Thomas Schneeweis Director CISDM/University of Massachusetts-Amherst Amherst, Massachusetts 01003 Ph: 413-545-5641 Email: ...
Thomas Schneeweis  is the Michael and Cheryl Philipp Professor of Finance at the University of Massachusetts, Director of ...
<ul><li>Hedge Fund Investment: Background </li></ul><ul><li>Return and Risk Analysis in Hedge Funds </li></ul><ul><li>Hedg...
I: Hedge Fund Background: What is a Hedge Fund? <ul><li>Term “Hedge Fund” is a misnomer with little descriptive power </li...
 
 
Source: Investments & Pensions Europe, May 2001 Wide International Interest
Recently, a substantial number of large U.S. and non-U.S. institutions, California Public Employees Retirement System, Nor...
Sources:  New York Times ,  Pensions and Investments ,  Financial Times, IHT Institutional Interest in Hedge Funds Institu...
Sources:  New York Times ,  Pensions and Investments ,  Financial Times, IHT Composition of Hedge Fund Investors Types of ...
Growth of Hedge Funds
Myths of Hedge Fund Investment <ul><li>Hedge Funds Are An Investment Product of the 1990’s </li></ul><ul><li>Hedge Funds A...
Hedge Fund Facts <ul><li>Hedge Funds Are Not More Volatile Than Traditional Stock and Bond Funds  </li></ul><ul><li>Many H...
Hedge Fund Facts <ul><li>Hedge Funds Provide Unique Return Opportunities Not Available in Traditional Markets)  </li></ul>...
Hedge Fund Facts <ul><li>Fees: (1 and 10 Fee Above Hurdle is Approximately 2-3% and Is Pure Active Return  Whereas  Tradit...
Goals of Hedge Fund Investment <ul><li>Take advantage of the ability to profit in a range of market environments </li></ul...
Hedge Fund Core Portfolio <ul><li>Manager Selection </li></ul><ul><ul><li>Select managers consistent with return and risk ...
 
II: Risk and Return Analysis in Hedge Funds <ul><li>Investors get paid for bearing certain risks </li></ul><ul><ul><li>Bet...
Each Hedge Fund Strategy or Managed Futures Strategy Has Own Economic Source of Return <ul><ul><ul><li>Equity Market Neutr...
Hedge Fund Exposure to Market Factors Univariate Regression of Returns Against Factors 1990-02
Managed Futures Exposure to Market Factors
Managed Futures Exposure to Market Factors
Hedge Fund Exposures During Extreme Periods <ul><li>Returns on hedge fund indices and various asset classes and factors we...
Exposures During Extreme Periods
Exposures During Extreme Periods
Exposures During Extreme Periods
Exposures During Extreme Periods
Managed Futures Exposures During Extreme Periods
Hedge Fund Managers <ul><li>Questions: </li></ul><ul><ul><li>How Persistent Are The Benefits Of Hedge Fund Managers? </li>...
Persistence of  Performance: Manager Based or Strategy Based <ul><li>We regressed monthly  excess  returns of several hedg...
Persistence of Alphas: Index Alpha High -  Manager Alpha Low
Persistence of Exposures
Persistence of Exposures
Summary <ul><li>Alphas at managers levels  are not  persistent. </li></ul><ul><li>Alphas at the index levels  are  persist...
<ul><li>Manager Based </li></ul><ul><li>Security Based </li></ul><ul><li>Factor Based </li></ul>III: Hedge Fund Indices an...
<ul><ul><ul><li>No Universe of Manager Performance Index Exists </li></ul></ul></ul><ul><ul><ul><ul><li>Current Universe o...
Hedge Fund Universe, Sub-Universe, Index Universe of Hedge Funds (5000) CISDM Sub-Universe (2500 approx) HFR Sub Universe ...
 
Overview of Hedge Fund Indices
Overview of Hedge Fund Indices
Overview of Hedge Fund Indices
Overview of Hedge Fund Indices
Alternative Hedge Fund Databases: Performance Comparisons (Jan 1998 – June 2002)
Relative Index Performance: Fund of Fund Performance
Hedge Fund Databases: Convertible Arbitrage Example
Index Creation: Index Based Replication
Security Based Passive Indices (CTA Example)
Multi-Factor Based Index Replication
IV: Asset Allocation <ul><li>Issues in Asset Allocation </li></ul><ul><ul><li>Number of Managers Required </li></ul></ul><...
