BOSTON – One of the themes discussed by alternative investment industry bigwigs at this week’s Global Absolute Return Congress in Boston was the future of the funds of funds sector.  One of the sessions on the agenda was called “Funds of funds are dead.  Long live funds of funds.”

That turned out to be quite a prescient title.  HFR released its Q3 run-down of asset flows into and out of the hedge fund industry.  The firm found that…

“Investors continued to withdraw assets from funds of hedge funds during 3Q, but at a reduced rate. Fund of fund redemptions totaled only $3.2 billion in 3Q, compared to a cumulative withdrawal of more than $180 billion in the previous four quarters. In contrast to single-manager strategies, over 73 percent of all fund of funds experienced net outflows for the quarter.”

This seems to suggest that, in this post Madoff environment, funds of funds are only just dying more slowly than before – but that they are dying nonetheless.  In fact, Dow Jones ran a story on Wednesday titled “Investors favour direct route to hedge funds’ doors” in which it referenced investors’ “growing predilection for placing their cash directly with managers.”

But wait!  Research firm Brightonhouse Associates found that Q3 marked a turning point and suggests that funds of funds may live a long and happy life after all.  That company’s Q3 analysis finds that,

“2009 has proved to be the year of the bounce-back for the fund of funds industry. In the third quarter, both managers and investors expressed high levels of optimism and confidence in funds of funds. This was reflected in the HFRI Fund of Funds Composite Index, which showed fund of fund performance increased 1.13 percent in the month of August, and 8.03 percent year to date. Additionally, during the quarter, BHA analysts spoke with more than 140 investors that voiced an interest in hearing from funds of funds for research and due diligence purposes. This number represents nearly a 20 percent increase over the first quarter when many investors were much more skeptical of funds of funds across the board.”

So there you go.  Funds of funds are dead.  Long live funds of funds!

Time to move out?

While we’re on the topic of Boston…

Although we aren’t allowed to report on the specific proceedings of the Global ARC, there were several sessions involving other news makers in attendance.  For example, The New York Times ran this front page article on Paul Volker the day he addressed the gathering here in Beantown.

The Times reports that Volker…

“…wants the nation’s banks to be prohibited from owning and trading risky securities, the very practice that got the biggest ones into deep trouble in 2008. And the administration is saying no, it will not separate commercial banking from investment operations.”

In general, the audience here seemed somewhat sanguine about the possibility of some kind of Glass-Steagel II – choosing instead to focus on the immediate investment opportunities before them.  In fact, the audience made up of hedge fund managers, institutional investors and “quants” from both groups actually applauded when Volker called on universities to produce more civil engineers and less financial engineers.

A remarkable show of unity between investors and managers?  Perhaps.  But what surprised us a little more was the apparent common ground shared by the hedge fund community and left-of-center thought leaders such as Joe Stiglitz, Paul Volker, and Niall Ferguson – none of whom minced words when it came to their opinions on the causes of (and solutions to) the financial crisis.  One hedge fund manager summed it up Volker’s commentary as “holding up a mirror to the industry.”

Koo and the Gang

Richard Koo, author and Chief Economist of the Nomura Research Institute in Japan has the ears of various leaders around the world.  He has become the spokesman for a school of thought that believes deficit spending is critical in a “balance sheet recession” like the one we’re in right now.  Drawing on the Japanese experience during the “lost decade”, he argued that inflation should not be a concern since government debt is just filling the gap left behind by suddenly-thrifty US consumers.  He warned the audience not to assume that the US is continuing it’s spendthrift ways.  In fact, he noted, the US savings rate is now higher than Japan’s.

Regular readers will remember his remarks at Global ARC in San Francisco in the spring when he said that debt must migrate from private balance sheets to public ones since only governments have the ability to avoid the paradox of thrift.

Teach a Man to Fish…

One of the most popular sessions here was probably one that compared biological processes to financial ones.  One of the speakers, Andrew Haldane, Executive Director of Financial Stability delivered a fascinating speech earlier this year on the topic of systemic risk.  Some have called it one of the best speeches ever written on the topic.  In the text of that speech, Haldane draws on natural science and diseases for lessons on how to contain financial contagion.

Two of the other panelists, Lord Robert May of Oxford and George Sugihara of the University of California, co-wrote this article in Nature called “Complex systems: Ecology for bankers” (with Simon Levine of Princeton).  In it, they discussed the credit crisis in the following terms:

“An analogous situation exists within fisheries management. For the past half-century, investments in fisheries science have focused on management on a species-by-species basis (analogous to single-firm risk analysis). Especially with collapses of some major fisheries, however, this approach is giving way to the view that such models may be fundamentally incomplete, and that the wider ecosystem and environmental context (by analogy, the full banking and market system) are required for informed decision-making. It is an example of a trend in many areas of applied science acknowledging the need for a larger-system perspective.”

