Hedge Funds: A Look Back and A Look Ahead - Dec. 2011
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Hedge Funds: A Look Back and A Look Ahead - Dec. 2011



Hedge Funds: A Look Back and A Look Ahead - Dec. 2011

Hedge Funds: A Look Back and A Look Ahead - Dec. 2011



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Hedge Funds: A Look Back and A Look Ahead - Dec. 2011 Hedge Funds: A Look Back and A Look Ahead - Dec. 2011 Document Transcript

  • Hedge Funds: A Look Back and a Look Ahead By Edward H. DeFrance and Michael J. Kelly SynopsisCRITICAL OBSERVATIONS: Hedge funds have proven to be• Including a group of broadly diversified hedge funds in a traditionally allocated portfolio worthy financial instruments over of stocks and bonds has been shown to potentially reduce portfolio volatility and the past 20 plus years, and have increase return. contributed to the growth of the• The investment environment for hedge funds going forward (2010 and beyond) could modern financial industry. The be attractive. Investment strategies that can make money in rising and falling equity addition of a well diversified group markets, such as those employed by many hedge funds, are better positioned for success of hedge funds to a traditional in an uncertain/volatile economy. portfolio has been shown to be an• Hedge funds and the interests of their constituents are better aligned now than they effective way to potentially increase were prior to 2008. returns, while also preserving capital• Due to the fallout of 2008 and the Bernie Madoff scandal, investors are assigning more during adverse market environments. value to the strength and integrity of a firm’s risk controls and procedures when conducting due diligence on potential hedge fund investments, as opposed to focusing While hedge funds have remained only on performance. somewhat of a mystery to the general public, and are often vilified by the• Investors are seeking better transparency, better liquidity, and more appropriate fee structures from funds. mainstream media (they were referred to as an “evil virus” in a 2005 Newsweek• Investors are requiring the use of independent, third-party services to support funds’ operations, manage custody of their assets and verify fund pricing. article for example), the reality is that many institutions and high-net-worth• Fund of hedge funds (FoHFs) will continue to be a major channel into hedge funds, providing more investors ease of access and exposure to a broad range of investment investors have invested in hedge funds styles and strategies, along with an additional level of risk management. for many years, and continue to do so as a means to add diversification to their portfolios. Going into 2010, the hedge fund industry appears to be healthier than it has been in more than a decade, albeit much smaller in terms of assets than it was at its peak two
  • years ago. While 2008 was without In 2009, investors are already starting doubt one of the most challenging to reap the benefits of this new investment environments we have hedge fund world order, as industry seen this century, the hedge fund returns appear to be on pace to industry emerged from the crisis reach 10-year highs. Looking ahead, case-hardened and remains a viable reduced competition and major compliment to traditional stock and macroeconomic trends could lead to bond investing. From an investment above average returns. opportunity standpoint, the landscape is attractive as many asset classes are A History of Success … offering substantial risk premiums and Misunderstanding? and competition has significantly “It is the nature of humans to diminished (with weaker, less- fear what it is they do not know qualified hedge funds closing in 2008, or understand.” fewer asset managers are chasing ~ Rod Serling, creator of similar trades – leaving more pie for The Twilight Zone the worthy survivors to share). Clearly, hedge funds have played an For investors, the most tangible important part in the expansion of positive outcome left by the shock of capital markets in recent years. Since 2008 has been a humbling of sorts for 1990, hedge funds have represented the industry. Many previously closed one of the fastest growing segments hedge funds have now opened their of asset management. The number doors to accept new capital, are much of hedge funds around the world more willing to be flexible on fees and exploded from 610 in 1990 to lock-up periods, and – perhaps most approximately 9,000 by the end significantly – are much more willing of 2008.1 Over the same period, to pull back the curtain and share industry assets under management information about their success. grew exponentially as well, from $39 billion to an all-time high of GRAPH 1: $1.9 trillion by the second quarter Total