AIMA/CAIA: The Way Ahead - Helping trustees navigate the hedge fund sector

By AIMA & CAIA Association

Published: 28 January 2015

The following is an online summary of this particular AIMA paper


Hedge funds have become part of the mainstream. Approximately one in every four dollars 1. managed by hedge
funds today are invested by public and private sector pension funds. This means that hedge funds are managing more than $700 billion on behalf of pension funds. For institutional investors as a whole, that figure rises to roughly three in every four dollars managed by hedge funds — over $2 trillion. The change in investor demographic reflects a gradual shift in sentiment towards hedge funds over the course of the last 10-20 years. Just as stocks and shares were once considered
too “risky” for pension funds and other institutional investors, so investing in hedge funds used to be thought of as a highly speculative pursuit for all but the wealthiest, and least risk-averse, in society. Hedge fund products have evolved however, the industry has matured, and gradually, almost imperceptibly, investor attitudes towards hedge funds have changed. Today, many hedge funds are legitimately known for their risk-management, not their riskiness. A recent institutional investor survey asked what impact a withdrawal from hedge funds would have on their portfolio; 80% responded that such an occurrence would increase, not decrease, their exposure to risk.2. Significant inflows from pension plans and other investors during 2014 have pushed the assets managed by the global hedge fund industry to record high levels. Investors are looking for a variety of benefits when they choose to allocate to hedge funds including downside protection and diversification. Such has been the change that has taken place that versions of certain hedge fund products are now being developed for retail investors. As the hedge fund industry has become institutionalised, hedge funds have become more open and transparent and less complex and opaque. It has not been a story of unbroken growth or success. 2008 stands out as being the industry’s most challenging year to date. Performance losses exceeded $300 billion. During the fourth quarter alone, more than 750 hedge funds were liquidated and investors withdrew more than $150 billion, according to Hedge Fund Research. As markets seized up, some hedge funds imposed significant restrictions on investor withdrawals. Since 2008, discussions have continued to persist about the pace of progress on issues like portfolio transparency, fund governance, fee levels and other issues. Many pension fund trustees and fiduciaries at institutional investors have begun to ask questions about their existing or prospective hedge
fund allocations. Rarely has there been such demand for a realistic assessment of the benefits — and also the risks — associated with hedge fund investing. With that in mind, the Alternative Investment Management Association (AIMA), the global hedge fund industry body, and the Chartered Alternative Investment Analyst (CAIA) Association, the global leader in alternative investment education, have launched a new initiative in which we will seek to help trustees and other fiduciaries better understand, and manage, these risks and opportunities. In this, the first of a series of papers that we will publish about hedge funds, we will set out the main benefits and challenges associated with investing in hedge funds. We will discuss the significant investment discretion and latitude typically granted to hedge fund managers, and how this can be both an advantage and a challenge to investors. We will show how much investors have earned from hedge funds and will discuss performance, risk, volatility and other factors related to hedge fund investments. At the same time, we will give practical guidance about how investors have managed issues and risks involved with investing in hedge funds. CAIA and AIMA have a proud shared history. AIMA is committed to developing industry skills and education standards and is a co-founder of the CAIA designation, the industry’s only specialised educational standard for alternative investment specialists. Established in 2002, the CAIA Association’s mission has been and remains to promote excellence in alternative investment education in a global arena. The alternatives market continues to grow at a rapid pace intensifying the need  for a broad and content-rich curriculum. With the creation of the Fundamentals of Alternative Investments Certificate, CAIA programs, including the CAIA Charter designation, ensure financial professionals at all levels stay current and relevant. Our organisations believe that as the landscape for hedge funds and other alternative investments has changed in recent years, it has become vital that those professionals charged with managing, analysing, distributing, and regulating these products keep pace with a focus that has knowledge and education as its central tenet. This is particularly true of trustees and other non-investment professionals who perform a fiduciary role at institutions. They are the primary audience for this series of papers. Special thanks are due to AIMA's Investor Steering Committee for its support in the production of this series of papers. We hope that these publications will help to improve understanding of hedge funds, provide practical guidance on issues to consider, and ultimately be considered a trusted source for trustees and other fiduciaries wishing to learn more about this important area of finance.

Jack Inglis

William Kelly
CAIA Association

Executive Summary

Most hedge fund investors are pension
funds and other institutional investors.

