Hedge Fund Overview Webinar - Callan€¦ · Hedge Fund Trends Early hedge fund investors were...

May 21, 2020

Hedge Fund Overview Webinar

Karen Heifferon

Fund Sponsor Consulting

Pete Keliuotis, CFA

Alternatives Consulting

Jim McKee

Hedge Fund Research

1

Presenters

Karen Heifferon is a senior vice president in Callan's San Francisco Fund

Sponsor Consulting office. She works with a variety of institutional investor

clients including corporate defined contribution plans, endowments, and

foundations. Her responsibilities include client service, investment manager

reviews, performance evaluation, research and continuing education, business

development, and coordinating special client proposals and requests.

Pete Keliuotis, CFA, is an executive vice president and the head of Callan’s

Alternatives Consulting group, which includes the private equity and hedge

fund consulting teams. Pete is a member of Callan’s Alternatives Review,

Client Policy Review, Management, and Editorial committees. He is a holder of

the right to use the Chartered Financial Analyst® designation.

Jim McKee is a senior vice president in Callan's Hedge Fund Research group.

Jim specializes in hedge fund research addressing related issues of asset

allocation, manager structure, manager search, and performance evaluation for

Callan's institutional clients.

2

● Hedge Funds Revisited

● First Quarter Performance and Future Opportunities

● How to Build a Successful Program

Agenda

Hedge Funds

Hedge Funds Revisited

Pete Keliuotis, CFA

4

Introducing Hedge Funds

Relative Value Matching purchase and sale of similar securities or related

assets to profit from price divergences, with low net market

exposure; high leverage often used

Event-Driven Equity and credit strategies that capitalize on company or

industry catalysts such as a merger or regulatory change;

modest leverage

Macro Thematic investing globally across asset classes including

equity, debt, currencies, commodities, and rates to exploit

trends and price dislocations

Equity Hedge (or Long / Short Equity) Bottom-up stock pickers seeking alpha from longs and / or

shorts, with significant net market exposure; leverage and

beta vary

Hedged portfolios with flexible and dynamic investment strategies

Relative Value 28%

Event-Driven 25%

Macro 19%

Equity Hedge 28%

Source: HFR® Global Hedge Fund Industry Report – First Quarter 2020 (www.hedgefundresearch.com)

Fees typically 1.5%–2.0% plus 15%–20% performance fee

Primary Hedge Fund Styles (% of Industry AUM)

http://www.hedgefundresearch.com/

5

Introducing MACs

Most traditional “long-only” portfolios are

dominated by equity risk.

MAC strategies mitigate equity risk with

broader diversification, more dynamic risk

management, and better drawdown

protection.

Scalable, low-cost solutions are constrained

only by liquidity and can offer better risk-

adjusted returns.

Multi-asset class strategies

Source: Callan

MAC

Hedge Fund

Ris

k-A

dju

ste

d

Retu

rn

Complexity

Shared

Characteristics

Flat fee

Highly liquid and

transparent

Shared

Characteristics

Can leverage, short, use

derivatives, and shift capital

between asset classes

Traditional

Long-Only

6

MAC Style Groups Defined Directional or relative value trades driven by macro perspectives

Source: Callan

Systematic Discretionary

Dyn

am

ic P

ositio

nin

g

Mark

et N

eutr

al

Rela

tive V

alu

e

Directional

Long

Biased

Risk Parity

Absolute

Return Risk Premia

Long Biased

Directional and dynamic strategy with an equity bias, managed

tactically

Absolute Return

Risk-controlled tactical strategy across multiple asset classes,

with low net market exposure

Risk Premia

Exposure to alternative risk premia and return anomalies,

implemented with relative value trades and portfolio leverage;

target volatility of 5% – 15%

Risk Parity

Balanced and strategic risk-weighted exposure to major asset

classes, including equity, credit, commodities, currencies,

and rates

7

Size and Structure of Hedge Fund Market

$3 trillion industry has reached maturity:

● Assets have recovered well from post-

GFC lows, with net outflows since 2015.

