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  1. 1. Pierre Laroche Managing director – R&D Analysis and Modelling of Hedge Fund Allocations The Funds described herein are indexed to a Morningstar Hedge Fund Index based on a MSCI HF Methodology
  2. 2. Table of contents 1. Introduction: overview of the hedge fund industry 2. Core-Satellite Hedge Fund Allocations 3. The Core: Synthetic Hedge Fund Index Replicators (SHFIRs) 4. The Satellite 5. Analysis, modelling and discussion of CSHFA 6. Concluding remarks
  3. 3. 1. Introduction
  4. 4. Overview of the Hedge Fund Industry <ul><ul><li>Poor performance: approximatively –20 % year-to-date (as of end October). </li></ul></ul><ul><ul><li>The “LIBOR + something” label more and more difficult to justify for the great majority of HFs and FoHFs. </li></ul></ul><ul><ul><li>From 3,000 HF in 1997 to 10,000 in 2008… to 7,000 - 8,000 at the end of 2009? </li></ul></ul><ul><ul><li>From USD 200 Bn assets under management in 1997 to USD 2.5 Tn in 2008… to USD 2 Tn (perhaps 1.5 Tn) in 2009? </li></ul></ul><ul><ul><li>Over 1000 “traditional” FoHFs and 12-15 managed-account based FoHFs. </li></ul></ul><ul><ul><li>Institutional investors now constitute the bulk of current HF investors: </li></ul></ul><ul><ul><li>Still, recent surveys suggest more than 80 % of institutional investors are not invested in HFs. New comers will be im- portant contributors to the AUM growth over the coming years. </li></ul></ul><ul><ul><li>Longer-term outlook: more liquidity and more transparency. To us, that is good news for modellers. </li></ul></ul>
  5. 5. 2. Hedge Funds as Core-Satellite composites
  6. 6. <ul><li>A Core-Satellite HF allocation consists in separating the Beta component from the other components (which include Alpha) of a traditional HF/FoHF investment: </li></ul><ul><ul><li>The Core investment is the Alternative Beta portion, allocated to the SHFIR. </li></ul></ul><ul><ul><li>The Satellite may be any Portable Alpha product of the Current FoHF Investment (from which Alt.-Beta component can be hedged) used as a self-financed overlay. </li></ul></ul>Funds of Hedge Funds as Core-Satellite Composites Target risk-adjusted return improvement: 50-100 pb/year from fee arbitrage
  7. 7. 3. The Core: Synthetic Hedge Fund Index Replicators (SHFIR)
  8. 8. What are Synthetic Hedge Fund Index Replicators? Sources: Academic studies and Innocap R&D Dpt. See disclaimer. <ul><ul><li>Approximate composition of HF indices’ returns: </li></ul></ul>1 % - 1.5 %. This portion of additional return is partly unrealizable. The rest is smaller or at best equal to FoHF fees. Long-term Expectation: LIBOR + 5 % Components Other: . Biases . Non-investability . Better diversification . Pseudo-Alpha (from index rebal.) Liquidity Risk Premium Beta and Alternative Beta LIBOR Approx. 1.5 % p.a. Approx. 2 % - 2.5 % p.a.
