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
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
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
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 +
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
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
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
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%
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
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
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)
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
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.
HOW WE GOT HERE . . .
The customer heard the following from active managers:
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!
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
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
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
NEW BREED OF ACTIVE MANAGEMENT
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?
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%