The Pros and Cons of Hedge Funds - IFEBP · Hedge Funds–Three Perspectives • Reintroduction to...

The opinions expressed in this presentation are those of the speaker. The International Foundationdisclaims responsibility for views expressed and statements made by the program speakers.

The Pros and Cons of Hedge Funds

Sharon M. GoodmanPrincipalSlevin & Hart, P.C.Washington, D.C.

Michael D. Joyce, Esq., CEBSExecutive Vice President and Senior ConsultantThe Marco Consulting GroupBoston, Massachusetts

Edward D. Patchett, CFADirector, Business DevelopmentGCM GrosvenorChicago, Illinois

I09-1

Hedge Funds–Three Perspectives

• Reintroduction to hedge funds and fund of funds strategies—Why do investors use hedge funds—An investment consultant’s perspective

• Hedge fund risks, returns and expectations—An investment manager’s perspective

• Ways to protect your plan—A plan counsel’s perspective

• After recent performance struggles, what does the future hold for hedge fund strategies and investors’ sentiment?

I09-2

What Are Hedge Funds?

• Privately-offered investment vehicles not constrained by a specific benchmark

• Use traditional and alternative asset classes

• Use specialized trading strategies—More tools available

• Attempt to take advantage of market inefficiencies

• Use an expanded set of financial instruments and securities

• Can use leverage• Generally have less exposure to market

risk

I09-3

Hedge Fund Strategies

4

RELATIVE VALUE

Convertible ArbitrageFixed Income ArbitrageEquity Market Neutral

EVENT DRIVEN

Merger ArbitrageSpecial Situations

Distressed Securities

DIRECTIONAL

Global MacroLong BiasedShort Sellers

Target Return %

LOWER

HIGHER

Expected Risk %LOWER HIGHER

I09-4

Why Plans Initially Got Involved

Diversification / Low Correlation

• HFOFs and hedge funds generally offer differentiated risk/return profiles relative to traditional bond and equity investments

• HFOFs and hedge fund strategies offer a variety of correlation benefits

Preservation of Capital / Downside Protection

• HFOFs and hedge funds have consistently preserved capital during more stressed market environments

Reduced Equity Volatility

• HFOFs and hedge funds use a variety of investment tools to mitigate equity risk in order to deliver steady returns with lower volatility

• Long-term, HFOFs and hedge funds have outperformed unhedged investments on a risk-adjusted basis

Diversification / Investment Flexibility

• HFOFs and hedge funds offer flexible investment mandates, enabling them to adapt to changing market environments and to capitalize on the prevailing opportunity set

I09-5

Why Plans Initially Got InvolvedDiversification / Correlation Benefits

Correlation Analysis: January 1994 - April 2016

HFRI FOF Composite S&P 500 S&P 400 Index

(Mid Cap)S&P 600 Index

(Small Cap) MSCI ACWI Barclays U.S Aggregate Bond

Barclays HY Credit

Bloomberg Commodity Index

S&P 500 0.607

S&P 400 Index (Mid Cap) 0.656 0.900

S&P 600 Index (Small Cap) 0.621 0.792 0.914

MSCI ACWI 0.684 0.944 0.881 0.789

Barclays U.S Aggregate Bond 0.038 0.035 0.007 -0.072 0.019

Barclays HY Credit 0.546 0.625 0.649 0.613 0.678 0.217

Bloomberg Commodity Index 0.445 0.317 0.374 0.328 0.428 0.045 0.359

CS Leveraged Loan Index 0.474 0.428 0.481 0.444 0.488 -0.022 0.756 0.368

I09-6

‐0.79%

1.70%

0.82%

‐3.51%

3.24%

0.84%

Down Market Up Market All Markets114 months 206 months 320 months

Why Plans Initially Got InvolvedDownside Protection

Up/Down Market Analysis

HFRI FW Composite

S&P 500 Index

Data sources: Hedge Fund Research (HFR); S&P. S&P and its third‐party information providers do not accept liability for the information and the context from which it is drawn.Past performance is not necessarily indicative of future results.

