In orderto present our extensive alternative investment research in a condensed way, and to discuss these results with the institutional investor and fund manager communities, Edhec has organised the Edhec Hedge Funds Days1. This three-day conference will be structured around four major themes, namely: (i) Hedge Funds in Institutional Investors' Portfolios, (ii) The Value of Funds of Funds and the Capacity Effect Controversy, (iii) Risk Management, and (iv) Asset Allocation as a Value Proposition.
Here is a short preview offered by Edhec, in partnership with The Hedge Fund Journal, of some of the key topics that will be discussed during the Edhec Hedge Fund Days.
In the aftermath of the bursting of the Internet bubble, institutional investors have once again been confronted with the limits of traditional diversification. In parallel, institutional investors realised that alternative investments, in particular hedge funds, could not only provide them with alpha benefits but also with beta benefits. More specifically, they observed that hedge funds were liable to provide them with increased protection during bear markets. They therefore massively increased their exposure to this new type of asset. 51% of European institutional investors are now exposed to hedge fund strategies and an additional 3% plan to take the same path in the near future. Furthermore, hedge fund strategies now represent a significant portion of European institutional investors' global assets (i.e., around 7%). Hedge fund strategies now clearly belong to the investment universe of European institutional investors.
It is not only the nature of their investments but also the way European institutional investors structure their allocation process that is changing. 33% of European institutional investors now implement a core/satellite type organisationof their allocation and an additional 5% are planning to do so shortly. This modern approach to investment consists of separating out beta management (i.e., choice and construction of a benchmark), and alpha management (i.e., management of active risk). It is used by institutional investors because of the following advantages it offers: (i) lower fees, (ii) access to the specific expertise of specialised managers, and (iii) improved risk management. With their dual properties, hedge funds fit perfectly within this modern organisation of the asset allocation process. On the one hand, thanks to their alpha benefits, they are natural candidates for the satellite. On the other, thanks to their beta benefits, they are natural candidates for the core portfolio. Hedge funds, which were still recently considered as standalone or marginal investments, are therefore progressively being integrated into investors' global asset allocation. 8% of European institutional investors already consider that hedge funds are an essential element of a well diversified core portfolio.
While a majority of European institutional investors have already integrated alternative investments, especially hedge funds, into their investment universe, they still have to define their investment ideology. They basically have two solutions to capitalise on hedge funds' beta benefits. They can either implement an optimal diversification policy, or an optimal substitution policy. The former consists of selecting the hedge fund strategies that show the highest degree of complementarity with the investor's initial allocation (i.e., risk reducers); the latter consists of selecting the hedge fund strategies that (i) outperform, and (ii) show the highest degree of commonality with the investor's initial allocation (i.e., return enhancers). Both approaches have the same objective – to improve risk-adjusted performance – but they reach it in a diametrically opposed way. While optimal diversification aims to reduce the level of risk without affecting the level of return, optimal substitution aims to increase the level of return without affecting the level of risk. 38% of European institutional investors are still wondering which way to go.
If European institutional investors are still at a loss when choosing the way in which to capture the beta benefits of hedge fund strategies, they seem to have made up their minds with regard to the way in which they intend to gain exposure to hedge fund strategies. While only37% of them invest directly in single hedge funds, 74% have opted for funds of hedge funds.
Traditional investors rarely have the resources (e.g., time, knowledge, network, assets under management) to invest directly in single hedge funds. That is the reason why they generally gain exposure to hedge fund strategies through third parties like funds of hedge funds. By doing so, they enter into a principal/agent relationship with the fund of hedge funds manager. Investors are therefore exposed to both visible (i.e., management and incentive fees) and invisible costs (i.e., agency costs). It is therefore natural to wonder whether funds of hedge funds, against this backdrop of costs, succeed in adding value. Surprisingly, very little is known about the value added by funds of hedge funds at the strategic allocation level and/or through active management (i.e., tactical style allocation and fund picking).
The performance of a fund of hedge funds can either be attributed to its investment style or to active management. Using Sharpe's style model we obtain the following decomposition:
In an attempt to fine tune the analysis, one can introduce a proxy for the performance of an uninformed investor (e.g., an equally-weighted portfolio of the different hedge fund strategies, neutral portfolio henceforth) and decompose the value added by the fund as seen in figure 2.
Based on a sample made up of 97 funds of hedge funds belonging to the Alternative Asset Centre (AAC) database and showing a continuous track record from January 1997 through December 2004, we find that the majority of funds of hedge funds, namely 57%, do add value. As a result, we can say that the fund of hedge funds market offers appealing investment opportunities for investors. However, contrary to what they generally claim, it is at the strategic allocation level and not through active management that fund of hedge funds managers add most of the value. Indeed, only a small proportion of fund of hedge funds managers, namely 31%, appear to have succeeded in adding value through active management. In other words, in the alternative arena, just like in the traditional world, strategic allocation appears to be the key determinant of the performance of a fund. Based on this evidence, it would not be surprising to see the development, in the near future, of funds of hedge funds made up of investable hedge fund indices and focusing on the portfolio construction process (we will present an allocation model that allows value to be added through tactical style allocation decisions in the final part of this article).
