Liquidity Risk and Alternative Beta Products

Dr Drago Indjic

London Business School

June 2012

,

What is Risk Then?

• Not just variance– Risk “off/on”

• Correlation• Beta• Loss of capital• Liquidity• Access to capital (“return of capital”)

– May 2012: Treasuries and Bunds

Downside Risk

• Hedged, more agile strategies outperform: smaller losses, lower variance

• Long-only, buy and hold strategies are riskier

Hedge Fund Exposure

• Funds of hedge funds (“Alpha”)– Best “Alpha” is still most often packaged in

form of private funds: illiquid, fees loaded• Index replicators (“Beta”)

– Passive alternatives: “alternative Beta”, commoditised and liquid (ETF)

• ►Separate Alpha and Beta components– mean vs tail; fair liquidity premium

Reminder: 2008 Performance

• A hedge fund strategy on the top – as in May 2012

Indirect Cost of “Alpha”

• 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!

Liquidity of funds0

20

40

60

80

Managed Futures

Duration

Co

un

t

0 31 60 90 120 150 180

05

10

15

Fixed Income: Mortgage-Backed

Duration

Co

un

t

0 60 130 210 390

•

Decoupled and disproportional to market liquidity

FoHF Liabilities

• Duration of liabilities is structurally mismatched – works in “normal” conditions

02

00

40

0

Fund of Funds

Duration

Co

un

t

0 90 215 360 498 750

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

FoHF “Run”: Liquidity Crisis

Alpha vs Beta Agency

• Fund of hedge funds are still required– Best managers are packaged as hedge funds– Inc. regulation, accessibility, monitoring ....

• But they failed in 2008 and 2011– Blocked assets by mismanaging liquidity:

gated, suspended redemptions, restructured ...– Sold Beta at Alpha price: questionable

performance attribution– Industry AUM reduced by 1/3 or more

Service Provider Brands

• PB– >50%: J.P. Morgan and Goldman Sachs – Administrators: BNY Mellon, GlobeOp and

Citigroup gained share

June 22nd

• Replication today• Hedge fund industry today• Indexation risk and benefits• “New Normal” (Jan 2011) • Stress and response• Mind your tail and momentum

New Products and Markets

• Single strategy replicators – Equity L/S, CTA, CB– Reverse (short) index replication– Tail protection products

• Secondary markets– Collateral management

Yet Another UCITS

HFR (1Q 2012)

• Births: 304– level not reached since 4Q2007

• Deaths: 232 – the highest since 240 in 1Q10– “FOF continued to experience a contraction”

64 closing while 34 launched; 4th consecutive quarter of decline in number”

• Fees rose slightly – Avg 1.63%/17.75%

Index XYZ?

The “New Normal”

“(HFR 1Q12) Hedge fund performance dispersion increased over 4Q11, with the top decile of all hedge funds averaging a gain of over 20%, while the bottom decile of all funds declined by 28% on average.

Rear View

May 2012 Performance

Risk On/Off, HFT Style

Portfolio De-Construction

New Dawn

Tail Risk Products

Modern Performance Charts

(Un)Managed Account Platform

Leverage

Watch Out

Emerging World

Not a Game

Year 1

Shipping Performance

• Navigate in the high seas of illiquidity

NB. Risk, optimisation et al quant tools irrelevant; even OpRisk considerations

Fees

Liquidity

BetaHF

Capacity

Counterparty