● To resume growth hedge funds will need

to demonstrate a clear risk-adjusted

return advantage to justify high fees.

● Current environment more advantageous

but short-term outflows likely

● Hedge funds still represent only a small

part of global capital markets (<5%).

Industry growth stopped pre-COVID-19 crisis: What’s next?

-2,000

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

-500

0

500

1,000

1,500

2,000

2,500

3,000

3,500

1990 1993 1996 1999 2002 2005 2008 2011 2014 2017 1Q20

Es

tim

ate

d #

of

Fu

nd

s (

ex

FO

F)

As

se

ts (

$b

illi

on

)

Estimated Assets (LHS) Net Asset Flow (LHS)

Estimated # of Funds ex FOF (RHS)



8

• Bloomberg Barclays Agg • 60 S&P 500 / 40 BB Agg

Role of Hedge Funds

● High potential risk-adjusted return

– Better performance in choppy or declining

markets due to shorts; lag in bull markets

● Less correlation to traditional assets

– Flexible strategies and performance fees drive

funds to pursue idiosyncratic trades.

● Powerful manager diversification effect

from strategy and return dispersion

– Hedge Funds: 6.0% annualized spread between

25th and 75th percentiles

– Active Global Equity: 4.4% spread

Portfolio diversifiers or return enhancers? Maybe both….

Source: Callan Institutional Hedge Fund and Callan Global Equity Peer Groups for 5 years ended March 31, 2020

D R D Rising D R D R D Rising D R D

00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 1920

-50%

0%

50%

100%

150%

200%

250%

Cumulative Returns (over Rising / Declining Periods) for 20 Years

41.1%

163.8%

154.8%

176.2%

169.3%

• Callan Hedge FOF • 90-Day T-Bills • S&P 500

9

0

10

20

30

40

50

60

70

80

12/29/06 12/29/08 12/29/10 12/29/12 12/29/14 12/29/16 12/29/18

VIX Index (30-day implied volatility)

VIX Average (19.5%)

Current Market Conditions and Volatility

● Hedge fund opportunities often improve with increased volatility

– Lack of volatility mutes ability of active traders to find profitable trades.

– Higher volatility creates more macro opportunities from market dislocation, and more micro opportunities from price dispersion.

Source: CBOE (www.cboe.com)

Lehman Bankruptcy (Oct 08)

China Slowdown

(Dec 18)

Greek Tragedy (Sep 11)

China Meltdown

(Aug 15) VIX Fit

(Feb 18)

COVID-19 Crash

(Mar 20)

http://www.cboe.com/

10

HFRI Hedge Fund Index Relative Performance vs. Global Equities

Dislocation Event Time Period Global Equities Fund-Wtd Equity Hedge Event Driven Relative Value Macro

Global Financial Crisis Jun 2008 – Jun 2009 -29.3 19.3 14.1 17.8 22.0 27.6

Euro Crisis Jun 2011 – Dec 2011 -11.5 5.5 0.7 4.6 8.0 9.6

China Slowdown 4Q 2018 -12.8 6.7 6.5 8.9 10.7 10.6

COVID-19 Crisis 1Q 2020 -21.4 10.5 9.1 8.1 14.3 18.2

Worst 5 Quarters* Time Period

1st 4Q 2008 -22.4 13.2 9.5 10.4 11.7 25.0

2nd 1Q 2020 -21.4 10.5 9.1 8.1 14.3 18.2

3rd 3Q 2002 -18.3 14.4 14.3 12.9 18.9 19.7

4th 3Q 2011 -17.4 10.7 6.4 10.5 13.9 17.6

5th 3Q 2008 -16.6 7.0 1.6 9.1 9.6 11.2

Recent Dislocations and Hedge Fund Performance Hedge funds have outperformed global equities during severe downturns

* Worst 5 quarters over the past 20 years for Global Equities (April 1, 2000 – March 31, 2020)

Sources: Global Equity: MSCI ACWI (net) Index; Hedge Funds: HFRI

11

Hedge Fund Trends

● Early hedge fund investors were primarily

endowments and private wealth pools

seeking to capture outsized and

idiosyncratic returns.