|Annual Added Value||Total||Strategic Allocation||Active Management|
|Nbr of positive (in %)||56.70%||88.66%||30.93%|
|Average Added Value||3.50%||2.10%||3.25%|
|Nbr of negative (in %)||43.30%||11.34%||69.07%|
|Average Added Value||-1.36%||-0.46%||-2.40%|
The value proposition of funds of hedge funds is twofold. On the one hand, funds of hedge funds are supposed to add value throughout the investment process (i.e., portfolio construction and fund selection). As we have just seen, even if funds of hedge funds tend to destroy value through active management, they still succeed in creating value compared to an uninformed investor, thanks to the strategic allocation process. On the other hand, funds of hedge funds are supposed to provide investors with relevant information via regular activity reports. This does not systematically prove to be the case. Indeed, only 46% of European institutional investors consider that they are capable of monitoring risk properly through the reports provided by the managers.
As long as private investors – looking for absolute returns – have made up the bulk of hedge fund investors, investor information has not been at the top of the agenda. However, with the massive arrival of institutional investors – looking for genuine diversification properties – priorities have changed. Now that investors are much more focused on risk management, information has become a crucial issue for the future development of the alternative industry. Having said that, designing an activity report that satisfies both parties is an extremely challenging task as investors and fund managers tend to have conflicting interests. The following question needs to be answered: what is the minimum level of information that investors need to receive so that they can monitor their investments properly? As one might have expected, the definition of relevant information is still subject to controversy.
The activity report must provide investors with tools that take into account the specific features of hedge fund strategies. This is true for the return dimension (e.g. autocorrelation of return data series) as well as for the risk dimension (e.g. extreme risks). In other words, activity reports in the alternative arena should not be pure transpositions of the templates used inthe traditional world. Traditional indicators (e.g. Sharpe ratio) should systematically be accompanied by alternative indicators (e.g. Omega ratio). On the other hand, hedge funds are playing an increasing role in the diversification policy of institutional investors. We thus argue that activity reports should cover the whole spectrum of risk dimensions (e.g. normal risk, loss risk, extreme risks) in order to offer investors a true and fair representation of the genuine risk profile of the fund. This is all the more important in that only 29% of European institutional investors appear to be capable of carrying out risk analysis on the investments independently from that provided by their manager.
Moreover, activity reports should not only be descriptive. They must also help investors understand the behaviour of the fund. This means that investors should be informed about the nature and the dynamics of underlying risk factors. The results of static and dynamic factor analysis should be included in activity reports. Finally, it is worth noting that activity reports are supposed to help investors in their decision-making process. They should therefore focus on relevant information and avoid any data overkill effect. We suggest adjusting the level of detail to the level of granularity (i.e., detailed information at the fund or at the strategy level, and selected information at the position level).
When investors gain exposure to hedge fund strategies through funds of hedge funds as opposed to single hedge funds, they clearly obtain more information, which in turn allowsthem to improve their risk management process. However, while fund of hedge funds investing allows investors to control their financial risks better, it does not prevent them from being exposed to operational risks. The efficiency of the fund selection process is limited by the relative opacity of single hedge funds. In other words, even the most experienced investors may not dispose of all relevant information to assess the actual operational weaknesses of a specific fund. This is particularly worrying since in 8 out of 10 cases, operational weaknesses are the root cause of the failure or have prevented a fund from managing a crisis situation appropriately in an unexpected financial context. Fortunately, being fully exposed to operational risks is not a fatality, even in the alternative arena.
One of the most important developments surrounding the hedge fund industry with regards to organisation and practices is probably the strong interest private and institutional investors have shown in the concept of 'managed accounts'. This concept of 'managed accounts' has been derived in numerous forms that offer different features: (i) standard custodial arrangements, (ii) prime brokerage custody, (iii) basic managed accounts and (iv) managed account platforms.
A significant element of protection in managed accounts comes from the limitation on manager access to the assets of the accounts. In full delegation, the manager may be entitled to execute and settle directly with trading counterparties. Such a situation would allow the manager to engage in OTC contracts that are not authorised under the conditions of the offering memorandum, or more simply transfer funds as part of a misappropriation scheme. It is therefore extremely important to ensure that trades impacting upon the cash or securities positions require countersigning by the depositary or the bank in charge of the managed account. Such a level of control will however require the list of counterparties, executing brokers and prime brokers to be clearly restricted and all parties informed of the authorised counterparties.
Segregated or managed accounts have been designed by investors to achieve a higher level of protection against possible fraudulent activities that can take place within a hedge fund structured around a private partnership.
|Traditional private partnership||Standard custodial account||Prime-
|Basic managed account||Advanced managed account|
|Segregation of assets||Y||Y||Y|
|Privileged redemption conditions||Y||Y|
|Elimination of misrepresentation risk||Y(2)||Y||Y|
|Elimination of misappropriation risk||Y(3)||Y(4)|
|Elimination of mispricing risk||Y|
|Mitigation of other operational risks||Y(5)|
Source: Giraud (2005)
2 Only when independent reporting of assets is performed by the custodian bank directly to the investor
3 Only when cash instructions are countersigned by the prime broker
4 Only when the manager mandate can be withdrawn at any time
5 Only when back office services are provided as part of the platform
Given the wide range of services managed accounts and similar platforms can provide, it remains essential for the investor to clearly understand and verify the nature of the contractual arrangements made between the management company and the service provider. Advanced managed account platforms that provide the full series of middle and back office services, alongside independent valuation and risk monitoring with contractual arrangements favouring stringent control of the hedge fund manager's operations can be considered the most secure environment.
