To help our American readers celebrate the Thanksgiving holiday, we have harvested a bushel-full of news items that show an industry in such transition that it may soon become a leading cause of indigestion.

PE firms getting into the HF business: “…Private equity firms will need to become more like asset managers, offering buyouts as just part of their portfolio…large U.S. private equity firms, such as Blackstone, KKR and Apollo, have spread their wings into new fields like real estate, hedge funds and general asset management…”

HF firms getting into the PE business: “Hedge fund investors stuck in products with illiquid assets are increasingly seeing interest in their stakes from specialist private equity or other buyers as markets recover…”

HF firms getting into the banking business: “Hedge funds provided as much as 40 percent of the money raised this year by U.S. and European banks as they sought to offset losses and meet government capital requirements…”

Banks getting into the HF business: “…despite their moniker of ‘highly-leveraged institutions’, most hedge funds today operate with leverage less than a tenth that of the largest global banks…”

Traditional Managers getting into the HF business: “When Gartmore Group goes public next month, most of the proceeds will go toward paying down its debt. But the new capital will also be used to boost the firm’s hedge fund business.”

Meanwhile, investors dispensing with HF, PE and “traditional” labels: “Institutional investors are gearing up to integrate hedge funds into their equity and fixed-income portfolios, part of a growing trend toward allocating assets based on their sources of return — alpha and beta…”

Decoupling?  Really?: “Emerging market decoupling accelerates in hedge fund industry…The HFRI Emerging Markets (Total) Index has gained 36.4 percent year-to-date through October, a sharp reversal from the record 37.2 percent loss suffered last year.”

Have they no shame?  Gamblers gambling with their winnings: “The New York Lottery is proposing a gamble where the odds aren’t always in its favor — moving its $1.3 billion prize fund into investments such as stocks, corporate bonds, real estate and hedge funds and out of the safety of U.S. Treasuries.”

Who knew? Madoff’s fee model turns out to be a winner: “(A) pattern of higher-charging funds generating higher returns is repeated over three years.  The one exception: funds without any annual management fees. They made 3.2% on average over the year to June, and 6.7% a year over three years – higher than anyone else.” (more coverage)

A perfectly Madoff-ian sales strategy…: “Anecdotal evidence supports the idea that investors are gaining fee advantages in return for giving into hedge fund demands in other areas…”

“Wide discrepancy” in HF quality or just a long left tail?: “The Hedgebay Global Hedge Fund Secondary Market Index showed the highest trade in October took place at net asset value (NAV) for the second time in three months. The lowest-priced trade was priced at just 40% of NAV…The average trade price was 86.73% of NAV…”

The financial equivalent of the old Saturday Night Live sketch,”The All-Drug Olympics“: Regulations on insider trading have gradually tightened over the years in the U.S. and many other countries, but some economists argue for a complete course reversal, making insider trading legal…”I think there are some libertarians who think we should allow it,” says Wharton finance professor Jeremy J. Siegel.

Hedge funds back to $1.75 trillion…: “Investment flows into hedge funds have turned net positive and the sector is heading toward having assets under management of around $1.75 trillion by year-end, according to Morgan Stanley.”

…then on to $2 trillion: “Hedge fund assets may top the previous $2 trillion high by the end of next year as double-digit average returns lure investors…”

- We’re back Friday, recovering from our tryptophan coma. Thanks for reading.

This week marks the publishing of our 1,000th post at AllAboutAlpha.com.  We’ve seen a lot over the past 3 years.  And despite its recent travails, the hedge fund industry remains approximately the same size now as it was back when we thought WordPress was a new type of laser printer and that blogs – like Pet Rocks and Cabbage Patch Kids before them – were another sign of the End of Times.

To celebrate this milestone, we thought we would highlight some popular posts in each topic area covered by AllAboutAlpha.com.  So throughout the summer, we’ll be pouring through the archives so you don’t have to.

(If you are a paying subscriber or a member of the CAIA Association and can’t remember your password, just hit “forgot password” at the right and we’ll have one of our army of overworked interns send you an email.)

This week, we’ll start with one of our favorite topics at AAA – CAPM/Alpha Theory.