● Larger institutions such as pensions later

entered the space, with an increased

focus on downside protection.

● Concurrently, changes to regulation (e.g.,

“Reg FD”), market structure, and central

bank policy created headwinds for equity

and macro traders.

● Managers also sought more scalable

trades, with quant strategies becoming

more prevalent.

Evolution of underlying strategies

Relative Value

Event-Driven

Macro

Equity Hedge

0%

20%

40%

60%

80%

100%

1990 1993 1996 1999 2002 2005 2008 2011 2014 2017 1Q2020


Strategy Allocations as a % of Total


12

Program Design Portfolio construction driven by risk and return expectation

Absolute return

Fixed-income alternative; focus on downside protection

Key goal: less-correlated returns from non-market risks such as

alternative beta, illiquidity premium, complexity premium, and

idiosyncratic risks

Directional

Equity complement (long / short equity, event driven); intended

to provide diversification vs. long-only strategies

Key goal: equity-like returns over a full market cycle with less

volatility

Balanced

Diversified mix of absolute return and directional strategies

Key goal: a more unconstrained approach that enables

varying degrees of market exposures over full market cycles

Risk / Return Tradeoff

Hig

h R

etu

rn

High Risk Low Risk

Lo

w R

etu

rn

Absolute

return

Directional

Balanced

TAKEAWAYS Hedge funds and MAC strategies:

– Are not a distinct “asset class”: can move across asset

classes and geographies

– Experienced rapid growth leading up to and following the

2008–2009 GFC, then much slower growth in recent years

– Mix of attractive long-term returns and strong downside

protection during market downturns, but high fees

– Saw a shift in the most prevalent strategies from more

directional but volatile equity hedge and global macro to

more scalable relative value and event driven

– Can be used to structure portfolios with a wide variety of

risk and return characteristics

First Quarter Performance and Future

Opportunities

Jim McKee

15

● Assessing the Impact of COVID Crisis

● Finding Opportunity amid Crisis

● Next Steps with Strategic Partners

Outline for hedge fund opportunities in the wake of COVID-19 crisis

Breaking Bad, Creating Good Opportunities

16

Assessing the Impact of COVID-19 Capital markets

-10.4%

-7.0%

-24.0%

-17.7%

-3.5%

-6.9%

-9.5%

5.4%

-6.5%

7.0%

17.9%

1.8%

-23.7%

MSCI World

S&P 500

Russell 2000

MSCI Emerging Markets

ML All US Convertibles

Bloomberg Barclays High Yield

Credit Suisse Leveraged Loan

Bloomberg Barclays CMBS IG

JPM GBI-EM Gl Div

Bloomberg MBS

FTSE Treasury 10-Yr

Bloomberg US Dollar Index

Bloomberg Commodity Price Idx

S&P Gold Spot Price 23.0%

---- Credit Suisse Hedge Fund Index (-4.3%)

