Hedge Funds: Data

Dr Drago Indjic

Sunningdale Capitaldindjic@london.edu

May 2013

Data on Hedge Funds

• Industry, but Regulated– Size and growth of “professional” funds

• Business– Entrepreneurs and their ventures

• Product: Funds – Data: reference, product, business and

market data

Macro View

• Size of AUM: $2.4 t (est. 2013Q1) • Exceeds pre-crisis peak (2007); >50%+ over low

$1.3 tn (1Q09); inflows $15b; ~10k funds (1,108 born vs 873 died (2011: 1,113 / 775), concentrated

• ~ ETF products, top 3 SWF or <Blackrock $3.8t • The largest hedge funds are ~$132b SPDR ETF

• Better businesses today• Consolidating value chain, more regulated• Survivors: 2008 crisis was an extraordinary year

for managed futures strategy (+15%)

MBA View of Value Chain

• Demand: “cheap Alpha”– End investors: direct and indirect sourcing

• Intermediaries: FoHF ($650b in 2013Q1)– Imperfect market of “professional” funds; Off-

shore fund services industry• Supply: start ups vs mature businesses

– Hedge fund managers as innovators; never too big to fail (LTCM; Pelaton)

Fin de siecle

• Financial “repression” era– Hedge funds as exit strategy: “unbundling” of

bank’s proprietary trading desk– An employee (trader) has to become an

entrepreneur, through a prime brokerage agreement and other services - including raising his own funds, but business costs increasing

• EU AIFMD, Dodd-Frank, SEC etc

Regulation

Fund Management Company

• Start-up, not a public listed corporate• Manager(s) = Founders-owners; micro-enterprise

(think credit score); cash-flow sensitive; taxable• Careful structuring

• Regulated entity and approved personnel• On-shore: (UK: FCA) authorised LLP (private LLP

agreements); staff, systems, service contracts• Off-shore Ltd, corporate “substance” and

governance, authorised (eg. Guernsey FSC) manages off-shore fund

Legal Documentation

• People: Partnership agreement– Equity%: ownership, not salaried partners;

control and economics

• Fund manager: Articles of incorporation• Fund: private placing memorandum

– Investment management agreement– Subscription forms (often “non US”)

• Service agreements– Counterparties, directors, distributors …

Private Fund

• Separate legal entity: off-shore incorporated, controlled and audited

• Governance (off-shore non-exec directors): non-voting investor shares: potential mismatch of investor expectations and fund board powers

• Tax benefits for international investors

• Private placement• on-shore distribution: business model of 3rd party

fund marketers and fund of funds (pooled, open-ended fund vehicles)

Counterparties and Services

• Prime broker– (+) Bank: securities lending and financing– (-) Most senior creditor: re-hypothecation

(Lehman; MF Global)• Fund Administrator

– NAV Calculator, registrar and transfer agent– Traditionally priced monthly, redemption less

often• Auditor, lawyer, secretarial services …

– Compliance, 3rd party marketing, IT …

Investors

• Eligibility– KYC and AML client classification; direct or

indirect (HNW, pension plans or FoF)– An investor domiciled in X buys units of fund

domiciled in jurisdiction Y: who should pays taxes – and where?

• Marketing and business strategy– Performance/flows: AUM may stay around

$100m for a long time (eg. Molinero LLP)

Micro-Enterprises

• Owner/Manager’s LLP– Staff <10: the largest are still SME!

• Median “fund” AUM <$50m– Today less profitable then in the past; higher

cost of seed capital• Very few long-term survivors and “brands”

– Most liquidated within 7 years– not unlike many other start-up businesses

Myths: Cashflow, Not “Blow Up”,

($1,000)

$0

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Case Study: Leverage - Lower

Case Study: Fees - Lower

• Clive Capital LLP, Europe’s biggest commodity hedge fund, will cut its fees after posting two consecutive years of losses, according to a letter sent to clients today.

• Clive will start charging investors in its class B shares a 2%/20% from April, down from 2.5%/25%. The decision comes after client withdrawals and investment losses prompted AUM to shrink 46% to $1.95 billion.