Real Estate Alpha
A lot of research has been conducted on real estate mutual funds.  But precious little has ever been conducted on the alpha produced by institutional funds that invest in commercial real estate – until now…

Crowds may not be so “wise” after all
A new book, an industry survey, and media reports have propelled the age-old topic of market efficiency into the spotlight this month.

Study hints that alpha may be finite (at least in the short term)
Is it a coincidence that hedge fund returns are exploding right after the biggest culling in the industry’s history?

More…

A lot of commentators – particularly in the mass media – have blamed hedge funds for the financial crisis.  But unfortunately, their rhetoric is often very knee-jerk and lacks the necessary detail to actually make their arguments convincing.   So in our yearning for a cogent argument against hedge funds, we were very excited to read this column yesterday by Kiplinger.com contributing columnist Steven Goldberg called “Ban Hedge Funds?”

But alas, Goldberg’s arguments don’t wash.  In fact, they’re so stained with apparent indignation toward hedge funds that we felt a need to document the fallacies and half-truths raised in the piece.  As players in financial markets, hedge funds – like mutual funds, banks, pension funds, and individual investors – are all accomplices to the calamities.  But the cause?  I guess that you can find research to prove anything.  But here’s our take on the arguments raised by Goldberg…

Claim: “Much of the demand for what Warren Buffett years ago termed ‘financial weapons of mass destruction’ came from hedge funds.”

More…

Several hundred hedge fund CEOs, COOs and operations personnel met today for day one of GAIM Ops, a three-day conference dedicated to hedge fund operational issues.  What follows is a description of several of today’s sessions reported directly from the conference floor of this timely event.

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4:30pm Eastern Time

Addy on Redemption Gates

Chris Addy, CEO of Montreal-based consultancy Castle Hall Alternatives and lead author behind the blog “Risk Without Reward” has been keeping a close eye on redemption gates since the first ones began to shut last year.

He is of two minds regarding gates and all-out redemption suspensions.  He says that on the one hand, hedge funds have just navigated through a “cataclysmic” financial event that was not its own making (making gates appropriate).  On the other hand, many hedge funds can be blamed for “over-selling” their liquidity (making gates less justifiable).  The root of the problem faced by many funds was an assumption that assets would not go down.

This was compounded by the complacency with which many investors approach offering documents – resulting in the playing field being tilted in the manager’s favour.  To add insult to injury, he says, the legal fees incurred in the creation of those offering documents are usually charged to the fund itself.  So although he says he doesn’t like to use the analogy, Addy says it’s like the investor is being “charged for the gun used to shoot themselves in the foot.”

More…

Britain’s Financial Services Authority (FSA) recently found that hedge fund leverage was nearly extinct (for now).  In what is billed by the FT as the “only authoritative data on the opaque industry”, the FSA found that the average hedge fund had leverage of 1.15x, down from about 2x a year ago and 1.44x as late as last spring.  According to the FT, the FSA defined leverage as long positions over NAV, “ignoring short positions.”

But what happens when you account for shorts?  Regular readers may remember the chart below left from a recent European Central Bank report (see post).  The ECB reported gross leverage (longs plus absolute value of shorts) from Hennessee Group and found leverage levels around 1.5x.  (To compare to the FSA’s estimate, note that longs over NAV was under 1.0 – likely due to the fact that only lower-leveraged long/short equity funds were counted.)  This seemed to back up what managers were telling Merrill Lynch in a survey cited by the ECB (right panel) – that a majority of managers were actually using no leverage at all.

More…

While the Edhec Risk and Asset Management Research Centre is bigger, smarter and better–connected than AllAboutAlpha.com, both organizations share the same genetic blueprint. Edhec’s Lionel Martellini confirmed this fact this morning in his introduction to day two of the university-affiliated organization’s annual hedge fund conference in London. Edhec sees alternative investments as a (the) central issue in institutional portfolio management and believes that we need stronger links between research and practice.

Some would say that this overstates the importance of emerging asset classes. But Martellini points to two unique aspects of alternative investments that are fundamentally unique: non-normality and data integrity. The introduction of higher moments such as skew and kurtosis le to an explosion of data since correlation was now joined by co-skew and co-kurtosis. These co-moments add exponentially to the amount of information required for portfolio construction. To compound things, monthly data that is susceptible to “smoothing” makes alternative investment research a whole new ball game for academics and practitioners.

