The Benefits and Challenges for Institutional Investors of...

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

[email protected]

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.

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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.

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Why?– Further diversification of traditional portfolios.

– Exposure to new sources of returns (credit risk, currencies, commodities, etc.).

– Better risk management than traditional managers.

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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?

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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.

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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

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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

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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

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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

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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

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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.

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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

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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.

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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.

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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 ? ?

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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

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Challenge 4: RiskManagement

– Style Analysis

– Correlation Monitoring

– Risk Attribution

– Analysis of Extreme Risks

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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

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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


Emerging Markets


Event Driven


Global Macro

Long/Short Equity

Merger Arbitrage

Relative Value

Short Selling

A multi-strategy Fund

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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


Event Driven


Emerging Markets


CTA Global

Convertible Arbitrage

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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

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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

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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%

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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

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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

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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

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Extreme Risks

-20 -16 -12 -8 -4 0 4 8 12 16 200.00

0.05

0.10

0.15

0.20

Return (%)

Probability

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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.

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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.

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Date post:	05-Jun-2018
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