Roadmap to Hedge Funds (2008 English Version)
By Alexander Ineichen & Kurt Silberstein
Published: 01 November 2008
The following is an online summary of this particular AIMA paper
One of the great things about hedge funds is that they have provided a field day for academic researchers to write scholarly articles on their risks and returns. Yet, for all of this scholarship, a practical roadmap to hedge funds has remained elusive. Until now.
On behalf of AIMA’s Investor Steering Committee, Alexander Ineichen has provided a reference roadmap that breaks down the world of hedge fund investing into fundamental and useful concepts. Alexander and Kurt Silberstein, who has contributed to this publication are practitioners. Kurt’s “day job” requires him to invest capital in the hedge fund world whilst Alexander’s role is to provide in-depth analytical insight into the hedge fund industry. Therefore, they speak with the wisdom and experience of those whose livelihoods actually depend upon making good hedge fund manager selections. This book reflects their accumulated knowledge.
In the first section of the roadmap, there is an introduction to and definition of hedge funds together with information on its growth, the overall returns, breakdown of strategies and manager locations, flow of funds and comparison to other asset classes. This section answers the fundamental question: are hedge funds worth the effort? The key is to provide a macro perspective for broader asset allocation decisions.
The second section of the roadmap hits squarely at the myths of hedge funds. Unfortunately, the hedge fund industry still remains poorly understood. Too many “myths” surround this industry and this leads to scepticism and avoidance. Alexander charges right at the myths, labelling them and explaining their lack of empirical support or theoretical grounding. For example, one myth is that hedge funds hedge market risk. Certainly, some hedge funds do just that, but many hedge fund styles take on calculated market risks with the expectation of earning superior returns than the market. More specifically, most hedge funds hedge only certain risks that they do not believe offer a sufficient return premium while loading up on risks where they believe the return premium is undervalued or will exceed the market return. The key to demystifying hedge funds is to understand their fundamental investment philosophy. Once the myths are removed, the reader will be much more educated as to the benefits and risks of hedge fund investing.
Section three gets down to the nuts and bolts of building a hedge fund program as well as identifying the main strategies. The reader is taken through a pragmatic review of how to build a hedge fund program from the ground up. It is clear from this section that they draw on their personal experience at building two of the largest hedge fund programs in the investment world. However, most investors do not have the internal resources necessary to build their own hedge fund program and, therefore, must rely upon a fund of hedge funds investment. This limitation is recognised and, consequently, the section provides an excellent discussion on the benefits of funds of hedge funds. Then, there being no uniform classification system for hedge funds, Alexander does as good a job as any at identifying the three major classes of hedge funds: Relative Value, Event Driven and Directional. Not only does he identify the major categories of hedge fund styles, he also begins to break down the return patterns associated with hedge funds. Alexander shows the asymmetry of returns including “fat tails” and financial shocks. He also demonstrates how hedge funds use liquidity premiums and leverage to generate their excess returns. The key benefit of this section is to get an understanding of how the different hedge fund styles produce their returns and the risks associated with those returns.
The fourth section of the roadmap touches on two topics: the value proposition of hedge funds and risk in both relative and absolute terms. The former reviews the keen appeal that hedge fund managers have for investors. It examines the less constrained investment style of hedge funds and applies the Fundamental Law of Active Management to demonstrate how hedge fund managers have a greater ability to generate a positive Information Ratio than long only managers. Also, it examines the asymmetric nature of hedge fund returns—one of the key benefits of hedge fund investing for which the term “alternative” applies. The latter acknowledges that hedge funds are often classified as absolute return investments — but what does this really mean? Is it an attempt by hedge fund managers to trick investors into ignoring benchmarks or is there a legitimate reason for claiming absolute returns? And even if a hedge fund manager is an absolute return manager, isn’t there some benchmark that could apply? Indeed, Alexander addresses these questions in a straightforward manner that leaves the reader better informed about the risk-taking nature of hedge funds.
I know the reader will enjoy this roadmap as much as I did. This is a pragmatic, user-friendly book that will go a long way to breaking down the myths of hedge funds while providing the user the ability to construct an intelligent hedge fund portfolio. Along the way, the psychobabble of the hedge fund world is eschewed to provide a commonsense guide in commonsense language that all can understand. Read and enjoy!
President and Executive Director
Investment Services Nuveen Investments, Inc
A hedge fund constitutes an investment program whereby the managers or partners seek absolute returns by exploiting investment opportunities while aiming to protect principal from potential financial loss. The first hedge fund was indeed a hedged fund. The hedge funds/alternative investment moniker is a description of what an investment fund is not rather than what it is. The universe of alternative investments is just that – the universe.
The favourable relative performance of hedge funds is worth highlighting as it is often brushed aside and is in stark contrast to the heavy artillery the industry regularly finds itself under: a hypothetical investment in the S&P 500 Total Return Index of a $100 at the beginning of this decade stood at $92.1 by September 2008. A hypothetical investment of $100 in the HFRI Fund Weighted Hedge Fund Index stood at $172.1. We think this to be a big difference.
