At the most general level, we believe there is always change. With respect to change within an industry such as investment management one could distinguish between structural and cyclical change. By structural change we mean permanent change – evolutionary, progressive jumps, where outdated ideas and approaches are replaced with new and improved ones (i.e. progress). A classical example of an industrial evolutionary jump was the well-deserved retirement of the horse and the switch to the automobile in the individual transport industry. Although the car has not entirely superseded the horse-powered coach, the latter today represents only a small part of the industry.
By cyclical changes, we mean some form of cyclical swing or mean reversion – ups and downs, or good times and bad times, or expansion and contraction, or, in its most erratic form, bubbles and bursts.
Cyclical change
In April 2004 we heard someone say the following at a conference: "Whenever Main Street falls in love with what Wall Street has to sell, there is a correction within 12-36 months." There is some empirical evidence that this thought is not without merit.
Under normal circumstances, there is a balance between buyers and sellers – what economists refer to as equilibrium. If there are more buyers than sellers, then prices go up a little (i.e. the marginal buyer outweighs the marginal seller). If there are more sellers than buyers, prices go down a little. However, every now and then the 'caveat emptor' rule is abandoned, and herd instinct results in contagion, which then results in some form of hysteria or mania. A bubble builds. At some stage, quite often out of the blue, size causes the bubble to burst. This is roughly the pattern of popping asset bubbles.
We believe the main characteristic of a bubble is mispriced assets. With respect to hedge funds, this seems not to be the case. Hedge funds are asset managers, not assets. However, we would like to reiterate some of our observations in this matter and discuss whether the current enthusiasm for hedge funds shows bubble-like symptoms. Apart from the swing from the 'hedge-fundsare- for-the-financially-suicidal' approach of only a couple of years ago to the current, shall we say, 'optimism' of an what some consider to be an amazing phase in financial history, there are some red flags nonetheless being raised. Some of these symptoms are shown in the accompanying table, where we have listed some bubble symptoms and assessed whether they are applicable in the case of hedge funds Furthermore, we made two somewhat disturbing observations.
'This time it's different'
First, we observe that there are now some investment professionals who argue, when presenting to other investment professionals, that 'this time it's different.' This should send a chill down any literate investment professional's spine. Certain things never change. Human mass behaviour/enthusiasm is probably one of these 'things' that never change. As Jim Rogers [2000] puts it:
In the laws of economics, in the laws of history, in the laws of politics, and in the laws of society, it's never different this time. The law of gravity isn't ever suspended for someone's convenience, and these laws are just as rigorous, though more subtle and complex. If they weren't universal, we wouldn't call them laws.
We agree. However, an asset bubble is not necessarily the same as the current inflows into hedge funds. We classify hedge funds as an alternative investment strategy – that is, an alternative to a long-only strategy. The most common way of differentiating this is in terms of alpha and beta: an alternative investment strategy is about performance being attributed to a skill, i.e. alpha, while a long-only strategy is primarily a market-based strategy that is exposed to a market beta of some sort.
Magical thinking – investors' placebo effect
Typically, people use magic to attempt to explain things that science has not yet explained, or to attempt to control things that science cannot. Many studies in the field of neuroscience have shown that the human brain excels at pattern matching, but that humans do not have a good filter for distinguishing between perceived patterns and actual patterns. Thus, people are often led to see 'relationships' between actions that do not actually exist, creating a magical belief. Behaviouralists call this phenomenon magical thinking.
The second observation that raised red flags was a headline where a pension manager was quoted as saying that he didn't believe in equities and bonds, he believed in hedge funds. This goes too far. It implies that hedge fund managers are magicians who deliver returns out of a bat without taking risk. It also implies a somewhat fuddled understanding of the concept of risk. The benefits of hedge funds to institutional portfolios are primarily complementary to the other moving parts of the portfolio. Searching for alpha as an alternative source of return and diversifying portfolio risk is, we believe, laudable, but we would not go as far as to abandon other parts in their entirety. The search for alpha is a zerosum game. The main benefits are an additional return component in the form of alpha (in those cases where it is achieved) and exposure to different (alternative) strategies and classes (i.e. different sources of return that are more or less independent from the rest of the portfolio, and which therefore reduce portfolio volatility. Many hedge fund strategies are difficult to execute, and more often than not, involve some form of skill. This is probably the only commonality with magicians.