Allocation for the Institutional Investor Naïve Multi-Manager Portfolios:  An equal weighted portfolio of 8 to 10 mangers ...
Naïve Multi-Manager Portfolios
Naïve Multi-Manager Portfolios
In Asset Allocation, Indices Must Reflect Asset Manager’s Sensitivity to Factors
Historical indexes May not Reflect Future Returns of Current Index
Historical Returns May Be Poor Forecasts Of Future Hedge Fund Return
Traditional Approach to Mean Variance Optimization
Asset Allocation <ul><li>Given problems in return forecasts, one may simply assume traditional asset weights are chosen co...
Stand Alone Substitutes for Assets Classes  Equity
Stand Alone Substitutes for Assets Classes  Equity
Stand Alone Substitutes for Assets Classes  Corporate Bonds
Stand Alone Substitutes for Assets Classes  Corporate Bonds
Traditional Assets & Hedge Funds Data: 1990-02
Strategic and Tactical Asset Allocation <ul><li>Strategic Asset Allocation (Long Term Allocation) </li></ul><ul><ul><li>He...
Hedge Funds can be used Replicate EACM 100 Index used in Asset Allocation
Hedge Funds can be used Replicate Russell Index used in Asset Allocation
Tactical Asset Allocation <ul><li>Returns on traditional assets classes are somewhat predictable using lagged values of ce...
Tactical Asset Allocation <ul><li>We considered rebalancing our portfolio on a systematic basis. </li></ul><ul><li>The est...
Tactical Asset Allocation
Tactical Asset Allocation To Best of Five <ul><li>Systematic reallocation is beneficial </li></ul><ul><li>Benefits are red...
V: Risk Analysis <ul><li>Manager Level </li></ul><ul><ul><li>Sophisticated risk management including VaR analysis to ensur...
VaR Analysis on Portfolio Assets
Due Diligence, Controls & Portfolio Monitoring <ul><li>Due Diligence   </li></ul><ul><li>Background checks </li></ul><ul><...
Conclusions <ul><li>Style Pure Fund or Manager Indices Provide Surrogates for Risk and Return Process Underlying Strategy ...
Appendix
Appendix
Appendix
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Thomas Schneeweis Director CISDM/University of Massachusetts ...

  1. 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. 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. 3. <ul><li>Hedge Fund Investment: Background </li></ul><ul><li>Return and Risk Analysis in Hedge Funds </li></ul><ul><li>Hedge Fund Indices and Benchmarks </li></ul><ul><li>Asset Allocation: Strategic and Tactical </li></ul><ul><li>Risk Analysis: VaR and Manager Analysis </li></ul>Hedge Fund Strategies: Risk and Return
  4. 4. I: Hedge Fund Background: What is a Hedge Fund? <ul><li>Term “Hedge Fund” is a misnomer with little descriptive power </li></ul><ul><li>1950’s: A.W. Jones Model </li></ul><ul><ul><li>Long/Short U.S. equities </li></ul></ul><ul><ul><li>“ Hedge fund” term accurately reflected his underlying strategy </li></ul></ul><ul><li>2000’s: Generic reference to a private, commingled vehicle investing in marketable securities </li></ul><ul><ul><li>Strategy characteristics vary widely </li></ul></ul><ul><ul><li>Risk/return characteristics vary widely </li></ul></ul><ul><ul><li>Common organizational and structural characteristics </li></ul></ul>
  5. 7. Source: Investments & Pensions Europe, May 2001 Wide International Interest
  6. 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
  7. 9. Sources: New York Times , Pensions and Investments , Financial Times, IHT Institutional Interest in Hedge Funds Institutional Interest
  8. 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
  9. 11. Growth of Hedge Funds
  10. 12. Myths of Hedge Fund Investment <ul><li>Hedge Funds Are An Investment Product of the 1990’s </li></ul><ul><li>Hedge Funds Are Unique In Their Investment Strategies </li></ul><ul><li>All Hedge Funds Are Risky Because They Use Derivatives </li></ul><ul><li>Hedge Funds Are Highly Levered Risky Investments </li></ul>
