Thomas Schneeweis Director CISDM/University of Massachusetts ...

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  • 1. Thomas Schneeweis Director CISDM/University of Massachusetts-Amherst Amherst, Massachusetts 01003 Ph: 413-545-5641 Email: [email_address] Web: WWW.CISDM.ORG October 4, 2002 THE PRESENTATION IS BASED ON INFORMATION OBTAINED FROM SOURCES THAT CISDM CONSIDERS TO BE RELIABLE; HOWEVER, CISDM MAKES NO REPRESENTATION AS TO, AND ACCEPTS NO RESPONSIBILITY OR LIABILITY FOR, THE ACCURACY OR COMPLETENESS OF THE INFORMATION. Hedge Fund Strategies What are the Real Risk and Return Characteristics
  • 2. Thomas Schneeweis is the Michael and Cheryl Philipp Professor of Finance at the University of Massachusetts, Director of the Center for International Securities and Derivatives Markets, Editor of The Journal of Alternative Investments and is on the Board of the Chartered Alternative Analyst Association. He has published over 70 articles in academic and financial practitioner journals, has presented papers at numerous professional meetings in areas of traditional and alternative investment, and has been quoted in widely in the financial press (Business Week, Financial Times, Wall Street Journal). He has edited several books including the Applications in Finance, Investment, and Banking (Kluwer, 1999) and The Handbook of Alternative Investments: An Investor's Guide (Institutional Investor, 1999). Dr. Schneeweis is also President of Schneeweis Partners LLC, which provides investment management and analytical support to institutional investors primarily in the area of alternative investments. Background
  • 3.
    • Hedge Fund Investment: Background
    • Return and Risk Analysis in Hedge Funds
    • Hedge Fund Indices and Benchmarks
    • Asset Allocation: Strategic and Tactical
    • Risk Analysis: VaR and Manager Analysis
    Hedge Fund Strategies: Risk and Return
  • 4. I: Hedge Fund Background: What is a Hedge Fund?
    • Term “Hedge Fund” is a misnomer with little descriptive power
    • 1950’s: A.W. Jones Model
      • Long/Short U.S. equities
      • “ Hedge fund” term accurately reflected his underlying strategy
    • 2000’s: Generic reference to a private, commingled vehicle investing in marketable securities
      • Strategy characteristics vary widely
      • Risk/return characteristics vary widely
      • Common organizational and structural characteristics
  • 5.  
  • 6.  
  • 7. Source: Investments & Pensions Europe, May 2001 Wide International Interest
  • 8. Recently, a substantial number of large U.S. and non-U.S. institutions, California Public Employees Retirement System, Northeastern University, Nestlé and UK Coal Pension and Yale University have indicated their continued interest in hedge fund investment. Sources: New York Times , Pensions and Investments , Financial Times, IHT Growth of Hedge Funds
  • 9. Sources: New York Times , Pensions and Investments , Financial Times, IHT Institutional Interest in Hedge Funds Institutional Interest
  • 10. Sources: New York Times , Pensions and Investments , Financial Times, IHT Composition of Hedge Fund Investors Types of Hedge Fund Investors High Net Worth Individual Offshore Individual Offshore Institution University Endowment Pension Fund
  • 11. Growth of Hedge Funds
  • 12. Myths of Hedge Fund Investment
    • Hedge Funds Are An Investment Product of the 1990’s
    • Hedge Funds Are Unique In Their Investment Strategies
    • All Hedge Funds Are Risky Because They Use Derivatives
    • Hedge Funds Are Highly Levered Risky Investments
  • 13. Hedge Fund Facts
    • Hedge Funds Are Not More Volatile Than Traditional Stock and Bond Funds
    • Many Hedge Funds Are As Transparent Than Traditional Stock and Bond Funds (Fund Based or Separate Accounts)
    • Most Hedge Funds Are As Liquid As Traditional Stock and Bond Funds (Depends on Strategy)
  • 14. Hedge Fund Facts
    • Hedge Funds Provide Unique Return Opportunities Not Available in Traditional Markets)
    • We Know the Source of Hedge Fund Returns
    • Indices Exist which Track Hedge Funds
  • 15. Hedge Fund Facts
    • Fees: (1 and 10 Fee Above Hurdle is Approximately 2-3% and Is Pure Active Return Whereas Traditional Mutual Funds Are About 1-2% much of which is Benchmarked to Index)
    • Lack of Liquidity Is Reduced By New Forms of Guarantees
    • Academic Evidence Shows That Trading Impacts on Local Market Are Limited Due To Relative Size of Hedge Fund Market In Comparison to Traditional Markets
    • Some Evidence of Hedge Fund Affecting Individual Securities tocks but Little Evidence of Systemic Risk Within Markets or Across Countries
  • 16. Goals of Hedge Fund Investment
    • Take advantage of the ability to profit in a range of market environments
    • Develop a diversified approach to capturing ‘alpha’
    • Efficiently deliver returns at a risk level defined by the investor
  • 17. Hedge Fund Core Portfolio
    • Manager Selection
      • Select managers consistent with return and risk stability
      • Consistent sensitivity to market factors which underlie return drivers
      • Stability over time in relationship to index and other managers in style
    • Strategy Selection
      • Take advantage of the ability to profit in a range of market environments
      • Develop a diversified approach to capturing ‘alpha’
  • 18.  
