There was more evidence last week that alpha-centric investing is rebranding itself.  Clearly alarmed about the negative imagery now associated with the term “hedge fund”, several alternative asset managers have adopted the moniker “absolute return” or have simply dropped any reference to alternative investments from their name.

One good example is the rebranding last week of Chicago’s Harris Alternatives LLC.  The firm adopted the name of its flagship fund, calling itself Aurora Investment Management since “Chicago already has too many Harrises“.

But notice another subtle change.  The firm also dropped the “Alternatives” bit in favor of the more traditional “Investment Management”.  In reference to investors’ habit of referring to Harris as “Aurora” all along, Pensions & Investments saw this as a case of “if you can’t beat ‘em, join ‘em.” But that observation also clearly applies to the firm’s decision to position itself as a provider of traditional investments – not just alternatives. (In fairness, Aurora’s home page makes it clear that the firm is still solidly in the alternative asset management business.)

Aurora isn’t alone.  Bridgewater Associates was recently crowned by Fortune Magazine as “The World’s Biggest Hedge Fund Manager”.  Yet despite this achievement, Fortune reports that Bridgewater “doesn’t use a lot of borrowed money” and that Dalio “hates being called a hedge fund manager.” (Though oddly, Fortune also says Bridgewater’s leverage ratio is 4:1, higher than the hedge fund industry average.)

Meanwhile, traditional investment managers continue to launch sorties into alternative territory.  More and more traditional UK asset managers are apparently adopting the “absolute return” moniker in effort to expand their product offerings.  As P&I also points out in this article:

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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.

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Special to AllAboutAlpha.com by: Dr. Lars Jaeger, Partner, Partners Group…

For a long time, many investors have regarded hedge funds as an investment class that generates absolute returns by means of managers’ sophistication in extracting inefficiencies from the complexity of the global capital markets.  However, the current financial crisis has forced investors to reconsider this belief.  Even before 2008, the hedge fund battlefield had been littered with the bodies of secretive funds such as LTCM, Quantum, Tiger, Niederhoffer, and Beacon Hill, all of which failed spectacularly in comparably much less severe market environments.

The crisis year 2008 saw countless new casualties.  Hedge funds have proven to be part of “the system” and even if they enjoy greater flexibility and certain advantages, they were not able to fight against the type of market distress we have recently seen.  The average hedge fund has lost around 20-25% in 2008. The industry has subsequently experienced several “worst months in history” only to be topped by one of the next months.  October and November 2008 were just the latest “menses horribilis” for hedge funds, months in which even some high flying stars of the scene experienced losses in the range of -25% to -50%.

Finally December brought another major blow of pain to hedge fund investors when the alleged Ponzi scheme of Wall Street icon Bernard Madoff fell apart pulling 50 billion USD out of the hedge fund industry (including high profile funds of hedge funds) and causing a big stain on the industry’s public reputation.

Figure 1 provides an overview of the industry’s returns in the various strategies.  (ed: HFRX is an investable index that generally underperforms traditional indexes such as its non-investable sister, the HFRI.)

These losses occurred just as hedge funds had expanded to a broader institutional investor base intrigued by their promise of “absolute returns”.  Watching their investments fall short of these promises, these investors are growing increasingly skeptical about what the “traditional hedge fund model” is able to deliver.

As a result, the institutional investors that drove recent industry growth have become less willing to drop billions into a black box and hope for the best.  In fact, they have started to pull out their money in unprecedented amounts – leading to another devastating blow: a liquidity trap (which ultimately led to the demise of Madoff’s fund).  In their search for returns, hedge funds had recently begun to invest in less liquid investments and apply private equity techniques to public targets (activist investing), thus extending the liquidity features of their underlying investments.

Many, including Partners Group, were concerned about this development since private equity funds had a much more stable and long term capital base.  In addition, we were concerned about hedge fund “black boxes”, as readers of our research will surely recall (see previous AllAboutAlpha.com posts).  Unfortunately, these concerns proved to be justified much faster than we could have ever anticipated.  In 2008, an asset-liability mismatch forces a number of hedge funds to withhold redemptions, and the revelation of the alleged Madoff Ponzi scheme caught many investors off guard (especially fund of funds that put insufficient emphasis on solid due diligence, transparency and active risk management).

2009 and Beyond

In light of the excruciating pain that hedge funds have suffered and a growing consensus – even among hedge fund advocates – that the industry is going to suffer short and mid-term redemptions, many investment professionals are asking themselves about the long term effects on the industry.