Average monthly net returnsJanuary 1990 – August 2016

I09-7

3 4

16

27

47

66

75

49

25

8

38

11

16

30

19

35

44

33

28

66

< ‐4% ‐4% to‐3%

‐3% to‐2%

‐2% to‐1%

‐1% to0%

0% to1%

1% to2%

2% to3%

3% to4%

> 4%

Extreme negative

Strongnegative

Modest negative

Modest positive

Strong positive

Extreme positive

38 instances of “extremenegative” monthly returns for equities; 3 instances for hedge funds

HFRI FW Composite

S&P 500

Count of monthly returns by rangeJanuary 1990 – August 2016

Why Plans Initially Got InvolvedPositive Slope to

Hedge Fund Returns


I09-8

Why Plans Initially Got InvolvedDownside Protection

Hedge Funds During Challenging Environments

‐2.8%

‐0.1%

‐1.3%

‐6.1%

‐3.5%

‐2.2%

‐1.2%

‐1.5%

‐8.7%

‐6.8%

‐8.1%

‐8.4%

‐8.4%

‐8.9%

‐9.0%

‐9.1%

‐10.6%

‐10.9%

‐14.5%

‐16.8%

Sep‐01

Jan‐09

Jun‐08

Sep‐08

Aug‐90

Feb‐01

Feb‐09

Sep‐02

Aug‐98

Oct‐08

Ten worst monthly S&P 500 drawdownsJanuary 1990 – August 2016


HFRI FW Composite

S&P 500 Index

I09-9

$0

$2,000

$4,000

$6,000

$8,000

$10,000

$12,000

$14,000

Jan‐90

Jan‐91

Jan‐92

Jan‐93

Jan‐94

Jan‐95

Jan‐96

Jan‐97

Jan‐98

Jan‐99

Jan‐00

Jan‐01

Jan‐02

Jan‐03

Jan‐04

Jan‐05

Jan‐06

Jan‐07

Jan‐08

Jan‐09

Jan‐10

Jan‐11

Jan‐12

Jan‐13

Jan‐14

Jan‐15

Jan‐16

$12,705.73, HFRI Fund Weighted Composite Index

$10,858.11, S&P 500 Index

$5,131.43, Barclays U.S. Aggregate Bond Index

Why Plans Initially Got InvolvedHigher Cumulative Return, Lower Volatility

Annualized Return VolatilityHFRI FW Composite 10.0% 6.7%

S&P 500 9.4% 14.5%

Barclays U.S. Agg. 6.3% 3.6%

Data sources: Hedge Fund Research (HFR); Barclays Bank PLC, 2016; S&P. S&P and its third‐party information providers do not accept liability for the information and the context from which it is drawn.Past performance is not necessarily indicative of future results.

Growth of $1,000 vs. market indicesJanuary 1990 – August 2016

I09-10

Why Plans Initially Got InvolvedImprove Risk Adjusted Performance

60%

40%

60/40 Portfolio

Asset Allocation: Time Period 01/1990 to 01/201660/40

Portfolio 5% to Hedge

Funds10% to Hedge

Funds15% to Hedge

Funds

Annualized Return 8.22% 8.16% 8.10% 8.04%

Annualized Standard Deviation 9.04% 8.75% 8.45% 8.17%

Sharpe Ratio 0.88 0.90 0.93 0.95

57%38%

5%

5% Allocation to Hedge Funds

54%36%

10%


51%34%

15%


Improve plan level risk adjusted performance

I09-11

Why Plans Initially Got InvolvedSummary Check List

Diversification / Correlation Benefits

Preservation of Capital / Downside Protection

Reduced Equity Volatility

Investment Flexibility

I09-12

Considerations When ERISA Plans Invest In Hedge Funds

• Plan Document Considerations• Who is the Fiduciary For Investment—

Manager or Trustees?• Due Diligence• Potential Contracting Pitfalls And Solutions

For Benefit Plan Investors

I09-13

Plan Document Considerations

• Do Your Plan Governing Documents Allow for this Hedge Fund Investment?– Trust Agreement– Investment Policy

• Avoid unnecessary ERISA fiduciary breach issue (ERISA Section 404(a) failure to follow plan documents)

I09-14

Who is Fiduciary For Investment?

