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- Slides by Drago Indjic 14 May 03 - Slides by Drago Indjic 14 May 03 Presentation Transcript

  • The Risks of Portfolios of Hedge Funds Drago Indjic Fauchier Partners PRMIA, 14 May 2003, London
    • Don’t believe everything you read
      • Negative media bias
      • Cliché: “LTCM”, “Soros”, “Courtisans” …
    • = Investor education, academic research
    El Pais, 24 Feb 2003 1 Speculators
  • 2 Early 21c. Risk Source: HFR, Pertrac, Fauchier
    • Hedge fund industry
    • Investment strategies
    • Investor’s perspective
    • Data, Transparency and Estimation Risks
    • Hedge fund r isk
    • Portfolios of Hedge funds (Any HF investors or FoHF in the audience?)
    3 Content
    • Unregulated private placements
      • (e.g.) A pooled investment vehicle that is privately organised, administered by professional investment managers, and not widely available to the public
    • “ Extralegality” (de Soto) => Frontier Creativity
      • Less restrictive liquidity, borrowing, derivatives … (taxation)
      • Creative investment strategies – efficient capital utilisation
      • Perpetual innovation ⇄ inefficiencies
    • Consider only hedged (off-shore) funds
    4 Hedge d Funds
    • The most dynamic sector of asset management today
      • Decreasing sell side research coverage; Higher servicing profitability
    • Regulators “lagging”
      • SEC: May 14/15 – “raising bar”?
    • Sustained growth
      • Highly creative and talented manager’s end game: “personal” styles
      • Owner/Manager mentality
      • Self-Regulation by adapting capacity, liquidity, fees
    5 Industry
  • Estimated Assets Asset Flows Estimated Hedge Fund Asset Growth and Flow 1990 - 2002 Estimated Number of Hedge Funds (ex FOF) 1990 - 2002 6 Assets (In $MM) Number of Funds 2003
    • Tass Asset Flows Report ™ 4Q2002
      • 3493 total -1337 “dead”= 2156 “live” funds
    • HFR 2002 Industry Report:
      • 4598 funds (exc. FoF)
      • (AUM most probably underestimated)
    7 Hedge Fund Environment $622 $310 2002 $536 $261 2001 HFR Tass Billions USD
    • Contra:
      • HF are “alternative investment strategies”: too heterogeneous, dynamic, evolving, with no brands
    • Pro:
      • Absolute returns paradigm, Ineichen (2002)
        • Specific liquidity (“mark-to-market”) and drawdown preferences
      • Very different sources of α , uncorrelated, –ve β , better Ω … ran by non-consensus thinkers in small enterprises
    Another Asset Class? 8
    • Hedge Fund (HF) “Indexes”
      • Composites of actively managed portfolio returns
      • Over a dozen commercial indices
      • Investible? Transparent? Capacity?
      • No independent verification
      • Enforcing “relative” rather than “absolute” return viewpoint
    • Evolving strategies
      • E.g. Quantitative credit arb, macro equilibrium models
      • Many styles within strategy (inc. different fund of funds styles)
      • “ Strategy drift” detection
    9 Investment Strategies
  • 10 Estimated Strategy Composition by AUM 1990 Estimated Strategy Composition by # of Funds (ex FOF) 2002 2003
  • Fund of Funds 11 Estimated Net Asset Flow by Strategy 2002 Estimated Net Asset Flow by Strategy Q4 2002 2003
  • 12 2002 HFRI Index Risk Return Comparison 5 Year Annualised (1998 – 2002) 2002 HFRI Index Risk Return Comparison 2003
  • AIMA Strategy Definitions
    • An index family for every commercial data source: too many indices but a lack of definitions
    • Ad-hoc committee under the under the auspices of AIMA called for “Expressions of interest” in April 2003
    • ‘ Non-commercial’, coordinated long-term research effort leading to the development of a set of definition "guidelines"
    • Survey planned during 3Q03
    13
    • How?
      • “ DIY”, advisor, specialist?
      • “ Fund of funds” (FoHF) route
    • Passive: Indexed
      • Pools of managed accounts
      • Which “index” and “HF Tracking error”?