• Clive, which was founded by former Moore Capital Management LLC trader Chris Levett, slumped 8.8% last year after falling 9.9% in 2011. Investors had been willing to pay a premium to Clive after it outperformed rivals in previous years, gaining 44% in 2008, 17% in 2009 and 20% in 2010 (Bloomberg, 8 February 2013)

Case: Liquidity - Better

• With about three weeks before investors in SAC need to decide on whether they are pulling their money out, Cohen is offering them a quicker way to in a bid to convince them to stick with him.

• Investors will now be able to get back 50% of their money in each of the last two quarters of the year, the firm told investors. Initially, the firm would pay back withdrawals spread out over four quarters. Then the firm hastened the payouts to one third of investors' fund stakes per quarter and now it will be half per quarter.

• This marks the second time in about two months that SAC has adjusted its liquidity conditions. Outsiders' money accounts for only about $6 billion of the AUM, but Cohen appears to be trying to pacify jittery clients who said in February that they wanted to pull out $1.7 billion at the end of the first quarter (Reuters, 26 April 2013)

Data Sources

• No standard security identifiers• Bloomberg etc screens are blank; data is not for

sale by fund administrators or brokers

• Specialist databases• Low quality: mainly “catalogues” of 1,000+

management companies by market research specialists like HFR, Lipper, Morningstar

• Lagged performance estimates for 20k+ fund share classes and fund “boiler plates”

• Self-selection and survivorship bias: the largest, the smallest and “defunct” funds excluded

Fundamental Data

• Mostly private, lagged and age fast– Static reference data

• Fund offering memorandum, counterparties

– Business • Due diligence: staffing, references, accounts• “Skin in the game”: monitoring incentives, conflicts

and sustainability

– Portfolio• portfolio exposure and holdings (“Opera” standard

aggregated), weekly NAV, investor letters ...

It Was Just One of Many Funds

Investment Strategies

• What exactly is a strategy?– Lack of standard definitions – or indices -

beyond labelling: stated in interviews and case studies

– Transparency: necessary, not sufficient criteria

• Lack of verification– Benchmarking and replication applications;

contract law: Legal text vs legal evidence

Indicative “Strategies”

• Danger: overpaying for Beta-like service• Not all “hedge” funds deploy hedging

strategies; varies across universe and time

Equity Hedge38.52%

Emerging Markets (Total) 5.53%

Distressed Securities2.74%

Equity Market Neutral5.94%

Equity Non-Hedge7.84%

Event-Driven 7.28%

FI: Arbitrage 2.78%

FI: Convertible Bonds0.25%

FI: Diversified 2.56%

FI: High Yield 1.14%

FI: MBS 1.37%

Convertible Arbitrage3.70%

Short Selling0.76%Sector (Total) 6.71%

Macro 2.15%

Market Timing 3.65%

Merger Arbitrage 3.78%

Regulation D 0.52%

Relative Value Arbitrage 2.77%

Estimated Strategy Composition by # of Funds (ex FOF) 2002

Indexes are Composites

• “Broad” indexes are just (non-investable) peer groups

• No reliable multi-source industry statistics• “average” performance, #hedge funds,

#management companies; % Strategies, domiciles, counterparties; $AUM, flows, liquidity, age; micro data: #births/deaths …

• Questionable Ranking• Statistical, operational or any other attributes in

typical investment mandate search (infeasible!)

Index Performance

• “non-investable” (HFRI) vs “investable”

Exposure

• Extinct and endangered• Structured: capital protected – disappeared• FoHF: full outsourcing, consultant’s stronghold

• Thriving• Advisors: outsourced due diligence• Managed Account Platforms• Direct: many endowments, pension funds

• Emerging• UCITS and index products

Risk and Reward

• Evaluate Total Hedge Fund Risk– Mostly business risk: contractual, SME, “key

man” LP’s “exit”, no EV, equity financed– Lesser portfolio and market risk (“hedged”)

• Benefits– Unique risk/return profiles (units priced in gold

or oil): not dependant on underlying assets – Negotiable investment terms, business co-

ownership (PE-like); discovery of fair active management “price”

Conclusion

• Global political economy– “On-shoring”; private equity is excluded from

AIFMD– High frequency traders became new “bad

boys”• New passive / active boundaries

– Active ETFs; “newcits”