• Who is ERISA fiduciary for investment—Trustees or Manager?

• Does Investment Hold Any ERISA Plan Assets?• If NO, Trustees remain fiduciary for investment.• If YES, Not Treated As ERISA Plan Assets if Participation

By ERISA Benefit Plan Investors Less Than 25% of Investors.– 25% Excludes Governmental, Certain Church and Foreign Plans.

• If ERISA Plan Assets over 25%, Manager is fiduciary (unless exception applies).

I09-15

Exceptions To Who is Fiduciary For Investment

• Not Plan Assets Subject to ERISA if investment in Venture Capital Operating Company (VCOC Rules)—Usually private equity strategy.

• VCOC is entity with at least 50% of its assets invested in “venture capital investments” in which it has “management rights”.

• Management rights = Rights to substantially influence management of the operating company.– Must be “direct” rights that VCOC can exercise.

• Asset/management tests done annually.

I09-16

Exceptions To Who is Fiduciary For Investment

• Not Plan Assets Subject to ERISA if investment in Real Estate Operating Company (REOC Rules).

• REOC is entity with 50% or more of its assets invested in qualifying real estate and directly engaged in real estate management or development activities.

• Tested with first investment and annually thereafter.

I09-17

Hedge Fund of Fund Special Delegation Issues

• Named Fiduciary = Only fiduciary with ability to delegate its ERISA fiduciary duty to another entity

• Must be identified in Plan Document (Trust Agreement)• Board of Trustees/Retirement Committee usually named fiduciary • “Master manager” of hedge fund of funds

– Is master manager also a named fiduciary to delegate ERISA fiduciary duty to sub-managers/underlying investment funds?

– Does Trust Agreement allow designation of master manager as named fiduciary?

– If not, does master manager acknowledge that it is liable for sub-manager’s actions?

I09-18

Due Diligence Before Investing In Hedge Fund

Investment Consultant Role• Selection And Ongoing Monitoring• Asset Allocation Decision• Modeling And Stress Testing

– Look-Through Analysis Of True Risk Exposures– Return expectation and timing/ “J curve”– Lock-ups and cash flows

• Independent Valuation• DOCUMENT PROCESS!

I09-19

Issues Under Investment Contract

• Side Letter To Hedge Fund Investment - Documents– Governs if investment fund documents inconsistent– Right to see side letters of other investors

• Standard of Care– ERISA fiduciary standard– ERISA-like contractual standard– ERISA-light contractual standard (prudence standard only)

• Indemnification– By manager of Plan and Trustees?– By investment fund of manager?– By Trustees personally?

I09-20


Fees• Most Favored Nations (“MFN”) Treatment on Fees, Rights

and Features• Fees on Un-called Capital• Incentive Fees

– Warrant under DOL guidance? – Valuation of Portfolio and Potential Conflicts

• Claw back– How is high-water mark for payment of incentive fees set and

reset?

I09-21


More Fees• Unrelated Business Taxable Income

– Effort to avoid?– Protections if taxable income is earned?– Impact of tax on net return/incentive fee?

• Imposition of Organizational and Operating Expenses – Charged to investor or manager absorbs?– Capped?– If early investor, spread to later investors?

I09-22


• Confidentiality– Of Plan’s information?– Of Plan’s identity?

• Reporting– Sufficient for ongoing monitoring by investment

consultant? – Financial statements of underlying investments? – Section 101(k) for multiemployer plans?

I09-23


• Conflicts of Interest– Avoided, either by ERISA or by contract?

– Limits on hiring its affiliates for middle & back-office services?

– Fees from underlying investments/investment managers?

– Valuation by independent entity

• Scope of other agent’s liability (administrator, custodian, board of directors)

I09-24


• Voting– Pro-rata? – Control over changes in future?