  9. 9. What are Synthetic Hedge Fund Index Replicators? <ul><ul><ul><li>HF index replicators result from 10 years of academic and institutional research showing that 50-80 % of HF returns result from so-called “alternative beta” exposures to markets. </li></ul></ul></ul><ul><ul><ul><li>Alternative beta is quite simple to obtain… at a cheap cost. </li></ul></ul></ul><ul><ul><ul><li>Hence, paying high fees (2 %/20% + at least 1 %) for the whole FoHF returns seems excessive. </li></ul></ul></ul><ul><ul><ul><li>What are the risks? </li></ul></ul></ul><ul><ul><ul><ul><li>“ Classical” (as opposed to Managed Accounts) FoHFs: </li></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Opacity </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Illiquidity </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Model risk of HF strategies </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>HF selection risk (of HF’s and allocations to them by FoHFs) </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>HF operational risk </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>FoHF selection risk (by investors) </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><li>Synthetic replicators: </li></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Some model risk (but much lower than HF’s model risk though) </li></ul></ul></ul></ul></ul>
  10. 10. What are Synthetic Hedge Fund Index Replicators? Factor-based replication methods are widely recognized as the most efficient ways to replicate hedge fund returns. Strategy mimicking Distribution replication Factor-based replication Taking the same positions as the hedge funds themselves, ie “build pseudo hedge funds and blend them together” Cons : - Difficult to be representative of the overall HF space as well as the single strategies - Illiquidity - Possibly exposed to complex assets Using copulas to obtain the returns distribution volatility, skewness and kurtosis of the target HF Index. The correlation with the main asset classes is preserved Pros: - As close as possible to genuine HF - May be made transparent - Access to illiquid and non linear assets Pros: - Creative and a different way to generate alternative beta returns Cons: - Difficult to apprehend - Long periods (i.e. several years) are required to demonstrate effectiveness - Difficult to implement and calibrate Exposing the portfolio to fundamental return generating factors through dynamic allocation to liquid assets Pros: - Very intuitive - Transparent and liquid - Very effective way to generate alternative beta returns Cons: - Replication lag - May be delicate to calibrate - Stability of the exposure depends on the choice of the model and of the factors
  11. 11. What are Synthetic Hedge Fund Index Replicators? <ul><li>Other non parametric models (e.g. neural networks) were considered but were quickly discarded, mostly because of their “blackbox” features. </li></ul>Linear regression Filters Synthetic hedge funds returns are obtained from the allocation to tradable factors. The allocation is the estimated linear regression coefficients. Cons : - Method not conceived for tracking objectives - Not adequate if HFs change their aggregate positions abruptly Pros: - Well known - Easy to implement - May deliver good results in favorable market conditions Pros: - Well known - Easy to implement Cons: - Limiting underlying assumptions: i.) Gaussian noises ii.) Linear allocation dynamics Filters are statistical models aimed at tracking trajectories. They are applied in various fields such as machine learning, missile interception, signal processing,… There are many kinds of filters. Pros: - Still very intuitive - Allow a better representation of reality - May better capture abrupt allocation changes Cons: - Harder to implement - More delicate to calibrate Kalman filters Advanced filters Advanced Filters are doing very well even during the current crisis
  12. 12. What are Synthetic Hedge Fund Index Replicators?
  13. 13. What are Synthetic Hedge Fund Index Replicators? <ul><ul><li>In the theoretical experiment below, 4 replication models are compared: linear regression, Kalman filter, IMM filter and advanced (SALTO) filter. </li></ul></ul><ul><ul><li>In this experiment, the HF industry abruptly changes its allocation over 3 periods of 24 months. The graphics below show how the different models capture these sudden shifts. </li></ul></ul><ul><ul><li>SALTO filter is more responsive than the other standard algorithms. This feature helps SALTO to track better the target Index under changing market conditions: </li></ul></ul>0.16 0.18 0.27 0.36 Tracking error SALTO filter IMM filter Kalman filter Linear regression Model NB: IMM: Interacting multiple model filter . The tracking error is the square root of the mean squared error (RMSE). Linear Regression vs Kalman filter Kalman filter vs IMM filter IMM filter vs SALTO filter IMM Filters –vs- Advanced Filter Kalman Filters -vs- IMM Filter Linear Regression -vs- Kalman Filters