Like Bo Jackson and others, Angelo Calvello is a “multi-sport athlete”.  The early and outspoken advocate of portable alpha and originator of the term “alpha-centric” has now established his thought leadership credentials in the emerging field of green investing.  He is the author of the forthcoming book “Environmental Alpha” (Wiley: 2009).

Calvello was one of several speakers addressing a standing room only crowd of nearly 400 people at Bloomberg’s New York headquarters at the inaugural CAIA Green Investing Symposium (organized by the New York chapter of the CAIA Association, and co-sponsored by the New York Society of Securities Analysts, the Connecticut Hedge Fund Association, and the Yale Center for Business and the Environment).

More than just a social issue, he describes climate change as the “mother of all investment themes.” In a refreshing departure from the usual (albeit important) socially-grounded view of climate change, he remained agnostic with regard to even the dirtiest of energy technologies (e.g. coal).  Instead, he focused his remarks today on how to generate returns given the realities of climate change.

The drivers of those returns, according to Calvello, can be categorized as science, economics, policy, and technology.  He divides “environmental investing” into 5 categories: clean technology, sustainable property, LULUCF (Land-Use, Land-Use Change, and Forestry), carbon, and water (although he acknowledges that water does not have a direct effect on green house gasses).

So what is environmental alpha?  Although environmental investing may show potential for outsized returns in the future, it could all just be environmental beta.  But Calvello argues that such a new field exhibits inevitable market inefficiencies.  He points to the complex choice of a wind farm location as an example of the type of investment that relies on emerging and uncommon knowledge.

Reducing dirty energy use by 50% before 2050 (as global policy makers have discussed) would require about $45 trillion dollars – or about 1% of GDP per year.  And that, according to Calvello is the heart of the investment opportunity.

“Backburner” no more

Rob McAndrew fondly recalls the heady days of 2006 and 2007 when carbon trading was the cat’s meow.  But as he said today, “in the midst of a global economic downturn, it’s no surprise that carbon trading has taken a back burner.”

But McAndrew, the SVP of the Chicago Climate Exchange, is bullish again.  He says his email is once again full of people wanting to know more about how to make money in the burgeoning market for carbon credits.  He listed off a series of trading strategies used by players in this space.

With 35 billion tons of carbon being dumped into the atmosphere every year, he says that the global market for carbon credits could reach a few trillion dollars by 2020.

If 2009’s carbon auctions are any indication of the future direction of this market, this is no pipe dream.  In June, the US Congress passed the “American Clean Energy and Security Act” that established the cap and trade system of carbon off-set credits.  And with the EPA estimating that it will cost between $13 and $20 per metrics tonne to pollute, carbon trading looks set to go from “backburner” to “boiling over.”

In advance of carbon emissions becoming a tangible cost, some institutional investors have already begun to calculate the carbon footprint of their holdings (e.g. Sweden’s AP2 pension fund).

Chile: The next Saudi Arabia?

More…

Yesterday we argued that value-added, not “absolute returns” should be the key metrics in judging the recent success of hedge funds.  Implicit in that argument is the assumption that hedge fund investors turn to the asset class for its diversification properties.  After all, losing less than the markets in 2008 was only commendable if it was not achieved by simply un-levering a market ETF.

Today, we learned of a recent survey of institutional investors that found just that.  According to Preqin (see other interesting research from this rather prolific organization) over half of institutional investors surveyed said they invested in hedge funds for diversification purposes.  The runner-up reason was “to improve the risk/return profile” of their portfolio” – another reference to the diversification properties of hedge funds.

Curiously, the survey also found that investors are now far more concerned about all issues except fund performance.  This time last year, over half said that the performance record was a “key consideration when choosing a hedge fund manager.”  This year, the number has fallen to a third.

Although “firm reputation” is slightly less of a key consideration this year, the number who said “quality of personnel” is a key consideration jumped four times over the course of 2009.  This may seem a little contradictory.  But we can think of several examples of firms with stellar reputations that were headed by “low quality” personnel…

Amazingly, the survey found that the vast majority (65%) of respondents hadn’t lost any confidence at all in their hedge fund managers over the past year.

“Backlash” (?)

These findings stand in stark contrast to a report by the FT that hedge funds are suffering an “investor backlash.”