More…

For generations, those who have predicted the end of the world have relied on specific dates of religious or astronomical significance (e.g. the Mayans, whose doomsday calendar is pictured at right).  This isn’t lost on Hollywood, which began filming the apocalypse movie “2012″ in August.  (Thankfully, the movie will be released in ‘09, giving us a couple of years to prepare).

Last week, Dow Jones reported that one consulting firm predicted a coming hedge fund apocalypse with between $650 billion and $700 billion being “withdrawn from hedge funds” this year.  A week before that, however, Citi said that it expected only $100 billion to be redeemed in Q4 and just this week Lipper TASS reported Q3 hedge fund outflows of only $18.6b or 1% of assets.   As we have reported here, estimates of hedge fund redemptions are all over the board.  The FT ran the following chart last week using HFR data, that shows the size of recent redemptions in relation to previous subscriptions:

More…

Alpha Magazine is releasing the winners of its 2008 Alpha Awards this week.  The four categories judged by a survey of hedge fund manager in the spring and summer are: law firms, prime brokerages, accounting firms and administrators.  Results are being released at Alpha’s website all this week.

Shartsis Friese and Walkers scored top spots for law firms in yesterday’s release.  And today (October 22), in what is surely a relief to the overworked and overstressed folks at Morgan Stanley, that firm took top spot in the prime brokerage rankings.

No category has been impacted as much by the credit crunch as prime brokerages.  As Alpha points out, the September 15 bankruptcy of Lehman left the prime brokerage industry “cracked open like an egg“.  The magazine reports that Morgan Stanley’s prime brokerage business has dropped by as much as 40% since the end of the third quarter.  But Alpha also writes that:

“Morgan’s franchise, especially among long-short equity clients, remains strong…And even today [Morgan and #2 Goldman] appear well positioned to consolidate their strengths in the hedge fund market over the long term.”

Merrill Lynch made a surprise jump from #10 last year to #5 this year.  So it appears that after selling its #4 ranked prime brokerage to BNP Paribas only weeks ago, Bank of America is back in the game with another top 5 franchise.

Earlier today, the CFA Institute released the results of a recent survey of its members on the topic of what has now become known simply as “The Bailout”.  Headlines suggest that the CFA charter holders overwhelmingly support the bailout (e.g. “Investors support bailout…”, “Investment Pros Like Bailout…”).  Indeed, the CFA Institute’s own press release is entitled, “Investors Overwhelmingly Agree: Fair Value Should Not be Suspended and the Bailout Plan Will Help the U.S. Economy.”

But according to the results contained in the Institute’s press release, there doesn’t seem to be “overwhelming” agreement on much at all.  And even if there were, it’s not clear whether the survey represents “investors” beliefs or those of “investment professionals” – a very different group.  Understanding this difference is critical to interpreting the survey’s results.

Despite being described as “investors” in the press release, the CFA website says that only 15% of its members work for pensions, foundations, insurance companies or private wealth management firms.  The rest work at mutual funds, I-banks, hedge funds, commercial banks, or in academia or consulting firms.  The press release appropriately reverts to the term “investment professionals” in the text itself, but the headline still suggests that respondents are predominantly investors and not members of the investment financial services industry itself.

More…

It’s been about two years since “hedge fund replication” hit the mainstream business press.  Over that time, many products have been launched and there has been much navel-gazing about the future of the hedge fund industry.  But today “real” hedge funds remain.  With such an elegent value proposition, and a stellar academic pedigree, why have the hedge fund clones not yet taken over the world?

This is one of the questions being addressed at a Terrapinn conference next week in New York.  To provide a bit of perspective on the challenges faced by hedge fund replication, we invite one of the speakers at that event, UK-based Nicola Ralston of Liability Solutions, to share her thoughts.  Ralston is also a former Chair of the CFA Society of the UK and a Governor of the CFA Institute.
Special to AllAboutAlpha.com by: Nicola Ralston, PiRho Consulting

Asset owners are an understandably sceptical group of people. They often feel it’s a jungle out there; investment banks and asset managers seem to make a very good living at their expense, yet everyone knows that real skill is a scarce commodity.  Where to turn?  In the equity markets, passive investing cuts the cost of gaining exposure to markets. It reduces the risk of being fleeced by managers who are trying, but failing, to add value and taking a big fee along the way. Why should hedge funds be any different?

