Post on 05-Jun-2018
The Benefits and Challenges for Institutional Investors of Investing in Hedge Funds
François-Serge LhabitantHead of Investment Research, Kedge Capital
Professor of Finance, HEC Lausanne and EDHEC
f@lhabitant.net
Evolution of the hedge fund industry
Ten years ago– 100 funds.– $50 billion of AUMs.– Investment club– Private clients.– Unregulated.– Secretive.– Hard to get access.– Fees: 1+20 Today
– 8000 hedge funds.– $1 trillion+ of AUMs.– Mainstream– Institutional and retail.– Increasingly regulated.– Publicitized.– Hard to get access to good managers, easy otherwise.– Fees: from 1+20 to 4+44 or 0+50.
KEDGE CAPITAL
Kedge Capital is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated by the Financial Services Authority.
Institutions are moving slowly into alternatives
U.S. Corporate Pension Funds: 2004 Asset Allocation
Fixed income29% International stocks
15%
Domestic stocks 46%Hedge funds
1%Private equity
4%
Other1%
Real estate4%
Source: Greenwich Associates.
Ivy Endowments Asset Allocation
Equity38%
Hedge funds22%
Bonds18%
Other6%
Real estate7%
Private equity6%
Venture capital3%
Source: Endowments annual reports.
KEDGE CAPITAL
Kedge Capital is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated by the Financial Services Authority.
Why?– Further diversification of traditional portfolios.
– Exposure to new sources of returns (credit risk, currencies, commodities, etc.).
– Better risk management than traditional managers.
KEDGE CAPITAL
Kedge Capital is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated by the Financial Services Authority.
Some Challenges– Diversification: How many funds should one have in a portfolio?
– Selection: How to select the funds in a portfolio?
– Asset Allocation: How to allocate assets within a portfolio?
– Risk Management: How to assess the risk of a hedge fund portfolio?
KEDGE CAPITAL
Kedge Capital is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated by the Financial Services Authority.
Challenge no 1: Diversification
– Hedge funds are not securities.
– Hedge funds are actively-managed and risk-controlled portfolios of securities.
– Over-diversification is really bad– Lower returns.– Slightly lower risk.– Higher equity market correlation.– No real due diligence.
KEDGE CAPITAL
Kedge Capital is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated by the Financial Services Authority.
Impact on Volatility
0
2
4
6
8
10
12
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49
Volatility (%)
Number of funds
KEDGE CAPITAL
Kedge Capital is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated by the Financial Services Authority.
Impact on Maximum Drawdown
-18
-16
-14
-12
-10
-8
-6
-4
-2
01 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49
Maximum Drawdown (%)
Number of funds
KEDGE CAPITAL
Kedge Capital is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated by the Financial Services Authority.
Impact on Correlationwith S&P 500
0
0,1
0,2
0,3
0,4
0,5
0,6
0,7
0,8
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49
Correlation withS&P 500
Number of funds
KEDGE CAPITAL
Kedge Capital is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated by the Financial Services Authority.
Impact on Skewness
-5
-4
-3
-2
-1
0
1
21 6 11 16 21 26 31 36 41 46
Multi-strategies
Convert. Arb.
Short sellers
Emerging
Market Neutral
Event Driven
Fixed IncomeArb.
Global Macro
Long-short Equity
Managed Futures
Number of funds
Skewness
KEDGE CAPITAL
Kedge Capital is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated by the Financial Services Authority.
Impact on Kurtosis
0
5
10
15
20
251 6 11 16 21 26 31 36 41 46
Multi-strategies
Convert. Arb.
Short sellers
Emerging
Market Neutral
Event Driven
Fixed IncomeArb.
Global Macro
Long-short Equity
Managed Futures
Number of funds
Kurtosis
KEDGE CAPITAL
Kedge Capital is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated by the Financial Services Authority.
Diversification– Diversification is clearly a protection against ignorance.
– Diversification brings most of its benefits already with very few funds in a portfolio.
– Funds of hedge funds seem over-diversified, at least from a market risk perspective.
– Diversification should not be a substitute for due diligence.
– Concentrate your portfolios, but not your risks.
KEDGE CAPITAL
Kedge Capital is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated by the Financial Services Authority.
Challenge no 2: Fund Selection
Hedge fund universeCommercial databases
Personal contacts(4,000 to 6,000 funds)
Potential Candidates for Investment(50 to 500 funds)
Serious Candidate(s) for Investment(1 to 5 funds)
InitialScreening
QuantitativeAnalysis
QualitativeAnalysis
Due Diligence Process
Selected Fund(1 fund)
Investor’s objectives and
constraints
KEDGE CAPITAL
Kedge Capital is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated by the Financial Services Authority.