In light of these developments, we anticipate the following effects on the global hedge fund industry:

1. With the shrunken balance sheets of the banks, hedge funds will have less access to leverage financing.  This will obviously affect those strategies that have been employing significant leverage, i.e. the “Relative Value” strategies such as Fixed Income Arbitrage, Convertible Arbitrage, and Statistical Arbitrage.
2. Regulatory constraints such as the banning on short-selling coupled with increased regulatory oversight are going to rob hedge funds of the flexibility necessary to exploit their return sources. This will affect most equity related strategies such as Long/Short Equity, Event Driven, and Equity Market Neutral.
3. The decline of alpha has been documented on countless occasions even before all the recent trouble started.  The majority of today’s hedge fund returns stem from risk premia rather than market inefficiencies, in others words, from “beta” instead of “alpha”.  Risk premia have risen across all markets in the ongoing flight to quality.  Consequently, declining and negative (alternative) betas have had a detrimental effect on hedge fund returns.  However, short to mid-term expected alternative beta returns will likely be significantly above historical averages.
4. Significant losses, the introduction of redemption gates, and the largest alleged fraud in the history of Wall Street means that opacity and illiquidity – once considered a source of strength for the hedge fund machine – has turned into a formidable liability.  The industry will finally have to give up its black box approach, and the major fund of hedge funds will have to revisit their investment and business model.
5. The prototypical 2/20 fee model and possibly higher trading and financing fees from their prime brokers will mean that the fee burden faced by hedge fund investors will have to come down in order for net returns to become attractive again.  Indeed, we can observe that this has already begun.

Hedge funds are here to stay, but not here to stay the same.  While the first three points above are structural rather than cyclical, alternative beta will remain a promising source of investment returns.  In other words, there is a tailwind for hedge funds.  Market dislocation and investors’ fears will provide for ample return opportunities in form of high “standstill returns” from alternative beta.

This means that 2009 will likely be a strong year for the surviving hedge funds.  Those investors and investment managers with cash to invest now are surely going to be richly rewarded.

Whither “Absolute Returns”?

But how about the original hedge fund promise of “absolute returns”?  Hedge funds have been marketing their “alpha” while many have actually delivered “diversified beta” (what a few years back we started calling the “alternative beta” game, i.e. diversify across a large spectrum of return drivers that balance the investment risk of each individual underlying risk).

The market distress this year has given a final vindication to this hypothesis.  In a painful way hedge fund investors had to learn what some academics and very few hedge fund product providers have told them all these years – that hedge funds delivered mostly (alternative) beta returns.

As a consequence of the recent financial crisis, the motto of hedge funds should now be, “Chase alpha where available, diversify across betas where necessary”.  As a result of declining alpha at home, many of the top hedge funds had already moved to where the fields were still green, namely the private capital markets.

Hybrid Hedge Fund Strategies and Liquidity

But there is an important prerequisite for hedge funds “going private” – having a stable and well-secured capital base. In other words, the hedge fund needs to persuade investors to forgo liquidity.  In other words, the hedge fund manager needs to know what he is doing with respect to asset/liability management.

That does not mean that the new “absolute return” portfolio will have to mimic a conventional private equity portfolio (requiring, for example, an investment commitment of eight to ten years).   Many investors already have that part of their portfolios managed by (pure) private equity players and will expect a different kind of exposure and liquidity from their absolute return investments.

This being said, the short duration end of private market investments such as mezzanine loans and late stage (purely financial) secondary investments offer a wide spectrum of opportunities that the investor with higher liquidity demands can benefit from in his absolute return bucket.  Mezzanine and senior bank loans for examples have payback periods of 36 months rather than ten years, and a late stage secondary can return the capital equally fast.

These are areas in which hedge funds have started to become very active in the recent years.  While the focus on generating absolute returns through alpha naturally drives investors to private market investments, in practice many investors have liquidity needs.  So institutional investors need to find the right balance between maximizing (risk adjusted) return and providing sufficient liquidity.  Too much liquidity means foregoing returns; too little liquidity can quickly turn off investors.

A New Approach to Portfolio Construction

Once the right balance between return objectives and liquidity profile is established, investors must turn to these asset allocation decisions.  With the traditional (mean variance based) optimization model and related statistical optimization techniques failing to deliver reliable results, we suggest a different macroeconomic scenario based approach for the portfolio construction.  (Other investment managers such as Bridgewater Associates have expressed similar ideas.)

Asset class pricing and investment returns are generally a function of expectations of changes in  macroeconomic variables such as growth and inflation.  However, exact forecasts of these parameters are extremely difficult, if not impossible.  For that reason the investor should balance an absolute return portfolio across an entire range of optimal portfolios in each respective scenario.  Concretely, this means averaging across the different “scenario portfolios” in order to obtain the final balanced asset allocation.  By balancing risk across the different environments, the investor is able to earn various asset class returns while minimizing the portfolio’s susceptibility to any one environment.