The article contains the usual complains about lock-ups, but then quotes one market participant as saying:

“In some cases, it benefited all investors to halt redemptions and wait out the liquidity crisis. Market conditions have improved and fire-sales have clearly been averted…”

The FT cites another player who makes a similar argument.  Reports the paper:

“Most market practitioners concur that restructurings have been constructive, as they have helped managers to safeguard the interests of their funds and their investors…”

Such positive reviews for redemption gates are sure to take some of the wind out of the sails of hedge fund “backlash”.

“Haunted” (?)

Okay.  No backlash.  But according to Reuters, hedge funds are  still “haunted” by high water marks.  The news service says,

“…hundreds of managers remain deep in the hole and face some tough decisions in the coming weeks…”

But like the FT piece, this article acknowledges that the problem has all but gone away compared to a year ago.  Reuters cites Credit Suisse research that found 45% of hedge funds are actually above their high water mark, and a further 20% had a legitimate shot at a performance bonus this year.  Only about a third was going to get a lump of coal in their Christmas stocking this year.

The article concludes that,

“…strong returns have quieted dire predictions, especially among the largest and best known funds…”

Fewer “dire predictions” may be what’s behind the Preqin numbers above.  But what can we expect from the industry over the final months of 2009?

Swinging for the fences…?

But will we start to see some managers “swing for the fences” as they clamor to get over their high water marks?  With prescient timing, the Journal of Alternative Investments provides an answer to that very question in this quarter’s edition.

The article “Locking in the Profits or Putting It All on Black? An Empirical Investigation into the Risk-Taking Behavior of Hedge Fund Managers” by Andrew Clare and Nick Motson explores whether hedge fund managers actually start making big bets if they’re down as the year comes to a close.

Regular readers may recall our review of Claire and Motson’s original paper on the topic.  The duo found that hedge funds who were down by year end tended not to ramp up volatility after all.  However, funds that were up YTD did tend to ramp down volatility and lock in their profits.

…Or nudging oneself over the finish line

While 2009’s losers may not swing for the fences or “put all on black”, we may find that those who are tantalizingly close to break even may end up eking out a small gain on the year.  After all, there’s nothing worse for a manager than a minus sign, right?

AAA regulars may also remember this 2007 study by Nicolas Bollen of Vanderbilt University and Veronika Pool of Indiana University that found an awfully fishy anomaly in the distribution of hedge fund returns – a dearth of “slightly negative results” (click to enlarge)…

The chances of this happening naturally, according to Bollen and Pool, are pretty small indeed.

It remains to be seen if these phenomenon play out in 2009.  But it would appear that managers won’t have to make any strategic gambles or use any tactical tricks to impress institutional investors this year.  At the very least, they’ll get a nice card this Holiday season.

By: Andrew Saunders, AllAboutAlpha.com Editorial Board.

This summer, Man Investments, one of the world’s largest alpha hunters announced a strategic reorganization of its hedge fund investment business. Long associated with systematic trading – AHL was launched way back in 1987 – Man has built a significant fund of funds (FoF) business, with the acquisition of Glenwood investments in 2000 and RMF Investment in 2002 making it one of the largest global investors in hedge funds through FoFs, seed investment and managed accounts.

Earlier this year, Man announced the consolidation of these well-known FOF franchises into one business, Man Investments. Spearheading the transition is John Rowsell, Managing Director who has leadership responsibilities over all business functions. We sought out John to see what drove the reorganization, his views on how a hedge fund investment business should be structured in this new era as well as gather his views on the managed account phenomenon where Man has been an early leader.

John has experience as both an allocator and manager. In the past, he served as CEO of Glenwood, Chief Investment Officer of Man Glenwood, Chairman of the Investment and Management Committees and also managed an internal hedge fund at McKinsey & Company.

Q1: Man Investments recently announced a strategic reorganization. Explain the strategic rationale for consolidating your investment businesses?

Man announced the creation of an integrated fund of fund business in March. The key strategic drivers behind this move are twofold: restructuring to ensure we maintain an obsessive focus on delivering long-term performance to investors; and ensuring that the business evolves to meet changing investor requirements.

Over the years we grew separate fund-of-fund businesses with unique competitive advantages: RMF’s systematic investment process; Glenwood’s bottom-up manager selection philosophy, and Man’s seeding and managed accounts. Structurally it was time to consolidate these processes and support them with Man’s capital, operational and technological infrastructure.