Bottom line
Expectations of future hedge fund returns could be too high, and potentially a source of disappointment. Some investors thought of the 180 basis point fall in the second quarter of 2004 in Alternative Investment Strategies (AIS) was a catastrophe. If such a loss is considered a catastrophe, then there is certainly room for disappointment going forwards.
The search for alpha, risk-adjusted returns and diversification – i.e. the current absolute returns phenomenon – is progress in the field of institutional investment management, but it is not a gradual endeavour – it is erratically jumpy and dotted with setbacks. The current shift in favour of AIS is unlikely to depart from this norm, and temporary setbacks remain a possibility.
Structural change
The catalyst that triggered the current structural change in the asset management industry was the equity bear market. Investors are migrating to the belief that time does not reduce risk. The accompany graph illustrates the negative effects of a volatile portfolio and its implications for short-term as well as longterm financial health and solvency. The bear market has triggered the change in risk perception among a wider investor audience, yet nothing at all has changed with respect to the concept of risk. A volatile portfolio is still a volatile portfolio, irrespective of equitymarkets going up or down, nor were there any scientific breakthroughs in financial theory causing the change – it was the live experience of capital depreciation that was the catalyst for the change in perspective. What we believe has changed is how investors perceive risk.
The chart shows the impact of large drawdowns on compounding capital over time. Called the 'underwater perspective', it shows an index as a percentage of its previous all-time high, i.e. how much is underwater. The problem with large drawdowns is that they kill the rate at which capital compounds. Any relative return approach (use of asset or liability benchmarks as risk-neutral position) does not give the avoidance of large drawdowns the high priority it deserves.
We argue that the post-TMT bubble period is being characterised by a transition from the second into the third stage of asset management. The three stages are defined as follows:
- Absolute return approach with low degree of manager specialisation
- Relative return approach with high degree of manager specialisation
- Absolute return approach with high degree of manager specialisation
It is fair to argue that there was an asset management industry before benchmarks. This first stage was characterised by an absolute return focus and low degree of specialisation on the part of the manager – they followed a balanced mandate whereby the asset allocation decision was the most important. It was an approach that suffered from poor performance in the mid-Seventies, as well as an agency problem as the objectives of the manager were misaligned with those of the principal.
This first stage was replaced by a second stage, the relative return game. The asset allocation mandate was taken away from the manager, resulting in higher specialisation. Next to poor performance and principal/agent issues, the introduction of the Employee Retirement Income Security Act (ERISA) in the US in 1974 was one of the primary catalysts for the industry to move from the first to the second stage, as it changed the fiduciary responsibility of the end investor. The introduction of an index was an improvement as it somewhat resolved the agency problem through using a rigid benchmark. In addition, the EMH (Efficient Market Hypothesis) rose to academic prominence through the work of Samuelson [1965] and Fama [1965, 1970], and the investment community was gradually moving away from the merits of active asset management in general and the feasibility of stock selection, as demonstrated by Brinson et al [1986] in particular. The main product to emerge from the 1964-2000 consensus thinking in the investment community was the index fund. Hedge funds – what some call 'active managers on steroids – are somewhat antithetical to the EMH and consensus view.
Compounding and drawdowns
The adoption of the absolute return approach is to some extent the industry 'returning to its roots', or at least for the active part of the asset management industry. What we refer to as the third stage is a combination of the absolute return approach from the first stage, and the high degree of specialisation of the second stage. Combining an absolute return approach with a high degree of manager specialisation results in the manager having a mandate to balance investment opportunity with capital at risk, a more flexible approach than adding value beyond a benchmark. It takes into account the fact that market inefficiencies have a tendency to go away when identified by too many investors, as well as the fact that the reward from a certain skill falls over time. Today, we call this a hedge fund. The term, essentially a misnomer characterising a legal construct, might disappear.
A different view from ours is the belief that the absolute return investment philosophy will somehow be integrated into the status quo – what we call the second stage of asset management, the relative returns game. The end investors have a multiple set of objectives, some of which are defined in relative terms. We do not share this point of view, and are inclined to treat the benchmarked long-only and absolute return approaches as opposites, or more formally as passive and active risk management.
