We’re in Chicago this week for the Managed Funds Association’s Forum 2009.  More on that later.  But for now, here is a compilation of some stories that caught our eye last week…

Gates designed to keep investors out, not in

It was bound to happen.  Reuters reports that:

“A small number of top hedge funds are once more shutting their doors to new clients in a sign that investors are putting their cash back with the best performing managers, said fund of funds Corazon Capital.

“While heavy outflows last year meant almost all hedge funds were open to new investors, Barrie Duerden, director of Corazon Capital, told the GAIM 2009 conference here that in recent weeks some managers were now turning away business again.”

Gated Communities

As in real estate, however, such “gated” communities are for a ratified crowd.  While “top hedge fund” are closing their doors, Reuters also reports that most hedge funds have ramped up the marketing machine, quoting one participant at a recent conference as saying:

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It is often argued that aggregate hedge fund performance data suffers from a near-fatal flaw: since it is voluntarily reported by the manager, hedge fund indices only include funds that the managers have deemed marketable.  In 2002, David Hsieh of Duke University and William Fung of London Business School wrote a seminal article on this issue called “Benchmarks of Hedge Fund Performance: Information Content and Measurement Biases.”

In contrast, regulations often require mutual funds to register with securities authorities before they can begin to assemble a track record.  As a result, mutual fund data is assumed to be free of such bias.

But as Alan Palmiter and Ahmed Taha, law professors at Wake Forest University write in a forthcoming article for the Vanderbilt Law Review called “Star Creation: The Manipulation of Mutual Fund Performance Through Incubation“, the requirement for a mutual fund to register does not eliminate the problems arising from so-called “mutual fund incubation.”

Observe the professors:

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BNP Paribas Hedge Fund Centre, London Business School

Director: Narayan Naik, nnaik [at] london [dot] edu

From the Institute’s Website: Key Aims: To undertake research into all aspects of hedge fund investing, including the impact of hedge funds on the asset markets they invest in; To encourage others to conduct research, for example through visiting research fellowships and through invitations to present research at London Business School; To encourage better understanding of hedge funds.  More…

Working Papers, Published Papers

Related AllAboutAlpha Content

Bill Fung

Visiting Research Professor at the Centre for Hedge Fund Research and Education, London Business School. Serves on the board of  financial services companies in Europe and North America and is currently Chairman of the Board of Directors of the Maple Financial Group, Canada.

Homepage/Contact Information (LBS)
Research (SSRN)
BNP Paribas Hedge Fund Centre
Relevant Postings (AllAboutAlpha.com)

Narayan Naik

Director of BNP Paribas Hedge Fund Centre, London Business School

Faculty Profile (LBS)
Research (SSRN)
Relevant Postings (AllAboutAlpha.com)

More from London (see yesterday’s posting for background)…

A pension plan as a financial services firm

As some pension funds begin to shift from funds of funds to single-manager hedge funds, they usually create what amounts to their own internal fund of funds.  The only difference between this fund of funds and a real fund of funds is that the pension has only one client: its own pension plan.

It turns out that this view of the hedge fund portfolio as a sort of arm’s length asset manager with only one client can also be applied to the pension fund as a whole.  That’s how one major private pension fund described it to a gathering here in London today – as a financial firm that produces pensions.

This view also has implications for liability-driven investing (LDI).  Some said that the process of liability-matching and return-enhancing should be kept separate within this financial services firm.  For example, one major pension fund here created a team focused on removing interest rate and inflation risk (via a matching portfolio designed to match the plan’s future liabilities to pensioners) and a separate team focused solely on trying to squeeze additional returns out of those assets.  In true arm’s length fashion, the return portfolio is required to literally borrow assets from the matching portfolio – creating a real economic incentive to beat the short-term rates charged on this internal loan.

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In the late 1990’s a couple of academics David Hsieh (Duke University) and Bill Fung (London Business School) wondered if traditional statistical analysis was appropriate for a new type of investment fund – the hedge fund. Although they had collaborated since early that decade, their 1997 paper “Empirical Characteristics of Dynamic Trading Strategies: The Case of Hedge Funds” put the two on a collision course with history.  Several years later they teamed up with the equally prolific Narayan Naik, who worked with Fung at LBS and met Hsieh at Duke while doing his PhD.  Last week the trio landed another in a long string of commercial successes advising some of the world’s most powerful financial institutions.

On Friday, State Street Global Advisors announced they had landed a US$200 million “hedge fund replication” mandate from the Universities Superannuation Scheme, a British pension plan serving the country’s academic community.  This is newsworthy since its one of the first major pensions to pursue such a strategy (although there has been lots of talk).

A State Street official sounded a refrain that will be familiar to regular readers of AllAboutAlpha.com:

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This week’s Economist contains a great analysis of how commonly-held beliefs about hedge funds may be urban folklore.  In fact, the piece makes so many succinct arguments, that we can’t really add much other than to suggest a few related AllAboutAlpha.com postings for anyone looking for additional perspective.

“Trying to assess the behaviour of hedge funds is a bit like attempting to nail a blancmange to the wall.  It is all too easy for the truth to slip away.”

“…Take hedge-fund failures. Most funds close down because it does not pay their managers to continue, not because their performance has been disastrous.  For every Bear Stearns ‘enhanced-leverage’ fund that loses all of its value, there are five or six funds that shut after a fall of a few percentage points…Doubtless more hedge funds will fail this year, but that will not necessarily be a sign of the industry’s demise.”