Over the past 12 months it has become clear that our investors are demanding enhanced transparency, institutional quality governance, flexible investment solutions and strong controls over invested assets. Creating an integrated business allows us to apply the full institutional scale and rigor of our global investment management franchise to solving our clients’ problems..

Q2: Under the new structure, you will have management responsibility over the integrated businesses including all business, operational and risk functions. What do you see as your biggest challenges and opportunities?

The lessons of 2008 have accelerated investor interest in managed account investments. The transparency, better liquidity management and control of assets that come from managed accounts have attracted a lot of attention. Some strategies are not appropriate for managed account investments in our view and transparency is only helpful if you have the systems, knowledge and expertise in place. Man has been investing through managed accounts for more than 12 years and is currently working to increase its assets invested through managed accounts (currently about $6 billion) in partnership with underlying managers. Keeping on the leading edge of risk management is essential here. This requires a huge investment of capital and expertise. There are tremendous benefits in having scale to help clients understand the risks and solve complicated investment problems.

Q3: How would you rate the investment opportunities over the next 6-12 months?

There has been a lot written lately about the potential shape of any economic recovery. While market conditions have visibly improved since Q1, we still feel that the risks of a severe dislocation, illiquidity and market failure remain. We have also seen over the course of the year that asset classes have become highly correlated, largely due to the ‘risk on/ risk off’ pattern that has occurred due to shifts in investor sentiment. As a result, we believe there is a high level of uncertainty surrounding the medium-term directional outlook and are therefore cautious about our levels of directional exposure at present. For this reason we are currently favoring liquid and fast-moving managers for the exposures we do take on.

We do however believe that this period of uncertainty and transition has provided strong risk/ return opportunities in other areas. One area is the existence of relative mis-pricing of related assets in global markets, which we believe can be exploited at an intra-capital structure, inter-company, inter-sector and inter-regional level. Practically this translates at present into: Equities, with a relatively low overall net exposure with a bias towards quality and dispersion; Credit, with a significant net long exposure within the limits of underlying liquidity; and Macro, with significant exposures to global macro and CTAs

Q4: Man Investments is a recognized leader in managed accounts, which have attracted considerable attention and popularity over the last 12 months. What key issues should managers and investors be aware of when establishing these structures?

Before considering a managed account solution, investors need to clearly understand their objectives and requirements. Risk management, portfolio construction, strategy exposure and operational control are all important dynamics. Understanding the infrastructure and expertise required to structure, manage and monitor the investment are also essential.

There are three main types of managed accounts solutions in the marketplace against which investors should evaluate their needs:  Direct access managed account platforms providing enhanced risk and operational monitoring but in a co-mingled structure giving little or no investor control; Customized, investor-driven managed accounts which provide large institutional investors with full control and segregated assets but which require significant expertise to manage; and Portfolio management driven managed accounts (as typified by the FoF model which allocates across many funds) where the investor sets up a “platform” of managed accounts and co-mingle their portfolios within the platform.

These accounts provide enhanced risk monitoring and full operational control but also require the expertise, resources and experience to set up, monitor and maintain a platform across a diversified set of strategies, styles and managers.

Whereas hedge fund investors need to be clear on the place for managed accounts in their portfolio, managers also need to understand the needs of their investors, evaluate the impact of each solution to their business and implement a solution which is scalable and meets the long term needs of their business. It’s important to keep in mind that running multiple managed account investments can be burdensome for hedge fund managers. Investors with a long track record of investing through managed account investments have a strong competitive advantage in this regard.

Q5: What is your view on the dynamic regulatory environments in the UK, Europe and the US. How are you staying on top of the developments?

From an investment standpoint one of the biggest surprises of the past year was the extent and willingness of Government to intervene in the economy. From global restrictions on short selling to government backstops, bank guarantees, private sector equity injections and the de-facto takeover of the GSEs – Fannie Mae and Freddie Mac – the scale of government intervention was unprecedented. From an investor’s standpoint, this intervention has been one of the most significant factors impacting investment returns and market/ price volatility.

Whilst it was notable that many of the regulatory reviews regarding the financial crisis have agreed that hedge funds were not the authors of the crisis, we are nonetheless in a world where regulation of all financial market participants is being looked at afresh. New initiatives run from the G20 Global Plan for Recovery and Reform, through the US Treasury Framework on Financial Regulatory Reform and review of markets, to the European Union’s draft Directive on Alternative Investment Fund Managers and the UK Turner Review. These proposals cover a wide range of market participants and activities, from executive remuneration to the capitalization of banks to the regulation of investment managers. We believe that the influx of new regulation will be capable of being addressed best by “institutional quality” managers, those with existing experience of operating in regulated environments around the globe, and with the resources to assess and address the changes as they are proposed and implemented.

