Hedge Funds for 2010sDr Drago Indjic

London Business SchoolSunningdale Capital LLP

15 January 2009GSB 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 ing le 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 PreservationGlobal 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 strategies0

2040

6080

Managed Futures

Duration

Cou

nt

0 31 60 90 120 150 1800

510

15

Fixed Income: Mortgage-Backed

Duration

Cou

nt

0 60 130 210 390

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: AgeAge vs FoHF.AUM

10.01 , 19.2%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

0 5 10 15 20 25 30 35

Age

% u

nive

rse

FoHF: VolatilityReturn vs Volatility

Montly Data from 31-03-99 to 31-03-09

-7%

-2%

3%

8%

13%

18%

23%

0% 5% 10% 15% 20%

Volatility

ACR

FoHF: Decorrelation

Return vs Correlation to MSCI WorldMontly Data from 31-03-99 to 31-03-09

-7%

-2%

3%

8%

13%

18%

23%

-100% -80% -60% -40% -20% 0% 20% 40% 60% 80% 100%

Correlation

ACR

Return vs Correlation to MSCI World (Down)Montly Data from 31-03-99 to 31-03-09

-7%

-2%

3%

8%

13%

18%

23%

-100% -80% -60% -40% -20% 0% 20% 40% 60% 80% 100%

Correlation

ACR

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)

020

040

0Fund of Funds

Duration

Cou

nt

0 90 215 360 498 750

“Normal” Liquidity Target

0%

20%

40%

60%

80%

100%

Oct-08 Apr-09 Oct-09 Apr-10 Oct-10 Apr-11 Oct-11 Apr-12

S Fund (MP=100%, GI=0%) - Redemption

S Fund (MP=0%, GI=0%) - Redemption

S Fund (MP=0%, GI=100%) - Redemption

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

Liquidity Crisis

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

Page 39 Indjic – 30 Sep 2008

FoF Underperformance

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

< -3

-3 to

-2.5

-2.5

to -2

-2 to

-1.5

-1.5

to -1

-1 to

-0.5

-0.5

to 0

0 to 0.

5

0.5 to

1

1 to 1.

5

1.5 to

2

2 to 2.

5

2.5 to

3

3 to 3.

5

3.5 to

4

4 to 4.

5

4.5 to

5

5 to 5.

5

5.5 to

6

6 to 6.

5

6.5 to

7

7 to 7.

5

7.5 to

8

8 to 8.

5

8.5 to

9 >9

Returns (May 2007 - May 2008)

• %FoF outperforming Alternative Beta replicator

Shipping Performance• Navigate in the high seas of illiquidity

NB. Risk, optimisation et al quant tools irrelevant

Fees

Liquidity

BetaHF

Capacity

Counterparty

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.

• No customer choice – vs 401k (US), SIPP (UK), private/HNW clients

Alpha Legal Form Beta Distribution Fees/Cost0 ETF “Constant” “Safe for public”,

PLC~0

UCITS

Non-UCITS (FCP)

“High” Cayman 0 “Unsafe”, private LP “High”

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