Hedge Funds for the 2010s

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Barcelona GSE Financial Institutions Seminar: Drago Indjic

Quantitative Investment Manager and Technologist Investment Manager, Blue White Alternative Investments; Project Manager, Hedge Fund Centre (London Business School)

More information about Barcelona GSE Financial Institutions Seminars: http://j.mp/BGSEFinSems

Any opinions, findings, and conclusions or recommendations expressed in this material are those of the author(s) and do not necessarily reflect the views of the Barcelona GSE or those of the home institution of the author(s).

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Hedge Funds for the 2010s

  1. 1. Hedge Funds for 2010s Dr Drago Indjic London Business School Sunningdale Capital LLP 15 January 2009 GSB Barcelona, Uni. Pompeu Fabra,
  2. 2. Warnings • The views are my own – Not Sunningdale Capital LLP, London Business School etc • Biases – By a “quant”, not an economist – Instant history bias • Length is only two hours (or less)
  3. 3. Contents • Status – Some numbers – Regulation • Quick Introduction – “User manual” – Structure rather than composition • Trends • Q&A
  4. 4. Alternative Investments • Many definitions ... – Valuation and liquidity: no secondary market • Search for uncorrelated, “absolute” returns – “absolute” (“cash + x”) objective ≠ tracking index • Many leading funds allocate to alternative investments – Not just real estate or private equity – Not indirectly: many structured investments failed or returned cash – Alternative investment strategies: non-β (or –β); exotic payoff
  5. 5. Post-Festum • “Investor redemptions were widespread and indiscriminate across fund strategies, regions, asset sizes and performance dynamics” – Many funds had to restrict investor outflows to protect their remaining investors – by applying “gates”, suspending redemptions or NAV calculation or even by fund restructurings and creating “side-pockets”
  6. 6. 2009: Recovery • CY investable HF indices:14-19%
  7. 7. A Few More 2009 Numbers • HFRI (non-investable) / HFRX indices – Fund Weighted 20% / Global 13.4% – FoF Composite 11% /RV MS 42% – RV FI CB 58.4% / 42.4% – Macro Total 4% / -2.6%
  8. 8. Status Quo • Total assets of $1 trillion – ~ 30% down (Huw van Steenis, MS) – Record $152 billion in withdrawals during 4Q08 (HFR) – The biggest redemptions were by FoHF, also to fund private-equity commitments. – NB. ETF iShares $~0.36 tn s ingle counterparty (inflows ~0.1t)
  9. 9. “Oversold”
  10. 10. Critical but Stable • Systemic stress costs $9tn, damaged investments • Crisis not caused by hedge funds (witch hunt – e.g. short sellers, etc) • Investment banks are investment fund counterparties: they increased portfolio funding risk, even defaulted – Rehypothecation.
  11. 11. What is Risk Then? • Not just variance • Loss of capital • Correlation • Beta • Liquidity • Access to capital (“return of capital”)
  12. 12. Capital Preservation Global Equity Hedge Funds January 2008 100 100 December 2008 55 80 December 2009 ~65 ~94 • Stability: lower variance and drawdowns
  13. 13. Hedge Fund Products (1) • Hedge funds: micro businesses – Owner/manager, entrepreneurs: SME in capital markets (credited) – Innovation, grassroots brands • Legal fund structures – Not just off-shore anymore – “Open by invitation” and risky – Labeling may be false “signalling” of skill- based investment?
  14. 14. Products (2) • Funds of hedge funds – Best “Alpha” is still packaged in hedge fund form, but illiquid • Synthetic – Passive alternatives: “alternative Beta”, commoditised and liquid (ETF) – →Decouple Alpha and Beta, mean and tail; fair liquidity premium
  15. 15. What is (not) a hedge fund? • Investment structures blurring – UCITS mutual hedge funds, absolute return funds • Indexes – Reuters Lipper TASS; Morningstar MSCI; HFR • “A placebo is a medical procedure that has no medicine in it”
  16. 16. Regulations • Legal structures – http://www.hedgefundmatrix.com/en/overview.cfm • EU – Prohibition-like? AIMA lobbying – future of listed, OEIC, ETP • Distribution ≈ investor “protection” – (In)dependent 3rd Party Marketers: case study: Sandra Manzke; commissions and incentives