In addition to being regulated by the UK FSA, Man is regulated in 16 different regions by 21 separate regulatory bodies. This insight and experience is an asset to the investment process and our advice to clients.

Q6: Is the market becoming better informed on the risk/return profile of hedge fund investment strategies?

Apart from managed futures strategies, there is little doubt that hedge funds delivered disappointing returns in 2008. That hedge funds outperformed equities by a wide margin and were a victim rather than a cause of the credit crisis offers little solace. Perhaps even more so than performance, liquidity – or a lack of it – has taken center stage. Some managers took unpopular measures such as gating, side-pocketing or suspending redemptions altogether. In many cases this was justified by market developments and was in the best interests of investors. Nonetheless these events cast a spotlight on some factors that we believe investors really need to pay attention to. These include the capital position, governance arrangements and infrastructure/ expertise of your provider, the level of transparency and liquidity within your portfolio and the degree of asset control you maintain.

To us investing and education go hand-in hand – it is very much a partnership-based approach. While we provide our clients with the benefits of our investment strategy and views, hedge fund and market commentaries and outlooks, we prefer to think about ‘education’ as more of a two-way street. Our approach is to work with clients to develop customized portfolios at the individual manager and strategy levels – through this process we learn a tremendous amount about our clients’ needs and experiences – which in turn impacts our own views and processes. Tailoring portfolios to meet specific risk/ return targets, or to act as completion portfolios to existing hedge fund exposures and accommodate specific investment policies or themes is thought provoking work; and scale helps. Part of the process involves producing optimizations, liquidity and risk analysis, and leveraging deep managed account expertise and legal and financial engineering capabilities.

Q7: What are you hearing from you clients? How are you adding or deploying new talent and resources to service your clients?

At its most basic level, building a fund of hedge funds business is about finding great hedge fund managers and building robust portfolios. Although it might sound simple – this does not mean that it easy to execute well. It takes a huge amount of resources and capital and a lot of talent to run a top tier asset management shop. We are fortunately to have the balance sheet strength of the Man Group behind us which provides us with stable funding for recruitment and retention, innovation and infrastructure. Deploying this strength for the benefit of our clients is more important than ever now. Many of our clients have been feeling the pinch of running their endowments, foundations and plans with fewer resources and smaller budgets. This puts greater responsibilities on the shoulders of remaining staff.

With investors needing to closely examine their overall portfolio liquidity, risk exposures and operational arrangements, this puts tremendous pressure on investment staff to cover all of the bases. This is where deep partners can really provide added value to investors.

Central to the reorganization, we have consciously beefed up our risk management [45 professionals] and quantitative analysis teams [19 professionals] and deepened the bench in hedge fund research [28 professionals] and portfolio management [20 professionals] to ensure that we can fully support our clients in these areas. Our investment staff are based in NY, Chicago, London, Switzerland and Singapore which is critical to our manager sourcing, due diligence and client service functions. We put a large emphasis on attracting and retaining staff with diverse backgrounds in trading, banking, structuring, research and portfolio construction, operations and IR. On the managed account side, we also have a 30 + strong team of professionals dedicated to structuring, monitoring and managing managed accounts.

As regular readers of AllAboutAlpha.com know, one needs to look beyond superficial labels such as “hedge fund” and “mutual fund” in order to understand the shifting asset management landscape.  As we like to say, it’s not about “hedge funds” or “mutual funds”, it’s all about alpha.

So we were very interested to read about this issue from a legal perspective on an excellent website called The Hedge Fund Law Report.  The site produces mainly in-depth articles and is subscription-only.  However, we are pleased to reproduce in its entirety, a recent article that illustrates how evolving European mutual fund regulations are fuelling the convergence of hedge funds and mutual funds.

Convergence of Hedge Fund Strategies and the UCITS Structure in Europe Mirrors Convergence of Hedge Fund Strategies and Mutual Fund Structures in the United States

By: Christopher Faille, The Hedge Fund Law Report

Undertakings for Collective Investment in Transferable Securities (UCITS) – retail investment funds authorized by one of the member states of the European Union (EU) and thereby passported into the rest of the EU – represent the dominant platform for retail investment funds in Europe.  See “UCITS: An Opportunity for Hedge Fund Managers,” The Hedge Fund Law Report, Vol. 2, No. 27 (Jul. 8, 2009).  Collins Stewart, a London-based financial advisory group, recently announced that it plans to launch a fund of funds within the UCITS structure.  This announcement, and a similar announcement from Schroders PLC that it is working with hedge fund managers to launch a range of UCITS funds for sophisticated investors, serve as evidence of the increasing convergence of hedge fund strategies and the UCITS structure.  The convergence mirrors a similar trend in the U.S. in which hedge fund strategies are being offered in mutual fund or exchange-traded fund vehicles.  These trends on both sides of the Atlantic are part of a more overarching trend toward retailization of hedge fund strategies, which heretofore have been the exclusive province of high net worth individuals and sophisticated institutional investors.