-21.1%

-19.6%

-30.6%

-23.6%

-13.6%

-12.7%

-13.2%

0.5%

-15.2%

2.8%

11.7%

2.8%

-23.5%

MSCI World

S&P 500

Russell 2000

MSCI Emerging Markets

ML All US Convertibles

Bloomberg Barclays High Yield

Credit Suisse Leveraged Loan

Bloomberg Barclays CMBS IG

JPM GBI-EM Gl Div

Bloomberg MBS

FTSE Treasury 10-Yr

Bloomberg US Dollar Index

Bloomberg Commodity Price Idx

S&P Gold Spot Price 4.8%


• Equities • Credit • Other Macro

Returns for Quarter Ended March 31, 2020 Returns for Year Ended March 31, 2020

17

Assessing the Impact of COVID-19 Alternative betas

-50.4%

-65% -55% -45% -35% -25% -15% -5% 5% 15% 25% 35%

-10.5%

-50.6%

24.9%

10.4%

6.4%

10.0%

15.7%

-4.9%

10.4%

5.8%

Equity Momentum

Rates Momentum

Currency Momentum

Commodity Momentum

Equity Carry

Rates Carry

Currency Carry

Commodity Carry

Equity Value

Rates Value

Currency Value

---- Eurekahedge Multi-Factor Risk Premia - 5% Vol Target (-8.3%)

Source: Hedge Fund Research, Inc.

-35.7%

-60% -50% -40% -30% -20% -10% 0% 10% 20% 30%

-3.8%

-46.3%

16.8%

18.5%

11.3%

18.5%

17.2%

-15.1%

19.8%

21.9%

Equity Momentum

Rates Momentum

Currency Momentum

Commodity Momentum

Equity Carry

Rates Carry

Currency Carry

Commodity Carry

Equity Value

Rates Value

Currency Value

---- Eurekahedge Multi-Factor Risk Premia - 5% Vol Target (-7.0%)

• Momentum • Carry • Value


18

Assessing the Impact of COVID-19 Hedge fund strategies

-2.6%

-19% -14% -9% -4% 1% 8%

-6.2%

-1.3%

-2.2%

-14.9%

-4.1%

-11.5%

-5.4%

-1.1%

-6.2%

5.7%

Long/Short Equity

Emerging Markets

Global Macro

Managed Futures

Event Driven Multi

Risk Arb

Distressed

Multi-Strategy

Equity Market Neutral

Convertible Arb

Fixed Income Arb


Source: Credit Suisse

-6.5%

-23% -18% -13% -8% -3% 2% 5%

-5.3%

-5.3%

-5.8%

-18.8%

-6.8%

-10.8%

-11.2%

-8.1%

-10.5%

0.0%

Long/Short Equity

Emerging Markets

Global Macro

Managed Futures

Event Driven Multi

Distressed

Risk Arb

Multi-Strategy

Equity Market Neutral

Convertible Arb

Fixed Income Arb


• Directional Equity / Macro • Event-Driven • Relative Value


19

FOF

Abs Ret

FOF

Diverse

Core

FOFs

Short Eq

Long-

FOFs

Macro

Funds

Hedge

Instl

-20%

-15%

-10%

-5%

0%

5%

10%

15%

10th Percentile 0.1 -4.8 -2.0 4.8 3.0

Median -8.5 -7.3 -10.8 -0.3 -6.3

90th Percentile -18.3 -15.5 -19.1 -10.4 -19.1

Peer Group Mean -9.9 -8.6 -11.4 -1.8 -6.4

FOF

Abs Ret

FOF

Diverse

Core

FOFs

Short Eq

Long-

FOFs

Macro

Funds

Hedge

Instl

-20%

-15%

-10%

-5%

0%

5%

10%

15%

10th Percentile 4.6 0.0 4.3 12.9 10.6

Median -6.7 -4.3 -6.5 0.8 -3.6

90th Percentile -15.7 -12.5 -18.9 -5.5 -19.8

Peer Group Mean -8.4 -5.2 -7.7 1.2 -3.6

Assessing the Impact of COVID-19 Hedge fund solutions

Callan Hedge Fund Peer Groups

Returns (net of fees) for Quarter Ended March 31, 2020

Callan Hedge Fund Peer Groups

Returns (net of fees) for Year Ended March 31, 2020

20

Assessing the Impact of COVID-19 Multi-asset class solutions

Benchmarks: T-bill + 4% (Absolute Return); Eurekahedge MFRP 5% Vol (Risk Premia); 60% MSCI ACWI/40% BB Aggregate (Long Biased); HFR Risk Parity 10% Vol (Risk Parity)