Our angle comes from looking at the world from what we believe is a risk management perspective. The bottom-up stock selection process of a long-only manager and a long/ short manager might be identical, or indeed very similar. However there is a big difference in the way risk is defined. If the definition of risk is different it is obvious that the whole risk management process will differ as a result. In a benchmark-driven investment process, risk is defined as tracking risk, while in an absolute investment process, risk is defined as total risk. Managing tracking risk means participating in any boom/bust cycle unhedged, whereas managing total risk means reducing risk when the risk/return opportunity set changes to the investor's disadvantage. The investment philosophy and culture resulting from this differentiation could not be further apart – indeed, they could be considered opposites.
When opposites merge
In 2003 we distinguished between investor protection and wealth of capital protection with respect to the structural change in the investment management industry. The merger between 'traditional' and 'alternative' has become more apparent over the past two years. The second table is reprinted from our 2003 study, where we contrasted long-only with hedge funds with respect to investor protection and wealth or capital protection. With respect to investor protection, we believe there is a trend from right to left – i.e. hedge funds are facing tougher regulatory scrutiny, becoming more transparent when catering to institutional investors, and, more recently, introducing benchmarked products. With respect to wealth or capital protection, we believe there is a trend from the right to the left, with traditional managers becoming more oriented to absolute returns.
One observation we regularly make is the long and continuous aversion to derivatives among a large majority of investors and market observers. This is remarkable, as derivatives are simply instruments used to manage tasks efficiently. It is over simplistic to be generally opposed to the use of derivatives in finance because their misuse has caused casualties
Bottom line
Progress is not smooth and gradual, but erratic and jumpy due to new discoveries and new ideas. A new development or idea is typically ridiculed, then it is contested as it does not fit nicely with current doctrine, then the opposing camp adapts to the changed environment, and then – finally – goes on to argue that 'we knew this all along'. With respect to absolute return investing, we have safely passed the first phase. There is only a minority of intransigentcontemporaries from the popular press and a minority of investors left arguing that the search for alpha, the preference for an asymmetric return profile over exposure to randomness, the quest for independent return streams (portfolio diversification), and thinking about the extreme impact of large drawdowns to investor survival probability is ridiculous.
We are somewhere in the second phase where there is still opposition, as the 'new' idea does not fit nicely with 'old' beliefs.
Risk un-controlled exposure to market forces could one day – looking back – be compared to the unsheltered exposure of our ancestors to the whims of natural forces. Most people probably agree that finding ways to control and shelter life and belongings from the natural elements is considered progress. We believe that same is true for controlling capital at risk.
Alex Ineichen is a Managing Director, and Global Head of Alternative Investment Strategies Research at UBS. The views and opinions expressed in this article are those of the author and are not necessarily those of UBS. UBS accepts no liability over the content of the article. It is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments.
- Rephrased: "Institutional investors, consultants and analysts had always assumed that they were more intelligent than absolute return investors because they achieved so much…benchmarks, tracking errors, performance attribution analysis, and so on, whilst all the absolute return investors had ever done was muck about making money. But conversely the absolute return investors believed themselves to be more intelligent than institutional investors, consultants and analysts for precisely the same reasons."
- Note that those who predict bubbles are normally too early. Robert Shiller and Alan Greenspan, for example, were referring to the 'irrational exuberance' of US equities markets in December 1996. Their reasoning, based on historical over-valuation, was sound. However, the index roughly doubled in the years after the argument. Others spent the whole of the 1990s arguing that US equities were overpriced.
- What we found interesting was that a 180 basis point loss in the traditional portfolio is perceived as 'just another day in the office.' Potentially, there is some serious mental accounting going on with investors new to AIS, where confidence in the recently made investment decision is low.
- See, for example, Brunnermeier and Nagel [2003], who examined hedge fund market behaviour in the technology bubble and bust that followed.
References
Brinson, Gary P., L. Randolph Hood, and Gilbert L. Beebower. (1986) "Determinants of Portfolio Performance," Financial Analysts Journal, Vol. 42, No. 4 (July/August), pp. 39.44.
Brunnermeier, Markus K., and Stefan Nagel (2003) "Hedge Funds and the Technology Bubble," Princeton University working paper.