Approximately one in every four dollars managed by
hedge funds worldwide is invested by public and
private sector pension funds, while roughly three out
of every four dollars invested in hedge funds come
from institutional investors worldwide. In the UK,
over half of all defined benefit (final salary) pension
schemes allocate to hedge funds or other alphaseeking

Investors’ earnings from hedge funds
top $1.5 trillion in the last decade.

According to new research commissioned for this
paper from Hedge Fund Research Inc, investors have
earned about $1.5 trillion from hedge funds, after all
fees have been deducted, over the last 10 years. That
is despite the performance losses of $306 billion in
2008, by far the industry’s worst year.

Pension funds would often rather
have steadier returns with lower
volatility than a higher return with
greater volatility.

This is why risk-adjusted returns are often as highly
valued as the headline figures. Moreover, the hedge
fund industry's risk-adjusted returns are competitive
with traditional asset classes such as stocks and bonds
partly because those returns tend to be less volatile
— meaning they are generally steadier and more
consistent over time.

Hedge funds are designed to provide
greater protection against the large
drawdowns or peak-to-trough losses
that the main asset classes
sometimes experience.

Hedge funds (as measured by the performance of the
HFRI composite index) experienced a maximum
drawdown in the last 10 years of only 21.4% (between
November 2007 and February 2009). Only bonds
experienced a smaller drawdown (10%) in this 10-year
period, while real estate suffered a drawdown of 35%,
the S&P 500 a 57% drawdown and commodities a
54% drawdown.

The challenge of finding the right fund
or funds is one of the reasons that the
hedge fund due diligence process is
deeper and longer-lasting than it has
ever been.

The most commonly used method for tackling due
diligence and manager selection challenges is to
outsource at least part of these processes to a
specialist third party — either a fund of hedge funds
manager (FoF) or a hedge fund consultant.

Hedge fund strategies can seem
complex or difficult to understand.

But changes in regulations since the financial crisis
and the growing influence of institutional investors
has improved transparency and public openness. In
addition, the on-going “institutionalisation” of the
hedge fund industry has resulted in the level of
portfolio transparency provided by the fund manager
to the investor being higher than in the past.

Reputational or headline risk is
increasingly at the forefront of trustees’
considerations when evaluating any
investment program.

In recent years, some hedge fund managers have
been charged with insider trading and theft of client
assets. Such publicity can be worrying for an investor
but is certainly not representative of the global hedge
fund industry. Recent regulation and adherence to
industry sound practices have considerably
strengthened investor protection and provided for
greater transparency. Carrying out thorough
operational due diligence (including background
checks) will greatly mitigate headline risks. Finally,
structuring investments in a particular manner can
reduce investor exposure to operational risks
associated with hedge funds to levels below those
faced in retail fund products.

The fact that hedge funds charge higher
fees than long-only managers or mutual
funds means there will always be a
debate as to whether hedge funds offer
value for money.

It is more costly to manage investment portfolios in
an active manner, especially if sophisticated and
flexible strategies seeking absolute returns are employed.
Investors in hedge funds should always
consider whether the quality of potential or actual
returns is worth the fees. Tools such as hurdle rates
and high watermarks assist in properly aligning
manager incentives aimed at obtaining and rewarding

Hedge funds are commonly (but
erroneously) referred to as an asset
class in their own right.

Instead, investing in hedge funds is a method for
accessing particular asset classes, and many hedge
fund strategies trade across multiple asset classes
such as stocks, commodities, fixed income and
foreign exchange. As investors become more
knowledgeable of the hedge fund industry and their
role in today’s investment portfolios, they are
deploying hedge fund strategies to act as a buffer or
as a risk mitigation tool.

For an institution investing in hedge
funds, issues around capacity and scale
can be significant headwinds to any
proposed allocation.

Some investors may allocate small amounts to a large
number of managers, while another approach is to
secure capacity with managers early on in their
investment lifecycle. As the hedge fund industry
grows assets to $3 trillion and beyond, investors
should include discussions of capacity and scalability
with their managers in order to determine whether
the assets under management in any strategy or
market sector are too large to predictably earn alpha,
especially in smaller investment markets, such as
small capitalisation emerging markets stocks.

Managers of hedge funds have a set
of tools at their disposal — including
lock-ups, gates and side pockets — to
prohibit or restrict withdrawals.

These are often designed to ensure that investment
strategies are capable of being carried out as
intended. Certain restrictions are designed to avoid
mismatches between liquidity offered to investors
and that of the underlying assets in the fund. Others
exist to allow managers to withstand periods of
significant market stress. It is vital for investors to
understand the methods that may be used and their



  1. Source: Preqin
  2. Source: Preqin