  • 19. II: Risk and Return Analysis in Hedge Funds
    • Investors get paid for bearing certain risks
      • Beta is an important one. Credit risk, term structure risk, volatility risk, and liquidity risk are others
    • Hedge fund strategies generally minimize beta and maximize exposure to the other risks
      • Often misconstrued as absolute return (or return to skill)
      • Factor models quantify a fund’s exposure to these risks - separate ‘natural’ return from ‘skill
  • 20. Each Hedge Fund Strategy or Managed Futures Strategy Has Own Economic Source of Return
        • Equity Market Neutral - Relative Mispricing
        • Convertible Arbitrage - Volatility, Credit Risk
        • Merger Arbitrage - Equity And Credit Exposure
        • Distressed Securities - Credit Spreads, Liquidity Risk
        • Hedged Equity - Equity Factor Sensitivity, Volatility
        • Managed Futures – Markets Trends
  • 21. Hedge Fund Exposure to Market Factors Univariate Regression of Returns Against Factors 1990-02
  • 22. Managed Futures Exposure to Market Factors
  • 23. Managed Futures Exposure to Market Factors
  • 24. Hedge Fund Exposures During Extreme Periods
    • Returns on hedge fund indices and various asset classes and factors were grouped in quartiles. Each group holds 25% of observations.
    • The bottom quartile holds 25% of observations that are the lowest, while the top quartile holds 25% of observations that the highest.
    • Returns on hedge fund indices and other asset classes were ranked using the dates that correspond to the observations in each quartile.
  • 25. Exposures During Extreme Periods
  • 26. Exposures During Extreme Periods
  • 27. Exposures During Extreme Periods
  • 28. Exposures During Extreme Periods
  • 29. Managed Futures Exposures During Extreme Periods
  • 30. Hedge Fund Managers
    • Questions:
      • How Persistent Are The Benefits Of Hedge Fund Managers?
      • How Persistent Are Benefits Of Hedge Fund Strategies?
  • 31. Persistence of Performance: Manager Based or Strategy Based
    • We regressed monthly excess returns of several hedge fund managers against monthly excess returns on S&P500 and Lehman Aggregate Bond Index
    • Risk is measured in terms of exposures to equity and bonds.
    • The intercept represents the manager’s alpha.
  • 32. Persistence of Alphas: Index Alpha High - Manager Alpha Low
  • 33. Persistence of Exposures
  • 34. Persistence of Exposures
  • 35. Summary
    • Alphas at managers levels are not persistent.
    • Alphas at the index levels are persistent.
    • The same story can be said about risk exposures.
    • With minor changes, these results hold for all strategies.
  • 36.
    • Manager Based
    • Security Based
    • Factor Based
    III: Hedge Fund Indices and Benchmarks
  • 37.
        • No Universe of Manager Performance Index Exists
          • Current Universe of Managers (e.g., Zurich, TASS, …) Provide only limited representation of true Universe
        • Most current ‘Universe Indices’ are not ‘True’ indices
          • Collection of self reporting managers
        • Passive Versus Active Indices
          • Passive Index requires systematic security (e.g., strategy) or factor based representation of manager strategy and should reflect active manager index
    Hedge Fund Universe Versus Hedge Fund Index
  • 38. Hedge Fund Universe, Sub-Universe, Index Universe of Hedge Funds (5000) CISDM Sub-Universe (2500 approx) HFR Sub Universe TASS Sub-Universe Zurich Hedge Fund Indices CSFB/Tremont Index
    • Composite of World Unknown
    • Sub-universe (e.g., HFR, TASS,Zurich) may or may not represent World Index
    • Personal Libraries (e.g., Zurich Hedge Fund Indices, CSFB, EACM) may better represent characteristics of specific area
    • than general random selection of books in general sub universe
    Some intersection of hedge funds in various Sub-universes
  • 39.  