  11. 13. Hedge Fund Facts <ul><li>Hedge Funds Are Not More Volatile Than Traditional Stock and Bond Funds </li></ul><ul><li>Many Hedge Funds Are As Transparent Than Traditional Stock and Bond Funds (Fund Based or Separate Accounts) </li></ul><ul><li>Most Hedge Funds Are As Liquid As Traditional Stock and Bond Funds (Depends on Strategy) </li></ul>
  12. 14. Hedge Fund Facts <ul><li>Hedge Funds Provide Unique Return Opportunities Not Available in Traditional Markets) </li></ul><ul><li>We Know the Source of Hedge Fund Returns </li></ul><ul><li>Indices Exist which Track Hedge Funds </li></ul>
  13. 15. Hedge Fund Facts <ul><li>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) </li></ul><ul><li>Lack of Liquidity Is Reduced By New Forms of Guarantees </li></ul><ul><li>Academic Evidence Shows That Trading Impacts on Local Market Are Limited Due To Relative Size of Hedge Fund Market In Comparison to Traditional Markets </li></ul><ul><li>Some Evidence of Hedge Fund Affecting Individual Securities tocks but Little Evidence of Systemic Risk Within Markets or Across Countries </li></ul>
  14. 16. Goals of Hedge Fund Investment <ul><li>Take advantage of the ability to profit in a range of market environments </li></ul><ul><li>Develop a diversified approach to capturing ‘alpha’ </li></ul><ul><li>Efficiently deliver returns at a risk level defined by the investor </li></ul>
  15. 17. Hedge Fund Core Portfolio <ul><li>Manager Selection </li></ul><ul><ul><li>Select managers consistent with return and risk stability </li></ul></ul><ul><ul><li>Consistent sensitivity to market factors which underlie return drivers </li></ul></ul><ul><ul><li>Stability over time in relationship to index and other managers in style </li></ul></ul><ul><li>Strategy Selection </li></ul><ul><ul><li>Take advantage of the ability to profit in a range of market environments </li></ul></ul><ul><ul><li>Develop a diversified approach to capturing ‘alpha’ </li></ul></ul>
  16. 19. II: Risk and Return Analysis in Hedge Funds <ul><li>Investors get paid for bearing certain risks </li></ul><ul><ul><li>Beta is an important one. Credit risk, term structure risk, volatility risk, and liquidity risk are others </li></ul></ul><ul><li>Hedge fund strategies generally minimize beta and maximize exposure to the other risks </li></ul><ul><ul><li>Often misconstrued as absolute return (or return to skill) </li></ul></ul><ul><ul><li>Factor models quantify a fund’s exposure to these risks - separate ‘natural’ return from ‘skill </li></ul></ul>
  17. 20. Each Hedge Fund Strategy or Managed Futures Strategy Has Own Economic Source of Return <ul><ul><ul><li>Equity Market Neutral - Relative Mispricing </li></ul></ul></ul><ul><ul><ul><li>Convertible Arbitrage - Volatility, Credit Risk </li></ul></ul></ul><ul><ul><ul><li>Merger Arbitrage - Equity And Credit Exposure </li></ul></ul></ul><ul><ul><ul><li>Distressed Securities - Credit Spreads, Liquidity Risk </li></ul></ul></ul><ul><ul><ul><li>Hedged Equity - Equity Factor Sensitivity, Volatility </li></ul></ul></ul><ul><ul><ul><li>Managed Futures – Markets Trends </li></ul></ul></ul>
  18. 21. Hedge Fund Exposure to Market Factors Univariate Regression of Returns Against Factors 1990-02
  19. 22. Managed Futures Exposure to Market Factors
  20. 23. Managed Futures Exposure to Market Factors
  21. 24. Hedge Fund Exposures During Extreme Periods <ul><li>Returns on hedge fund indices and various asset classes and factors were grouped in quartiles. Each group holds 25% of observations. </li></ul><ul><li>The bottom quartile holds 25% of observations that are the lowest, while the top quartile holds 25% of observations that the highest. </li></ul><ul><li>Returns on hedge fund indices and other asset classes were ranked using the dates that correspond to the observations in each quartile. </li></ul>
  22. 25. Exposures During Extreme Periods
