Hedge Funds for 2010s
Dr Drago Indjic
London Business School
Sunningdale Capital LLP
15 January 2009
GSB Barcelona, Uni. Pompeu Fabra,

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)

Contents
• Status
– Some numbers
– Regulation
• Quick Introduction
– “User manual”
– Structure rather than composition
• Trends
• Q&A

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

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”

2009: Recovery
• CY investable HF indices:14-19%

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%

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)

“Oversold”

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.

What is Risk Then?
• Not just variance
• Loss of capital
• Correlation
• Beta
• Liquidity
• Access to capital (“return of capital”)

Capital Preservation
Global Equity Hedge Funds
January 2008 100 100
December 2008 55 80
December 2009 ~65 ~94
• Stability: lower variance and drawdowns

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?

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

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”

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

Trustee Regulatory Constraints

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”

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

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

Hedge Fund Techniques
• Only legal
– Madoff ≠ hedge fund
• Borrowing
– Cash: Leverage
– Securities: short selling
• Hedging
• Non-standard instruments

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”

Investment Strategies
• Beyond taxonomy
– Insight from replication techniques
• Best α is ideally like “extremophile
bacteria”
– Astrobiology

Reminder: 2008 Performance
•
One hedge fund strategy was the top performer

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

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.

Case Study
• Institutional investors: increased liabilities
– “BA/Iberia pension fund”
• Mandate Search
– Structure, performance, correlation, liquidity
management, costs

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

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?

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

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

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

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 …

“Normal” Market

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

“Normal” Liquidity Target

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

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

10%
12%
14%
16%
18%
20%
0%
2%
4%
6%
8%
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Returns (May 2007 - May 2008)
4.
Indjic – 30 Sep 2008
5
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FoF Underperformance
8
• %FoF outperforming Alternative Beta
to
8.
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9
>9

Shipping Performance
• Navigate in the high seas of illiquidity
Liquidity
Counterparty
BetaHF
Capacity
Fees
NB. Risk, optimisation et al quant tools
irrelevant

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)

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)

3 Year Old Alternative Beta

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

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

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)

Big Lesson

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)

Downside Risk
• Hedged strategies outperform: smaller
losses, lower variance
• Long-only strategies are riskier

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

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”

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