  • 40. Overview of Hedge Fund Indices
  • 41. Overview of Hedge Fund Indices
  • 42. Overview of Hedge Fund Indices
  • 43. Overview of Hedge Fund Indices
  • 44. Alternative Hedge Fund Databases: Performance Comparisons (Jan 1998 – June 2002)
  • 45. Relative Index Performance: Fund of Fund Performance
  • 46. Hedge Fund Databases: Convertible Arbitrage Example
  • 47. Index Creation: Index Based Replication
  • 48. Security Based Passive Indices (CTA Example)
  • 49. Multi-Factor Based Index Replication
  • 50. IV: Asset Allocation
    • Issues in Asset Allocation
      • Number of Managers Required
      • Index and Fund Tracking
      • Return Forecasting
    • Traditional Approaches Fund Creation
    • Strategic and Tactical
  • 51. Allocation for the Institutional Investor Naïve Multi-Manager Portfolios: An equal weighted portfolio of 8 to 10 mangers generally Reduces the risk of the portfolio to that of the universe of managers from which they are drawn: Variance of an Equal Weighted Portfolio= 1/N*(average variance of all managers – average covariance between managers) + average covariance between managers. Naïve diversification is more effective the larger the difference between the average variance and the average covariance of all managers (e.g., more heterogeneous the manager strategies) Markowitz Mean/Variance Asset Allocation: Managers are naively selected to maximize the return to risk (e.g., standard deviation) tradeoff. The Return of the Portfolio = weighted average of the individual managers and the Variance of the Portfolio = the combination of the weighted variances of the individual managers plus their weighted covariances. The benefits of mean/variance asset allocation depend on the relative returns, variances and covariances (e.g., correlations and standard deviations). Inputs to Markowitz Mean/Variance Problem
  • 52. Naïve Multi-Manager Portfolios
  • 53. Naïve Multi-Manager Portfolios
  • 54. In Asset Allocation, Indices Must Reflect Asset Manager’s Sensitivity to Factors
  • 55. Historical indexes May not Reflect Future Returns of Current Index
  • 56. Historical Returns May Be Poor Forecasts Of Future Hedge Fund Return
  • 57. Traditional Approach to Mean Variance Optimization
  • 58. Asset Allocation
    • Given problems in return forecasts, one may simply assume traditional asset weights are chosen correctly and one wishes to chose hedge fund replacement strategies which produce alpha.
    • We consider the case of an investor who wants to reduce his/her holdings of a traditional asset class and invest the proceeds in a portfolio of hedge funds.
    • The goal is to make the new portfolio a close substitute for the original portfolio.
  • 59. Stand Alone Substitutes for Assets Classes Equity
  • 60. Stand Alone Substitutes for Assets Classes Equity
  • 61. Stand Alone Substitutes for Assets Classes Corporate Bonds
  • 62. Stand Alone Substitutes for Assets Classes Corporate Bonds
  • 63. Traditional Assets & Hedge Funds Data: 1990-02
  • 64. Strategic and Tactical Asset Allocation
    • Strategic Asset Allocation (Long Term Allocation)
      • Hedge Funds to Replicate Hedge Fund Indices
      • Hedge Funds to Replicate Cash Market Indices
    • Tactical Asset Allocation (Short Term Rebalancing)
      • Hedge Fund Strategies Lead/Lag Relationships with Economic Variables
  • 65. Hedge Funds can be used Replicate EACM 100 Index used in Asset Allocation
  • 66. Hedge Funds can be used Replicate Russell Index used in Asset Allocation
  • 67. Tactical Asset Allocation
    • Returns on traditional assets classes are somewhat predictable using lagged values of certain variables
      • Credit risk, Volatility, Term Premium, Returns, etc
    • We used the lagged values of a set of factors to predict returns to various hedge fund strategies.
  • 68. Tactical Asset Allocation
    • We considered rebalancing our portfolio on a systematic basis.
    • The estimation period is a rolling 2-years period and starts on Jan 1990 and ends with Dec 1999.
  • 69. Tactical Asset Allocation
  • 70. Tactical Asset Allocation To Best of Five
    • Systematic reallocation is beneficial
    • Benefits are reduced when the reallocation interval is increased.
  • 71. V: Risk Analysis
    • Manager Level
      • Sophisticated risk management including VaR analysis to ensure style consistency, and leverage management
      • Segregated accounts to eliminate possibility of fraud, and gross mismanagement
    • Style Level: Oversight ensures level of concentration within individual securities/sectors within appropriate limits
    • Portfolio Level: Daily reports to clients/structuring partners outlining risk levels
  • 72. VaR Analysis on Portfolio Assets
  • 73. Due Diligence, Controls & Portfolio Monitoring
    • Due Diligence
    • Background checks
    • Registrations and regulatory checks
    • Verification of education and certification
    • Investment methodology and risk protocol
    • Systems and procedures review (including disaster recovery, back office and compliance practices)
    • On-site visits
    • Controls & Portfolio Monitoring
    • Separate account structure
    • Custody of all assets
    • Leverage limitations
    • Favorable liquidity terms
    • Transparency and risk analytics
    • Defined portfolio guidelines
  • 74. Conclusions
    • Style Pure Fund or Manager Indices Provide Surrogates for Risk and Return Process Underlying Strategy
    • Factor Based Indices Provide Surrogates for Risk and Return Process Underlying Strategy If Strategy Has Fundamental Market Factor Driving Process
    • Security Based Indices Provide Tradable Surrogate Risk and Return Process Underlying Strategy If Strategy Is Traded In A Systematic Manner
  • 75. Appendix
  • 76. Appendix
  • 77. Appendix