  23. 26. Exposures During Extreme Periods
  24. 27. Exposures During Extreme Periods
  25. 28. Exposures During Extreme Periods
  26. 29. Managed Futures Exposures During Extreme Periods
  27. 30. Hedge Fund Managers <ul><li>Questions: </li></ul><ul><ul><li>How Persistent Are The Benefits Of Hedge Fund Managers? </li></ul></ul><ul><ul><li>How Persistent Are Benefits Of Hedge Fund Strategies? </li></ul></ul>
  28. 31. Persistence of Performance: Manager Based or Strategy Based <ul><li>We regressed monthly excess returns of several hedge fund managers against monthly excess returns on S&P500 and Lehman Aggregate Bond Index </li></ul><ul><li>Risk is measured in terms of exposures to equity and bonds. </li></ul><ul><li>The intercept represents the manager’s alpha. </li></ul>
  29. 32. Persistence of Alphas: Index Alpha High - Manager Alpha Low
  30. 33. Persistence of Exposures
  31. 34. Persistence of Exposures
  32. 35. Summary <ul><li>Alphas at managers levels are not persistent. </li></ul><ul><li>Alphas at the index levels are persistent. </li></ul><ul><li>The same story can be said about risk exposures. </li></ul><ul><li>With minor changes, these results hold for all strategies. </li></ul>
  33. 36. <ul><li>Manager Based </li></ul><ul><li>Security Based </li></ul><ul><li>Factor Based </li></ul>III: Hedge Fund Indices and Benchmarks
  34. 37. <ul><ul><ul><li>No Universe of Manager Performance Index Exists </li></ul></ul></ul><ul><ul><ul><ul><li>Current Universe of Managers (e.g., Zurich, TASS, …) Provide only limited representation of true Universe </li></ul></ul></ul></ul><ul><ul><ul><li>Most current ‘Universe Indices’ are not ‘True’ indices </li></ul></ul></ul><ul><ul><ul><ul><li>Collection of self reporting managers </li></ul></ul></ul></ul><ul><ul><ul><li>Passive Versus Active Indices </li></ul></ul></ul><ul><ul><ul><ul><li>Passive Index requires systematic security (e.g., strategy) or factor based representation of manager strategy and should reflect active manager index </li></ul></ul></ul></ul>Hedge Fund Universe Versus Hedge Fund Index
  35. 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 <ul><li>Composite of World Unknown </li></ul><ul><li>Sub-universe (e.g., HFR, TASS,Zurich) may or may not represent World Index </li></ul><ul><li>Personal Libraries (e.g., Zurich Hedge Fund Indices, CSFB, EACM) may better represent characteristics of specific area </li></ul><ul><li>than general random selection of books in general sub universe </li></ul>Some intersection of hedge funds in various Sub-universes
  36. 40. Overview of Hedge Fund Indices
  37. 41. Overview of Hedge Fund Indices
  38. 42. Overview of Hedge Fund Indices
  39. 43. Overview of Hedge Fund Indices
  40. 44. Alternative Hedge Fund Databases: Performance Comparisons (Jan 1998 – June 2002)
  41. 45. Relative Index Performance: Fund of Fund Performance
  42. 46. Hedge Fund Databases: Convertible Arbitrage Example
  43. 47. Index Creation: Index Based Replication
  44. 48. Security Based Passive Indices (CTA Example)
  45. 49. Multi-Factor Based Index Replication
  46. 50. IV: Asset Allocation <ul><li>Issues in Asset Allocation </li></ul><ul><ul><li>Number of Managers Required </li></ul></ul><ul><ul><li>Index and Fund Tracking </li></ul></ul><ul><ul><li>Return Forecasting </li></ul></ul><ul><li>Traditional Approaches Fund Creation </li></ul><ul><li>Strategic and Tactical </li></ul>
  47. 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
  48. 52. Naïve Multi-Manager Portfolios
  49. 53. Naïve Multi-Manager Portfolios
  50. 54. In Asset Allocation, Indices Must Reflect Asset Manager’s Sensitivity to Factors
  51. 55. Historical indexes May not Reflect Future Returns of Current Index
  52. 56. Historical Returns May Be Poor Forecasts Of Future Hedge Fund Return
  53. 57. Traditional Approach to Mean Variance Optimization