Fund Selection– What are the managers that you would really like to have in your portfolio?
– How many managers in a database are serious candidates for investing?
– The example of CSFB Tremont indices.– Size vs. effective due diligence.
– Selecting funds is an inefficient patch to fight capacity constraints.
– Institutional investors should focus on getting access to the best managers rather than spend time selecting second-tier ones.
KEDGE CAPITAL
Kedge Capital is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated by the Financial Services Authority.
Challenge 3: Asset Allocation
– Mixing the best ingredients does not necessarily provide the best portfolio.
– Optimizers do not work well with hedge funds.– Lack of reliable data.– Backward looking process.– Dynamic nature of the risk and return.
– Equal weighting provides the illusion of security.
– Risk budgeting is a much better solution – Returns are linked to performance in markets where HF
positions are concentrated.– Avoid paying for camouflaged beta.
KEDGE CAPITAL
Kedge Capital is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated by the Financial Services Authority.
The Traditional Vision
alpha 1 alpha 2 alpha 3
alpha 4 alpha 5
beta 1 beta 2 beta 3
beta 4 beta 5
Traditional Assets Alternative Assets
Bond and Stock Markets ? ?
KEDGE CAPITAL
Kedge Capital is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated by the Financial Services Authority.
The Risk BudgetingPerspectivealpha 1 alpha 2 alpha 3
alpha 4 alpha 5
betas 1 betas 2 betas 3
betas 4 betas 5
Traditional Assets Alternative Assets
Markets Sectors Liquidity Credit
Economic cycles
MonetaryPolicy
Volatility...
Leverage Spreads
Risk budget
Alpha budget
SMB HML Momentum
Currencies Commodities
KEDGE CAPITAL
Kedge Capital is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated by the Financial Services Authority.
Challenge 4: RiskManagement
– Style Analysis
– Correlation Monitoring
– Risk Attribution
– Analysis of Extreme Risks
KEDGE CAPITAL
Kedge Capital is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated by the Financial Services Authority.
Style Analysiswhere – I1,t = return on the Edhec Convertible Arbitrage index – I2,t = return on the Edhec CTA Global index – I3,t = return on the Edhec Distressed Securities index – I4,t = return on the Edhec Emerging Markets index – I5,t = return on the Edhec Equity Market Neutral index – I6,t = return on the Edhec Event Driven index – I7,t = return on the Edhec Fixed Income Arb. index – I8,t = return on the Edhec Global Macro index – I9,t = return on the Edhec Long/Short Equity index – I10,t = return on the Edhec Merger Arbitrage index – I11,t = return on the Edhec Relative Value index – I12,t = return on the Edhec Short Selling index
– Impose a positive beta constraint!
∑=
ε+⋅β+α=12
1itt,iit IR
KEDGE CAPITAL
Kedge Capital is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated by the Financial Services Authority.
Hedge Fund Radars-50%
0%
50%
100%
150%Convertible Arbitrage
CTA Global
Distressed Securities
Emerging Markets
Equity Market Neutral
Event Driven
Fixed Income Arbitrage
Global Macro
Long/Short Equity
Merger Arbitrage
Relative Value
Short SellingA CTA Fund
-50%
-30%
-10%
10%
30%
50%Convertible Arbitrage
CTA Global
Distressed Securities
Emerging Markets
Equity Market Neutral
Event Driven
Fixed Income Arbitrage
Global Macro
Long/Short Equity
Merger Arbitrage
Relative Value
Short Selling
A multi-strategy Fund
KEDGE CAPITAL
Kedge Capital is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated by the Financial Services Authority.
The Full Picture
0
0.2
0.4
0.6
0.8
1
1.2
1.4
1.6
1.8
2
Feb-00 Aug-00 Feb-01 Aug-01 Feb-02 Aug-02 Feb-03 Aug-03
Short Selling
Relative Value
Merger Arbitrage
Long/Short Equity
Global Macro
Fixed Income Arbitrage
Event Driven
Equity Market Neutral
Emerging Markets
Distressed Securities
CTA Global
Convertible Arbitrage
KEDGE CAPITAL
Kedge Capital is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated by the Financial Services Authority.