• Investor Advisory Councils– Right to position (if desired)

• Involuntary Redemptions– Allowed?– At any time?– For limited reasons or manager’s complete discretion?

I09-25


• How To Get Out? – No Fault Divorce/Liquidity—When and with What

Notice?– Lock Up?– Liquidation impractical or inadvisable?– Extended beyond initial term? If so, who decides? – Unilateral by manager as GP or vote of investors?– What is Fund getting—in kind or cash? – If in kind, who manages until liquidated and for what

fee?

I09-26

Hedge Funds as Return Enhancers or Help Reduce Volatility?

Limited Recent Outperformance (Alpha) Compared to Public Markets

Annualized net returns by calendar year

Rolling period returns and volatility

2010 2011 2012 2013 2014 2015 YTD 2016

HFRI FW Composite 10.3% ‐5.3% 6.4% 9.1% 3.0% ‐1.1% 3.5%

S&P 500 15.1% 2.1% 16.0% 32.4% 13.7% 1.4% 7.8%

Barclays U.S. Agg. 6.6% 7.8% 4.2% ‐2.0% 6.0% 0.6% 5.9%

Trailing 1‐year Trailing 3‐years Trailing 5‐years

Ann. return Volatility Ann. Return Volatility Ann. Return Volatility

HFRI FW Composite 2.8% 4.6% 3.6% 4.0% 3.5% 4.6%

S&P 500 12.6% 12.4% 12.3% 10.7% 14.7% 11.6%

Barclays U.S. Agg. 6.0% 2.2% 4.4% 2.6% 3.2% 2.6%

Data sources: Hedge Fund Research (HFR); Barclays Bank PLC, 2016; S&P. S&P and its third‐party information providers do not accept liability for the information and the context from which it is drawn.Past performance is not necessarily indicative of future results.

I09-27

Hedge Fund PerformanceV-Shaped MarketsOver The Last Year

1800

1900

2000

2100

2200

Jul‐15 Oct‐15 Jan‐16 Apr‐16

+13.0%

‐13.3%+15.9%

‐6.4%

‐12.2%

S&P 500 Index Level

Significant up and down fluctuations in equity marketsJuly 2015 – June 2016

Data sources: S&P. S&P and its third‐party information providers do not accept liability for the information and the context from which it is drawn.

I09-28

Hedge Funds PerformanceSaturation – Impact on Market Efficiency

$-

$500

$1,000

$1,500

$2,000

$2,500

$3,000

$3,500

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

10,000

AU

M ($ bil)

Num

ber o

f Hed

ge F

unds

Growth of Hedge Fund & ETFsOver Time

Number of Hedge Funds Hedge Fund AUM ($ bil) ETF AUM ($ bil)

Select Reasons for ETF Proliferation Simplicity

Enhanced Liquidity

Speed of Execution

Diversification

Attractive fees

Source: Eurekahedge, Preqin, http://www.statista.com/statistics/224579/worldwide‐etf‐assets‐under‐management‐since‐1997/, Global Trends in Institutional ETF Adoption: Drivers from Growth Through 2020 (Greenwich Associates)

Select Risks of ETF Proliferation

Market instability

Market efficiency

Herd mentality

I09-29

Hedge Funds PerformanceEfficient Markets Impact Performance

8%

87%77%

51%

80%91%

74%

44%

-92%

-13%-23%

-49%

-20%-9%

-26%

-56%

-100%

-80%

-60%

-40%

-20%

0%

20%

40%

60%

80%

100%

2008 2009 2010 2011 2012 2013 2014 2015

S&P 500 Dispersion CY 2008 - CY 2015

I09-30

Hedge Funds PerformanceOver-Diversification? Similar Fund

Characteristics?