Hedge Fund Assets of 20082 (Graph 1). December 1990 through June 2009 Estimate For something that has grown so $2,100 $1,868 rapidly and become such an integral part of the global financial system $1,600 Hedge Fund Assets ($ billion) $1465 $1407 through the years, there is still a $1,100 $973 $1105 $1000 general lack of understanding about $820 the hedge fund industry. Indeed, it $626 $600 $456 $491 $539 is often surprising to those of us who $368 $375 $168 $167 $186 $257 work in the industry just how much $100 $58 $96 $39 misinformation is circulated, not 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Jun 09 $(400) just among small investors, but even Source: HFR Global Hedge Fund Industry Report, second quarter 2009. Hedge Fund Research, Inc., at the highest levels of sophisticated August 2009, www.hedge-fundresearch.com institutional asset management. 240% 190% Bonds -2- Hedge Fundsive Return 140% Stocks
  • The confusion, and in some cases “Absolute” Returns Hedge Funds: A Primer controversy, over hedge funds is By design, most hedge funds are What is a hedge fund? likely a function of their private intended to provide consistent • he term ‘hedge fund’ refers to T structure. As opposed to a mutual positive returns regardless of the pooled investment structures fund, almost all hedge funds are direction of the broad markets, • edge funds may utilize a broad H private offerings because they are not utilizing a wide variety of financial array of financial instruments to sold publicly on open exchanges. instruments to do so. This approach generate performance Because of this, the Securities and stands in contrast to that of traditional • here are many types of hedge T Exchange Commission strictly limits managers, who measure themselves funds using many different the amount of information that in relative terms and are prepared to investment strategies can be shared about them with the accept losses in value, if those losses • ension funds, endowments, P general public. insurance companies, private banks, are less than a stated benchmark and high-net worth individuals and As such, many investors consider (such as the S&P 500 Index). families invest in hedge funds hedge funds highly risky, highly Hedge funds have, for the most part, aggressive and somewhat speculative • any hedge funds attempt to achieve M succeeded in achieving this goal positive returns in both rising and investments. Sensationalized hedge and in preserving capital during bear falling capital market environments fund blow-ups and frauds, like Long markets. From 1990 to 2008, the • he inclusion of hedge funds in a T Term Capital Management or the industry experienced only two down traditional portfolio is intended to Madoff scandal (see page 5) naturally years, weathering difficult periods add diversification, reduce risk and contribute to this misconception. like the Mexican peso crisis, the potentially increase returns While in some cases this is true, the Asian financial crisis, the collapse of • edge funds seek to maintain low H reality is that there are a wide variety correlations (definition on page 4) of different types of hedge funds, Long Term Capital Management, the with traditional assets classes (stocks each utilizing different levels of risk bursting of the dot-com bubble, and and bonds) and each seeking different types of the collapse of the credit markets in • ost hedge funds do not measure M $2,100 returns. Many hedge funds actually 2001-2002. From a performance $1,868 $2,100 themselves against traditional market $1,600 pursue very conservative strategies $1,868 perspective, hedge funds have been Hedge Fund Assets ($ billion) $1465 benchmarks (like the S&P 500 Index) $1,600 that target modest but consistent successful in achieving their objective $1407 Hedge Fund Assets ($ billion) $1465 but instead target “absolute” returns $1407 of providing consistent returns that $1105 $1,100 (positive performance regardless of returns and – above all – relatively $1105 $973 $1000 $1,100 low risk. $973 $1000 exhibit low correlation to the broad $820 the direction of the broad markets) $820 $626 $600 $600 $539 $626 $368 $375 $456 $491 $539 equity markets, while maintaining $456 $491 $257 $368 $375 $58 $96 $168 $167 $186 $257 low volatility (Graph 2). $168 $167 $186 $100GRAPH 2: $100 $39 $58 $96 $39 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Jun 09Hedge Funds at Work – Providing Consistent Returns 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Jun 09 $(400) $(400) Cumulative Return and Value of $1 Million Investment October 1994 through September 2009 240% 240% 190% 190% Bonds: $1.91 million BondsBonds: $2.78 million Bonds Hedge Funds: Hedge Funds Hedge Funds: $2.52 million Hedge Funds $1.84 million Cumulative ReturnCumulative Return 140% 140% Stocks Stocks Stocks: $2.29 million 90% 90% All data is sourced from Pertrac. Hedge funds are 40% represented by the Edhec Fund of Hedge Funds Index. 