    • Active: Portfolio of funds
      • “ Off the shelf”
      • Tailor made and managed
    • Structured
      • What type of security do you own?
      • Total costs?
    14 Creating Exposure
    • Two hedge funds
    • A Hedge fund Index, S&P 500-hedged
    • Selection of a dozen funds from “platform”, wrapped
    • Five funds, 8 x levered portfolio
    • Single-strategy, multi-manager (levered)
    • Any including a fund that rebates 50% of fee to anyone
    15 FoHF Examples
    • Business rather than investment management:
      • Seeding, incubation, equity stakes
      • Capacity marketing, fees splits
      • Selection vintage year
    • Asset gatherers:
      • Collecting fees on gross assets?
      • Layered fees transparency (e.g. structured products)
      • 2 nd level Performance fee
      • Hurdle, Highwatermark
    16 Investment Biases
    • Collection of HF accounts – a trivial solution?
    • Portfolio construction biases
      • “ Products” or portfolios?
      • Captive market?
      • Can “good” funds be included?
      • Where is manager self-invested?
    • Should “on going” Due Diligence be outsourced?
    17 Managed Account “Platforms”
    • Data: not liquid market prices but performance estimates of “hyperactive” portfolios skilfully managed in different, very personal styles
    • Problematic valuation: IAFE Hedge Fund Valuation Practice recommendations
    • Hedge fund strategy modelling
      • Multifactor models: R 2 from 0.1 to 0.9?
      • Option replication (Naik and Agrawal, 2001)
      • Calibration: NAV (RiskData) or model exposure data
    18 Data and Modelling
    • No unique answer
      • “ Those people who need it will find managers who will provide it”
      • “ Those managers who won’t give it will be able to find investors who don’t need it”
      • Greatest fear: hedge fund ruin (default)
      • Aggregated disclosure
      • Mutual trust: the “agent” in real-time dialogue
    • Full Transparency Paradox
      • Un-actionable without active overlays
      • Diminishing need for managers if operating “active” overlay?
    19 Transparency Debate
    • Long/Short Equity Report Template
    20 Hedge Fund Exposures Source: Fauchier
  • 21 Transparency Compliance (2002) Source: Fauchier
  • Estimation Risk
    • Taboo topic: non-asymptotical statistics, very short and noisy data samples
    • Volatility and VaR – Figlewski (2003)
    • Portfolio - Kempf (2002)
      • The equal weighting is theoretically optimal solution when data and forecasts are not reliable
    22
    • Estimate correlation: n=12 data points:
    • “ ρ =0” ↔ ρ ∊ [-0.3, 0.3] (85% )
    • “ secretary problem” - but fund may be already closed
    23 Small sample bias
  • 24 Correlation Matrix 1 April 2001 to 31 March 2003 Source: Fauchier
  • Weekly vs Monthly Data View Surprising differences in certain fund correlations pairs 25 Source: Fauchier
  • Weekly HF “Indexes” Equally weighted index of weekly returns: non-normality 26 Source: Fauchier
  • Keating and Shadwick (2002) 27 Omega Ratio
    • HF are SME (~7 people => no IT, client service …)
      • Can portfolio manager run (grow) a small business?
      • “ Disgraceful aging”
    • Total Hedge Fund Risk =
      • Market Risk + Operational Risk
      • Operational Risk >> Market Risk
      • Principal/Agency Problem
    • Balance “Qualitative and Quantitative” Risks
    28 Hedge Fund Risk
  • 29 The Real Risk
    • Primary (individual hedge fund level):
      • Many market risks are (most often) hedged
      • Balance sheet dynamics: leverage and hedge skills
      • Kept in check by Prime Broker margin policy
    • Secondary (portfolio of funds level):
      • Risk measurement + portfolio management
      • Operational risk management
    30 Risk Management
    • Mandatory: Prime brokers
      • Are VaR and margin policy private information not to be disclosed (timely) to (all) investors?
    • Optional: Third party “Risk aggregators”
      • HF -> TTP -> Investor
      • New generation fund administrators?