1

3 ‐ 6

25 ‐ 50

8,000+Underlying Security

Investments(Long & Short)

Underlying Hedge Fund Investments

Month Liquidity Provisions (On Average)

Traditional Multi‐Strategy HFOF Vehicle

Source: Lighthouse Partners, K2 Advisors

I09-31

Investors’ intentions for their hedge fund allocations in next 12 months

20%10% 9%

20%8%

16%

32%

51%

54% 53%

47%60%

58%

44%

29%35% 38% 33% 32%

26% 25%

0%

20%

40%

60%

80%

100%

Dec‐09 Dec‐10 Dec‐11 Dec‐12 Dec‐13 Dec‐14 Dec‐15

Prop

ortio

n of Investors

Source: Preqin Hedge Fund Investor Interviews

Increase allocation

Maintain allocation

Decrease allocation

Commitment to HedgeFunds Today

How Investors View Hedge Funds

Source: The 2016 Preqin Global Hedge Fund Report.

I09-32

Commitment to HedgeFunds Today

How the Investment Consultant Community Views Hedge Funds

Despite recent performance struggles, institutions and consultants alike remain steadfast in their pursuit of hedge fund‐like exposures as critical

components of broader portfolios.

40%25%

45%58%

15% 17%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2014 2015

Investment Consultant Recommendations for HF Allocations, 2014 vs. 2015

Recommended ClientsInvest Less Capital inHFs than in PreviousYear

Recommended ClientsInvest the Same Amountof Capital in HFs as inPrevious Year

Recommended ClientsInvest More Capital inHFs than in PreviousYear

12%

24%

32%

20%

8%

4%

0%

5%

10%

15%

20%

25%

30%

35%

Recommended Portfolio Allocation to HFs (as % of AUM)

Source: 2016 Preqin Global Hedge Fund Report

I09-33

0

1,500

3,000

4,500

6,000

7,500

9,000

$0

$500

$1,000

$1,500

$2,000

$2,500

$3,000

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2Q 201

6

Estimated Hedge Fund Assets ($ billions) Estimated Number of Hedge Funds

As of June 30, 2016:

AUM: $2,898 billion

Count: 8,406 hedge funds

Despite Recent Performance, Hedge Fund

Industry Is StableAUM (left) and number of funds (right)January 1990 – June 2016

Source: HFR Global Hedge Fund Industry Report – Second Quarter 2016 © HFR, Inc. 2016, www.hedgefundresearch.com.

I09-34

Evolving Hedge Fund Investment Landscape

Improved partnership between managers and investors• Customization • Transparency• Fees

Portfolio concentration• New strategies blur the lines of PE vs. HF vs. traditional investing

Regulatory changes• Increase in talent leaving banks to join hedge funds• Hedge funds replacing banks as longer-term liquidity providersHedge Fund Alternatives

I09-35

Potential for widening credit spreads and increasing defaultsHigh yield spreads near pre‐crisis levels

Potential for rising bond yields and falling bond pricesGovernment bond yields continue to compress

Equity m

arkets

Potential Headwinds for Traditional Assets?

0 bp

500 bp

1000 bp

1500 bp

2000 bp

Jan‐00 Jan‐02 Jan‐04 Jan‐06 Jan‐08 Jan‐10 Jan‐12 Jan‐14 Jan‐16

‐5%

0%

5%

10%

15%

20%

25%

Jul‐11 Jul‐12 Jul‐13 Jul‐14 Jul‐15 Jul‐1612

13

14

15

16

17

18

19

20

Jul‐11 Jul‐12 Jul‐13 Jul‐14 Jul‐15 Jul‐16

0%

1%

2%

3%

4%

5%

6%

7%

Jan‐00 Jan‐02 Jan‐04 Jan‐06 Jan‐08 Jan‐10 Jan‐12 Jan‐14 Jan‐16

Fixed income markets

Declining earnings growthYear‐over‐year earnings per share growth has turned negative

High equity market valuationsPrice‐to‐earnings ratios remain high

S&P 500 Index Trailing Quarter P/E RatioS&P 500 Index Trailing 12‐Month Weighted EPS Growth

Credit Suisse High Yield Spread to Worst

?