  17. 17. Trustee Regulatory Constraints
  18. 18. Above Law or Under It • “Optimal intervention” – (+) Regulation of distribution; off- vs on-shore (“import / export”); service providers – (-) Corporate governance: minority investor rights, non-voting shares, claw back • Market efficiency policing – Social enterprise, not prop trading and “OPM”
  19. 19. Asset Control • Lehman, Madoff: lessons learned – Valuation fraud + fund control – Fund seizure and forced liquidation • Structurally liquid portfolio components – Liquidity management – Non-commingled custody; separated managed accounts
  20. 20. Capital Market Policing • Great Accidents: – LTCM (12 years ago): leverage – Amaranth (5): overbetting – Maddoff (1): security fraud • Small accidents – Market timers – Death spiral “private” convertibles
  21. 21. Hedge Fund Techniques • Only legal – Madoff ≠ hedge fund • Borrowing – Cash: Leverage – Securities: short selling • Hedging • Non-standard instruments
  22. 22. Operational Risk • Valuation – Fund Administrators: “independent directors” ordered to suspend NAV calculation – value of “audit” (Enron) • Counterparty – Lehman (7c/$) ; Sentinel (est. 40c/$) – Cash investments – “money market” funds not AAA? • “Due dilligencing”
  23. 23. Investment Strategies • Beyond taxonomy – Insight from replication techniques • Best α is ideally like “extremophile bacteria” – Astrobiology
  24. 24. Reminder: 2008 Performance • One hedge fund strategy was the top performer
  25. 25. Liquidity of strategies Managed Futures Fixed Income: Mortgage-Backed 15 20 40 60 80 10 Count Count 5 0 0 0 31 60 90 120 150 180 0 60 130 210 390 Duration Duration
  26. 26. Aggregated Transparency • "One of the challenges that we need to address (...) is to have a common language to describe derivatives. Every firm uses a different set of terminologies, a different set of representations to describe their derivatives portfolios." – Kenneth Griffin, Citadel, U.S. House Committee, November 13, 2008.
  27. 27. Case Study • Institutional investors: increased liabilities – “BA/Iberia pension fund” • Mandate Search – Structure, performance, correlation, liquidity management, costs
  28. 28. 2009 Case study • Supranational reserve pension fund • Strategic allocation advise – 3% to “defensive” investment strategies – Diversified fund of hedge funds (FoHF) – At least 10 year track record – Negative correlation to equity and bonds – Low volatility, EURIBOR target
  29. 29. Fund Liabilities • Macro view: shortfalls and underfunding – Low inflation, government deficits ... • Regulation and mandate – Legal risk: asset control and contractual liquidity • Competition – How to outperform peers and benchmarks?
  30. 30. FoHF Universe: Age Age vs FoHF.AUM 100% 90% 80% 70% 60% % universe 50% 40% 30% 20% 10.01 , 19.2% 10% 0% 0 5 10 15 20 25 30 35 Age
  31. 31. FoHF: Volatility Return vs Volatility Montly Data from 31-03-99 to 31-03-09 23% 18% 13% ACR 8% 3% 0% 5% 10% 15% 20% -2% -7% Volatility
  32. 32. FoHF: Decorrelation Return vs Correlation to MSCI World Return vs Correlation to MSCI World (Down) Montly Data from 31-03-99 to 31-03-09 Montly Data from 31-03-99 to 31-03-09 23% 23% 18% 18% 13% 13% ACR ACR 8% 8% 3% 3% -100% -80% -60% -40% -20% 0% 20% 40% 60% 80% 100% -100% -80% -60% -40% -20% 0% 20% 40% 60% 80% 100% -2% -2% -7% -7% Correlation Correlation
  33. 33. Indirect Cost • Monthly redemptions, 45 days notice • Quarterly, 65 bd, 12 month Lockup • Quarterly, 120d, 20% gate • Quarterly, 60d OR Monthly 35d @ 2% • 1y hard Lockup, 2.5y soft lockup @ 6%, 1/3 per year, 2/3 @ 6% with 20% gate • … • Anniversaries, side pockets, side letters …
  34. 34. “Normal” Market
  35. 35. FoHF Liabilities • Duration of liabilities is structurally mismatched to assets (hedge funds) Fund of Funds 400 Count 200 0 0 90 215 360 498 750 Duration
  36. 36. “Normal” Liquidity Target