Retailization can dramatically change the game for hedge fund managers.  Among other things, it can open up a vast new market for their services.  See “Hedge Fund Managers Launching Mutual Funds in an Effort to Stay a Step Ahead of Regulatory Convergence,” The Hedge Fund Law Report, Vol. 2, No. 15 (Apr. 16, 2009).  But at the same time, it can dramatically increase the number and heft of competitors, and can introduce a variety of new conflicts.  See, e.g., “New Study Offers Surprising Findings on the Incentives Created by Concurrent Management of Hedge and Mutual Funds,” The Hedge Fund Law Report, Vol. 2, No. 23 (Jun. 10, 2009).  A related trend is so-called hedge fund replication, in which hedge fund strategies are supposed to be reproduced in non-hedge fund, often retail, vehicles.  See “Hedge Fund Replication is Gaining in Popularity, but is it a Viable Alternative to Hedge Fund Investing?,” The Hedge Fund Law Report, Vol. 2, No. 28 (Jul. 16, 2009).

This article examines retailization on the European side.  In particular, it analyzes the promise, limits and mechanics of the UCITS structure; replication as an alternative route to retailization; the likelihood that the onerous Alternative Investment Fund Manager (AIFM) Directive may increase the use of UCITS funds for hedge fund strategies; and how UCITS IV will change structuring and management of UCITS funds, focusing on increased ease of passporting, new rules regarding fund mergers and master-feeder structures and new standards for risk measurement and management.

More…

By: Andrew Saunders, CAIA (AllAboutAlpha.com Editorial Board)

The last 12 months have been, to put it mildly, “disruptive” for the hedge fund investor.  No more so than for endowments, foundations and pensions that may have only recently invested in alternative investments.  This month we direct our “seven questions” to someone at the mine face who advises and educates these investors on their alternative allocations.

Greg Dowling is Managing Principal and Director of Hedged Strategies at Fund Evaluation Group, a 70-person investment consulting firm serving institutions such as pensions and foundations.

Q1: Greg, what about the recent 12 months surprised you the most, and how has it changed the advice you have given your clients?

It would be hard to pinpoint just one surprise. The whole sequence of events that occurred post-Lehman was not only surprising, but also all together shocking.  For years, you would hear from analysts covering the financial sector who worried about the investment banks and large money center banks’ exposure to hedge funds. In the end, it was hedge fund’s exposure to the banks that almost brought them down. There is certainly some irony here. One of the most regulated industries, banking, nearly collapsed, yet those “evil” unregulated hedge funds held up fairly well in comparison.

What has changed?  Well, you simply cannot make recommendations solely on a pure investment risk/return basis anymore.  You now need to consider the health and liquidity of both the client and the manager.

Q2: What do you see as the areas requiring the most client education today?

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Today, we bring you another installment of our “Summer of 1,000 posts” (more…)

This week we’ll be looking back through our archives to cull posts on the topic of CAPM/Alpha Theory…

How Hollywood, lotteries and mutual funds show that all risk is relative
Since the birth of the CAPM, empirical evidence has been uncooperative – showing that high risk investments produce lower returns, not higher ones.  Now one author looks beyond equity markets and finds even more evidence against the vaunted CAPM.

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…

Yesterday, we covered the first half of an interesting academic study on hedge fund redemption terms.  We learned that the auto-correlation of monthly returns was positively related to the actual redemption terms of a fund.  Today, we cover the second half of this paper by MIT’s Amir Khandani and Andrew Lo – in which the duo estimate an actual premium associated with redemption terms.

Rather than comparing actual redemption terms to see if illiquid funds perform better than liquid ones, the duo can now compare autocorrelation to (risk adjusted) returns.  In the table from their paper reproduced below, they create 5 separate hypothetical portfolios based on autocorrelation buckets (click to enlarge).  Lo and behold (pardon the pun), the funds with the highest autocorrelation of returns generally also had the highest risk-adjusted returns.

