An alternative Christmas cardOpalesque Alternative Market Briefing, 30 November 2011http://www.opalesque.com/639673/An_alternative_Christmas_card967.htmlBy Drago Indjic, Sunningdale Capitals co-founding partner and Project Manager at the London BusinessSchool:It appears that Christmas came early for all underperforming funds offering longer than "monthly + 30days notice" redemptions. Tomorrow, the last window of opportunity to redeem hedge funds will beclosed and since major broad hedge fund indexes are expected to be in "high single digit" negativeterritory, many will say that 2011 calendar year losses have been inevitable.Are managers still rewarded for pursuing "absolute" returns? Regardless of type of explanations forlosses, many discussions will involve "relative" performance against investable indexes and/or peers. Inparticular, diversified FoHF performance will have to be compared principally against the broad hedgefund market. There is little need for verbosity on probable causes of losses since here we are looking fortreatments: have investors had access to any cure?It is recognised that the third quarter of 2011 was one of the worst ever quarters for hedge funds.Obviously, most losing FoHF followed the market wide losses through their natural "long" marketposition. We should accept that investing in hedge funds does not guarantee absolute returns. Inaddition, most managers had the benefit of the relatively fresh experience of September 2008 and theopportunity to adopt to survive the next crisis. Moreover, market instruments and liquidity evolved:Exchange Traded Funds and similar products will probably overtake hedge funds in terms of sizesometime next year.Not being very different from the market – and in practice a typical diversified FoHF will find it difficult –implies exhibiting effective hedge fund market Beta uncomfortably close to one. If only this unwantedand highly damaging Beta exposure could have been avoided, 2011 would be a happier year for many.The glaring "missing trade" was to be short hedge funds starting from May 2011. This singlediscretionary trade – or risk management action - could have been taken to stop losses. Regrettably,many FoHF still ran with excessively long duration of their portfolios and thus were unable to take anyspecific action to avoid losses, in stark contrast with end investor demands to follow formal risk policies.As equity volatility continued to be high since Q3 and trends were punctuated by sharp reversals, hedgefund market Beta easily obscured and damaged any residual outperformance, preventing delivery ofhedge fund product Alpha relative to hedge fund market Beta.The short trade could have been implemented using modern index products. Being long hedge fundmarket index in a single trade was possible for over five years and became increasingly commoditisedthrough the launch of new UCITS and ETF products. The hedge fund index replication can be hardly anynews: Opalesque media covered many alternative Beta opinion leaders: Lars Jaeger (May 2010),Narayan Naik (September 2010) and Christof Schmidhuber (September 2011). There are a few dozen
alternative Beta purveyors offering index products of all shapes and forms and similar to modern ETFproduct ranges, alternative Beta index exposure can be obtained in derivative and reverse form. Byvirtue of alternative Beta taking form of index products and securities, there are additional oft-quotedbenefits: fixed cost, no operational risk, transparency, daily and better liquidity, to name a few.Since all required components for protecting downside and improving liquidity existed, it is becomingharder to rationalise avoiding using them in the best interest of investors or not acquiring necessaryadditional skills and strategies. Notably, demand for specific skills traditionally aspiring to seek Alpha thatwould not guarantee performance delivery will change (becoming commoditised through outsourcedoperational due diligence, manager selection advisory etc): indexes are not Alpha but specific, tradablerisk premiums. If not available in-house, additional skills can be found in independent specialist firms,academia or even offered by product vendors. In essence, 2011 and beyond cannot be navigatedsuccessfully by using old, "buy and hold" hedge fund products.Let us imagine that instead of performing a single discretionary trade in Q3 we would like to exploitalternative Beta risk premium, in conjunction with "core" underlying investment strategy or producttargeting specific risk profile. Today one can respond to hedge fund market conditions accordingly –decide to follow the market direction or not - even daily and intra-daily if required. In the simplestconsideration, one