Fama, Eugene F. (1965) "The Behaviour of Stock Prices," Journal of Business, 38, pp. 34-105.
Fama, Eugene F. (1970) "Efficient Capital Markets: A Review of Theory and Empirical Work," Journal of Finance, 25, pp. 383-417.
Rogers, Jim (2000) "Investment Biker – around the world with Jim Rogers," Chichester: John Wiley & Sons. First published 1994 by Beeland Interest, Inc.
Samuelson, Paul A., (1965) "Proof that Properly Anticipated Prices Fluctuate Randomly," Industrial management Review, 6, pp. 41-49.
Shiller, Robert J. (2000) "Irrational Exuberance," Princeton: Princeton University Press.
UBS (2003) "Fireflies before the storm," UBS Warburg, Global Equity Research, June.
Q & A with Alex Ineichen
Do you think that the high aggregate leverage of the whole industry could pose a potential threat to the international financial system, if allowed to increase?
No. I believe the average leverage per fund is lower than it was pre-LTCM, i.e., early 1998. Far more than 50% of the hedge fund industry is equity related, i.e., long/short or a variant thereof, where leverage is lower. For example, levering a directional net exposure to the equity market of 10% five times over is still just an exposure of 50%, i.e., half the exposure of a longonly way of managing money without leverage.
If the bubble bursts, do you think institutions already invested in hedge funds will remain wedded to them as an investment?
I believe there is the potential that in a crisis or scandal, newer and/or less sophisticated investors might run for the doors similar to Private Equity a couple of years ago. In Private Equity it was the last ones who invested, who exited first. We could call this a "LIFO-effect" (Last in, first out). I do not believe this will happen, but it remains a possibility.
Could there be a fourth stage in asset management or is this a cyclical evolutionary model?
Certainly. Evolution does not happen gradually and smoothly; it is an interchange of smooth periods and erratic interruptions (paradigm shifts) as new ideas and approaches quickly replace the old ones as soon as it becomes obvious that the new way is an improvement. "Quickly" is a relative term. In finance it just takes a while until everyone agrees that the new idea/approach is superior.
Can you comment on the growth in popularity of funds of hedge funds linked to a protected structure as a possible additional layer of capital preservation?
My view is that, with a capital guarantee, your probability of losing money at a certain date in the future is close to zero, while without a capital guarantee it is very low, but not zero. Investors seem willing to pay for this additional safety margin. As is quite often the case with insurance, its market price is higher or much higher than fair value, i.e., economically an attractive long-term proposition for the insurance seller – especially in markets that are not frictionless and have imperfect competition.
Some intermediaries who are offering hedge fund products to their investors and who buy these capital guarantees from investment banks are managing their reputation risk. In many countries the reputation and press of hedge funds is still negative. However, the economic logic of investing in them is, today, quite convincing to many investors. If something goes wrong in the hedge fund industry however, the intermediary who sold capital guaranteed products still has a product that returns the principal in the end. The intermediary then can book it as a bad experience without taking a similar hit to reputation as when recommending TMT stocks a couple of years earlier.
What is more likely: increased regulation of hedge funds, or deregulation of mutual funds?
Increased regulation of hedge funds seems more likely in most jurisdictions. However, the distinction between hedge funds and non-hedge funds is blurring so fast these days, that the question could become obsolete within two or three years.
Will fee structures have to be revised in order to make hedge funds more attractive to investors, especially pension funds?
Pension funds have been investing now for a while and continue to invest. Today, I believe it is the laggards who are complaining. Pioneers and early-adopters have now 5-10 years' experience of absolute return strategies.
As with most products in investment management and elsewhere in business, at one stage in a product life cycle, competition kicks in and the entrepreneurs' margins fall. Hedge funds are no exception. The exception is that fees have been increasing for the past couple of years due to an imbalance between supply and demand, and the fact that it is (at the moment) an impossibility to compete through gaining market share by reducing price (this is not necessarily true for funds of hedge funds). In other words, a competitor cannot come along and offer an identical product with lower fees. If he has an identical product, why should he reduce his fees?
However, at some stage investors will find a better way to distinguish between alpha and beta. I believe that alpha generators will continue to keep margins high for some time to come, while generators of camouflaged alpha (beta camouflaged as alpha) might not.
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