Note that while  high auto-correlation is generally associated with higher risk-adjusted returns, there are some exceptions.  In particular, Khandani and Lo highlight the fact that the Global Macro funds with the highest auto-correlation (lowest liquidity) actually posted below average results.  Also, we noted that very few of the relationships were monotonic (with the best performing funds of funds, for example, being the ones with the second lowest autocorrelation).

Okay.  So you read yesterday’s post and you get the idea above.  But so what, right?

More…

If one word could sum up the multi-dimensional train wreck we’ve seen in financial markets over the past few years, it might be liquidity.  Illiquidity-driven death spirals have affected individual hedge funds, liquidity “mismatches” have hurt funds of funds and university endowments, which had long benefited from an “illiquidity premium” recently came crashing back to earth (see this recent Vanity Fair article for a great example).

Several experts have contemplated the value of liquidity on these pages.  Some have even suggested that hedge funds owe much of their “alpha” returns to illiquidity, not skill.

But what exactly is this illiquidity premium and how do you even begin to measure “illiquidity”?  You could, for example, look at the bid/ask spread.  Or, you could look at the “metrics such as the “percent of day’s-trading-volume”.  Or in the case of managed or structured vehicles, you could simply find out the redemption terms.

Each of these techniques presents complexities when applied to hedge funds, however.  But academics use a technique that might save a lot of time for those trying to measure the illiquidity of hedge funds: return autocorrelation.  The serial correlation between monthly returns can reveal a lot about the actual illiquidity of a fund according to a study by MIT’s Amir Khandani and the absurdly prolific Andrew Lo, his MIT colleague.

In “Illiquidity Premia in Asset Returns: An Empirical Analysis of Hedge Funds, Mutual Funds, and U.S. Equity Portfolio“, Lo and Khandani prove that hedge fund return autocorrelation is a proxy for actual redemption terms.  In their words:

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E.M.H. R.I.P. W.T.F?

In an ironic twist, the Economist suggests that financial engineering (and by extension the hedge funds built with its outputs) are built on the shoulders of the efficient market hypothesis.  Yet the much ballyhooed demise of the EMH should, in theory, pave the way for skill-based, alpha-centric returns.  In fact, the newspaper even makes the case for hedge funds in this weeks edition:

“…In 1980 Sanford Grossman and Joseph Stiglitz, another subsequent winner of a Nobel prize, pointed out a paradox. If prices reflect all information, then there is no gain from going to the trouble of gathering it, so no one will. A little inefficiency is necessary to give informed investors an incentive to drive prices towards efficiency…”

Confirmation that fund of funds investment is a trailing indicator

Hedge Funds Review reports on S&P’s latest fund of funds asset flow data, observing that “…Investors quick to respond to disappointing returns have been much slower to react to improving performance.”

Is new 130/30 ETF active or passive?

While it’s originators, Andrew Lo and Pankaj Patel call it a “passive” strategy, the model upon which the new Proshares 130/30 ETF is built looks a lot different that a typical passive index.   Says Lo: “The quantitative model behind our 130/30 Large-Cap index is based on extensive, robust research on the real-world factors contributing to stock performance.”

(btw,did you know Lo’s first science project was to make a battery out of a lemon.  Amazing but true.)

When is a rebound not actually a rebound?

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Today, we bring you the first in a series of exclusive interviews with key players in the world of alpha-centric investing.  Approximately once a month, we’ll pick someone from the pages of AllAboutAlpha.com or from the alternative investment industry in general and pose 7 topical and straightforward questions.

By Andrew Saunders, CAIA (AllAboutAlpha.com Editorial Board)

Roger Ibbotson, Ph.D., is the Chairman and Chief Investment Officer of Zebra Capital, a role he has held since the firm was founded in 2001.  However, many of you will know Roger as the founder and former Chairman of Ibbotson Associates, which he founded in 1977. (He sold his interest in Ibbotson Associates to Morningstar in 2006 and is no longer an executive with the company.)

Roger is also a professor in the Practice of Finance at the Yale School of Management.  His book with Rex A. Sinquefield, Stocks, Bonds, Bills and Inflation serves as the standard reference for information on investment market returns.  He also co-authored two books with Gary Brinson, Global Investing and Investment Markets, and in 2001 completed an investments textbook with Jack Clark Francis, Investments: A Global Approach.  Roger also recently published the Equity Risk Premium with William Goetzmann and Lifetime Financial Advice with Chen, Milevsky, and Zhu.