40% Stocks: $1.31 million Global equities are represented by the MSCI World Equity Index. Bonds are represented by the Barclays -10% US Corp. IG Index. Please see page 11 for additional -10% information on data sources. 4 95 96 6 97 98 8 99 4 0 95 0 96 1 t 9 02 n 02 b 03 t9 4 4 Fe n 05 Oc 06 06 07 08 08 09 t9 t9 t9 t9b0 n t0 b 0 Oc b 0 Ju c t 0 n b n b n Fe Jun Oc Feb Ju O c t Fe un b ct 01n b 02t 03n 6 J7 Fe8 O8 J99 Fe0 00 0e2 04 4 05 06 6 07 08 8 09 Oc Oc Oc Ju O c t Oc Ju Ju Ju u u n Ju Fe Fe Oc Fe 9 9 0 tO t0 t0 t0 bF nJ n b b n b n b n Oc Oc Oc Oc Ju Ju Ju Ju Ju Fe Fe Fe Fe 14% 14% -3- Risk reduced by 28% 12% 11.6% Risk reduced by 28% 12% 11.6% Return Increased 10% by 3% Return Increased
  • Going Mainstream recently demonstrated an ability to Demonstrating success during the add value to a traditional portfolio 2000-2002 bear market, hedge allocation, by both enhancing returns funds essentially signaled their arrival and reducing risk (see Graph 3). to the world. What had been until Growth and Consequences then a vehicle that only the most $2,100 Correlation is a statistical measure of sophisticated and ultra-high-net- As a by-product of this surge in how two securities move in relation to investor appetite, industry assets worth investors were privy to – or $1,868 each other. Perfect positive correlation $1,600 interested in, for that matter – hedge under management grew Hedge Fund Assets ($ billion) implies that as one security moves, $1465 $1407 either up or down, the other security funds began garnering attention from substantially. From 2000 to 2008, $1105 $1,100 will move in lockstep, in the same other parts of the investor spectrum, $973 hedge fund assets expanded 20% $1000 direction. Alternatively, perfect negative most $626 $820 notably institutions and other per year,3 growing nearly four times $600 correlation means that if one security $456 wealthy investors. $491 $539 in size since 2000.4 There were some $368 $375 moves in either direction the $257 security negative consequences of this $100 $168 $167 $186 that is$58 $96 negatively correlated perfectly Institutions began seeking them out $39 exponential growth: transparency will move by an equal amount in the much more frequently as a source levels were not satisfactory, as 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Jun 09 $(400) opposite direction. If the correlation is 0, of diversification and “absolute” investors often acquiesced to the movements of the securities are performance following on the stable said to have no correlation; they are  manager’s preferences for secrecy; returns hedge funds had demon-% completely random. due diligence standards were often strated during the dot-com bust. compromised (as was clearly the Sustained low interest rates during% case for some feeder funds directing this period, coupled with a flat Bonds Hedge their clients to Madoff); and poor equity environment, also contributed Funds Stocks liquidity management practices% to this interest. From a performance emerged, high-lighted by the high perspective, a broadly diversified number of funds who gated their% portfolio of hedge funds has fairly investors in 2008.% Extreme growth also diluted the GRAPH 3: quality and skill of fund managers.% Hedge Funds at Work – Benefits to Traditional Portfolio Previously, hedge fund managers had been Wall Street’s best and brightest. 4 95 96 6 97 98 8 99 00 0 01 02 2 03 04 4 05 06 6 07 08 8 09 t9 t9 t9 t0 t0 t0 t0 t0 Impact on Risk and Return – October 1994 through September 2009 n b n b n b n b n b n b n b nOc Oc Oc Oc Oc Oc Oc Oc Ju Ju Ju Ju Ju Ju Ju Ju Fe Fe Fe Fe Fe Fe Fe 14% However by late 2006, anyone with a 11.6% Risk reduced by 28% financial calculator suddenly believed 12% Return Increased he or she was qualified to do the job. 10% by 3% 8.3% Annualized Volatility 8% 6.4% 6.6% Annualized Volatility (Risk) 6% (Risk) Annualized Annualized 4% Return Return 2% 0% Traditional Portfolio Traditional Portfolio with Hedge Funds (70% stocks, 30% bonds) (40% stocks, 30% bonds, 30% hedge funds) Volatility is measured by standard deviation. Standard deviation is a measure of the dispersion versus the mean or experienced value: the higher the standard deviation, the greater the volatility. Please see page 11 for additional information on data sources. -4-