(Related posting: “Are some hedge funds sinking or just sailing into the sunset?”)

“…A survey by William Fung and Narayan Naik of the London Business School examined five different benchmarks and found that only 3% of constituents were common to all of them.”

(Related posting: “Only 3% of Hedge Funds in All Five Major Databases“)

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So hedge fund indices are all over the board.  But why?

Displaying perfect timing, French business school and hedge fund research hot-bed Edhec just released the presentations and back-ground reports from its recent conference in London – including a July ‘07 paper entitled ”Revisiting the Limits of Hedge Fund Indices: A Comparative Approach“.  Says the paper:

“One of the reasons for this lack of homogeneity in hedge fund index return data is that none of these existing indices is fully representative. In other words, this is a sampling problem: a number of funds that should be part of an index are not included in the index. Because of the lack of regulation on hedge fund performance disclosure, existing databases cover only a relatively small fraction of the hedge fund population. It is likely that only slightly more than half of existing hedge funds choose to self-report their performance to one of the major hedge fund databases.”

Regular readers may remember this illustration from the London Business School which makes the same point graphically (see related posting):

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Alpha Male has attended more hedge fund conferences than he cares to remember.  Many of them have begun with several empty seats and ended with far more.  But apparently the good citizens of Geneva know a hot financial topic when they see one.  You know all those seats along the back wall for late comers?  All packed.  You know the aisle – where you walk – to get to your seat?  Also packed (with extra chairs that had to be brought in).  The main conference hall of the Hotel “President Wilson” in Geneva was overflowing yesterday morning as Professor Bill Fung of the London Business School kicked off this two-day gabfest on hedge fund replication.  Thankfully, it appears the Geneva fire marshal must have been off having a chocolate eclair at some swanky cafe by the lake.

Why all the interest?  Hedge fund replication – that esoteric and highly quantitative discipline that had struggled for attention only a year ago – has suddenly hit the mainstream.

But rather than freaking out about it, it seems that many hedge fund operators have embraced the old enemy and have positioned hedge fund clones as a complement, not a substitute, to traditional hedge funds.  For example, Fung himself told the audience:

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Heard on the floor at Terrapinn’s “Hedge Fund Replication & Alternative Beta” conference in Geneva so far today…

“His trading process may be “naive”, but his fees sure aren’t!”

- Professor Harry Kat on the hedge fund replication strategy pursued by another well-known firm.

“The asset information submitted to any of the databases is absolutely useless.  How many of the biggest hedge funds in the world actually provide an information to any database?  BGI, one of the world’s largest hedge fund managers, does not submit its data to any of the hedge fund indexes.”

“Five years from now, all hedge fund replicators will be out of business.  We’ll all look back and think ‘what a silly idea that was’!”

- Stan Beckers, Head of Alpha Management, BGI on hedge fund databases and hedge fund cloning in general

“Tom Schneeweis and I published our own hedge fund replication results on our website 6 years ago.  But we only got 2 phone calls…No one cared…so eventually we stopped doing it.  Apparently we should have continued.”

- Hossein Kazemi, Center for International Securities and Derivatives Markets (CISDM), jokes about his sense of timing in front of an overflow conference audience

Click below for more quotes from the lakeside…

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Pensions & Investments reports this week that quant managers all scrambled for the same exit doors last week because they were all in the same theater at once.  Lehman’s Matthew Rothman tells the newspaper:

“The traditional quant factors that everyone (uses) because they work — like EBITDA (earnings before interest expense, taxes, depreciation and amortization) to EV (enterprise value), price momentum — did very badly. The more correlated you were to these factors and to other managers who use them, the worse you performed.

Jim Simons’ letter to investors concerning the recent performance of the quant behemoth Renaissance Technologies echoes the same idea.  Simons says:

August (down 8.7% through today) is a different story. The culprit is not the Basic System but our predictive overlay. While we believe we have an excellent set of predictive signals, some of these are undoubtedly shared by a number of long/short hedge funds. For one reason or another many of these funds have not been doing well, and certain factors have caused them to liquidate positions.

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Managing a hedge fund requires a veritable arsenal of trading tools.  Among them are the trusty duo of leverage and short-selling.  The arms merchants in these pitched financial battles are the prime brokerages – the bank divisions that cater to the needs of nearly all hedge funds.  Apparently, it’s good work if you can find it.  Hedgeworld cites a new study that pegs the industry at “$8 billion to $10 billion annually”.

Lending money is an ancient business.  But what’s not so old is the business of facilitating short-sales (short-selling began in the 18th century).  And the business of short-selling is about to change dramatically with the entry of what seems to be a flood of traditional managers into the 130/30 space.  This will inevitably put new pressures on the prime brokerages and force them to address a common concern: fee transparency.

Some have wondered if there would be enough stock to short and whether the end was nigh.  Last fall Goldman Sachs hypothesized that the end wasn’t imminently nigh, but might not be far off (we were less sold on their concerns – see posting).  Goldman’s numbers and those cited in the Hedgworld story are quite similar.  Both say there is about $4.5 to 5 trillion of stock available to short in the world (about 10% of the world’s lendable stock and 3% of the world’s total equity supply).

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