  14. 14. What are Synthetic Hedge Fund Index Replicators? SHFIRs are at least as good as classical FoHFs for these criteria
  15. 15. 4. The Satellite
  16. 16. The Satellite <ul><ul><li>The Satellite component of CSHFA is a self-financed overlay invested in whatever portfolio that delivers absolute returns. </li></ul></ul><ul><ul><li>If the satellite is composed of a FoHF, it may be preferable (if not necessary) to eliminate the alternative-beta component of its returns in order to obtain “purer” absolute returns. This can be done by using: </li></ul></ul><ul><ul><ul><li>A short version of a Synthetic Hedge Fund Index Replicators. </li></ul></ul></ul><ul><ul><ul><li>A custom hedge. </li></ul></ul></ul><ul><ul><li>The satellite can also be composed of an Absolute Return Portfolio (i.e. from which beta components have been removed). </li></ul></ul>
  17. 17. 5. Analysis, modelling and discussion of CSHFA
  18. 18. will be neg. or near 0 will always be positive Core-Satellite Hedge Fund Allocation (Plain Vanilla) <ul><ul><li>Base case analysis (simple mean-variance setup ; constant overlay allocation k ): </li></ul></ul><ul><ul><ul><li>Setup: </li></ul></ul></ul><ul><ul><ul><li>Variance equalizing requires: </li></ul></ul></ul><ul><ul><ul><li>Feasibility Condition will usually be met </li></ul></ul></ul><ul><ul><ul><li>Other condition: the CSHFAS will outperform the current HF allocation if </li></ul></ul></ul>abp = « alpha-beta » ptf h = hedge ptf (to extract alpha) f = risk-free asset will usually be positive
  19. 19. Core-Satellite Hedge Fund Allocation (Plain Vanilla) <ul><ul><li>Empirical Analysis: 71 FoHF –vs- Typical CSHFA (January 2000 – September 2008) </li></ul></ul><ul><ul><ul><li>CSHFA: NBCG SALTO + 25 %(60 % BNPP Millenium + 40 % NBCG ABSO) </li></ul></ul></ul><ul><ul><ul><li>Monthly rebalancing ; net of fee returns ; HFRI FoHF Database </li></ul></ul></ul>Nota: FoHF data contains some survivorship bias and is not adjusted for (3mth+) liquidity risk. Average 1-month USD LIBOR rate: 3.57 % p.a. 6.08 % 6.08 % Volatility 7.43 % 4.98 % Avg. Return CSHFA Median FoHF Annualized:
  20. 20. Core-Satellite Hedge Fund Allocation (Plain Vanilla) <ul><ul><li>Empirical Analysis: FoHF –vs- Typical CSHFAS (January 2000 – September 2008) </li></ul></ul><ul><ul><ul><li>CSHFA: NBCG SALTO + 25 %(60 % BNPP Millenium + 40 % NBCG ABSO) </li></ul></ul></ul><ul><ul><ul><li>Monthly rebalancing ; net of fee returns ; HFRI FoHF Database </li></ul></ul></ul>CSHFAS (9th/72) Median
  21. 21. Core-Satellite Hedge Fund Allocation (Plain Vanilla) <ul><ul><li>Modelling: </li></ul></ul>1. O-U or Brownian Bridge 2. O-U or AR(1) 3. From 1. and 2. with constraints 4. From 3. plus market stress adjustments 5. From 1. + noise 6. From 1. + f(Dur,Conv) 7. From 1. + VA + TE 12. From 1. to 9. (replication model) 8. From 6. + risk prem. 9. From 8. + linear model 10. Non-linear fct. of 6. and 8. 11. From 8. and 10. 13. From 12. + VA + TE
  22. 22. Core-Satellite Hedge Fund Allocation (Plain Vanilla) <ul><ul><li>Modelling: typical outcome (SHFIR only) </li></ul></ul>
  23. 23. Core-Satellite Hedge Fund Allocation (Plain Vanilla) <ul><ul><li>Modelling: main challenges </li></ul></ul><ul><ul><ul><li>Modelling and integrating macroeconomic factors (e.g. corporate profits, equity risk premium) </li></ul></ul></ul><ul><ul><ul><li>Better modelling of SHFIR weights dynamics in order to obtain a more stable correlation matrix with respect to the fundamental asset classes </li></ul></ul></ul><ul><ul><ul><li>Modelling Emerging Markets equity differently (integrating their own economic factors) </li></ul></ul></ul><ul><ul><ul><li>Improve exchange rate modelling (especially to obtain more sensible and stable correlations) </li></ul></ul></ul><ul><ul><ul><li>Generalize the model to include the new dynamic CSHFAS that are currently being developed and should gain momentum in the coming years) </li></ul></ul></ul>