is not forced to be long hedge fund market continuously. Yet there is no imminentneed to demand full transparency of the underlying portfolios and then "micro-hedge" all possibleresidual Betas all the time. Therefore, the starting point can be to understand the admissible alternativeBeta "budget" of your product (an aspiring Alpha source), its liquidity and to contrast it with thealternative Beta style currently rewarded in the market. Moreover, as hedge fund market risk premiumhas a life on its own, one can consider systematic exploitation of structural inefficiencies.Hence looking at hedge fund market performance from May 2011 onwards and being short the hedgefund index could have been such an easy trade. Even a purely directional view or a simple momentummodel could have created value. Now consider that we can start analysing various alternative Betacycles and styles, looking for new frontiers of exploiting hedge fund market inefficiencies. This may evenrequire additions a new strategy definition. If used "naked", these strategies would directly exploitevolution of market alternative Beta premium, or if used together with other hedge fund underlying, couldaddress deficiencies in risk budgets and formal risk policies. There is no need to bias the active selectionof hedge fund managers or to start second guessing their actions. The objective is to make portfolios ofhedge funds better – and over 50% cheaper as it avoids "2/20" cost of exposure to pure market Betaopportunities – thus enabling filtering of "non-Alpha" components.Using index products for discretionary trading and risk management is straightforward. However, if"naked" alternative Beta investment strategy is expected to deliver Sharpe ratios over one in disciplinedtrading, additional skills are required. Our research has demonstrated the feasibility of producingsustained annualised performance of 10%+ with high Sharpe ratio by doing only a few monthly tradessystematically (see Chart). There is a significant scope for improvement. Beyond "varying" hedge fundmarket Beta, strategies can temporarily include "tilted" exposure to a different alternative Beta style, likesystematic CTA Beta.
Unlike Alpha capacity that may be limited and costly, the replication capacity can be continuouslyincreased, reflecting demand, and reduced trading spreads will follow. Investment banks will create asmuch capacity as investors demand. If the size of market of passive Beta opportunities is today matchingthe size of Alpha hedge fund opportunities, why limit yourself to searching for needle-like Alphas fromhedge fund haystack (as everybody else does) rather than actively dealing with obvious Betas?I have been lucky to participate in the young days of both FoHF and alternative Beta development andremained a believer in their successful marriage. Investors can lose patience with FoHF for the secondtime after 2008 and demand only those exhibiting Alpha above the hedge fund index. Just operating inthe "average" – as classic diversified FoHF keep doing – delivers Beta only and misses deliveringvaluable (socially beneficial) genuine FoHF functions in seeding and secondary markets. Over time,markets remove inefficiencies and push the bar upward: in 2012 we will be closer to long/shortalternative Beta products that will be able to outperform a significant portion of FoHF universe and long-only index position than ever before. How would underperforming FoHFs explain to investors losses thatresults from Beta management inactivity?Like traditional Beta, alternative Beta products are here to stay: waves of financial innovation andExchange Traded Products are unstoppable. The New Year resolutions may include: FoHF adding Beta"seasoning" to improve product performance, the end investors considering alternative index strategiesand hedge fund managers thinking about becoming pure Alpha source or satellite on top of the core,variable bias alternative Beta.Dragos recent interview on Opalesque Radio:SourceReferenced in 9 January briefing by Bailey McCann, Opalesque New York:http://www.opalesque.com/640140/Alternative_beta_products_can_provide_returns_even014.html
rd[Figure comment – not included in the original article] Simulated fully systematic trading of basket of 3 partyhedge fund replicators (black) vs HFRX Global index (red). Blue shaded periods denote reverse exposure to hedgefund market. Together with discretionary risk management, a similar systematic model has been used in real-timesimulated and reported trading trial within Sunningdale Alpha Fund, a hybrid fund of HF and replicators betweenJanuary 2010 and December 2011 (closed). The strategy is today available only in managed account format.Source: Sunningdale Capital