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1
Hedge Funds:
Issues for Institutional Investors
Robert A. Jaeger, Ph.DVice Chairman and Chief Investment Officer
September 2005
2
Motives for Investing
Potential for
Attractive absolute return
LIBOR plus 3% to 8%, depending on risk tolerance
Volatility lower than standard equity benchmarks
Low correlation with standard markets, especially in down markets
Above points apply to a diversified portfolio of hedge funds. Individual funds are substantially more risky.
3
Issues
Return/risk profile
Historical
Expected
Sources of return and risk
Leverage and short selling
Performance fees
Transparency
Is there a hedge fund bubble?
4
A Cautionary Note on Historical Data Many databases suffer from biases that may skew the
returns upward. Survivor bias “Bad news travels slow”
Many indexes show historical records that precede the construction of the index: these are purely hypothetical results.
EACM100® Index* Public record since January 1996 100 managers covering all main strategies and sub-
strategies Qualitative manager screening
*EACM100® Index – Onshore Funds was launched January 1, 1996.
5
Major Hedge Fund CategoriesM
ore
Ris
k
L
ess
Ris
k Relative value: long vs. short positions, minimal net market exposure.
Event-driven: net long bias, emphasizing specific corporate transactions (mergers, acquisitions, reorganizations, etc.) likely to produce definable changes in value within a definable period (typically 3-12 months).
Equity hedge funds: “micro” investors focused on stock selection and company analysis, enhanced with ability to use leverage and sell short.
Global asset allocators: “macro” investors who can be long, short or neutral with respect to multiple markets (interest rates, currencies, equity indexes, commodities).
Short sellers: net short, usually focused on US equities, designed as hedge against down markets.
6
Deal Arbitrage
Distressed Debt
ED/Multi-Strategy
Domestic Long Biased
Domestic Opportunistic
DiscretionarySystematic US Equity
US Bonds
International Bonds International Equity
T-Bills
RV/Multi-Strategy
Bond Hedge
Mkt Neutral Equity
Global/International
Convertible Hedge
0
2
4
6
8
10
12
14
16
0 5 10 15 20 25
Annualized Standard Deviation (%)
Ann
uali
zed
Rat
e of
Ret
urn
(%)
Historical Risk/Return Characteristics
January 1996 – July 2005
Analysis based on statistical measures calculated from monthly total returns. Source: Standard & Poor’s 500, MSCI EAFE $, Lehman Bros Govt/Credit Index, Citigroup World Govt Bond ex US Index ($), Merrill Lynch 90 Day T-Bills and EACM100® Index. Performance results for the various hedge fund strategies are derived from strategy components returns for the EACM100® Index Onshore Funds (January 1996 – December 2003) and EACM100® Offshore Funds (January 2004 – July 2005) See www.eacm.com for more information regarding the EACM100® Index.
7
Conv Hedge
Global/International
Mkt Neut Eq
Bond Hedge
RV/Multi-Strategy
T-Bills
InternationalEquity
Inter'lBondsUS Bonds
US Equity
Short Selling
Systematic
Discretionary
Dom Oppo
Domestic Long Biased
ED/Multi-Strat Distressed
Deal Arbitrage
-4
-3
-2
-1
0
1
2
3
4
5
6
0102030405060708090100
Gain Frequency (%)
Ave
rage
Ret
urn
(%)
Performance in S&P 500 Negative Months
US Equity (S&P 500 Composite) was down 38% of the months, with an average monthly loss of 3.9%.
Analysis based on statistical measures calculated from monthly total returns. Source: Standard & Poor’s 500, MSCI EAFE $, Lehman Bros Govt/Credit Index, Citigroup World Govt Bond ex US Index ($), Merrill Lynch 90 Day T-Bills and EACM100® Index. Performance results for the various hedge fund strategies are derived from strategy components returns for the EACM100® Index Onshore Funds (January 1996 – December 2003) and EACM100® Offshore Funds (January 2004 – July 2005) See www.eacm.com for more information regarding the EACM100® Index.
January 1996 – July 2005
8
Two Kinds of Strategies
Many hedge fund strategies employ “enhanced active management”: traditional active management enhanced with short selling, leverage, and other techniques. For example:
Market neutral equity Fixed income arbitrage Equity hedge funds Global macro investing
Some hedge fund strategies are genuinely distinctive, not based on traditional techniques. These strategies are important sources of liquidity for financial markets.
Convertible hedging Risk arbitrage Distressed debt
9
How Do Hedge Funds Make Money?
Hedge funds make money the old-fashioned way: they take risk.
Beware of common stories that underestimate risk:
“They exploit market inefficiencies” – not enough to go around
“They supply liquidity to markets” – some do, some don’t
“They take advantage of manager skill” – there are many skilled managers in the long-only universe, and many hedge fund managers who are not as skilled as they think.
10
Do Hedge Funds Make Money?
Our working assumption is that hedge funds, in aggregate, do not make money. Manager selection and strategy
allocation are critical Hedge funds are like venture capital:
the object of the game is not to earn “the average return”
11
Risk Factors
General risks Leverage Concentration Illiquidity
Market-related risks Directional market risk Non-directional systematic risks (“alternative betas”),
e.g., Equity: long value vs. short growth, long small cap vs.
short large cap Fixed income: carry trades: long higher risk vs. short
lower risk Exposure to volatility and “trendiness”
Organizational risks Small shops, smaller asset bases, shorter records Blow-up risk, headline risk
12
Leverage and Short Selling
Short selling is sometimes designed to reduce risk, sometimes designed to enhance return, sometimes both.