No investor can expect to be fully insured against deliberate fraud or operational risks. It is however very important to stress that a managed account platform accompanied by terms and conditions that allow the risk management team to instantly cease the relationship with the manager, and the use of a systematic and independent valuation and risk monitoring function can allow 85% of the sources of risks that have caused hedge fund debacles to be restricted:
It would be erroneous to believe that all cases could be avoided within a managed account environment as the complexity of some strategies may involve very difficult or unexpected situations occurring (for example, market conditions leading to pricing and risk models not being applicable) but regular stress tests and privileged terms and conditions will certainly allow the investors to recover with significantly less damage than direct investors.
Since an advanced managed account platform structure addresses the most important risk factors identified in hedge fund debacles (fraudulent or not), the infrastructure is certainly a key element to be investigated when entering the hedge fund market.
When hedge funds are integrated into investors' global asset allocation this poses two problems in terms of portfolio optimisation. On the one hand, ample evidence of the non-normality of hedge fund returns can be found in the literature. Traditional mean/variance optimisation techniques therefore appear to be ill-suited. On the other hand, estimatinghedge fund expected returns is extremely difficult, in part due to the presence of multiple performance measurement biases. The optimisation process thus tends to suffer from a certain lack of robustness.
While both problems (non-trivial preferences about higher moments of the asset return distribution and the presence of parameter uncertainty) have been studied independently, what was still missing for active style allocation in the hedge fund universe was a model that would take both of these two aspects into account. One pragmatic solution that has been used in the hedge fund literature to overcome the problem of large estimation risk in the estimated expected returns is to focus on selecting the one portfolio on the efficient frontier for which no information on expected returns is required, i.e., the portfolio with the minimum amount of risk. This approach, however,does not allow for the inclusion of active views on expected returns on hedge fund strategies. We therefore introduced an optimal allocation model that incorporates an answer to both challenges within a unified framework. This model is a suitable extension to the Black-Litterman Bayesian approach to portfolio construction that allows for the incorporation of active views about hedge fund strategy performance in the presence of non-trivial preferences about higher moments of hedge fund return distributions.
Since the seminal work of Markowitz there is a strong consensus in portfolio management on the trade-off between expected return and risk. In the Markowitz world, the risk is represented by the standard deviation. Given the investor's specific risk aversion, optimal portfolios and the so-called efficient frontier can be derived. Based on this mean/variance approach, Sharpe and Lintner designed an equilibrium model, the Capital Asset Pricing Model (CAPM), aimed at describing asset returns. Assuming homogenous beliefs, every investor holds the market portfolio derived from this equilibrium model. Subsequently, Black and Litterman proposed a formal model based on the desire to combine neutral views consistent with market equilibrium and individual active views. They introduce confidence levels on the prior distribution and on individual beliefs and obtained the joint distribution. Based on a Bayesian approach, the expected return incorporates market views and individual expectations.
While the Black-Litterman model is well-suited for portfolio construction in the context of active asset allocation decisions, it suffers from an important limitation, namely that it is based on the Markowitz model, where volatility is used as the definition of risk. In order to apply a Black-Litterman approach to hedge funds, we need to extend the Black-Litterman model by taking higher moments into account so as to turn it into a four-moment portfolio selection model. Apart from this, the philosophy of the Black-Litterman approach remains the same. It thus consists of implementing the following procedure:
For illustration purposes we focus on the standpoint of an investor with an initial allocation made up of 20% stocks and 80% bonds. The objective of this investor is to design a fund of hedge funds that provides both beta and alpha benefits. On the one hand, the strategic allocation of the fund of hedge funds is chosen so that when combined with the investor's initial portfolio, the global portfolio shows the minimum modified Value-at-Risk. On the other hand, value is added at the fund of hedge funds level through active style allocation decisions. The active views are generated thanks to a simple univariate conditional factor analysis.
Exhibit 3: Performance of Active Allocation Strategies
– from January 2000 through December 2004
|MinVaR Portfolio||B&L Portfolio 1||B&L Portfolio 2||B&L Portfolio 3|
|Mean annual return||8.79%||9.79%||10.48%||10.71%|
|Sharpe ratio (r=3%)||1.58||1.80||1.93||1.95|
As can be seen from Exhibit 3, much value can be added through active style allocation decisions. As a matter of fact, the most active portfolio (i.e., "B&L Portfolio 3") presents an information ratio of 1.41 for a tracking error of 1.37% versus the Minimum-Value-at-Risk portfolio. Not surprisingly, the more active the portfolio, the greater the value added.