  • Not only did the industry experience further on, but before doing so weHedge Fund Fraud and a dilution of quality fund managers, thought it would be valuable to firstBlowups: Myth Versus the exponential increase in assets led look back and understand what itMadoff Reality to a decline in the number of true was that led up to last year’s crisis inThe Bernie Madoff fiasco was very alpha-generating5 opportunities. As the global markets.unfortunate, not only for the investors a result, in order for hedge fundwho lost money, but also for the Creating the Leverage Monster managers to maintain their expectedreputation of the hedge fund industry return targets (often expressed as 1% “Crazy, am I? We’ll see whether I’mas a whole. The reality is that organizations such as Madoff’s are by or 1.5% per month), they began crazy or not!”far the exception and not the rule (in employing greater levels of leverage, ~ Frankenstein, 1931fact Madoff likely takes the cake in and often engaged in less attractive Debt use across the financial systemterms of exceptions). and riskier trading strategies. In increased dramatically over the lastIt is important to note that Madoff’s essence, many less-disciplined fund 10+ years, spurred by bull markets,purported success, secrecy, organiza- managers began taking on more andtional structure, and nepotism were soft lending standards, a presumption more beta6 (or market) risk, ashighly unusual, and should not be of continued prosperity and the opposed to providing their investorsconsidered representative of the hedge belief that real estate prices wouldfund business. Established Fund of true alpha driven gains. Thus, by never decline. Consumers, businesses,Hedge Funds (FoHFs) with structured 2008, the returns reported by many investors and investment banksapproaches to due diligence require of the hedge funds in the industry – financed more, while Wall Streetadequate transparency on trading although better than the equity developed elaborate structuredstrategies, which stands in the face of markets – fell greatly short ofhow Madoff’s organization operated. products to meet their credit achieving their self-professed mandate demands. Corporations’ substitutedEven at a very high level, there were of uncorrelated returns, independentmany red flags within the Madoff firm. debt for equity in their companies’ of overall market direction.As an example, Madoff’s son served as capital structures, levered up resultschief compliance officer, the firm 2008: The Year of Our Discontent and reduced any margin for error.custodied its own assets (for what was Consumers carried unpaid credit cardpurportedly the largest hedge fund in 2008 will forever be considered one debt, rolled over credit card balances,the world) and its books were audited of the worst periods in the history of and in some cases maintainedby an unknown audit firm with a single global financial markets (globaloffice in Jersey City. Some of the less multiple lines of credit. Homeowners equities declined 42% and high-yield financed home purchases using ascrupulous feeder funds that invested client money in Madoff’s fund bonds lost 26%). For hedge funds, it variety of exotic and complexacknowledge seeing “warning signs” was likely the worst year the industry mortgage structures (interest only,before the end. In our view that ranks had ever seen, with the Edhec Fund adjustable rate loans, 100%with “Don’t worry it was only an of Hedge Funds Index dropping financing, etc.). And, perhaps mosticeberg.” in terms of historical 21%. The silver lining lies in theunderstatements. pertinent to 2008’s crisis – and by contention that the hedge fund extension hedge funds – it was theFoHFs that employ a rigorous and industry is learning from the events norm for investment banks’ balancesystematic approach to due diligence – of 2008, and emerging stronger thanincluding onsite visits and background sheets to be levered as much as 20 to before. We view last year as a much 30 times larger than their capitalchecks, as well as a clear understanding of the trading strategies being employed needed and valuable correction – base. In fact, a 2004 rule change by– would be very unlikely to ever allocate separating the wheat from the chaff, the SEC exempted the five largestto an organization like Madoff’s. leaving the worthy hedge funds that banks from regulation that had survived better positioned for future capped their debt-to-capital ratio at success. We discuss this in detail 12-to-1.7 -5-