Abs Return Risk Premia Long Bias Risk Parity

-25%

-20%

-15%

-10%

-5%

0%

5%

10th Percentile 2.3 -3.1 -6.9 -8.5

Median -4.7 -10.0 -14.7 -13.9

90th Percentile -10.8 -15.7 -20.1 -22.4

Peer Group Mean -4.3 -10.3 -14.0 -14.3

Benchmark 1.5 -12.0-12.0-7.0

Callan Multi-Asset Class (MAC) Peer Groups

Returns (gross of fees) for Quarter Ended March 31, 2020

Abs Return Risk Premia Long Bias Risk Parity

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

10th Percentile 8.1 -3.7 0.5 0.7

Median 0.0 -11.8 -5.4 -5.4

90th Percentile -9.2 -20.3 -13.3 -17.4

Peer Group Mean -0.9 -11.5 -6.5 -7.0

Benchmark 6.3 -4.5-2.8-8.3

Callan Multi-Asset Class (MAC) Peer Groups

Returns (gross of fees) for Year Ended March 31, 2020

21

Renewed appreciation for more dry powder, lower risk tolerance, and better diversification

Closed-end and open-end hedge funds as well as MACs

Finding Opportunity amid Crisis

Cash is king

– Previously closed hedge funds are

now selectively open to new

investors

– Hedge funds willing to negotiate

fees and high watermarks, though

NAVs may need extra vetting

– New closed-end funds also present

sizable opportunities to allocate

fresh capital

Less-directional hedge funds vs. bonds

– Short-duration risk of cash + x%

returns is less sensitive to inflation

risk

– Choppy markets ahead help hedge

funds reap more alpha from

mispriced securities

Additive and complementary solutions

– Hedge funds and flat-fee, scalable

MACs

– Beware of “broken clocks that are

right twice a day,” given lessons

learned post-GFC

22

More structural selling expected ahead, creating discounts for liquidity providers

– Short time frames to vet opportunities require strategic relationships with experienced, specialized managers

Secondaries, co-investments, and direct investments


Hedge fund secondaries

– Sourced by specialized advisers;

buy illiquid hedge fund interests at

attractive discounts to NAV

– Sellers highly motivated to raise

cash

Co-investments

– Trade in securities that are too

illiquid or too large, with significant

discounts to their intrinsic values

– Collaboration with discretionary

advisers (e.g., FOFs, hedge funds)

– Managed in a commingled fund or

separate account at discounted

fees

Direct investments

– Executed independent of a third-

party adviser but often in concert

with that adviser

– Investor is responsible for all due

diligence and implementation risks

– No fees paid to a third party

23

Macro strategies do not need to be 2% and 20% hedge funds

Highly liquid investments that can be ideal funding sources for rebalancing portfolios

Trend-following, systematic macro, and macro hedges


Trend-following

– Feeds on market volatility and

diverse economic recoveries that

lead to divergent outcomes

– Profits occur in either rising or

declining markets, but risk lies in

nothing happening

Systematic macro

– Focuses on scalable alternative risk

premia often not correlated with

stocks and bonds

– Embraces both long and short

exposures across stocks, bonds,

currencies, and commodities

Macro hedges

– Offer asymmetric returns in both

inflationary and deflationary

environments

– Example: gold serves as a crisis-

risk hedging tool in the short run

and a proven store of value over the

(really) long-term relative to cash

24

The hunt for diversification beyond traditional capital markets continues

Reinsurance and other non-traditional alternatives


Reinsurance

– Supports insurance companies needing to offload excess

weather, fire, and other event-related risks

– Risk premia uncorrelated to major asset classes, while

offering attractive returns versus fixed-income alternatives

– Pricing has risen recently to attract more capital needed to

back insurance needs

Private credit

– Lending to gold-mining companies at attractive loan-to-value

measures based on proven reserves

– Capital for law firms helping plaintiffs with viable claims

against corporations or governments

– Life settlement cash to insureds needing liquidity, in

exchange for future insurance policy payouts

25

● Matching implementation with resources, experience, and styles of governance

● Non-discretionary advisers

● Discretionary gatekeepers

● Direct hedge funds and MACs

Are you ready, willing, and able?