    • Voluntary: Customised risk reporting
      • IAFE IRC and AIMA: Strategy-specific templates
    31 Market Risks
    • Age and stability
      • Immature business models
      • Incentives, succession planning
    • Capacity
      • “ Chicken & Egg” capacity games:
        • Day 1 fund closures, secondary market
      • Big isn’t beautiful: median AUM $40m
      • “ Know your client”: max. two dozen investors
    • Liquidity
      • Lockups, penalties, gates, suspended and forced redemption rights
    32 Operational Risks (1)
    • Organisational Structure
      • Legal structure
      • Performance fee models
    • Counterparties
      • Fund administration, Audit, Prime Broker
    • Manager Utility: “Path-Dependant”
      • Risk aversion = f ( Δ AUM, Losing streak, YTD, Wealth…)
    33 Operational Risks (2)
    • FoHF A ≠ FoHF B
      • % own (or owned) funds, %funds of funds, % multi-strategy funds …
      • Liquidity, costs (fee sources)
    • Portfolio Analysis
      • Performance Attribution: Manager selection vs Strategy allocation
      • Turnover (usually low), ROCE
      • Style analysis
    • Monitoring
      • In-situ: business and operational risk
    34 Funds of Hedge Funds
    • “ One size doesn’t fit all”
      • Single-strategy, multi-manager: mitigate decision making?
      • “ All weather”
      • Tailor-made
    • Levered or not?
    • “ Optimised” or not?
    • Avoid behavioural biases
    35 Portfolio Construction
    • Kempf (2002): Optimal portfolios for data length T, market inhomogeneity τ , identical prior mean.
    • Comment: funds of hedge funds are in T -> 0/ τ -> ∞
    36 Portfolio Estimation Risk Two-step Markowitz Minimum variance T ->∞ Equally weighted Minimum variance T=0 τ->∞ τ =0 Case
  • 37 Portfolio Construction
    • Constrained optimisation
      • Asymmetric calendar trading constraints (illiquidity)
      • Inherent slippage
    • Not mean-variance but scheduling and constraint programming
    • Monitoring Costs: Communication density
      • #meetings/funds/year/analyst(s)
    38 Operational Risk Optimality
  • M/M+30/15 March 04 Jan 03 March 03 May 03 Sept 03 Nov 03 July 03 Jan 04 Jan 03 March 03 May 03 Sept 03 Nov 03 July 03 Jan 04 March 04 Jan 03 March 03 May 03 Sept 03 Nov 03 July 03 Jan 04 March 04 M/M+60/20 2/Q+60 39 Calendar Liquidity Constraints Source: Fauchier
  • 40 Manager Research and Monitoring Total number of meetings Number of meetings Source: Fauchier
    • Balance true risks and costs
      • Attention to vested business interests and incentives (are we all “eating our own cooking”?)
      • Quantitative, but also confident
    • Product divergence
      • “ Optimal” transparency
      • Commoditisation vs customisation
    41 Conclusion
    • AIMA (2002) A Guide to Fund of Hedge Funds Management and Investment
    • AIMA (2003) Hedge Fund Strategy Definition Standardisation
    • Inechien, A. (2002) Absolute Returns, Wiley
    • L’ Habitant, F.-S. (2002) Hedge Funds: Myths and Limits, Wiley
    • Rahl, L. (2003) Hedge Fund Risk Transparency, Risk Books
    42 Bibliography - Introduction
    • Figlewski, S. (2003) Assessing the Risk in Risk Assessments, IAFE/ PRMIA Seminar, April 23rd, NYC
    • Kempf, A., Memmel, C. (2002) On the Estimation of the Global Minimum Variance Portfolio, Discussion Paper 2002-2, Uni. Koeln
    • Keating, C., Shadwick, W. (2002) “Omega: A Universal Performance Measure” Journal of Performance Measurement, Spring 2002
    • Lo, A. (2002) Risk Management for Hedge Funds: Introduction and Overview, AIMR
    • Naik, N., Agrawal, V. (2001) Performance Evaluation of Hedge Funds with Option-based and Buy-and-Hold Strategies, LBS
    43 Bibliography - Research