  • Ultimately, as we all experienced first most long-only indices in 2008 –hand in 2008, this long-term trend though not as successfully as duringtoward credit creation collapsed upon previous downturns.8itself, eventually evolving into the 2009: A New Chapter for Hedgemost substantial global financial crisis Funds – Better, Stronger, Fasterin modern history. When considering the state of theThe Impact on Hedge Funds hedge fund industry today and theFor hedge funds, the unprecedented opportunities going forward, we aremarket decline – and, more specifically, reminded of the 1970s televisionthe distress in the investment bank show “The Six Million Dollar Man.”community – proved troublesome. After being severely injured, theAs the banks swiftly moved to reduce show’s protagonist (Steve Austin)risk (by selling whatever they could), undergoes a grueling medicalhedge funds were also impacted. procedure. He is “rebuilt,” using theInvestment banks and hedge funds latest in “bionic” technology to createheld many common positions, so the world’s first bionic man – better,liquidation of bank holdings put stronger, faster.significant downward pressure on Similarly, hedge funds have emergedhedge fund portfolios as well. from their own crash of sorts, andIn addition, at the height of last year’s we derive they are better and strongercrisis, the government instituted a than they were before. While nottemporary ban on selling stocks employing “bionic” technology“short” in an effort to stem the tide of (and, unfortunately, costingpanic (unlike most investments that constituents a good deal more thanbet on the markets going up, hedge six million dollars), we believe thefunds often sell equities short, which hedge fund industry is now betteris a trading strategy aimed at profiting positioned for the future than at anywhen the prices of securities they time in its history.believe are fundamentally overvalued A peripheral effect of an event sucheventually decline). While the intent as the dislocation of 2008 is that allwas good, the end result of the short parts of a hedge fund are tested, notsale ban may have only served to just the viability of its investmentmake matters worse. The ban strategy. Also tested are the strengthsignificantly hindered the ability of of a fund’s operational infrastructure,many hedge funds to reduce risk investment judgment, execution,and/or profit during the severe commitment to portfolio diversifica-market decline. Instead, they were tion, risk mitigation, IT infrastructure,again forced to sell their long positions investor relations, and operationalinto plunging equity markets just to and counterparty risk assessments.reduce risk, which further Those that emerged from the gauntletexacerbated the market collapse. of 2008 likely possess more wisdomStill, despite the severity of the crisis, and have demonstrated their abilityhedge funds in general outperformed to survive in one of the worst of environments in recent history. -6-
  • Opportunities in 2010 and from the industry. FoHFs whose dueWhat is a Fund of Beyond: The Potential for Above- diligence procedures fell short – and,Hedge Funds? Average Returns, Lower Risk, in some egregious cases, was non- • FoHF is a pooled investment A Better Access and Lower Fees existent – have also been exposed. vehicle that invests in multiple In addition, there will be less reliance hedge funds pursuing different Surviving funds are now reaping the benefits of the fertile investment on financing counterparties with investment strategies. landscape that remains. The financial weak balance sheets. • FoHF provides ease of access A and exposure to a broad range of markets are once again operating Finally, for investors seeking hedge investment styles and strategies. normally so asset prices more fund exposure, it is clearly a buyer’s • FoHF seeks to mitigate the A accurately reflect their true market. The terms of investments – idiosyncratic risk of investing in fundamental value, as opposed to the management and incentive fees a single hedge fund through being driven down by forced selling. charged by funds – are more diversification. Leverage has been drastically favorable to investors than they have • FoHF provides professional A reduced, liquidity has returned been in years. In addition, we are management of hedge fund and, most notably, competition seeing a number of funds reducing or investments. has substantially diminished. eliminating lock-ups, a pre-defined • FoHF seeks to deliver more A Historically, this type of environ- period where an investor’s capital is consistent returns than portfolios ment has resulted in periods of above prevented from being withdrawn – of stocks, mutual funds, unit trusts average returns for hedge funds.9 typically one year; moving to more or individual hedge funds. The dramatic decline in competition frequent withdrawal periods; and • FoHF may provide access to A is potentially the most significant becoming much more transparent.10 otherwise “closed” hedge fund managers. change we see going forward. In Looking Ahead: A Renewed addition to the hedge funds that Focus on True Due Diligence were forced to close due to the failure of their individual business The events of 2008 have changed models, many investment bank investor preferences in terms of the trading desks no longer exist, focus of the due diligence they seek and others have been required to from FoHF