Leverage definitely increases risk, may or may not increase return.
Levels of leverage vary by strategy. For most strategies, maximum leverage (gross exposure/net capital) is 2:1. Main exceptions: convertible hedging, fixed income arbitrage, global asset allocators. Note: leverage has to be adjusted for volatility of positions.
13
Performance Fees
Most hedge funds charge a combination of asset-based and performance-based fees, often 1% plus 20%, or more.
Performance fees grant the hedge fund manager a “free call option” on the fund’s performance, may create an incentive to take incremental risk.
Most hedge fund managers are long-term greedy, not short-term.
14
Hedge funds generally offer much less transparency than traditional separately managed accounts.
Many institutional investors are overly obsessed with transparency, failing to distinguish between
Daily position and transaction reports
and
Useful portfolio information
Even 100% transparency does not guarantee protection from problems. Staying out of trouble is much more important than getting out of trouble.
Transparency
15
The Current Environment
Dramatic growth 8,000-10,000 hedge funds 1,000 funds of funds $1 trillion in assets
Growth driven by: Demand: the search for absolute return Supply: the search for more money and
more freedom Recent returns below some people’s
expectations Are hedge funds destroying their own
opportunities?
16
The Brain Drain
The world does not need 10,000 hedge funds. The number of funds has grown dramatically; the number of worthwhile funds has not
The “brain drain”: starting a fund is easy, succeeding is not. This applies even to “celebrity managers”
Beware of the “life cycle” myth: newer is better than older
17
The Currently Fashionable Cynicism Recent returns have been poor.
There are too many funds.
Recent returns have been poor because there are too many funds.
Our view: Returns have been in line with reasonable
expectations. There are too many funds Some strategies face “crowding issue,” others
do not.
18
Performance by Strategy
Performance results for the various hedge fund strategies are derived from strategy components returns for the EACM100® Index Offshore Funds (January 2004 – July 2005) See www.eacm.com for more information regarding the EACM100® Index. Source: EACM Advisors LLC and Standard &Poor’s 500
EACM 100® Index – Offshore Funds 4.7 2.4 Allocation %
Relative Value 30 2.3 2.2Market Neutral Equity 10 -0.2 5.1Convertible Hedge 6 0.6 -3.1Bond Hedge 7 5.1 3.6Multi-Strategy 7 4.4 1.3
Event-Driven 15 11.3 4.1Deal Arbitrage 5 4.4 3.1Bankruptcy/Distressed 5 13.8 4.4Multi-Strategy 5 15.5 4.9
Equity Hedge Funds 30 7.1 3.8Domestic Long Biased 10 6.6 2.9Domestic Opportunistic 10 5.4 4.9Global/International 10 8.7 3.6
Global Asset Allocators 20 4.1 0.3Discretionary 10 5.8 0.5Systematic 10 2.3 0.6
Short Selling 5 -10.9 -1.4
S&P 500 Composite 10.9 2.9
2004 Annual Return %4.7
2.3-0.2
0.65.1
4.4
11.34.4
13.815.5
7.16.6
5.48.7
4.15.8
2.3
-10.9
10.9
-15 -10 -5 0 5 10 15 20
2005:Jan - July Return %2.4
2.25.1
-3.13.6
1.3
4.13.1
4.44.9
3.82.9
4.93.6
0.30.50.6
-1.4
2.9
-15 -10 -5 0 5 10 15 20
19
Is there too much money chasing too few opportunities? Important to separate homogeneous strategies from heterogeneous strategies.
Homogeneous: Managers tend to “herd” around similar positions, e.g., convertible hedging, risk arbitrage, distressed debt.
Heterogeneous: Wide divergence among manager positions, e.g. equity hedge funds, global asset allocators. Beware of glib generalizations about “what hedge funds are doing.”
Homogeneous strategies are more vulnerable to “crowded trade” problem.
If hedge funds were in business to exploit market inefficiencies, then growth would be a major problem. But: inefficiencies are not the drivers of return.
Are Hedge Funds Destroying Themselves?
20
The Real Problems: Low Volatility and Low Dispersion
Historical Volatility
Implied Volatility Dispersion
OEX Historical Index and Stock Volatility, Implied Index and Stock Volatility, and Cross-Sectional VolatilitySource: Citigroup Smith Barney and the Chicago Board of Options Exchange
21
Did Hedge Funds Cause these Problems?
No – they would do this only if hedge funds, in aggregate, pursue contrarian trading strategies that act as a negative feedback loop in the markets. In fact, many hedge funds are more momentum-oriented, acting as a positive feedback loop.
Several years ago, hedge funds were blamed for adding to market volatility. You can’t have it both ways.
22
Which market has the highest return volatility?
100
105
110
115
120
125
1 3 5 7 9 11 13 15 17 19 21
100
105
110
115
120
125
1 3 5 7 9 11 13 15 17 19 21
100
105
110
115
120
125
1 3 5 7 9 11 13 15 17 19 21
100
105
110
115
120
125
1 3 5 7 9 11 13 15 17 19 21
Panel A Panel B
Panel C Panel D
Hint: Standard deviation is not sensitive to the order of returns.Each panel represents the same number of observations, with the same starting and ending point of 100. The cumulative rate of return is 0.0%.