The “Relative Value” Approach

Once the general scenario based portfolio is determined, allocations to different segments should be based on current relative value assessments (e.g. alpha opportunities in private equity markets are bigger than they are in public equity markets), fees (e.g. fee-efficient access to certain hedge fund strategies via alternative beta strategies) and liquidity.

In fact, while the overall asset mix across private markets, alternative beta, offshore hedge funds, and other asset classes and risk premia can be kept rather static, there is room to manoeuvre within each.  For example, it makes a difference whether one accesses leveraged buyout returns through a direct investment in a limited partnership or in the secondary market.  In addition, the relative attractiveness of hedge fund strategies fluctuates over time – demanding a tactical allocation process.

The final step in this asset allocation process is to conduct solid bottom up investment research (i.e. finding the best companies, the right structures, and the right types of instruments to extract the highest possible return from in a given market environment).

In summary, what is really needed for effective absolute return asset management is a holistic perspective on investing instead of one contained to particular asset classes and return drivers.  The key to absolute return investing is to combine all available asset classes and investment strategies.  Some of the smartest money managers in the world have already executed this successfully (and silently).

The new challenges and opportunities presented by the recent financial crisis require just such an integrated business model and investment approach.  Alternative asset managers with highly focused capabilities will struggle in 2009 and beyond.

- L. Jaeger, January 15, 2009

The opinions expressed in this guest posting are those of the author and not necessarily those of AllAboutAlpha.com.

It’s becoming difficult to tell whether the mass hysteria surrounding hedge funds this month is driven by reality or schadenfreude. There is little doubt that some high profile hedge funds will experience some redemptions this week. But today alone, we saw the hedge fund industry being described as a “horror show”, a “hellfire” and a “bloodbath” that is “heading for the rocks“. We heard about “investors pounding on the doors to get out”. We were warned by experts that there is “smoke billowing from Greenwich” and that the “suffering will be profound”.

While this is great copy, it simplifies the hedge fund industry in the same way that talk of hedge fund managers all buying yachts was de rigueur only a few years ago.  Less widely reported was that hundreds of hedge funds closed up shop every year during those Halcyon days.  And less widely reported today is that fact that many funds are thriving in today’s environment (and not just the mega-short funds like Paulson & Co.). The high dispersion of hedge funds illustrates their attractive quality – idiosyncractic risk. In aggregate, hedge funds are down around 10% YTD. But recent reports suggest that over half of hedge funds were reporting positive YTD returns right up to the end of August.

It’s becoming a knee-jerk reaction to warn of the perils of hedge fund leverage.   Some estimates suggest the $2 trillion hedge fund industry had amassed up to $600 billion in cash by the end of September in preparation, some hypothesize, for quarter-end redemptions. This dramatic de-leveraging has also been picked up by various measures of leverage (see related posts).

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Axing investment managers is nothing new for institutional investors.  So initially we didn’t see anything particularly interesting about this story in P&I about how the pension fund for Massachusetts teachers and public employees was dumping a few of its underperforming managers.

But when we took a closer look, it was apparent that something else was at play here.  P&I reports that this move was actually a “strategic shift in the $50.6 billion system’s domestic equity program to index funds and portable alpha”. In other words: a shift out of traditional “pre-packaged” alpha and beta and into a bifurcated alpha/beta program.

A third of the freed-up capital was immediately reallocated to three portable alpha managers and two-thirds was destined for an index fund.

But the story gets even more interesting.  Bridgewater, a company we applauded for not messing around when it came to portable alpha, was actually fired in the shake-up.  Why?  Remember a couple of years ago when we told you about the firm’s plan to drop clients that didn’t want to move to a portable alpha strategy?  Well, apparently, Mass PRIM let them do just that.  According to P&I, the pension said “no way” to a pure alpha mandate and it promptly showed Bridgewater the door…

“Bridgewater Associates, which ran $591 million in global inflation-linked bonds, including an allocation to commodities via swaps, was terminated after the board rejected its request to change the portfolio to a pure alpha strategy. Bridgewater’s offer to wind it down over the coming 12 months was turned down; Mr. Mavromates said PRIM decided it didn’t want someone who wasn’t interested in managing the strategy over the long term to look after it for the coming year.”

It appears Bridgewater’s Ray Dalio wasn’t kidding.

Ray Dalio

President and Chief Investment Officer of Bridgewater Associates (manages $170 billion, $30 billion+ in its “Pure Alpha” hedge fund strategy).