managers, as well as the reduce trading activity to reflect depth and rigor of the process itself. their new bank holding company According to a survey by Deutsche charters. The hedge fund industry’s Bank, conducted in 2009, “Risk largest competitor has historically Management” moved to being the been investment banks, meaning second most important factor when there will be fewer asset managers selecting a manager. “Transparency” chasing similar trades now that the also moved up in priority. ranks have thinned. Historically, investors had indicated the “3Ps,” Performance, Philosophy Equally important, we believe the and Pedigree, to be the most risk associated with hedge fund important characteristics when investing has also declined. Weaker selecting a manager. less qualified managers who may have used excessive beta (over Clearly, institutional and high-net- exposure to the market direction) to worth investors today are more generate returns have been purged focused on examining every aspect -7-
  • of a hedge fund program, not just he or she will have with thethe quality/performance of its track investment manager.record, but also the integrity of itsrisk control/compliance procedures. Looking Ahead: Hedge FundFor example, sophisticated investors Asset Flowsare seeking a rigorous and systematic Following more than 15 months ofapproach to due diligence from redemptions, flows are returning toFoHFs – one that focuses on the hedge funds. After four consecutiveoperational integrity of a program, quarters of net withdrawals, hedgeconducts ongoing risk monitoring funds recorded a net asset inflow inand manages the liquidity needs the third quarter of 2009, withof its clients. In addition, investors investors adding $1.1 billion in neware also spending more energy capital during the period. Forecastsassessing the creditworthiness/ are that industry assets could approachfinancial stability of prime brokers, $2.6 trillion by year-end 2013.and are requiring an independent Investors and advisors have broadlythird-party administrator to provide indicated they still believe in theindependent valuations. premise behind hedge fund investing.Transparency has also become an In fact, many withdrew capital inimportant issue. In our view, 2008 because of liquidity demandscomplete transparency with clients that they could not meet with theirwill become a trademark of quality equity holdings, which experiencedFoHF investment programs. That losses much more severe than thoseis to say, any and all portfolio of their hedge fund positions.information that a firm possesses Funds of hedge funds are expectedshould be shared with all of its to continue to be the major channelclients. This would extend well into hedge funds. For many investors,beyond that of simply providing a FoHFs represent the only viable orlist of underlying manager names. prudent way to access hedge fundClients should know and understand strategies. Institutional qualitya fund’s investment rationale, its FoHFs can provide at least four keyreasons for allocating to a particular services most investors find difficultorganization versus another, and its to replicate, even with a consultantview and outlook for the future. or advisor:11Frankly, with regard to transparency, • Manager-sourcingwe have always taken the view thatthe more a client is willing to learn • Thorough manager due diligenceand understand regarding procedures • On-going risk monitoringand decision-making patterns, the • Appropriate diversificationbetter and stronger a partnership -8-
  • Looking Ahead: Economic gain and qualified dividend rates,Uncertainty which are currently 15%. AsWe believe the aforementioned flows legislated, capital gain and dividendinto hedge funds may be a byproduct rates will automatically rise at the endof the less attractive environment we of 2010. In a previous whitepaper,13predict for other asset classes. As we we showed that the impact of thesetalk with investors, we continue to rising tax rates on a relative basishear concerns about the equity would favor hedge funds as an assetmarkets, as well as the potential class in asset allocation modeling.for higher inflation and/or rising This is due to an expected higherinterest rates. percentage change in capital gain and dividend rates than theThe current rally in the global percentage change in ordinarymarkets has two historical precedents income rates. The result of this is ain terms of size and velocity. The much more negative tax impact onS&P 500 Index rallied by over 50% asset classes that have historicallyin 1938 and in 1974-75.12 After both benefitted from the lower capitalspikes, it spent the next couple of gain and dividend rates, leaving theyears treading water. Those sharp after-tax returns from hedge fundsrallies also came during