Correlation is time dependent
-1.00
-0.80
-0.60
-0.40
-0.20
0.00
0.20
0.40
0.60
0.80
1.00
-1.00 -0.80 -0.60 -0.40 -0.20 0.00 0.20 0.40 0.60 0.80 1.00Equities
Bonds
Global MacroManaged Futures
Event Driven
KEDGE CAPITAL
Kedge Capital is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated by the Financial Services Authority.
Correlation is market dependent
-8
-6
-4
-2
0
2
4
6
-15 -10 -5 0 5 10
Russell 3000 Index Returns
OLS fit
LOWESS fit
Writing an at-the-money Put
Event Driven Index Returns
KEDGE CAPITAL
Kedge Capital is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated by the Financial Services Authority.
Correlation is index dependent
Strategy Date Min (%) Max (%) Spread
Merger Arbitrage Sep. 98
Altvest: -0.11 HFR: 1.74 1.85%
Convertible Arbitrage Oct. 98
CSFB: -4.67 Henessee: 0.08 4.75%
Fixed Income Arb. Oct. 98
HF Net: -10.78 Van Hedge: 0.20
10.98%
Funds of funds Dec. 99
MAR: 2.41 Altvest: 10.42 8.01%
Global Macro May 00
Van Hedge: -5.80
HF Net: 12.00 17.80%
Long/Short Equity Feb. 00
EACM: -1.56 Zurich: 20.48 22.04%
Emerging Markets Aug. 98
MAR: -26.65 Altvest: -7.2 19.45%
Market Neutral Dec. 99
Henessee: 0.2 Van Hedge: 5.2 5.00%
Event Driven Aug. 98
CSFB: -11.77% Altvest: -6.71 5.06%
Distressed Aug. 98
HF Net: -12.08 Van Hedge: -4.70
7.38%
Relative Value Sep. 98
EACM -6.07 Van Hedge: 4.40
10.47%
Dedicated Short Feb. 00
Van Hedge: -24.3
EACM: -3.09 21.20%
KEDGE CAPITAL
Kedge Capital is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated by the Financial Services Authority.
Risk Contribution
0%
10%
20%
30%
40%
50%
60%
70%
Weights 33.00% 33.00% 33.00% 0.00% 0.00%Risk 29.11% 7.41% 63.48% 0.00% 0.00%Return 26.34% 22.15% 51.51% 0.00% 0.00%
ArbitexInvestors Fairfield Sentry Caxton Global
InvestmentsGraham K4
Program (1.5x) Maverick
Dollar allocation, return contribution and risk contribution of the funds in a portfolio
KEDGE CAPITAL
Kedge Capital is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated by the Financial Services Authority.
Risk Contribution
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
Weights 33.00% 33.00% 20.00% 7.00% 7.00%Risk 23.66% 3.77% 27.64% 43.13% 1.79%Return 27.96% 23.51% 33.14% 10.89% 4.49%
Arbitex Investors Fairfield Sentry Caxton Global
InvestmentsGraham K4
Program (1.5x) Maverick
Dollar allocation, return contribution and risk contribution of the funds in a portfolio
KEDGE CAPITAL
Kedge Capital is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated by the Financial Services Authority.
Marginal risks
-1%
0%
1%
2%
3%
4%
5%
6%
Marginal risk. 2.36% 0.60% 5.15% 3.72% -0.97%
Arbitex Investors Fairfield Sentry Caxton Global Investments
Graham K4 Program (1.5x) Maverick
KEDGE CAPITAL
Kedge Capital is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated by the Financial Services Authority.
Extreme Risks
-20 -16 -12 -8 -4 0 4 8 12 16 200.00
0.05
0.10
0.15
0.20
Return (%)
Probability
KEDGE CAPITAL
Kedge Capital is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated by the Financial Services Authority.
Conclusions– True hedge funds still provide an interesting set of strategies for institutional investors
– To diversify traditional portfolios– To provide moderate growth with limited risk.
– However– Market inflows are causing capacity exhaustion.– Not all new managers are necessarily good.– Experience and risk control will make the difference.
– Future keys to success are– Long term investment.– Portfolio concentration.– Due diligence.– Portfolio construction and monitoring.– Risk management.– Co-investment.
KEDGE CAPITAL
Kedge Capital is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated by the Financial Services Authority.
Disclaimer– The ideas expressed in this document represent the personal opinion of its author and do not engage any of the entities he may be affiliated to.
– This document should not be considered as an offer or solicitation to sell, nor as an investment recommendation.
KEDGE CAPITAL
Kedge Capital is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated by the Financial Services Authority.