Average since 2000: 638 bp

U.S. 10‐year Treasury Note

Average since 2000: 3.7%

Trailing 5‐year average: 16.6

Trailing 5‐year average: 6.8%

Data sources: Federal Reserve Bank of St. Louis; Credit Suisse; Bloomberg Finance L.P.; S&P. S&P and its third‐party information providers do not accept liability for the information and the context from which it is drawn. These opinions represent our good‐faith expectations concerning future actions, events or conditions, and should not be viewed as indications of whether particular actions, events or conditions will occur.

I09-36

Setting the Stage for the FutureCapital Market Assumptions

Asset Classes 2016 Assumptions 2011 Assumptions Difference 2016 Standard Deviation/Risk

EquityU.S. Large Cap 6.6% 9.3% ‐2.7% 16.9%Emerging Markets 8.5% 12.5% ‐3.0% 26.4%Fixed IncomeCore 3.4% 4.2% ‐0.8% 6.0%AlternativesHedge Fund of Funds 5.4% 7.4% ‐2.0% 8.4%

Source: Horizon Actuarial Services, LLC – 2016 Survey of Capital Market Assumptions

I09-37

Greater Macroeconomic Uncertainty

Why we might see increased global equity/credit market dispersion:• Slower economic growth globally• Diverging global monetary policies• Unprecedented central bank actions• Binary macro events like Brexit• Geopolitical risks globally• Potential for U.S. interest rate hikes• Detrimental effects of negative interest rates in Europe and Japan• Decline in inflationary expectations globally• Rising risk of credit-driven crises due to high leverage levels

(China)• Technical factors increasingly driving stock valuationsThese opinions represent our good‐faith expectations concerning future actions, events or conditions, and should not be viewed as indications of whether particular actions, events or conditions will occur.

I09-38

Incorporating Hedged Investment Solutions Today

Hedge Fund-Like Investments Across the Liquidity Spectrum

Liquid Alternatives• Risk Parity• GTAA• Style Premia• Equity Options• 40 Act Alternative

Mutual Funds• Other

HFOFs / Direct HFs• Multi‐Strategy• Strategy‐Specific• Sector‐Specific• Region‐Specific

Illiquid Alternatives• Opportunistic

Beta / Volatility Risk Illiquidity Risk

…Hedge fund‐like exposures come in various shapes, sizes, and liquidity profiles today. Traditional multi‐strategy HFOF vehicles remain viable, but other solutions exist across the

spectrum.

I09-39

62nd Annual Employee Benefits ConferenceNovember 13-16, 2016Orlando, Florida

Session #I09

The Pros and Cons of Hedge Funds

• Be Sure Your Plan Document Allows The Hedge Fund Investment

• Know Who is Fiduciary For Investment—Manager or Trustees?

• Complete and Document Due Diligence• Negotiate Over Contracting• New Investors—Understand What is the Role of the Hedge Fund Allocation

• Existing Investors—Review Why were Hedge Funds Added

• Review Whether or Not Hedge Funds have Met Goals—Have Goals or Expectations Changed?

• Consider Recent Hedge Fund Performance in Light of Current and Potential Market Conditions

• Understand the Evolution of Hedge Fund Products and Alternatives—Including a Consideration of Liquidity Needs

I09-40

2017 Educational ProgramsInvestments

63rd Annual Employee Benefits Conference October 22-25, 2017 Las Vegas, Nevadawww.ifebp.org/usannual

Investments InstituteMarch 13-15, 2017 Phoenix, Arizonawww.ifebp.org/investments

Portfolio Concepts and ManagementMay 1-4, 2017 Philadelphia, Pennsylvaniawww.ifebp.org/wharton

Related ReadingVisit one of the on-site Bookstore locations or see www.ifebp.org/bookstore for more books.

The Tools & Techniques of Investment Planning, 3rd EditionItem #9029www.ifebp.org/books.asp?9029

816

I09-41

The Pros and Cons of Hedge Funds - IFEBP · Hedge Funds–Three Perspectives • Reintroduction to...

Documents

Transcript of The Pros and Cons of Hedge Funds - IFEBP · Hedge Funds–Three Perspectives • Reintroduction to...