short-lived in a relatively better position.economic revivals in the midst of adifficult structural backdrop. In fact, Looking Ahead: Increasingsharp rallies in the first year of Regulationrecovery have historically been In July, the Obama administrationfollowed by horizontal movement outlined a broad proposal for changesin stocks for at least 12 months. to the U.S. financial regulatoryUnlike traditional long only system. For the most part, theinvestments, hedge funds have proposed changes were directed attypically demonstrated they are the industry as a whole and notcapable of earning profits central to hedge fund managers,independent of a steady run up though there were two keyin the markets. implications for the hedge fund industry. The first would require allLooking Ahead: Higher Taxes? hedge funds with at least $30 millionIf we are to enter a period of rising under management to register astax rates, after-tax hedge fund returns investment advisors with the SEC.may actually become more attractive The second would authorize the SECon a relative basis to other traditional to share fund manager informationinvestments. For the high-net-worth with the Federal Reserve on ainvestor, hedge fund returns are confidential basis. The Federalgenerally considered tax-inefficient Reserve would then be tasked withbecause much of their return is determining if any of those funds ortypically taxed at ordinary income fund families requires greaterrates as opposed to the lower capital regulation in terms of risk. -9-
  • Regardless of the outcome, we think strategies (i.e., less reliant onthese proposals are investor friendly directional market moves) are betterand represent good housekeeping for positioned for success in an uncertain/the industry at large. Based on our volatile economy, and the crisis ofexperience, we estimate roughly 2008 has resulted in a significantly70-80% of the funds worthy of more sustainable industry in whichinvestment are already registered with there are fewer excesses and a betterthe SEC anyway. As SEC-registered alignment of interests between all ofinvestment advisers, each fund the various participants.manager will be required to have a Institutional and high-net-worthCCO and compliance manual, which investors are still committed to thewe consider to be sound practices. value hedge funds add to a diversified portfolio, but they are assigningSummary much more weight to the strengthAdding a group of broadly diversified and integrity of a firm’s risk controlshedge funds to a traditional portfolio and procedures when determiningallocation can be an effective way where to put their money. They alsoto potentially enhance returns while are conducting thorough duepreserving capital during adverse diligence when assessing a firm’smarket environments. For qualified qualifications. Outsized returns areinvestors that do not possess the much less important than aretime, expertise or resources to consistent returns that exhibit lowconduct the necessary due diligence correlations to other asset classes.and ongoing risk monitoring, FoHFs Going forward, investors will likelyrepresent an appropriate vehicle for enjoy better transparency, improvedgaining exposure to hedge funds. liquidity and better alignment ofFoHFs provide investors ease of interests from the funds they select.access and exposure to a broad In a sense, the crisis of 2008 markedrange of investment styles and the start of a new and compellingstrategies, help mitigate the chapter for the hedge fund industryidiosyncratic risk of investing in whose story, on balance, has beena single hedge fund through one of steady success. Based on thediversification and offer professional industry’s history as well as thehedge fund management expertise. robust performance it has deliveredIn our view, the environment for so far in 2009, hedge fund investorshedge fund investing is more appear poised for a potentiallycompelling than it has been in many rewarding future.years. Less-directional trading - 10 -
  • ABOUT THE AUTHORS:Edward H. DeFrance, CPA, CFA, CAIA, is Vice President of Baird’s Private Wealth Management group in Milwaukee. He workswith his two partners, Christopher Didier and David Klenke, to provide wealth management solutions to high-net-worthfamilies. The team currently advises on over $3 billion of assets across approximately 50 clients. Prior to Baird, Ed was a seniormanager in Deloitte & Touche’s Investment Consulting Services group and was a manager in Arthur Andersen’s InvestmentAdvisory Services division. Ed received a B.A. in Economics from the University of Illinois and a B.S. in Accounting from IllinoisState University. He is a Certified Public Accountant, and holds the Chartered Financial Analyst (CFA) and the CharteredAlternative Investment Analyst (CAIA) designations. You can contact Ed at 414-298-7396 or edefrance@rwbaird.com.Michael J. Kelly, CAIA, is responsible for all client communications for Aetna Capital Management, LLC, a RegisteredInvestment Adviser headquartered in West Hartford, CT. Michael graduated with a Bachelor of Arts degree from SyracuseUniversity, and is a CAIA charter holder. Michael has worked as a writer in the financial services industry for more thannine years, focusing specifically on hedge funds since December 2005. Aetna Capital Management specializes in theconstruction and management of multi-manager hedge fund portfolios. The firm is a wholly-owned indirect subsidiary ofAetna Inc., a Fortune 100 insurance holding company, and manages/advises on more than $600 million in affiliated andexternal hedge fund investments. You can contact Michael at 860-380-1224 or kellym3@aetna.com.Important Information:Hedge funds engage in leveraging and offer specialized investment practices including the use of derived securitiesand short positions. These positions may increase the risk of investment loss. Hedge funds often charge higher feesthan other forms of investment and can be highly illiquid. Hedge funds are not subject the same regulations asmutual funds. Hedge funds are not required to provide periodic pricing or valuation information and may involvecomplex tax strategies. Hedge fund investing is not suitable for all investors and it is important to carefully evaluatethe risks and benefits of individual strategies before investing.This material is provided for informational and educational purposes and is not provided in an attempt to influenceparticular or pending investment decisions with any particular public jurisdiction or government entity. Theinformation and any disclosures provided in this document do not constitute a solicitation or offer to purchase orsell any security or other financial product or instrument. Past performance is based on historical data and is notnecessarily indicative of future results.The Edhec Fund of Hedge Funds Index uses returns on competing hedge fund indices to calculate the returns onthe EDHEC Fund of Hedge Funds Index. They are dollar denominated and net of fees. The Edhec Index AdvisoryBoard determines the inclusion or exclusion of an index in the calculation of the Edhec Alternative Indexes. Thecriteria upon which the committee bases its decisions are as follows: >The available history, >The clarity of itsconstruction method >Its representativity in terms of being a reference index for managers and/or investors, as wellas whether it takes existing funds into account >The completeness of the provider’s indexes >The stability of thecomposition >The regularity with which the data/index is published. This committee is composed of nine specialistprofessionals and recognized researchers in the domain of alternative investment. The information and any disclosuresin this document may be considered confidential and any distribution, modification, copying, forwarding or disclosureby any person is strictly prohibited. Hedge fund indices are limited by a number of factors including survivorshipbias where results for funds are excluded and results from poor performing funds are not reported. - 11 -
  • 1 Hedge Fund Research, Inc.2 Ibid3 The new power brokers: How oil, Asia, hedge funds, and P/E are shaping global capital markets, McKinsey Global Institute, July 2009.4 Ibid5 Alpha is a risk-adjusted measure of the so-called “excess return” on an investment. It is a common measure of assessing an active manager’s performance as it is the return in excess of a benchmark index or “risk-free” investment.6 Beta is a quantitative measure of the volatility of a given portfolio, relative to the overall market, usually the S&P 500. Specifically, it measures the performance the stock, fund or portfolio has experienced in the last 5 years as the S&P moved 1% up or down. A beta above 1 is more volatile than the overall market, while a beta below 1 is less volatile.7 Roger G. Ibbotson and Peng Chen. “The A,B,Cs of hedge funds: Alphas, betas, and costs,” Yale ICF working paper, September 2006.8 “The hedge fund of tomorrow: Building an enduring firm,” Casey Quirk and BNYM, April 2009.9 Bryan Goh, Hedge Fund Law Blog: June 2009 “Overview of the Hedge Fund Industry in June”10 2009 Alternative Investment Survey. Deutsche Bank, March 2009.11 The new power brokers: How oil, Asia, hedge funds, and P/E are shaping global capital markets, McKinsey Global Institute, July 2009.12 Investing in a Horizontal World. Morgan Stanley Investment Focus, October 2009.13 David A. Klenke and Mark Blumenthal, “Asset Allocation in a Rising Tax-rate Environment”, 2008 - 12 -© 2009 Robert W. Baird & Co. Incorporated. www.rwbaird.com 800-RW-BAIRD MC-27006 First use: 12/09