Bridgewater Associates
Interview (Derivatives Strategy)
Relevant Postings (AllAboutAlpha.com)

Angelo Calvello has been around the alpha-centric investing world longer than almost anyone.  In fact according to our research, he actually coined the term “alpha-centric” investing.  In a guest posting today, he applies this thinking to hedge fund fees.  And what he concludes will surely surprise many.  

Special to AllAboutAlpha.com by: Angelo A. Calvello, Ph.D. 

I recently attended a conference on 130/30 strategies.  The discussion eventually and inevitably drifted to the well worn but poorly understood topic of hedge fund fees and more specifically the inevitable compression of those charges. 

It is a debate founded on the belief that hedge fund fees are simply too high, although it is not clear what yardstick is being used to support this conclusions. Hedge fund fees could be compared to those charged by traditional long-only managers, but this would assume that fees charged for ‘active’ long only management fairly represent the value added by these strategies.  This, of course, is questionable. 

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As the hedge fund industry matures, assets are flowing disproportionately to the larger players in what some have called a “shakeout”.  Taking a page from TV’s “Survivor”, investors are apparently starting to vote smaller players off the (Manhattan) island.

Usually, the term “shakeout” refers to the culling of weaker, smaller players in an industry in favour of the larger and more dominant competitors.  So it’s striking that Business Week this week suggests that the “parade of cave-ins” in Hedgistan included funds managed by major financial institutions (e.g. Citi, UBS, and parade-marshal Bear Stearns).

The ones doing the culling?  Pure play asset managers such as Bridgewater and BGI.  In fairness, JP Morgan (which bought and subsequently grew Highbridge) and Goldman (which today announced its hide was saved in Q2 by its asset management business), buck the trend.  But 8 of the top 10 largest hedge fund managers in Alpha magazine’s listing of the largest US hedge funds last month were NOT run by investment banks or other large financial services firms (we’d say that #9 BGI runs pretty independently of Barclays).  So the question remains, what’s up with the bank-run hedge funds?

Despite a rocky road for some bank-owned hedge funds, size continues to be an advantage.  Reports BusinessWeek:

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One of our all-time favorite alpha-centric companies, Bridgewater Associates, released an interesting edition of its “Daily Observations” Newsletter earlier this week that caught our eye when a loyal reader passed it along to us.  First, here’s why we’re fans.  Says the latest edition of Daily Observations:

“As you know, we generally view the move into hedge funds as part of the evolution of money management. As we have described for many years now, the investment world should—and will—evolve towards a world of separating passive investment decisions (we call them beta) from active investment decisions (alpha). Most institutional investors continue to tie together their alpha and beta decisions (i.e. an institution typically decides how much money they want in equities and then goes out and hires equity managers to manage it). This is clearly inefficient, as the two decisions need not be linked. Instead, investors should decide which asset classes they want to be in and then overlay on top of these asset classes the best alpha managers they can find, no matter which asset class they get their alpha from. This is alpha overlay and it is a better way to run a portfolio. Cutting-edge institutions have begun to manage their assets this way, and the rest of the world will eventually adopt this superior strategy.”

Later in this issue, the firm reiterates its January 2007 observations about alternative beta.  While we are fans, we felt that Bridgewater didn’t address a few key issues in its analysis.  Knowing first hand, however, how the like to keep to itself, we opted to bite our tongues (Ed: to clarify, each opting to bite their own tongues).

But since our friends at HedgeWorld chose to run with the story, we felt that now might be a good time to chime in.

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As you probably know if you are a regular reader, The Institute for Quantitative Research in Finance” (or Q-Group for short) is one of the world’s foremost communities of quant rock-stars from the academic and practitioner communities.  In his video interview for the American Finance Association’s “History of Finance” project, William Sharpe tells of how he was actually at a Q-Group annual seminar when he learned of his Nobel Prize.

Well, no one won a Nobel Prize at last spring’s meeting.  But the 17 pages of session summaries, now available here, are well worth a read.  Here is a selection of what you’ll find:

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With the ink still wet on UBS’s agreement to manage a 130/30 fund for Canadian retail investors (see related posting), Deutsche Bank is now pitching its institutional “portable alpha” strategy to the US mass market.

The fund is called DWS Alternative Allocation Plus and according to the DB’s press release, it will use the firm’s year-old “iGAP” strategy (”Integrated Global Alpha Platform”).  The iGAP has so far been offered only to institutional investors (see press release announcing that fund’s launch back in 2006).

We put portable alpha in quotations since we’re still not clear whether this fund really involves porting alpha – the refining, manipulating, or recompiling alpha and beta.  According to DB, the fund is a simple fund-of-funds that may also include “other derivative instruments”.