Working out what to replicate

The concept of hedge fund replication assumes that we have an understanding of what we seek to replicate. This may seem fairly straightforward – even basic – but there are serious issues to consider.  Even indices that broadly measure the same thing can differ significantly.

More…

Barbells have been around a long time.  According to historian Jan Todd, a Boston area strong man named George Barker Windship was the first to patent the now ubiquitous variable-weight barbells found in most gyms.  That was 1865.  But the first use of the term “barbell” was in an obscure 1870 British book called “Madame Brennar’s Gymnastics for Ladies, A Treatise on the Science and Art of Calisthenics and Gymnastic Exercises.”

Today, the term “barbell” is routinely applied to anything that maintains its balance even though its bulk is distributed mainly at two ends.  Take, for example, the asset management industry.  As the Financial Times reports this week:

“Things are looking good for the asset management barbell thesis Morgan Stanley (AMEX:MWD) first put forward five years ago. This suggested traditional asset managers would lose out as money increasingly shifted to cheap passive strategies on the one hand and alternative investments and high return specialists on the other.”

As we’ve reported extensively on these pages, the big winners in the asset management industry have been alternative investments and ETFs – both of which represent the constituent elements of any traditional active fund – the variable weights at each end of the proverbial barbell.  The Morgan Stanley report covers the European asset management industry and clearly illustrates this trend.

The chart below from the report shows that passive (ETFs) and high-alpha (short-extensions, funds of hedge funds etc.) are growing the fastest.

More…

Morgan Stanley Investment Management

From corporate website:  Morgan Stanley Investment Management’s alternative investment offerings span a wide range of disciplines, including hedge funds and funds of funds; absolute return strategies; real estate; senior loans; structured products; and private equity, which encompasses direct investments, joint ventures, leveraged buyouts and infrastructure

Click here for related AllAboutAlpha content

Jack Coates

Head of Portable Alpha, Managing Director, Portable Alpha Team, Morgan Stanley Alternative Investment Partners.  Former head of pension plan for Weyerhaeuser.

Morgan Stanley AIP Portable Alpha
Relevant Postings (AllAboutAlpha.com)

Inalytics launches new service to analyse 130/30 funds: Thomson reports that “The firm specialises in quantitative forensic analysis to identify 130/30 managers that can add value from skill by verifying that their short positions actually generate returns.”

Nervous alternatives managers could be leaving alpha on the table: P&I reports from ”AlphaMax” in Madrid that “Fees became a point of contention between pension fund executives and hedge fund managers…with the pension executives arguing that the typical hedge fund management fee of 2% and performance fee of 20% can be a deterrent…”

8 out of 10 managers fail to add value: Meanwhile in Stockholm, Watson Wyatt’s Roger Urwin tells another conference why pensions have an allergy to “2 and 20″.

Credit Suisse kicks off launch of hedge fund replication products with index: Also not oblivious to pensions’ concern over fees, Credit Suisse launched their long-awaited “Alternative Index Replication” product (see previous posting).

Portable Alpha/Overlay Strategies Slides (pdf): Thomas Picciochi of Deutsche Asset Management and Francois Bourdon, of Fiera Capital deliver a presentation to the Society of Actuaries in March.

Prime time at Morgan Stanley’s hedge-fund debutantes ball: Asian Investor reports from a Morgan Stanley cap intro event where organizers say “2008 will be about the separation of alpha and beta”.

Merseyside seeks UK 130/30 managers: Big UK pension plan looks for someone to manage around $1billion using 130/30 or portable alpha – confirming a growing realization that the two are basically the same thing.

Japan public pensions ‘need revamp’: We’re not the only ones who think Ikea and maple syrup have a lot in common (see posting).  The FT reports that “The more aggressively managed state pension funds of countries such as Sweden and Canada, whose investment strategies serve as a model for the proposals”.