As regular readers are aware, Ibbotson conducts research on a broad range of financial topics, including investment returns, mutual funds, hedge funds, international markets, portfolio management and valuation. He is a regular contributor and editorial board member to various trade and academic journals and has received several awards, including the Review of Financial Studies Award (Best Paper in 1992) and the Graham and Dodd Scrolls (6 times).   His publications are regularly listed in the Top Ten Social Science Research Network Download lists.

He has also served as a consultant to many companies in the financial and investment industry and has managed bond portfolios, traded equity securities, and managed asset allocation accounts.

Q1: Roger, as we approach the second year anniversary of the great quant meltdown of August 2007, how would you characterize investor familiarity, knowledge of and openness to quant strategies?

During the summer of 2007 the risk (volatility) of hedge funds doubled.  It was also a time when many strategies were highly levered and underperforming.  Since most hedged funds targeted volatility, many had to unlever at the same time. Many of the quant funds had similar holdings, which caused the meltdown as they rushed to the same exits.  During the summer of 2008, something similar happened, but this time the cause was the short selling restrictions that the government implemented in an attempt to prop up the most vulnerable companies.  Once again the quant strategies suffered.

In both cases, the quant funds that were able to stick with their strategies were able to quickly recover.  But those who targeted volatility got whiplashed.  Those who kept their leverage intact did reasonably well.  Unfortunately, many investors lumped quant funds into one big category, and have become wary of the whole group.

Q2: Are there questions that investors should ask about quant strategies but do not?

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Today, we bring you another installment of our “Summer of 1,000 posts” (more…)

This week’s sampling from our archives covers the topic of Alternative Beta and and Hedge Fund Replication…

With hedge funds back in the black, how are the hedge fund “clones” doing?
At least one hedge fund “replicator” has recently been replicating the aspirations, if not the actual experiences of hedge fund managers.

A novel approach to monitoring daily HF returns when they don’t actually exist
Hedge fund replication is now put to a different use by researchers.  Call it “assisted hedge fund replication”.

Pendulum swinging back to investable hedge fund indices for passive HF exposure
It wasn’t long ago that investors were graduating from simple investable hedge fund indices to more sophisticated hedge fund replication products for their passive hedge fund exposure.  Now, it seems that “simple” is back as some investors are willing to stomach the high hedge fund fees in exchange for transparency and liquidity.

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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?

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We were in Chicago earlier today (Tuesday) at the Managed Funds Association’s Forum 2009.  “MFA” used to stand for “Managed Futures Association”.  So as you’d expect from a Chicago-based meeting of this group, there were plenty of CTAs and global macro managers discussing trend following and pork bellies.

But not far beneath the surface of nearly every session was the 800 pound gorilla in the room: the ongoing saga of hedge fund regulation around the world (see our category by that name at right, or our research dossier containing over 60 critical documents on the topic).

The days when hedge funds and regulators squared off in a perennial grudge match seem to be long gone.  Phil Goldstein, the colourful and tenacious advocate of hedge funds, who challenged and beat back the SEC’s 2006 attempt at regulation, has been replaced by the more sanguine approach taken by the MFA’s Richard Baker and AIMA’s Andrew Baker (no relation – but bizarre coincidence nonetheless we note).

Both groups, along with a smattering of others in Washington DC, have stepped up their educational efforts on Capitol Hill this year.  The Wall Street Journal reported on Monday that,

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Linear regression models (a.k.a. factor models) have a number of emerging applications in the hedge fund industry.  One of the most often-cited here and elsewhere is hedge fund replication (see related posts).  But as we discovered recently, regression-based models can also be used to estimate the daily returns occurring between monthly hedge fund reporting cycles (see related post).  In addition, MIT’s Andrew Lo has proposed several other applications of linear factors models to address situations such as transitioning between managers and portfolio rebalancing for risk management purposes (see related post).

Now Lo has teamed up with Alexander Healy of Alpha Simplex Group (the company with which Lo is closely affiliated) and proposed yet another application of this truly alpha-centric approach to portfolio management: dealing with redemption gates.

The two suggest that when hedge fund investors are confronted with redemption gates, they can essentially remove their economic exposure to many of the underlying hedge fund betas in much the same way an executive can monetize un-vested stock options.  By basically shorting the basket of betas that make up the returns of lock-up hedge fund allocations, investors can reduce volatility dramatically and in some cases, even increase returns (i.e., if the alternative betas in question temporarily deliver negative risk premia).

Drawing on a knack for colourful metaphors, Lo says this is not unlike the strategy taken by the drugs often prescribed to those with high blood pressure:

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