  54. 58. Asset Allocation <ul><li>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. </li></ul><ul><li>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. </li></ul><ul><li>The goal is to make the new portfolio a close substitute for the original portfolio. </li></ul>
  55. 59. Stand Alone Substitutes for Assets Classes Equity
  56. 60. Stand Alone Substitutes for Assets Classes Equity
  57. 61. Stand Alone Substitutes for Assets Classes Corporate Bonds
  58. 62. Stand Alone Substitutes for Assets Classes Corporate Bonds
  59. 63. Traditional Assets & Hedge Funds Data: 1990-02
  60. 64. Strategic and Tactical Asset Allocation <ul><li>Strategic Asset Allocation (Long Term Allocation) </li></ul><ul><ul><li>Hedge Funds to Replicate Hedge Fund Indices </li></ul></ul><ul><ul><li>Hedge Funds to Replicate Cash Market Indices </li></ul></ul><ul><li>Tactical Asset Allocation (Short Term Rebalancing) </li></ul><ul><ul><li>Hedge Fund Strategies Lead/Lag Relationships with Economic Variables </li></ul></ul>
  61. 65. Hedge Funds can be used Replicate EACM 100 Index used in Asset Allocation
  62. 66. Hedge Funds can be used Replicate Russell Index used in Asset Allocation
  63. 67. Tactical Asset Allocation <ul><li>Returns on traditional assets classes are somewhat predictable using lagged values of certain variables </li></ul><ul><ul><li>Credit risk, Volatility, Term Premium, Returns, etc </li></ul></ul><ul><li>We used the lagged values of a set of factors to predict returns to various hedge fund strategies. </li></ul>
  64. 68. Tactical Asset Allocation <ul><li>We considered rebalancing our portfolio on a systematic basis. </li></ul><ul><li>The estimation period is a rolling 2-years period and starts on Jan 1990 and ends with Dec 1999. </li></ul>
  65. 69. Tactical Asset Allocation
  66. 70. Tactical Asset Allocation To Best of Five <ul><li>Systematic reallocation is beneficial </li></ul><ul><li>Benefits are reduced when the reallocation interval is increased. </li></ul>
  67. 71. V: Risk Analysis <ul><li>Manager Level </li></ul><ul><ul><li>Sophisticated risk management including VaR analysis to ensure style consistency, and leverage management </li></ul></ul><ul><ul><li>Segregated accounts to eliminate possibility of fraud, and gross mismanagement </li></ul></ul><ul><li>Style Level: Oversight ensures level of concentration within individual securities/sectors within appropriate limits </li></ul><ul><li>Portfolio Level: Daily reports to clients/structuring partners outlining risk levels </li></ul>
  68. 72. VaR Analysis on Portfolio Assets
  69. 73. Due Diligence, Controls & Portfolio Monitoring <ul><li>Due Diligence </li></ul><ul><li>Background checks </li></ul><ul><li>Registrations and regulatory checks </li></ul><ul><li>Verification of education and certification </li></ul><ul><li>Investment methodology and risk protocol </li></ul><ul><li>Systems and procedures review (including disaster recovery, back office and compliance practices) </li></ul><ul><li>On-site visits </li></ul><ul><li>Controls & Portfolio Monitoring </li></ul><ul><li>Separate account structure </li></ul><ul><li>Custody of all assets </li></ul><ul><li>Leverage limitations </li></ul><ul><li>Favorable liquidity terms </li></ul><ul><li>Transparency and risk analytics </li></ul><ul><li>Defined portfolio guidelines </li></ul>
  70. 74. Conclusions <ul><li>Style Pure Fund or Manager Indices Provide Surrogates for Risk and Return Process Underlying Strategy </li></ul><ul><li>Factor Based Indices Provide Surrogates for Risk and Return Process Underlying Strategy If Strategy Has Fundamental Market Factor Driving Process </li></ul><ul><li>Security Based Indices Provide Tradable Surrogate Risk and Return Process Underlying Strategy If Strategy Is Traded In A Systematic Manner </li></ul>
  71. 75. Appendix
  72. 76. Appendix
  73. 77. Appendix

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