% 4.0% International 1.1% 3.0% 4.0% Fixed Income - 0.3% 0.5% 4.0% Client's Summit's Portable Experience Expectation Alpha Large Cap Equity 1.3% 1.0% 4.0% Non - Large Cap Equity 2.1% 2.5% 4.0% International 1.1% 3.0% 4.0% Fixed Income - 0.3% 0.5% 4.0% VALUE-ADDED (ALPHA)
  • 12. IMPACT OF PORTABLE ALPHA ON TOTAL PORTFOLIO Total Portfolio: Actual Client Experience Total Fund Actual Total Fund Actual Total Fund with Portable Alpha Total Portfolio: Hypothetical 4% Excess Return from Portable Alpha Total Fund with Portable Alpha
  • 13. WHERE DO WE GO FROM HERE?
    • How did we get here?
      • Why are fiduciaries throwing billions into an asset class that has no quality defendable track record, too little disclosure, with too much money, chasing too few ideas?
      • Either they really like the above characteristics, OR they’re just moving away from something unpleasant.
    • What’s so active about ACTIVE management? (long only)
      • “Our economic forecast shows very strongly that rates will rise 1.5 to 2% next year, therefore we have positioned your portfolio to be 26 hours short of the benchmark duration.”
      • “This is our number one-ranked stock idea, so we've double-weighted it to 1.2% of the portfolio (which is 1/3 the weight of GE, but we have to own it at the benchmark weight).”
      • Or, as I asked a small cap growth momentum manager in November, 1999, “How can you own a portfolio with a total P/E ratio of 130x?”, and he replied, “I don’t know.”
    • What I believe about all asset classes . . .
      • Investors get too little for too much.
      • The supply of true investment talent is much smaller than the industry assumes. Genius is rare!
      • Any time large fees are predicated on vast future returns, check your wallet.
      • Customers create markets in the long run.
  • 14. HOW WE GOT HERE . . .
    • The customer heard the following from active managers:
      • 1995-1999
        • No way can we keep up with a cap-weighted benchmark; however, if we get a broad market or, even better, a down market, watch the genius come out!
      • 2000-2003
        • Because of our strict adherence to the benchmark, when the Russell 2000 Growth Index was down 75%, we were only down 71%!
        • We all blindly sailed your ship, Mr. Investor, into the same iceberg, but since my boat sank slower than the other boats, then I must be a great captain.
    • Into the fray steps the hedge fund manager who says:
      • “I’ll think with your money.”
      • “I’ll be my own person.”
      • “I’m going to charge more but at least I’ll do something!”
      • For a while it worked
        • Markets played into hedge funds’ hands
          • Being short anything helped relative to long only managers
        • Strong relative returns came in
          • Clients got wealthier
          • Hedge fund managers got fabulously wealthy
  • 15. WHERE DO WE GO NOW?
    • Traditional investment managers will look to remove benchmark constraints from portfolios in order to generate “alpha”
    • Clients will demand more active management from managers
    NOT-SO-ACTIVE MANAGEMENT Active Management IN THE BEGINNING . . . PASSIVE MANAGEMENT “ If you’re not going to think, I’m not going to pay you not to think.” STEP 1 ALPHA TILTS, ENHANCED INDEX STEP 2 HYPER-ACTIVE MANAGEMENT “ I don’t care what I pay you as long as you deliver.” Hedge Funds STEP 3
  • 16. WHAT WE’RE SEEING . . .
    • Real World Examples:
      • Western, BlackRock offering long only products with allocations that are not tied to a benchmark
      • Freeman Associates offering long/short products in order to capture additional alpha from shorting securities, at flat asset-based fee (no carry)
      • Maverick Capital launching long only products to provide investors with an alternative to traditional active management that is less index sensitive
      • MOSERS using portable alpha structures in order to separate the alpha/beta decision in their portfolio
        • Take steps to generate additional “alpha” in more efficient areas of the portfolio
      • Clients building their own portfolios of direct hedge funds to lower the overall expense of implementation
    NOT-SO-ACTIVE MANAGEMENT HYPER-ACTIVE MANAGEMENT PASSIVE MANAGEMENT ALPHA TILTS, ENHANCED INDEX More thinking
    • Lower fees
    • Greater transparency
    NEW BREED OF ACTIVE MANAGEMENT
  • 17. ACTIVE MANAGEMENT EXAMPLES Western Absolute Return Fixed Income Portfolio
    • The Lehman Aggregate Index is the most commonly used proxy for the U.S. “Core” fixed income market
    • In order to beat the benchmark, the portfolio must be different from the benchmark
      • Any position different from the benchmark is a “bet” which will ultimately be right or wrong
      • All “bets” are relative to the benchmark; e.g., over or underweighting issues, sectors or duration
    • Managers do not take big “bets” with traditional core fixed income portfolios – why not?
      • Business risk
    • Inconsistent with the asset class philosophy of stability of principal and income generation
    • In 2004, Summit asked Western and BlackRock to construct portfolios of their “best ideas,” unconstrained in terms of sector allocation and duration. Target return = LIBOR + 2.5%.
    • The end product was a portfolio much different from traditional core or core plus mandates
    Lehman Brothers Aggregate Bond Index Cash 0% Agencies 15% Corporates 20% CMBS 3% ABS 1% MBS 35% ` U.S.Treasuries 26% Western Asset Management Absolute Return Portfolio Cash 20% Credit 5% High Yield 10% Bank Loans 20% Emerging Markets 12% Non-Dollar 10% Global Inflation Linked 3% TIPS 18% ABS 2%