  37. 37. Liquidity Crisis 100% S Fund (MP=100%, GI=0%) - Redemption S Fund (MP=0%, GI=0%) - Redemption S Fund (MP=0%, GI=100%) - Redemption 80% S Fund (MP=100%, GI=0%) - Still at risk S Fund (MP=0%, GI=0%) - Still at risk S Fund (MP=0%, GI=100%) - Still at risk 60% 40% 20% 0% Oct-08 Apr-09 Oct-09 Apr-10 Oct-10 Apr-11 Oct-11 Apr-12
  38. 38. Alpha vs Beta Distributors • Fund of hedge funds are still required – Best managers are packaged as hedge funds – Inc. regulation, accessibility, monitoring .... • But they failed in 2008 – Blocked assets by mismanaging liquidity: gated, suspended redemptions, restructured ... – Underweighted systematic strategies – Sold Beta at Alpha price – Industry AUM reduced by 1/3 or more
  39. 39. 10% 12% 14% 16% 18% 20% 0% 2% 4% 6% 8% <- 3 -3 to Page 39 -2 .5 -2 .5 t o -2 -2 to -1 .5 -1 .5 t o -1 -1 to -0 .5 -0 .5 to 0 replicator 0 to 0. 5 0. 5t o 1 1 to 1. 5 1. 5t o 2 2 to 2. 5 2. 5t o 3 3 to 3. 5 3. 5t o 4 4 to Returns (May 2007 - May 2008) 4. Indjic – 30 Sep 2008 5 4. 5t o 5 5 to 5. 5 5. 5t o 6 6 to 6. 5 6. 5t o 7 7 to 7. 5 7. 5t o 8 FoF Underperformance 8 • %FoF outperforming Alternative Beta to 8. 5 8. 5t o 9 >9
  40. 40. Shipping Performance • Navigate in the high seas of illiquidity Liquidity Counterparty BetaHF Capacity Fees NB. Risk, optimisation et al quant tools irrelevant
  41. 41. Conclusions • Increased regulation – “False positive” test for hedge fund – Safer custody – Calls for “Financial Product Safety Board” like FDA in the US (Lo, Stiglitz) • Optimise liquidity and Beta • hybrid Alpha (satellite) + ETF/ synthetic (core)
  42. 42. Takeaway • Managing investments relative to benchmark index ≠ managing to preserve capital • Long only equity investment managers lost ~50% twice during 2000s • Costs and fees – Indexing (passive) << benchmark relative (traditional active) < <skilled (highly active)
  43. 43. 3 Year Old Alternative Beta
  44. 44. Product Design/Selection • Plan • Objective, target, mandate, delegation and approval • Structuring • Regulation: Listing, domicile, liquidity; Capacity • Marketing – “(UCITS hedge) providers intend to launch despite higher costs and lower returns”, FTfm Jan 11th, 2010
  45. 45. Evolving Packaging • Wrappers, feeders, guarantees etc. Alpha Legal Form Beta Distribution Fees/Cost 0 ETF “Constant” “Safe for public”, ~0 PLC UCITS Non-UCITS (FCP) “High” Cayman 0 “Unsafe”, private LP “High” • No customer choice – vs 401k (US), SIPP (UK), private/HNW clients
  46. 46. Packaging Innovation • NAV denomination experiments: valuation fiat money vs “real” units – commodities like oil, gold, CPI baskets? • Santander’s Maddoff investors – Repay in 2% prefs @10 years: better response than UBP, UBS (Holocaust custodian) and others (esp. FoHF)
  47. 47. Big Lesson
  48. 48. Future • Capital protection and diversification – Maintain exposure to (liquid) alternative investments – Non-traditional sources: e.g. convertible arbitrage, managed futures • Indices and benchmarks can be “alternative” – Convergence of long and hedged strategies (UCITS, indices)
  49. 49. Downside Risk • Hedged strategies outperform: smaller losses, lower variance • Long-only strategies are riskier
  50. 50. Research • Alpha/Beta/Gamma separation • Optimal contracting: fees decomposition into α, β subject to options (inc. clawbacks); pricing α; active portfolio insurance (Δ risk appetite cursors) • Demand in equilibrium: passive indexing (Beta, ETF) vs skilled • Liquidity • Corporate law requires illiquid funds to be frozen in order to prevent them becoming insolvent • Fund governance
  51. 51. Principles Revisited • A Green Pig Down Wall Street, A. Inechien • Perpetual Innovation – Bookstaber, R. (2007) “A Demon of Our Own Design”, Wiley • Incentives – Das, S. (2006) “Traders, Guns and Money”, FT Prentice Hall; Shiller & Axlerod (2009) “The Animal Spirit”; Hare, D. “Power of Yes”
  52. 52. References • www.london.edu/hedgefunds • www.aima.org • Indjic, D., Billieux, S. (2009) “Feature: Hedge Fund Redemptions, Hedge Fund Value”, Professional Investor, CFA UK , Spring 2009 • Kärki, J. P., Indjic, D. (2009) “A new investment paradigm: Alpha-Beta separation”, Euromoney Hedge Fund Handbook 2009; the Hedge Fund Journal, November 2008

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