Next Steps with Strategic Partners

TAKEAWAYS Breaking Bad, Creating Opportunity

– COVID-19 crisis has severely dampened economic

outlook, challenging capital markets, alternative betas, and

hedge fund strategies.

– Opportunities created by the crisis are now plentiful for

investors providing liquidity to meet structural selling

ahead.

– Next steps require an investor to match its given

resources, skill sets, and styles of governance with the

appropriate strategic partners.

How to Build a Successful Program

Karen Heifferon

28

How do clients build a successful hedge fund program?

Program Success


Know what you want, ask the following:

What risk expectations do you have for

hedge funds?

What is the role of hedge funds in the portfolio?


29

Program Design What are your risk expectations?

Absolute Return Balanced Directional

– Return goal of T-bills + 4%

– Bond-like volatility

– Less-correlated returns

– Downside protection through hedged

book

– Seek to capture illiquidity premium

– Exposure to both absolute return

(non-directional) and directional

strategies

– Better upside potential than absolute

return with less market beta than

directional

– Broadly diversified return stream;

more resilient portfolio

– Equity-like returns with less volatility

than public equity

– Favorable upside / downside capture

– More beta exposure than absolute

return

– More variable alpha driven by stock-

selection edge, which may not be

reliable

30

Program Design Sample portfolios

Absolute Return Balanced Directional

Relative Value

Event Driven

Long-Short Equity

Global Macro

Relative Value

Event Driven

Long-Short Equity

Global Macro

Long-Short Equity

Global Macro

Risk Low High

31

Case Study Strategy: diversify long-only public markets portfolio

Profile

$70 billion defined benefit plan with a

7.5% allocation to diversifying

strategies

Extensive internal resources with five

dedicated investment professionals

who cover alternatives

Highly engaged board

Goal

Utilize non-traditional systematic

strategies to provide differentiated

returns relative to long-only public

equities

Build a low-beta portfolio diversified by

style and alpha engine with limited

incremental fees

Strategy

Initial allocation to alternative risk

premia

Followed by managed futures and

systematic global macro

32

Case Study Strategy: improve risk-adjusted total fund returns

Profile

$500 million total fund client with 15%

allocation to hedge funds

Sophisticated investment committee

that includes mostly investment

professionals

No dedicated investment team

Goal

Improve the risk-adjusted return profile

of the total fund

Desire for assets having a low

correlation of returns relative to

traditional (long-only) equity and fixed

income investments

Net annualized return expected to

exceed 5%, or T-bills + 3%

Annualized standard deviation of

returns of less than 5%

Strategy

Reduce exposure to higher-volatility

funds such emerging market-focused

macro

Eliminate sector-targeted fund-of-funds

to reduce fees and over-diversification

Maintain smaller allocation to diversified

multi-manager portfolio for core hedge

fund exposure

Multi-manager portfolio complemented

with a handful of multi-strategy funds

Broaden scope of portfolio to include

other diversifying strategies

33

Program Design: the first and most important step guiding implementation

Portfolio Structure: risk and return profile of the hedge fund portfolio can be managed dynamically

Manager Selection: understand manager edge, style, and consistency

Board and staff education to understand the risks involved and impact of market environment

Revisit each component annually

How to stay on track

Lessons Learned

TAKEAWAYS Program Success:

– Spend time on clearly understanding what your

organization is trying to achieve

– Hedge fund strategies and managers are not linear;

understand their nuances

– Evaluate your program

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