The pursuit of absolute returns is much older than the idea of beating a benchmark. Constructing portfolios with low compound annual returns, high volatility and high probability of large drawdowns is easy. Constructing portfolios with high compound annual returns, low volatility and low probability of large drawdowns is not. Losses kill the rate at which capital compounds. Defining risk as the attempt to avoid losses is materially different than trying to avoid underperforming a benchmark. The paradigm of relative returns might soon be perceived as a short blip or ideological error in the evolution of investment management.
Hedge funds are active investment managers. Active investment management is dependent on the willingness to embrace change and, more importantly, to capitalise on it. Adaptability is the key to longevity. In active risk management, it is important to apply a skill that carries a reward in the market place within an opportunity set where the risk/reward trade-off is skewed in favour of the risk-taker. The reward from skill is not constant. Profitable ideas, approaches and techniques get copied and markets become immune to the applicability of the skill — that is, markets become more efficient. Skill needs to be dynamic and adaptive — that is, it needs to evolve to remain of value.
Hedge funds do not hedge all risks. If all risks were hedged, the returns would be hedged, too. Hedge funds take risk where they expect to get paid for bearing risk while hedging risks that carry no premium.
The investment process of a hedge fund investor is dynamic and can be classified into two selection processes (manager selection and portfolio construction) and two monitoring processes (manager review and risk management). Initial and ongoing assessment and due diligence of the hedge fund managers is probably the single most important aspect of the investment process for all hedge fund investors. Portfolio construction and managing the risk of the hedge fund portfolio are also mission-critical in the hugely heterogeneous and dynamic hedge fund industry. Manager evaluation and monitoring has become more difficult despite increases in transparency and information flow, and it has become more labour-intensive. Investors with vast resources for research are likely to continue to have an edge over investors with little or no research capabilities.
Large parts of mainstream academia repeatedly highlights that hedge fund data is poor, markets are efficient and hedge funds engage in short put strategies, essentially defrauding their investors. What academia never seems to mention is that there are few investors who have invested in diversified hedge fund portfolios for ten years or longer yet are unhappy with their investments. Most investors who moved into alternative investments have done so for conservative, financial purposes. These investors moved away from relying fully on equities and bonds increasing in value to achieve sustainable and smooth wealth accumulation and preservation.
One of the central drivers of alternative investments in this decade is the realisation by an increasing number of investors that the source of returns from various alternative asset classes and hedge fund strategies is not identical. While there are varying complicating matters such as valuation and liquidity issues as well as non-linear payouts, the bottom line is that the source of return from various “alternatives” differs fundamentally.
Benjamin Graham, arguably one of the founding fathers of investment management as a profession, distinguished investment from speculation in both his main works, Security Analysis and The Intelligent Investor, by writing:
An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.
It is interesting, then, to note that in the investment management industry today, “safety of principal” is, in fact, a rare thing. Surprisingly, the emphasis on “safety of principal” is found not in mainstream traditional asset management but in the “alternative fringe” of the industry, i.e. among absolute return managers such as hedge funds and funds of hedge funds. Absolute return managers seek to exploit an edge of some sort to make profits while at the same time attempting to limit the loss of principal. Protecting principal is an essential part of their mandates. This is materially different from the traditional asset management industry, where the focus is on outperforming or replicating a market benchmark. Safety of principal is not part of a standard relative return mandate.
It is ironic then that hedge funds have been vigorously criticised (by nearly everyone except for their long-term investors) as being dangerously intransparent, unregulated and excessively levered. The irony is that banks have - until quite recently - not been criticised, are tightly regulated and therefore perceived as transparent, use much more leverage than hedge funds and, as a sector, recently lost around a half of its market value in a period where the hedge fund sector lost around 9 %. And at the time of writing the credit crunch is not over.
While hedge funds have caught the eyes of a large variety of constituencies, such as academia, governmental bodies, regulators and (campaigning) politicians, this report is designed for investors and fiduciaries who have not yet invested in hedge funds. (We assume that current hedge fund investors have already managed to circumvent all the “barriers to entry” and have dealt pragmatically with the various trade-offs that are involved.) AIMA’s Roadmap has been designed to offer the reader a clear and methodical ‘intermediate’ analysis of the hedge fund industry, which complements the US President’s Working Group Investors’ Committee Report. We aim to clarify, differentiate and especially de-stigmatise and de-mystify this investment alternative. The main purpose of this report is to get investors who are not yet invested in hedge funds confident with the space.
The roadmap was written during the rather “special” financial episode of 2008 and based on research conducted throughout the decade. Last minor revisions were done in the last week of September 2008 that was arguably a month of unprecedented change. With markets moving fast and ideologies and business models being modified nearly on a daily basis, Mr. Marx and Mr. Mao were probably laughing from wherever it is communists go when they die. Some of our remarks, therefore, need to be taken with a pinch of “investment salt”. Given recent market events, our brief essay on failure and survival could have been placed more prominently than in the appendix on page 142.
The author would like to thank John Ardley, Tanya Styblo Beder, Charlotte Burkeman, Iain Cullen, Richard Main, James Nicholas, Kerri Pacello, Paul Parkins-Godwin, Jerome Raffaldini and Sanjay Tikku for their invaluable comments. A special thanks goes to Kurt Silberstein from Calpers for co-authoring the report, Mark Anson from Nuveen Investments for writing the foreword and Emma Mugridge from AIMA for making it all happen. The author is solely responsible for errors and omissions. Opinions are the author’s own.