  24. 24. This publication is intended for your personal use only. Innocap Investment Management Inc. and BNP Paribas believe that the information contained herein is reliable, but cannot guarantee its accuracy or completeness considering its various sources. This publication may not be reproduced, in whole or in part, in any way and under any circumstances, prior to the obtaining of Innocap Investment Management Inc.’s or BNP Paribas' written approval. Any financial operation contains a variety of risks and factors to consider. Before entering into an operation, it is recommended to carefully examine all conditions, assess the risks and determine whether it is appropriate for your financial needs and objectives in all respects. It is also recommended to consult financial, legal and/or tax advisors before entering into a transaction. Although past or anticipated returns may be stated in this publication, Innocap Investment Management Inc. and BNP Paribas wish to specify that past returns are not necessarily indicative of future results. Moreover, although the Sub-Fund aims at tracking the MSCI HFI Composite, some significant variations may occur from time to time. Also, past tracking error levels do not necessarily reflect future tracking error levels . This document may also contain performance simulation which are merely indicative. This statement does not purport to describe all the risks associated with financial transactions and should not be construed as advice on any transactions. The information and opinions contained herein are for informational purposes only and are subject to change depending on the market conditions and general conjuncture to which they relate. The attached materials do not constitute and should not be construed as an offer or solicitation to enter into any transaction in a jurisdiction where such offer would be unlawful under the laws of that jurisdiction. Neither BNP Paribas nor Innocap Investment Management Inc. is an agent of the Altma Fund. Innocap Investment Management Inc.is the investment advisor of the Altma Fund. Any offer or solicitation with respect to the tracker, a collective investment scheme (the &quot;Fund&quot;), will be made solely by means of a definitive offering document. Such definitive offering document will set forth the actual terms of the Fund and will contain material information regarding the fund and the transactions described herein that is not contained in this document. Any decision to invest in Fund must be based solely on the information in the offering document and not on the information in this document. Further more investors in the Fund should have such knowledge and experience in financial and business matters and be capable of evaluating the merits, risks and suitability of investing in the Fund including any risk associated with the Fund. Prospective investors should review and understand the offering document in respect of the relevant Fund – in particular, the section dealing with risk factors. BNP Paribas and Innocap Investment Management Inc make no representation and have given you no advice concerning the appropriate accounting treatment or possible tax consequences of any product indexed on the Fund. Each holder of the Fund shall assume and be responsible for any and all taxes of any jurisdiction or governmental or regulatory authority and should consult their own tax advisers in this respect. Before July 17, 2007, the estimated returns are a simulation of Innocap’s filter-based replication model with monthly rebalancing. From July 2003 to 16 July 2007, the simulation uses tradable replicating factors (e.g. futures and ETFs); before July 2003, it uses non tradable total return indices. The simulated returns include National Bank of Canada (Global) Limited’s and Innocap’s respective management and advisory fees (50 bp/year), the administrator fees (14.5 bp/year) and other operating fees (legal, audit, etc., which sum to 2.5 bp/year). The historical simulation returns do not include trading costs since they depend on market conditions and whether or not the fund benefited from new subscriptions or withdrawals during any given month. The average trading costs are estimated at approximately 1 bp/month (12 bp/year). Even if the estimated past returns are believed accurate, there is no guarantee regarding their infallibility. Also, note that past returns are not necessarily representative of future returns. SALTO’s inception date is July 17, 2007. Hence, the monthly returns history is fully effective from July 17, 2007 and is net of all fees and costs, including National Bank of Canada (Global) Limited’s and Innocap’s respective management and advisory fees (50 bp/year). The funds or securities referred to herein are not sponsored, endorsed or promoted by MSCI, and MSCI bears no liability with respect to any such funds or securities or any index on which such funds or securities are based. The offering documents contain a more detailed description of the limited relationship MSCI has with Innocap Investment Management Inc. and any related funds.