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Surveys of the hedge fund replication field often divide the various offerings into three distinct classes: factor models, distribution replication and mechanical trading.  We hear a lot about factor models and now about distributional replication, but “mechanical trading” seems to be the neglected sibling in the cloning family.

Now one advocate of the mechanical trading approach, a CTA manager called Conquest Capital Group, has made their case in a paper available here at Eurekahedge.  While a portion of the paper describes the benefits of their particular passive CTA replication fund (a managed futures beta replication strategy with “a fee schedule that is more appropriate for a beta product”), it does make a number of general observations about the field of hedge fund replication.

The authors base their arguments on several papers we have also discussed at AllAboutAlpha.com, namely: the March 2007 Edhec study on replication, Northwater’s recent survey of replication methodologies, Bridgewater’s 2005 observations about hedge fund correlations and Harry Kat’s original papers on distributional replication.

Other examples of the so-called mechanical-trading approach to hedge fund replication (cited by Kat in this paper) include: the Merrill Lynch Equity Volatility Arbitrage Index, the Merrill Lynch FX Clone, and Deutsche Bank’s Currency Return Index.

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While nearly all institutional investors are now clear about the benefits of portable alpha, many are still put off by its often complex mechanics.  Unlike a simple active long-only mandate, a portable alpha strategy can often involve multiple accounts, the assumption of counterparty risk when using swaps for beta exposure, and cash management and rebalancing due to collateral requirements, not to mention new reporting and analytical requirements.  These challenges – amplified by the headline risk of potentially dropping the ball somewhere along the line – have put the breaks on portable alpha programs at many institutions.  This, even as these investors readily acknowledge the theoretical advantages of such a strategy.

So says Angelo Calvello of Man Investments in an “institutional investor only” white paper released earlier this year.  Calvello is one of the instigators of the alpha-centric revolution, using the term “alpha-centric” as far back as 2005 (see related posting).  Acknowledging the operational challenges inherent in a relatively complex strategy such as portable alpha, he now proposes a “bundled” solution that wraps the various components of portable alpha into one entity, such as a special purpose vehicle or a fund).  According to Calvello, this would dramatically simplify the lives of pensions and endowments that are current reticent about diving into portable alpha.

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In a follow-up from Friday’s posting about the potential global financial calamity that might be caused by the seemingly benign pension fund community, we stumbled across this report (also released last week) by the Brussels-based International Trade Union Confederation (ITUC).  The report is called “Where the House Always Wins: Private Equity, Hedge Funds and The New Casino Capitalism“.

Look, we’re obviously biased toward private equity and hedge funds.  But we’re also sensitive to their impact on other stakeholders.  Private equity, by its very nature, will always be a tug-of-war over economic output between the owners of capital and other stakeholders (employees, suppliers, neighbours, NGOs etc.)  Given the massive and sudden growth in private equity and hedge funds, there is no doubt these issues will need to be addressed sooner rather than later.  In fact, we know of various multi-lateral initiatives tackling these problems right now and we are following them closely.

However, while attempting to make an important contribution to the global debate, this report makes excessive use of fallacies and half-truths that reveal a populist anger over the bigger issues of economic inequality.  The resulting potpourri of socio-economic beefs does little to advance a rationale dialogue.

Before cracking the cover, we took a wild guess that these guys weren’t crazy about alternative investments.  And since most of you may not be crazy about unions (or reading the report’s 52 pages), we distilled a few of the more outrageous claims below.

To begin with, this excerpt sums of up ITUC’s overall feelings about hedge funds and private equity:

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Bridgewater CEO Ray Dalio was in the news again last week with this New York Times story on his concerns over the “high correlation” between hedge funds and the S&P500 during the past few years.  (Hat-tip to Greg Newton of Naked Shorts for the heads-up as we were “WiFi-ing” around Canada last week).

Hedge fund replication researchers say that the heterogeneity of hedge fund strategies is diluted when hedge funds are analyzed as one aggregate mass.  They say that, overall, hedge funds can be replicated (or at least approximated) by the S&P 500.  However, they also say that sub-strategies are far more difficult to replicate using a simple long position in any broad equity index.

According The Times, Dalio essentially says the same thing in a recent private letter to investors - that hedge funds, overall, have a relatively high correlation to the S&P 500.  (But at 0.6-ish range, not nearly as high as mutual funds).  On an individual substrategy level, Dalio points the finger at long/short equity (0.84 correlation to the S&P 500 over the past 24 months).  But the Times makes no mention of the correlation between other strategies and the market (e.g. market neutral).

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